Edgar Filing: HIGHLANDS BANKSHARES INC /VA/

f10q063011.htm

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

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

of the Securities Exchange Act of 1934

For the quarterly period ended June 30, 2011

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

of the Securities Exchange Act of 1934

For the transition period from ____________ to _____________

Commission File Number: 0-27622

HIGHLANDS BANKSHARES, INC.

(Exact name of registrant as specified in its charter)

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

276-628-9181

(Registrant’s telephone number, including area code)

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

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

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or smaller reporting company (See definition of “large accelerated filer, accelerated filer and smaller reporting company” in Rule 12b-2 of the Act). Large Accelerated Filer [ ] Accelerated Filer [ ] Non-Accelerated Filer [ ] 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 [ ] No [X ]

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

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

outstanding as of August 12, 2011

Highlands Bankshares, Inc.

FORM 10-Q

For the Quarter Ended June 30, 2011

INDEX


PART I. FINANCIAL INFORMATION	PAGE

Item 1. Financial Statements

Consolidated Balance Sheets at June 30, 2011 (Unaudited) and December 31, 2010
	3

Consolidated Statements of Income (Unaudited) for the Three Months and Six Months Ended June 30, 2011 and 2010	4

Consolidated Statements of Cash Flows (Unaudited) for the Six Months Ended June 30, 2011 and 2010	5

Consolidated Statements of Changes in Stockholders’ Equity (Unaudited) for the Three Months and Six Months Ended June 30, 2011 and 2010	6

Notes to Consolidated Financial Statements (Unaudited)	8-30

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations	33-38

Item 3. Quantitative and Qualitative Disclosures About Market Risk	40

Item 4. Controls and Procedures	40

PART II. OTHER INFORMATION

Item 1. Legal Proceedings	40

Item 1A. Risk Factors	40

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds	40

Item 3. Defaults Upon Senior Securities	40

Item 4. Removed and Reserved	40

Item 5. Other Information	41

Item 6. Exhibits	41

SIGNATURES AND CERTIFICATIONS	42

PART I.

FINANCIAL INFORMATION

ITEM 1. Financial Statements

Consolidated Balance Sheets

(Amounts in thousands)

ASSETS	June 30, 2011 (Unaudited)			December 31, 2010 (Note 1)

Cash and due from banks	$	16,829		$	15,693
Federal funds sold		54,379			66,459

Total Cash and Cash Equivalents		71,208			82,152

Investment securities available for sale (amortized cost $71,095 at June 30, 2011, $62,093 at December 31, 2010)		66,418			56,096
Other investments, at cost		5,674			6,026
Loans, net of allowance for loan losses of $11,157 at June 30, 2011, $10,320 at December 31, 2010		418,757			440,274
Premises and equipment, net		22,931			23,509
Deferred tax assets		12,638			11,887
Interest receivable		2,695			2,544
Bank owned life Insurance		13,001			12,777
Other real estate owned		16,917			15,316
Other assets		4,572			4,927

Total Assets	$	634,811		$	655,508

LIABILITIES AND STOCKHOLDERS’ EQUITY

LIABILITIES

Deposits:
Non-interest bearing	$	93,538		$	85,923
Interest bearing		433,362			450,849

Total Deposits		526,900			536,772

Interest, taxes and other liabilities		1,386			1,786
Other short-term borrowings		57,670			65,952
Long-term debt		14,058			14,968
Capital securities		3,150			3,150

Total Other Liabilities		76,264			85,856

Total Liabilities		603,164			622,628

STOCKHOLDERS’ EQUITY

Common stock (5,011 shares issued and outstanding)		3,132			3,132
Additional paid-in capital		7,783			7,783
Retained earnings		23,822			25,923
Accumulated other comprehensive income (loss)		(3,090	)		(3,958	)

Total Stockholders’ Equity		31,647			32,880

Total Liabilities and Stockholders’ Equity	$	634,811		$	655,508

See accompanying Notes to Consolidated Financial Statements

Consolidated Statements of Income

(Amounts in thousands, except per share data)

(Unaudited)

	Six Months Ended June 30, 2011			Six Months Ended June 30, 2010			Three Months Ended June 30, 2011			Three Months Ended June 30, 2010
INTEREST INCOME
Loans receivable and fees on loans	$	12,728		$	14,442		$	6,301		$	7,223
Securities available for sale:
Taxable		410			365			126			157
Exempt from taxable income		656			1,057			431			512
Other investment income		35			55			18			34
Federal funds sold		73			12			37			7

Total Interest Income		13,902			15,931			6,913			7,933

INTEREST EXPENSE
Deposits		3,438			4,581			1,640			2,259
Federal funds purchased		-			1			-			-
Other borrowed funds		1,765			1,829			858			932

Total Interest Expense		5,203			6,411			2,498			3,191

Net Interest Income		8,699			9,520			4,415			4,742

Provision for Loan Losses		3,789			1,891			186			679

Net Interest Income after Provision for Loan Losses		4,910			7,629			4,229			4,063

NON-INTEREST INCOME
Securities gains, losses, net		143			171			114			172
Service charges on deposit accounts		1,031			972			537			515
Other service charges, commissions and fees		895			723			499			385
Other operating income		345			320			179			164
Other than temporary impairment		(269	)		(724	)		(155	)		(724	)
Total Non-Interest Income		2,145			1,462			1,174			512

NON-INTEREST EXPENSE
Salaries and employee benefits		5,062			5,235			2,534			2,599
Occupancy expense of bank premises		520			579			260			277
Furniture and equipment expense		699			834			361			434
Other operating expense		2,863			2,392			1,526			1,222
Foreclosed Assets – Loss on Sale / Write-down		717			407			464			218
Foreclosed Assets – Operating Expenses		695			271			383			197
Total Non-Interest Expense		10,556			9,718			5,528			4,947

Income (Loss) Before Income Taxes		(3,501	)		(627	)		(125	)		(372	)

Income Tax Expense (Benefit)		(1,400	)		(633	)		(147	)		(334	)

Net Income (Loss)	$	(2,101	)	$	6		$	22		$	(38	)

Basic Earnings Per Common Share – Weighted Average	$	(0.42	)	$	-		$	-		$	(0.01	)

Earnings Per Common Share – Assuming Dilution	$	(0.42	)	$	-		$	-		$	(0.01	)

See accompanying Notes to Consolidated Financial Statements

Consolidated Statements of Cash Flows

(Amounts in thousands)

(Unaudited)

	Six Months Ended			Six Months Ended
	June 30, 2011			June 30, 2010
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income (loss)	$	(2,101	)	$	6
Adjustments to reconcile net income (loss) to net cash provided by operating activities
Provision for loan losses		3,789			1,891
Depreciation and amortization		576			666
Net realized (gains) losses on available for sale securities		(143	)		(171	)
Net amortization on securities		242			93
Other than temporary impairment charge		269			724
Amortization of Capital issue costs		3			3
(Increase) decrease in interest receivable		(151	)		120
Valuation adjustment of other real estate owned		601			365
(Increase) decrease in other assets		(955	)		(1,772	)
Increase (decrease) in interest, taxes and other liabilities		(400	)		886

Net cash provided by operating activities		1,730			2,811

CASH FLOWS FROM INVESTING ACTIVITIES:
Securities available for sale:
Proceeds from sale of securities		6,776			19,156
Proceeds from maturities of debt and equity securities		2,914			2,081
Purchase of debt and equity securities		(19,175	)		(12,418	)
Redemption of other investments		352			2,034
Net (increase) decrease in loans		14,057			(5,434	)
Proceeds from sales of other real estate owned		1,466			927
Premises and equipment expenditures		-			(53	)

Net cash provided by investing activities		6,390			6,293

CASH FLOWS FROM FINANCING ACTIVITIES:
Net increase (decrease) in time deposits		(21,773	)		304
Net increase in demand, savings and other deposits		11,901			5,437
Decrease in short-term borrowings		(8,282	)		(8,100	)
Increase (decrease) in long-term debt		(910	)		4,359

Net cash provided by (used in) financing activities		(19,064	)		2,000

Net (decrease) increase in cash and cash equivalents		(10,944	)		11,104
CASH AND CASH EQUIVALENTS AT BEGINNING OF YEAR		82,152			29,337

CASH AND CASH EQUIVALENTS AT END OF PERIOD	$	71,208		$	40,441

SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION
Cash paid during the year for:
Interest	$	5,305		$	6,031
Income taxes	$	-		$	-

SUPPLEMENTAL DISCLOSURE OF NONCASH TRANSACTIONS
Transfer of loans to other real estate owned	$	3,670		$	6,873

See accompanying Notes to Consolidated Financial Statements

Consolidated Statements of Changes in Stockholders’ Equity

(Amounts in thousands)

(Unaudited)

Common Stock

Paid-in

Retained

Comprehensive

Stockholders’

	Shares		Par Value		Capital		Earnings			Income			Equity

Balance, March 31, 2010		5,011	$	3,132	$	7,783	$	28,107		$	(3,462	)	$	35,560

Comprehensive income:
Net income / (loss)		-		-		-		(38	)		-			(38	)
Change in unrealized loss on securities available for sale, net of deferred income tax expense of $311		-		-		-		-			604			604
Less: reclassification adjustment net of deferred tax expense of $58		-		-		-		-			(113	)		(113	)
Total comprehensive income		-		-		-		-			-			453


Balance, June 30, 2010		5,011	$	3,132	$	7,783	$	28,069		$	(2,971	)	$	36,013


Balance, March 31, 2011		5,011	$	3,132	$	7,783	$	23,800		$	(3,702	)	$	31,013

Comprehensive income:
Net income		-		-		-		22			-			22
Change in unrealized loss on securities available for sale, net of deferred income tax expense of $354		-		-		-		-			687			687
Less: reclassification adjustment net of deferred tax expense of $39		-		-		-		-			(75	)		(75	)
Total comprehensive income		-		-		-		-			-			634


Balance, June 30, 2011		5,011	$	3,132	$	7,783	$	23,822		$	(3,090	)	$	31,647

See accompanying Notes to Consolidated Financial Statements

Consolidated Statements of Changes in Stockholders’ Equity

(Amounts in thousands)

(Unaudited)

										Accumulated
					Additional					Other			Total
	Common Stock				Paid-in		Retained			Comprehensive			Stockholders’
	Shares		Par Value		Capital		Earnings			Income			Equity

Balance, December 31, 2009		5,011	$	3,132	$	7,783	$	28,063		$	(3,550	)	$	35,428

Comprehensive income:
Net income		-		-		-		6			-			6
Change in unrealized (loss) on securities available for sale, net of deferred income tax expense of $356		-		-		-		-			692			692
Less: reclassification adjustment net of deferred tax expense of $58		-		-		-		-			(113	)		(113	)
Total comprehensive income		-		-		-		-			-			585


Balance, June 30, 2010		5,011	$	3,132	$	7,783	$	28,069		$	(2,971	)	$	36,013


Balance, December 31, 2010		5,011	$	3,132	$	7,783	$	25,923		$	(3,958	)	$	32,880

Comprehensive income:
Net income (loss)		-		-		-		(2,101	)		-			(2,101	)
Change in unrealized (loss) on securities available for sale, net of deferred income tax expense of $495		-		-		-		-			962			962
Less: reclassification adjustment net of deferred tax expense of $49		-		-		-		-			(94	)		(94	)
Total comprehensive income (loss)		-		-		-		-			-			(1,233	)


Balance, June 30, 2011		5,011	$	3,132	$	7,783	$	23,822		$	(3,090	)	$	31,647

See accompanying Notes to Consolidated Financial Statements

Notes to Consolidated Financial Statements

(Unaudited)

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

Note 1 - General

The consolidated financial statements of Highlands Bankshares, Inc. (the “Company”) conform to United States Generally Accepted Accounting Principles and to banking industry practices. The accompanying consolidated interim financial statements are unaudited. In the opinion of management, all adjustments necessary for a fair presentation of the consolidated financial statements have been included. The consolidated balance sheet as of December 31, 2010 has been extracted from the audited financial statements included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2010 (the “2010 Form 10-K”). The notes included herein should be read in conjunction with the notes to consolidated financial statements included in the 2010 Form 10-K. The results of operations for the three-month and six month periods ended June 30, 2011 are not necessarily indicative of the results to be expected for the full year.

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

Notes to Consolidated Financial Statements

(Unaudited)

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

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

A summary of transactions in the consolidated allowance for loan losses for the six months ended June 30 is as follows:

	2011		2010
Allowance for loan losses at beginning of year	$	10,320	$	11,681
Loans charged off:
Residential 1-4 Family		291		286
Multifamily		40		175
Construction and Land Loans		1,242		877
Commercial, Owner Occupied		135		-
Commercial, Non-owner occupied		89		-
Second Mortgages		271		306
Equity Lines of Credit		10		28
Farmland		143		-

Secured (other ) and unsecured
Personal		233		269
Commercial		502		571
Agricultural		28		24
Overdrafts		88		75
Total		3,072		2,611
Recoveries of loans previously charged off:

Residential 1-4 Family		5		-
Multifamily		-		-
Construction and Land Loans		50		-
Commercial, Owner Occupied		-		-
Commercial, Non-owner occupied		-		-
Second Mortgages		10		-
Equity Lines of Credit		-		-
Farmland		20		-

Secured (other ) and unsecured
Personal		25		37
Commercial		9		4
Agricultural		1		3
Overdrafts		-

Total		120		44

Net loans charged off		2,952		2,567
Provision for loan losses		3,789		1,891
Allowance for loan losses end of period	$	11,157	$	11,005

Notes to Consolidated Financial Statements

(Unaudited)

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

The composition of net loans is as follows:

	June 30, 2011		December 31, 2010
Real Estate Secured:
Residential 1-4 family	$	172,693	$	175,522
Multifamily		15,079		15,593
Construction and Land Loans		27,048		30,901
Commercial, Owner Occupied		78,975		78,279
Commercial, Non-owner occupied		36,962		43,652
Second mortgages		12,960		14,132
Equity lines of credit		10,055		10,016
Farmland		12,220		12,790
		365,992		380,885

Secured (other) and unsecured
Personal		24,657		26,773
Commercial		36,043		40,471
Agricultural		3,430		2,848
		64,130		70,092

Overdrafts		359		214

		430,481		451,191
Less:
Allowance for loan losses		11,157		10,320
Net deferred fees		567		597
		11,724		10,917

Loans, net	$	418,757	$	440,274

Notes to Consolidated Financial Statements

(Unaudited)

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

The following table is an analysis of past due loans as of June 30, 2011:

	30-59 Days Past Due		60-89 Days Past Due		Greater Than 90 Days		Total Past Due		Current		Total Financing Receivables		Recorded Investment > 90 Days and Accruing

Real Estate Secured
Residential 1-4 family	$	3,302	$	1,917	$	5,186	$	10,405	$	162,288	$	172,693	$	332
Equity lines of credit		35		165		110		310		9,745		10,055		110
Multifamily		-		1,632		-		1,632		13,447		15,079		-
Farmland		-		-		-		-		12,220		12,220		-
Construction, Land Development, Other Land Loans		1,144		63		2,291		3,498		23,550		27,048		423
Commercial Real Estate- Owner Occupied		1,343		-		6,383		7,726		71,249		78,975		328
Commercial Real Estate- Non Owner Occupied		296		-		452		748		36,214		36,962		-
Second Mortgages		244		-		339		583		12,377		12,960		-
Non Real Estate Secured
Personal		267		65		206		538		24,478		25,016		61
Business		265		94		1,356		1,715		34,328		36,043		161
Agricultural		20		76		-		96		3,334		3,430		-

Total	$	6,916	$	4,012	$	16,323	$	27,251	$	403,230	$	430,481	$	1,415

The following table is an analysis of past due loans as of December 31, 2010:

	30-59 Days Past Due		60-89 Days Past Due		Greater Than 90 Days		Total Past Due		Current		Total Financing Receivables		Recorded Investment > 90 Days and Accruing

Real Estate Secured
Residential 1-4 family	$	3,780	$	1,245	$	4,937	$	9,962	$	165,560	$	175,522	$	1,726
Equity lines of credit		-		99		-		99		9,917		10,016		-
Multifamily		-		-		40		40		15,553		15,593		-
Farmland		348		-		774		1,122		11,668		12,790		-
Construction, Land Development, Other Land Loans		825		152		3,153		4,130		26,771		30,901		53
Commercial Real Estate- Owner Occupied		1,612		105		6,301		8,018		70,260		78,278		1,776
Commercial Real Estate- Non Owner Occupied		-		165		1,520		1,685		41,967		43,652		602
Second Mortgages		234		-		529		763		13,369		14,132		-
Non Real Estate Secured
Personal		303		101		74		478		26,510		26,988		14
Business		190		406		1,456		2,052		38,419		40,471		289
Agricultural		7		-		96		103		2,745		2,848		68

Total	$	7,299	$	2,273	$	18,880	$	28,452	$	422,739	$	451,191	$	4,528

Notes to Consolidated Financial Statements

(Unaudited)

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

The accrual of interest on loans is discontinued at the time the loan is 90 days delinquent unless the credit is well-secured and in process of collection. Credit card loans and other personal loans are typically charged off no later than 180 days past due. In all cases, loans are placed on non-accrual or charged-off at an earlier date if collection of principal or interest is considered doubtful. The June 30, 2011 total includes approximately $4,366 of loans that are current and paying under the terms of their existing loan agreement but are included due to regulatory guidelines.

The following is a summary of non-accrual loans at June 30, 2011 and December 31, 2010:

	June 30, 2011		December 31, 2010
Real Estate Secured
Residential 1-4 Family	$	5,054	$	3,211
Multifamily		1,632		40
Construction and Land Loans		2,868		3,100
Commercial-Owner Occupied		6,055		4,525
Commercial- Non Owner Occupied		4,818		918
Second Mortgages		339		529
Equity Lines of Credit		-		-
Farmland		630		774
Secured (other) and Unsecured
Personal		145		60
Commercial		1,195		1,167
Agricultural		-		29

Total	$	22,736	$	14,353

Notes to Consolidated Financial Statements

(Unaudited)

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

The following tables represent a summary of credit quality indicators of the Bank’s loan portfolio at June 30, 2011 and December 31, 2010: The grades are assigned and / or modified by the Company’s credit review and credit analysis departments based on the creditworthiness of the borrower and the overall strength of the loan.

Credit Risk Profile by Internally Assigned Grade as of June 30, 2011

Grade (1)	Residential 1-4 Family		Multifamily		Farmland		Construction, Land Loans		Commercial Real Estate- Owner Occupied		Commercial Real Estate Non-Owner Occupied

Quality		38,901		1,258		883		4,283		7,123		2,322
Satisfactory		78,233		9,474		3,973		6,816		26,058		14,486
Acceptable		35,579		1,782		4,987		5,955		25,897		9,354
Special Mention		3,620		-		2,007		2,224		5,483		1,500
Substandard		15,992		2,565		370		7,770		13,999		9,300
Doubtful		368		-		-		-		415		-

Total	$	172,693	$	15,079	$	12,220	$	27,048	$	78,975	$	36,962

Credit Risk Profile by Internally Assigned Grade as of December 31, 2010

Grade (1)	Residential 1-4 Family		Multifamily		Farmland		Construction, Land Loans		Commercial Real Estate- Owner Occupied		Commercial Real Estate Non-Owner Occupied

Quality		40,371		1,911		977		4,298		7,102		3,604
Satisfactory		80,759		9,258		4,399		7,355		26,055		16,729
Acceptable		36,411		1,806		4,285		5,585		27,878		13,013
Special Mention		4,778		946		178		2,346		5,430		304
Substandard		12,832		1,672		2,951		11,317		11,390		10,002
Doubtful		371		-		-		-		424		-

Total	$	175,522	$	15,593	$	12,790	$	30,901	$	78,279	$	43,652

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

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

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

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

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

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

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

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

Notes to Consolidated Financial Statements

(Unaudited)

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

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

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

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

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

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

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

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

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

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

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

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

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

The weaknesses may include, but are not limited to:

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

·	Declining or inadequate liquidity

·	Improper loan structure or questionable repayment sources

·	Lack of well-defined secondary repayment source, and

·	Unfavorable competitive comparisons.

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

Notes to Consolidated Financial Statements

(Unaudited)

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

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

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

·	Injection of capital

·	Alternative financing

·	Liquidation of assets or the pledging of additional collateral.

Credit Risk Profile based on payment activity as of June 30, 2011:

	Consumer - Non Real Estate		Equity Line of Credit / Second Mortgages		Commercial - Non Real Estate		Agricultural - Non Real Estate

Performing	$	24,451	$	22,566	$	34,687	$	3,430
Nonperforming (>90 days past due)		206		449		1,356		-

Total	$	24,657	$	23,015	$	36,043	$	3,430

Credit Risk Profile based on payment activity as of December 31, 2010:

	Consumer - Non Real Estate		Equity Line of Credit / Second Mortgages		Commercial - Non Real Estate		Agricultural - Non Real Estate

Performing	$	26,699	$	23,619	$	39,015	$	2,751
Nonperforming (>90 days past due)		74		529		1,456		97

Total	$	26,773	$	24,148	$	40,471	$	2,848

Notes to Consolidated Financial Statements

(Unaudited)

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

The following tables reflect the Bank’s impaired loans at June 30, 2011:

	Recorded Investment		Unpaid Principal Balance		Related Allowance		Average Recorded Investment		Interest Income Recognized
With No Related Allowance
Real Estate Secured
Residential 1-4 family	$	8,315	$	8,694	$	-	$	7,883	$	135
Equity lines of credit		-		-		-		-		-
Multifamily		933		933		-		487		32
Farmland		-		-		-		387		-
Construction, Land Development, Other Land Loans		2,708		2,708		-		3,281		67
Commercial Real Estate- Owner Occupied		9,698		9,698		-		7,598		66
Commercial Real Estate- Non Owner Occupied		3,359		3,420		-		3,433		106
Second Mortgages		619		619		-		660		15
Non Real Estate Secured
Personal /Consumer		34		34		-		28		1
Business Commercial		2,013		2,682		-		1,640		8
Agricultural		-		-		-		-		-
Credit Cards		-		-		-		-		-

Total	$	27,679	$	28,788	$	-	$	25,397	$	430

	Recorded Investment		Unpaid Principal Balance		Related Allowance		Average Recorded Investment		Interest Income Recognized
With an Allowance Recorded
Real Estate Secured
Residential 1-4 family	$	5,554	$	5,757	$	922	$	5,035	$	64
Equity lines of credit		-		-		-		-		-
Multifamily		1,632		1,652		278		1,632		11
Farmland		310		310		40		311		10
Construction, Land Development, Other Land Loans		3,759		5,012		697		5,397		50
Commercial Real Estate- Owner Occupied		3,063		3,063		965		3,670		67
Commercial Real Estate- Non Owner Occupied		4,485		4,485		845		4,759		68
Second Mortgages		313		313		92		199		-
Non Real Estate Secured
Personal /Consumer		94		94		35		72		2
Business Commercial		2,892		2,985		1,112		2,512		40
Agricultural		-		-		-		14		-
Credit Cards		-		-		-		-		-

Total	$	22,102	$	23,671	$	4,986	$	23,601	$	312

Notes to Consolidated Financial Statements

(Unaudited)

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

The following tables reflect the Bank’s impaired loans at December 31, 2010:

	Recorded Investment		Unpaid Principal Balance		Related Allowance		Average Recorded Investment		Interest Income Recognized
With No Related Allowance
Real Estate Secured
Residential 1-4 family	$	7,451	$	7,772	$	-	$	6,857	$	191
Equity lines of credit		-		-		-		-		-
Multifamily		40		40		-		1,314		1
Farmland		774		1,300		-		924		-
Construction, Land Development, Other Land Loans		3,853		3,853		-		5,768		141
Commercial Real Estate- Owner Occupied		5,498		5,498		-		3,318		260
Commercial Real Estate- Non Owner Occupied		3,506		3,506		-		2,215		77
Second Mortgages		700		700		-		516		25
Non Real Estate Secured
Personal /Consumer		21		21		-		11		2
Business Commercial		1,266		1,266		-		1,162		55
Agricultural		-		-		-		-		-
Credit Cards		-		-		-		-		-

Total	$	23,109	$	23,956	$	-	$	22,085	$	752

	Recorded Investment		Unpaid Principal Balance		Related Allowance		Average Recorded Investment		Interest Income Recognized
With an Allowance Recorded
Real Estate Secured
Residential 1-4 family	$	4,515	$	4,515	$	644	$	2,377	$	262
Equity lines of credit		-		-		-		-		-
Multifamily		1,632		1,632		92		770		51
Farmland		312		312		34		191		21
Construction, Land Development, Other Land Loans		7,035		7,515		917		4,264		139
Commercial Real Estate- Owner Occupied		4,277		4,277		110		2,981		37
Commercial Real Estate- Non Owner Occupied		5,033		5,033		1,071		1,981		88
Second Mortgages		84		122		-		42		-
Non Real Estate Secured
Personal /Consumer		50		50		-		54		1
Business Commercial		2,132		2,132		1,250		956		58
Agricultural		28		28		12		8		-
Credit Cards		-		-		-		-		-

Total	$	25,098	$	25,616	$	4,130	$	13,624	$	657

Notes to Consolidated Financial Statements

(Unaudited)

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

The following table presents the balance in the allowance for loan losses and the recorded investment in loans by loan category and is segregated by impairment

evaluation method as of June 30, 2011.

	Residential 1-4 Family		Multifamily		Construction and Land Loans		Commercial Owner Occupied		Commercial Non-Owner Occupied		Second Mortgages		Equity Line of Credit		Farmland		Personal and Overdrafts		Commercial and Agricultural		Unallocated			Total
Allowance for Credit Losses:
Beginning Balance December 31, 2010	$	1,521	$	229	$	2,155	$	504	$	1,353	$	323	$	83	$	229	$	516	$	2,185	$	1,222			10,320
Provision for Credit Losses		697		372		882		823		144		510		43		179		588		643		(1,092	)		3,789
Charge-offs		291		40		1,242		135		89		271		10		143		321		530		-			3,072
Recoveries		5		-		50		-		-		10		-		20		25		10		-			120
Net Charge-offs		286		40		1,192		135		89		261		10		123		296		520		-			2,952
Ending Balance June 30, 2011		1,932		561		1,845		1,192		1,408		572		116		285		808		2,308		130			11,157
Ending Balance: Individually evaluated for impairment		922		278		697		965		845		92		-		40		35		1,112		-			4,986
Ending Balance: Collectively Evaluated for Impairment		1,010		283		1,148		227		563		480		116		245		773		1,196		130			6,171
Loans:
Ending Balance: Individually Evaluated for Impairment		13,869		2,565		6,467		12,761		7,844		932		-		310		128		4,905		-			49,781
Ending Balance: Collectively Evaluated for Impairment		158,824		12,514		20,581		66,214		29,118		12,028		10,055		11,910		24,888		34,568		-			380,700
Ending Balance: June 30, 2011	$	172,693	$	15,079	$	27,048	$	78,975	$	36,962	$	12,960	$	10,055	$	12,220	$	25,016	$	39,473		-		$	430,481

Notes to Consolidated Financial Statements

(Unaudited)

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

A loan is considered impaired when according to contractual terms the collection of interest and principal is in doubt. An allowance for loan loss is established on loans for which it is probable that the full collection of principal is in doubt. Once a loan is identified as individually impaired, management measures impairment using one of several methods, including collateral value based on recent appraisal and /or tax assessment value, liquidation value and/or discounted cash flows. Those impaired loans not requiring an allowance represent loans for which the fair value of the expected repayments or collateral exceed the recorded investments in such loans. At June 30, 2011, all of the total impaired loans were evaluated based on the fair value of the collateral. On a quarterly basis, the ALLL methodology begins with the determination of individually impaired loans. All loans that are rated “7” (Doubtful) are assessed as impaired based on the expectation that the full collection of principal and interest is in doubt. All loans that are rated “6” (Substandard) or are expected to be downgraded to “6”, are analyzed to determine whether they may be impaired. All loans that are rated “5” (Special Mention) are presumed not to be impaired. However, “5” rated loans with the following characteristics may be analyzed for impairment:

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

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

•	A loan is newly modified; or

•	A loan is expected to be modified.

The Company’s credit administration personnel and senior financial officers are responsible for tracking, coding, and monitoring loans that become Troubled Debt Restructurings. Concessions are made to existing borrowers in the form of modified interest rates and / or payment terms. The loans are segregated for regulatory and external reporting. Each specific TDR is reviewed to determine if the accrual of interest should be discontinued and also reviewed for impairment. The Company’s senior credit administration officer performs this analysis on a quarterly basis in addition to determining any other loans that are impaired within the loan portfolio. The Company had a total of $12.27 million and $13.98 million of loans categorized as troubled debt restructurings as of June 30, 2011 and December 31, 2010, respectively. Interest is accrued on TDRs if the loan is otherwise not impaired and the full collection of principal and interest under the modified terms is still deemed likely.

Note 3 - Income Taxes

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

	2011			2010

Tax expense (benefit) at statutory rate	$	(1,191	)	$	(214	)
Reduction in taxes from:
Tax-exempt interest		(159	)		(360	)
Other, net		(50	)		(59	)

Income tax benefit	$	(1,400	)	$	(633	)

Notes to Consolidated Financial Statements

(Unaudited)

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

Note 4 - Capital Requirements

Regulators of the Company and its subsidiary, Highlands Union Bank (the “Bank”), have implemented risk-based capital guidelines which require compliance with certain minimum capital ratios as a percent of assets and other certain off-balance sheet items that are adjusted for predefined credit risk factors. The regulatory minimum for Tier 1 and combined Tier 1 and Tier 2 capital ratios are 4.0% and 8.0%, respectively. Tier 1 capital includes tangible equity reduced by goodwill and certain other intangibles. Tier 2 capital includes portions of the allowance for loan losses, not to exceed Tier 1 capital. In addition to the risk-based guidelines, a minimum leverage ratio (Tier 1 capital as a percentage of average total consolidated assets) of 4.0% is required. The following table presents the capital ratios for the Company and the Bank at June 30, 2011.


Entity	Tier 1			Combined Capital			Leverage

Highlands Bankshares, Inc.		6.85	%		8.12	%		4.64	%

Highlands Union Bank		7.53	%		8.79	%		5.09	%

As of December 31, 2010, both the Company and Bank were considered “well-capitalized.” However, during the first quarter of 2011, as a result of additional loan loss provisions and approximately $5.4 million in additional deferred taxes being disallowed for regulatory capital purposes, the Bank’s total risk based capital ratio fell below the required minimum to be “well-capitalized.” The Bank’s Tier 1 Capital to Risk Weighted assets ratio and Tier 1 capital to Adjusted Total Assets remain above the “well-capitalized” thresholds. The additional $5.4 million of disallowed deferred taxes represents a non-cash adjustment related to Tier 1 capital for regulatory capital purposes only. The disallowance does not affect stockholders’ equity or book value per share. Because the Bank’s total risk-based capital ratio was below 10% as of June 30, 2011, the Bank is considered to be “adequately-capitalized” under the regulatory framework for prompt corrective action. As a result of our status as “adequately-capitalized” for regulatory capital purposes, the Bank cannot renew or accept brokered deposits without prior regulatory approval and cannot offer interest rates on our deposit accounts that are significantly higher than the average rates in our market area.

Note 5 - Capital Securities

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

Subject to certain exceptions and limitations, the Company may elect from time to time to defer interest payments on the debt securities, which would result in a deferral of distribution payments on the related Capital Securities. Due to the economic environment, effective April 15, 2010, the Company began deferring interest payments on the debt securities held by Highlands Capital Trust I. As a result, distribution payments to holders of the Highlands Capital Trust I 9.25% Capital Securities are also being deferred.

Notes to Consolidated Financial Statements

(Unaudited)

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

Note 6 – Per Share Amounts

The following table contains information regarding the Company’s computation of basic earnings per share and diluted earnings per share for the six and three months ended June 30, 2011 and 2010.

	Six Months Ended June 30,					Three Months Ended June 30,
	2011			2010		2011		2010

Basic Earnings (loss) per Share	$	(0.42	)	$	0.00	$	0.00	$	(0.01	)

Basic Number of Shares		5,011,152			5,011,152		5,011,152		5,011,152

Diluted Earnings (loss) per Share	$	(0.42	)	$	0.00	$	0.00	$	(0.01	)

Diluted Number of Shares		5,011,152			5,011,152		5,011,152		5,011,152

Note 7 – Commitments and Contingencies

The Bank is a party to various financial instruments with off-balance sheet risk arising in the normal course of business to meet the financing needs of its customers. Those financial instruments include commitments to extend credit and standby letters of credit. At June 30, 2011, these commitments included: standby letters of credit of $611 thousand; equity lines of credit of $9.99 million; credit card lines of credit of $5.46 million; commercial real estate, construction and land development commitments of $2.09 million; and other unused commitments to fund interest earning assets of $23.59 million.

Note 8 – Summary of Significant Accounting Policy Update For Certain Required Disclosures

In July 2010, the Receivables topic of the Accounting Standards Codification (“ASC”) was amended by Accounting Standards Update (“ASU”) 2010-20 to require expanded disclosures related to a company’s allowance for credit losses and the credit quality of its financing receivables. The amendments require the allowance disclosures to be provided on a disaggregated basis. The Company adopted ASU 2010-20 in its December 31, 2010 financial statements. Certain disclosures about Troubled Debt Restructurings (“TDRs”) required by ASU 2010-20 were deferred by the Financial Accounting Standards Board (“FASB”) in ASU 2011-01 issued in January 2011. In April 2011 FASB issued ASU 2011-02 to assist creditors with their determination of when a restructuring is a TDR. The determination is based on whether the restructuring constitutes a concession and whether the debtor is experiencing financial difficulties as both events must be present. Disclosures related to TDRs under ASU 2010-20 will be effective for reporting periods beginning after June 15, 2011.

In April 2011, the criteria used to determine effective control of transferred assets in the Transfers and Servicing topic of the ASC was amended by ASU 2011-03. The requirement for the transferor to have the ability to repurchase or redeem the financial assets on substantially the agreed terms and the collateral maintenance implementation guidance related to that criterion were removed from the assessment of effective control. The other criteria to assess effective control were not changed. The amendments are effective for the Company beginning January 1, 2012 but are not expected to have a material effect on the financial statements.

ASU 2011-04 was issued in May 2011 to amend the Fair Value Measurement topic of the ASC by clarifying the application of existing fair value measurement and disclosure requirements and by changing particular principles or requirements for measuring fair value or for disclosing information about fair value measurements. The amendments will be effective for the Company beginning January 1, 2012 but are not expected to have a material effect on the financial statements.

Notes to Consolidated Financial Statements

(Unaudited)

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

The Comprehensive Income topic of the ASC was amended in June 2011. The amendment eliminates the option to present other comprehensive income as a part of the statement of changes in stockholders’ equity. The amendment requires consecutive presentation of the statement of net income and other comprehensive income and requires an entity to present reclassification adjustments from other comprehensive income to net income on the face of the financial statements. The amendments will be applicable to the Company on January 1, 2012 and will be applied retrospectively.

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

Note 9 – Fair Value

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

Fair Value Hierarchy

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

	Level 1		Valuation is based upon quoted prices for identical instruments traded in active markets.

	Level 2		Valuation is based upon quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active, and model-based valuation techniques for which all significant assumptions are observable in the market.

	Level 3		Valuation is generated from model-based techniques that use at least one significant assumption not observable in the market. These unobservable assumptions reflect estimates of assumptions that market participants would use in pricing the asset or liability. Valuation techniques include use of option pricing models, discounted cash flow models and similar techniques.

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

Notes to Consolidated Financial Statements

(Unaudited)

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

Recurring - Investment Securities Available for Sale

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

As of June 30, 2011, the Company holds approximately $4.07 million (amortized cost) in collateralized debt obligation securities that are backed by trust preferred securities issued by banks, thrifts, and insurance companies (TRUP CDOs). The market for these and similar securities at June 30, 2011 is not active. The TRUP CDOs have been classified within Level 3 of the fair value hierarchy because it has been determined that significant adjustments are required for fair value assessment at the measurement date.

The following tables summarize the Company’s available for sale securities portfolio measured at fair value on a recurring basis as of June 30, 2011 and December 31, 2010, segregated by the level of the valuation inputs within the fair value hierarchy.

June 30, 2011

	Level 1		Level 2		Level 3		Total Fair Value
Available for Sale Securities
US Treasuries	$	-	$	6,059	$	-	$	6,059
State and Political Subdivisions	$	-	$	18,621	$	-	$	18,621
Mortgage Backed Securities	$	-	$	32,065	$	-	$	32,065
TRUP CDO’s	$	-	$	-	$	130	$	130
Single Issue Trust Preferred	$	-	$	1,878	$	-	$	1,878
SBA Pools	$	-	$	7,183	$	-	$	7,183
SLMA	$	-	$	482	$	-	$	482
Total AFS Securities	$	-	$	66,288	$	130	$	66,418

December 31, 2010

	Level 1		Level 2		Level 3		Total Fair Value
Available for Sale Securities
State and Political Subdivisions	$	-	$	18,291	$	-	$	18,291
Mortgage Backed Securities	$	-	$	29,442	$	-	$	29,442
TRUP CDO’s	$	-	$	-	$	173	$	173
Single Issue Trust Preferred	$	-	$	1,804	$	-	$	1,804
SBA Pools	$	-	$	5,934	$	-	$	5,934
SLMA	$	-	$	452	$	-	$	452
Total AFS Securities	$	-	$	55,923	$	173	$	56,096

Notes to Consolidated Financial Statements

(Unaudited)

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

Pursuant to ASC Topic 820, the following table shows a reconciliation of the beginning and ending balance at June 30, 2011 for Level 3 assets measured on a recurring basis using significant unobservable inputs. Level 3 assets represent the Company’s TRUP CDOs.

Investment Securities Available for Sale

Beginning balance, December 31, 2010	$	173
Total losses included in net income		(269	)
Included in other comprehensive income		226
Transfers in or out of Level 3		--
Ending balance, June 30, 2011	$	130

The losses included in net income represent the other than temporary impairment charges taken during the six months ended June 30, 2011 for the securities classified as Level 3.

Loans

The Company does not record loans at fair value on a recurring basis. However, from time to time, a loan is considered impaired and an allowance for loan losses is established. Loans for which it is probable that payment of interest and principal will not be made in accordance with the contractual terms of the loan agreement are considered impaired. Once a loan is identified as individually impaired, management measures impairment using one of several methods, including collateral value, recent appraisal value and /or tax assessed value, liquidation value and discounted cash flows. Those impaired loans not requiring an allowance represent loans for which the fair value of the expected repayments or collateral exceed the recorded investments in such loans. The total of these impaired loans not requiring an allowance at June 30, 2011 was $27.68 million. At June 30, 2011 all of the total impaired loans were evaluated based on the fair value of the collateral. Fair value is based upon independent market prices or appraised values of the collateral which the Company considers as nonrecurring Level 2. The following tables summarize the Company’s impaired loans by loan category at fair value on a non - recurring basis as of June 30, 2011 and December 31, 2010, segregated by the level of the valuation inputs within the fair value hierarchy for which a specific allowance has been allocated.

	June 30, 2011
	Level 1	Level 2		Level 3	Total Fair Value
Residential 1-4 family		$	4,632		$	4,632
Multifamily		$	1,354		$	1,354
Construction and Land Development		$	3,062		$	3,062
Commercial Real Estate-Owner Occupied		$	2,098		$	2,098
Commercial Real Estate-Non Owner Occupied		$	3,640		$	3,640
Second Mortgages		$	221		$	221
Farmland		$	270		$	270
Personal		$	59		$	59
Commercial		$	1,780		$	1,780
Agricultural		$	-		$	-
Total		$	17,116		$	17,116

Notes to Consolidated Financial Statements

(Unaudited)

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

	December 31, 2010
	Level 1	Level 2		Level 3	Total Fair Value
Residential 1-4 family		$	3,871		$	3,871
Multifamily		$	1,540		$	1,540
Commercial, Construction and Land Development		$	6,118		$	6,118
Commercial Real Estate-Owner Occupied		$	4,167		$	4,167
Commercial Real Estate-Non Owner Occupied		$	3,962		$	3,962
Second Mortgages		$	84		$	84
Farmland		$	278		$	278
Personal		$	50		$	50
Commercial		$	882		$	882
Agricultural		$	16		$	16
Total		$	20,968		$	20,968

Foreclosed Assets / Repossessions

Foreclosed assets and repossessions are adjusted to fair value upon transfer of the loans to foreclosed assets and repossessions. Subsequently, foreclosed assets and repossessions are carried at the lower of carrying value or fair value. Fair value is based upon independent market prices or appraised values of the collateral which the Company considers as nonrecurring Level 2. If additional write-downs have occurred due to the recessionary economic environment, then the foreclosed asset balances are reclassified as non-recurring Level 3. The following tables summarize the Company’s foreclosed and repossessed assets at fair value on a non-recurring basis as of June 30, 2011 and December 31, 2010

	June 30, 2011
	Level 1		Level 2		Level 3		Total Fair Value

Repossessions/OREO	--	$	15,378	$	1,559	$	16,937

	December 31, 2010
	Level 1		Level 2		Level 3		Total Fair Value

Repossessions/OREO	--	$	15,347	$	--	$	15,347

Notes to Consolidated Financial Statements

(Unaudited)

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

General

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

Fair Value of Financial Instruments

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

Cash and Cash Equivalents

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

Securities Available for Sale

Fair values are determined in the manner as described above.

Other Investments

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

Loans

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

Deposits

The fair value of deposits is based on discounted cash flows using current market rates applied to the cash flow analysis for each time deposit.

Other Short-Term Borrowings

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

Notes to Consolidated Financial Statements

(Unaudited)

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

Long-term Debt and Capital Securities

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

Off-Balance Sheet Instruments

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

The carrying amounts and fair values of the Company's financial instruments at June 30, 2011 and December 31, 2010 were as follows:

	June 30, 2011						December 31, 2010
	Carrying Amount			Fair Value			Carrying Amount			Fair Value
	Carrying Amount			Fair Value			Carrying Amount			Fair Value

Cash and cash equivalents	$	71,208		$	71,208		$	82,152		$	82,152
Securities available for sale		66,418			66,418			56,096			56,096
Other investments		5,674			5,674			6,026			6,026
Loans, net		418,757			418,545			440,274			438,952
Deposits		(526,900	)		(511,559	)		(536,772	)		(519,111	)
Other short-term borrowings		(57,670	)		(64,573	)		(65,952	)		(72,687	)
Long-term debt		(14,058	)		(14,947	)		(14,968	)		(15,779	)
Capital Securities		(3,150	)		(2,502	)		(3,150	)		(2,502	)

Notes to Consolidated Financial Statements

(Unaudited)

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

Note 10. Investment Securities Available For Sale

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

	June 30, 2011
	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses		Fair Value
	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses		Fair Value

US Treasuries		6,061				2		6,059
State and political subdivisions		19,287		136		802		18,621
Mortgage backed securities		32,053		191		179		32,065
Pooled Trust Preferred		4,067		-		3,937		130
Single Issue Trust Preferred		1,925		-		47		1,878
SBA Pools		7,202		82		101		7,183
SLMA		500		-		18		482
	$	71,095	$	409	$	5,086	$	66,418

	December 31, 2010
	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses		Fair Value
	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses		Fair Value

US Treasuries
State and political subdivisions		19,885		78		1,673		18,291
Mortgage backed securities		29,465		289		312		29,442
Pooled Trust Preferred		4,339		-		4,165		173
Single Issue Trust Preferred		1,926		-		122		1,804
SBA Pools		5,978		1		45		5,934
SLMA		500		-		48		452
	$	62,093	$	368	$	6,365	$	56,096

Investment securities available for sale with a carrying value of $55,533 and $42,885 at June 30, 2011 and December 31, 2010, respectively, and a market value of $55,512 and $41,849 at June 30, 2011 and December 31, 2010, respectively, were pledged as collateral on public deposits, FHLB advances, correspondent federal funds credit lines and for other purposes as required or permitted by law.

Notes to Consolidated Financial Statements

(Unaudited)

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

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

	June 30, 2011
	Less Than 12 months				12 Months or More				Total
	Fair Value		Unrealized Losses		Fair Value		Unrealized Losses		Fair Value		Unrealized Losses

US Treasuries	$	6,058	$	2		-		-	$	6,058	$	2
States and political subdivisions		6,745		207		5,144		595		11,889		802
Mortgage-backed securities		15,413		179		-		-		15,413		179
Pooled Trust Preferred Securities		-		-		130		3,937		130		3,937
Single Issue Trust Preferred		395		16		983		31		1,378		47
SBA Pools		2,005		101		-		-		2,005		101
SLMA		-		-		482		18		482		18

Total	$	30,616	$	505	$	6,739	$	4,581	$	37,355	$	5,086

	December 31, 2010
	Less Than 12 months				12 Months or More				Total
	Fair Value		Unrealized Losses		Fair Value		Unrealized Losses		Fair Value		Unrealized Losses

States and political subdivisions	$	10,822	$	807	$	4,372	$	865	$	15,194	$	1,672
Mortgage-backed securities		19,193		313		-		-		19,193		313
Pooled Trust Preferred Securities		-		-		173		4,165		173		4,165
Single Issue Trust Preferred		391		21		913		101		1,304		122
SBA Pools		4,018		45		-		-		4,018		45
SLMA		-		-		452		48		452		48

Total	$	34,424	$	1,186	$	5,910	$	5,179	$	40,334	$	6,365

Notes to Consolidated Financial Statements

(Unaudited)

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

The segment of our portfolio that contains the largest unrealized loss is our pooled trust preferred securities (TRUP CDOs) which represent trust preferred securities issued primarily by banks and a limited number of insurance companies and real estate investment trusts. As of June 30, 2011, our TRUP CDOs book value totaled $4.07 million.

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

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

At June, 2011, the following assumptions were used in our cash flow projections:

·	Deferral / default ranges for 2011 – 1.00% to 2.56%.

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

·	Deferral / default rate for 2013 – 1.00%.

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

·	Prepayments - 1% annually, 100% at maturity

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

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

·	0% recovery on existing defaults

·	Cash flows are discounted at the effective interest rate.

Underlying banks can prepay their trust preferred securities on a quarterly call date after a five year period from the original date of issue. We use a constant prepayment assumption of 1% annually and 100% at maturity. The extent of future prepayments is difficult to project. Since trust preferred securities will count as Tier 1 capital until the end of 2012, it is conceivable that there will not be an initial burst of prepayment activity as tax-deductible Tier 1 capital is still attractive. As large issuers lose Tier 1 treatment beginning in 2013, some of them will likely prepay their trust preferred securities; however, trust preferred will still be eligible as Tier 2 capital so some large issuers may not prepay until closer to maturity.

Notes to Consolidated Financial Statements

(Unaudited)

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

For issuers with assets of less than $15 billion but greater than $500 million, existing trust preferred securities were grandfathered, but these issuers are prohibited from issuing new trust preferred securities that can be counted as Tier 1 capital, making it unlikely that these issuers will prepay their existing trust preferred. Our projections also include for existing deferrals a 15% recovery after a two-year lag (if an issuer has been in deferral for two years, we extend the assumed recovery to the end of the 5-year deferral period, or an additional 3 years).

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

During the first six months 2011, the Company incurred credit-related OTTI charges on our TRUP CDOs of $269 thousand of which $155 thousand was incurred during the second quarter of 2011. OTTI charges of $724 thousand were incurred during the first six months of 2010.

The Company also assesses other securities for OTTI quarterly by reviewing credit ratings, financial and regulatory reports as well as other pertinent published financial data. As of June 30, 2011 and December 31, 2010, the Company's assessment revealed no impairment other than that deemed temporary on those securities.

The amortized cost and estimated fair value of securities available for sale at June 30, 2011 by contractual maturity are shown below. Expected maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.

	Amortized Cost		Approximate Market Value

Due in one year or less	$	3,358	$	3,366
Due after one year through five years		3,012		3,012
Due after five years through ten years		2,860		2,761
Due after ten years		29,812		25,214
		39,042		34,353

Mortgage-backed securities		32,053		32,065
	$	71,095	$	66,418

Note 12 –Holding Company Note and Line of Credit

On April 27, 2009, the Company announced that it entered into a Loan Agreement with Community Bankers Bank (“CBB”), pursuant to which CBB agreed to extend to the Company an aggregate of $7,500,000 under a Revolving Line of Credit and a Closed-End Term Loan (collectively, the “Loans”). The Company pledged the stock of the Bank as collateral for the Loans. Proceeds of the loans of $3,200,000 were down-streamed into the Bank as additional Tier 1 capital with the remaining proceeds of $2,300,000 held in cash by the Company. Subsequently, during the second quarter of 2011, the Company requested and CBB agreed to modify the closed-end loan to extend the amortization period of the loan for a new 20-year period. The Company simultaneously paid off the Revolving Line of Credit. The Closed – End Term Loan has a balloon maturity in April 2014 and the Company has deposited the 35 monthly payments up to the balloon date into a reserve account held at CBB. One of the covenants included in the loan documents requires that the Bank and Company remain well-capitalized. The Company did receive a covenant waiver from CBB during the second quarter of 2011 after falling below “well-capitalized” to “adequately capitalized “.

Notes to Consolidated Financial Statements

(Unaudited)

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

Note 13 –Formal Written Agreement

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

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

·	strengthen credit risk management and administration;

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

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

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

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

·	maintain sufficient capital at the Company and the Bank;

·	establish a revised written contingency funding plan;

·	establish a revised investment policy;

·	improve the Bank’s earnings and overall condition;

·	revise the Bank’s information technology program;

·	establish a disaster recovery and business continuity program;

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

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

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

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

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

Critical Accounting Policy

The financial condition and results of operations presented in the Consolidated Financial Statements, accompanying Notes to Consolidated Financial Statements and management’s discussion and analysis are, to a large degree, dependent upon the accounting policies of the Company. The selection and application of these accounting policies involve judgments, estimates, and uncertainties that are susceptible to change. For a discussion of the Company’s critical accounting policies related to its allowance for loan losses and other than temporary impairment, see the Company’s Annual Report on Form 10-K for the year ended December 31, 2010.

Regulatory Environment

. On July 21, 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”) was signed into law. The Dodd-Frank Act contains significant modifications to the current bank regulatory structure and requires various federal agencies to adopt a broad range of new rules and regulations throughout 2011 and beyond. While not determinable at this time, the impact of the Dodd-Frank Act and the rules and regulations that will be promulgated there-under could significantly affect our operations, increase our operating costs and divert management resources and attention from the primary business of the Bank.

Formal Written Agreement

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

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

·	strengthen credit risk management and administration;

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

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

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

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

·	maintain sufficient capital at the Company and the Bank;

·	establish a revised written contingency funding plan;

·	establish a revised investment policy;

·	improve the Bank’s earnings and overall condition;

·	revise the Bank’s information technology program; and

·	establish a disaster recovery and business continuity program.

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

The Company has taken the following actions to comply with the items in the Written Agreement as of June 2011.

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

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

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

·	Completed revising the written contingency funding plan;

·	Completed revising the investment policy;

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

·	Completed a Business Continuity Plan and Disaster Recovery Plan;

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

·	Completed a loan portfolio stress test under four separate scenarios.

Results of Operations

Results of operations for the three-month and six month periods ended June 30, 2011 reflected earnings of $22 thousand and a net loss of $2.10 million, respectively. For the first six months of 2011, provisions for loan loss reserves increased $1.89 million over the corresponding period in 2010 as the Company’s non-performing loans continued to increase due to the effects of the recession. The current regulatory environment and regulatory oversight has also impacted the additional loan loss provisioning. The Company reported earnings of $6 thousand for the six months ended June 30, 2010 and a net loss of $38 thousand for the three month period ended June 30, 2010.

Net interest income for the three-month period ended June 30, 2011 decreased $327 thousand or 6.90% compared to the three months ended June 30, 2010. For the six-month period ended June 30, 2011 net interest income decreased $821 thousand or 8.62% as compared to the six month period ended June 30, 2010. Average interest-earning assets decreased $7.80 million from the six - month period ended June 30, 2010 to the current six-month period, while average interest-bearing liabilities decreased $2.93 million over the same period. The tax-equivalent yield on average interest-earning assets was 4.99% for the six-month period ended June 30, 2011 representing a decrease of 70 basis points from the same period in 2010. The primary reasons for the decline in yield is due to the additional loans placed in non-accrual and the increase in federal funds sold balances. The average balance of federal funds sold during the quarter was $58.84 million as a result of the loan and securities portfolios reducing during the period. The average yield on federal funds sold was .24% during the period. The rate on average interest-bearing liabilities decreased 45 basis points to 2.00% for the six month period ended June 30, 2011 as compared to 2.45% for the same period in 2010.

Total interest income for the three and six months ended June 30, 2011 was $1.02 million and $2.03 million less than the comparable 2010 periods due primarily to a reduction in loan and securities balances, new loan and investment securities volume being booked at lower rates, and existing adjustable rate loans and investment securities re-pricing at lower rates. Yields on typical investment securities during the current economic cycle have decreased significantly; therefore, management has intentionally decreased its security portfolio and maintained a significant amount of cash and cash equivalents during 2010 and 2011. The majority of pay-downs during the last year have been callable agency securities and agency mortgage backed securities. The Company has also reduced its municipal bond holdings by approximately $28.72 million over the last 18 months in an effort to reduce its exposure to municipal debt and related potential credit risk. This has negatively affected the Company’s net interest income as these proceeds were placed back into overnight federal funds sold balances.

The Company’s total interest expense decreased by $693 thousand for the three months and $1.21 million for the six months over the same periods in 2010, due primarily to new interest-bearing deposits being recorded at lower rates and existing interest-bearing deposits and other liabilities re-pricing lower as they mature or re-price. The Company continues to face considerable competition in all of its market areas as it pertains to rates on deposits.

During the first six months of 2011, the Company’s non-interest income increased by $683 thousand over the corresponding period for 2010. Service charges on deposit accounts increased by $59 thousand for the six-month period. OTTI write-downs for the first six months of 2011 were $269 compared to $724 for the first six months of 2010. Total non-interest income for the three months ended June 30, 2011 increased $662 thousand over the three month period ended June 30, 2010 due primarily to a reduction in OTTI charges.

Total non-interest expense for the six month period ended June 30, 2011 increased $838 thousand over the comparable period in 2010. Total non-interest expense for the three month period ended June 30, 2011 increased $581 thousand as compared to the three months ended June 30, 2010. FDIC insurance premiums increased to $789 thousand for the six months ended June 30, 2011 compared to $468 thousand for the six months ended June 30, 2010. OREO expenses, write-downs and losses on the sale of OREO and repossessions in the amount of $1.41 million increased $734 thousand for the six month period ended June 30, 2011 as compared to the prior period due to the increasing number of foreclosures. Salaries and employee benefits decreased $173 thousand for the six months ended June 30, 2011 as compared to the prior year period. Total non-interest expense for the three month period ended June 30, 2011 increased $581 thousand over the three month period ended June 30, 2010. This increase was largely a result of increased expenses and write-downs related to foreclosed properties.

In addition to FDIC insurance premiums, for the six months ended June 30, 2011, other operating expenses that exceeded 1% of total interest income and other operating income were charges for other contracted services totaling $310 thousand, software licensing and maintenance costs totaling $298 thousand, and legal expenses totaling $240 thousand.

For the six months ended June 30, 2010, other operating expenses that exceeded 1% of total interest income and other operating income were charges for FDIC insurance totaling $468 thousand, other contracted services totaling $270 thousand, software licensing and maintenance totaling $363 thousand and telephone / data costs totaling $235 thousand.

For the three month period ended June 30, 2011, other operating expenses that exceeded 1% of total interest income and other operating income were charges for FDIC insurance totaling $360 thousand, legal expenses totaling $151 thousand, other contracted services totaling $180 thousand, and software licensing and maintenance totaling $152 thousand.

For the three month period ended June 30, 2010, other operating expenses that exceeded 1% of total interest income and other operating income were charges for FDIC insurance totaling $234 thousand, other contracted services totaling $139 thousand, software licensing and maintenance totaling $179 thousand and telephone / data costs totaling $128 thousand.

Operating results of the Company when measured as a percentage of average equity reveals a decrease in return on average equity to (13.19%) for the six-month period ended June 30, 2011 from 0.03% for the corresponding period in 2010. Return on average assets for the six months ended June 30, 2011 was (0.65%) compared to 0.00% for the six months ended June 30, 2010.The provision for loan losses for the three-month and six month periods ended June 30, 2011 totaled $186 thousand and $3.79 million, respectively, a $493 thousand decrease and $1.90 million increase as compared to the corresponding periods in 2010. This increased provision during the first quarter of 2011 was due to the continued recession, increased charge-offs and past due loans, and also to comply with regulatory requirements. In particular, the additional provisions were in response to additional loans being placed into non-accrual status, primarily in the Company’s Tennessee and North Carolina market areas, in response to regulatory guidance. The Company continually monitors the loan portfolio for signs of credit weaknesses or developing collection problems. Loan loss provisions for each period are determined after evaluating the loan portfolio and determining the level necessary to absorb current charge-offs and maintain the reserve at adequate levels. Net charge-offs for the first half of 2011 were $2.95 million compared with $2.57 million for the first six months of 2010. Year–to–date net charge-offs were .69% and 0.53% of total loans for the periods ended June 30, 2011 and June 30, 2010, respectively. Loan loss reserves increased 1.38% to $11.16 million at June 30, 2011 from $11.01 million at June 30, 2010. The Company’s allowance for loan loss reserves at June 30, 2011 increased to 2.60% of total loans versus 2.28% at June 30, 2010. At December 31, 2010, the allowance for loan loss reserve as a percentage of total loans was 2.29%.

Financial Position

Total loans decreased from $482.01 million at June 30, 2010 to $429.91 million at June 30, 2011. Total loans at December 31, 2010 were $450.59 million. Over the last 3 years, the Company has significantly decreased its construction portfolio as a result of the economic downturn. Since June 30, 2010 the Company has reduced its construction loan and other land loan balances approximately $7.67 million. The Company has also been reducing its overall commercial real estate loan portfolio in an effort to increase its risk based capital ratios. Overall loan demand has slowed significantly over the last 2 years due to the recessionary environment. The loan to deposit ratio decreased from 91.70% at June 30, 2010 to 81.59% at June 30, 2011 due to the reduction in the loan portfolio. The loan to deposit ratio at December 31, 2010 was 83.95%. Deposits at June 30, 2011 have increased $1.26 million since June 30, 2010 and have decreased $9.88 million since December 31, 2010. During the last 24 months, the Company has continued to lower the interest rates paid on time deposits in a continuing effort to reduce its cost of funds. As a result being “adequately-capitalized” for regulatory capital purposes, the Bank cannot renew or accept brokered deposits without prior regulatory approval and cannot offer interest rates on deposit accounts that are significantly higher than the average rates in our market area.

The Company also owns approximately $4.07 million (carrying value) in collateralized debt obligation securities that are backed by trust preferred securities issued by banks, thrifts, and insurance companies (TRUP CDOs). The market for these securities at June 30, 2011 is not active and markets for similar securities are also not active. These securities are currently in non-accrual status. As of June 30, 2011, the unrealized loss in these securities totaled $3.94 million. Management feels that these losses are temporary and primarily a result of the current inactive market. The market discounts reflect the current illiquidity and the negative credit events within the banking sector. Continuing deterioration of profits of banks nationally and the possibility of increased bank failures could result in changes in the Company’s outlook for these securities and cause the Company to consider recording additional OTTI charges on these securities. During the six months ended June 30, 2011, the Company recorded OTTI credit related impairment charges on its TRUP CDOs in the amount of $269 thousand.

Below is a table of the Company’s remaining pooled trust preferred balances as of June 30, 2011.

Description	Type	Class	Original Amount $		Book Value 6/30/11 $		Fair Value 6/30/11 $		Unrealized Gain/(Loss) $			Lowest Credit Rating

Pretsel 4-B	Pooled	Mezz B		700,000		85		29		(56	)	Ca
Prestel 11-B	Pooled	Mezz B		500,000		398		39		( 359	)	Ca
Prestel 12-B	Pooled	Mezz B		750,000		394		18		( 376	)	Ca
Prestel 13-B	Pooled	Mezz B		500,000		326		16		( 310	)	Ca
Prestel 15-B	Pooled	Mezz B		500,000		263		4		( 259	)	Ca
Prestel 18-C	Pooled	Mezz C		500,000		325		3		(322	)	Ca
Prestel 19-C	Pooled	Mezz C		500,000		306		1		( 305	)	Ca
Prestel 20-C	Pooled	Mezz C		500,000		14		1		( 13	)	Ca
Prestel 21-C	Pooled	Mezz C		500,000		293		7		(286	)	Ca
Prestel 22-C	Pooled	Mezz C		500,000		283		1		(282	)	Ca
Prestel 22-C	Pooled	Mezz C		500,000		316		2		( 314	)	Ca
Prestel 22-C	Pooled	Mezz C		500,000		316		2		(314	)	Ca
Prestel 23-C	Pooled	Mezz C		500,000		442		5		(437	)	C
Tropc CDO III	Pooled	Subordinate		1,000,000		306		2		(304	)	C
Totals						4,067		130		3,937

In previous years, the Company has used the Federal Home Loan Bank and other alternative funding sources to fund loan and asset growth. The Company currently has approximately $67.98 million in outstanding FHLB advances. No new advances were originated during the last 12 months. The Company reduced its borrowings with the FHLB by $8 million over the last six months as one of the advances was called by the FHLB. The rate paid on the called advance was 2.61%. The Company secures all of its existing and future advances from the FHLB with a selected group of in-house residential and commercial real estate secured loans and a selected group of securities that are held in safekeeping by the FHLB.

Non-performing assets are comprised of loans on non-accrual status, loans contractually past due 90 days or more and still accruing interest, other real estate owned and repossessions. In addition, the market value of any securities available for sale placed in non accrual status are included. Non-performing assets were $41.22 million or 6.49% of total assets at June 30, 2011, compared with $34.37 million or 5.25% of total assets at December 31, 2010. Non-performing assets decreased $1.59 million from the March 31, 2011 total of $42.81 million. Approximately $4.37 million of the increase in non-accrual loans during the first half of 2011 represent loans paying interest only as agreed under the terms of their loan agreement but are classified as non-accrual to comply with regulatory guidance.

The adequacy of the allowance for loan losses is based on management's judgment and analysis of current and historical loss experience, risk characteristics of the loan portfolio, concentrations of credit and asset quality, as well as other internal and external factors, such as general economic conditions. The internal credit review department performs pre-approval analyses of large credits and also conducts credit review activities that provide management with an early warning of loan deterioration. The senior credit administration officer prepares quarterly analyses of the adequacy of the allowance for loans losses. These analyses include individual loans considered impaired for direct exposure. In addition, potential losses on loan pools and pool allocations are based upon historical losses and other factors, as adjusted, for various loan types. In recent years, the Company used a rolling three-year history by loan category in determining pool allocation factors. However, due to the severe economic recession, the Company based its pool allocations as of June 30, 2011 and December 31, 2010 to more closely match losses incurred during 2009 and 2010 rather than the average of the prior three years. In addition to the change in the period of historical losses included in the calculation, additional amounts were allocated based upon internal and external factors such as changing trends in the loan mix, the effects of changes in business conditions in our market area, unemployment trends, the effects of any changes in loan policies, the effects of competition, regulatory factors, and environmental factors related to our loan portfolio. The calculation for allowance for loan losses is reviewed by both the Credit Administration Committee and the Board of Directors.

At June 30, 2011 and December 31, 2010, the internal credit review department as well as management determined that the Company's allowance for loan losses is sufficient and is appropriate based on the requirements of US Generally Accepted Accounting Principles.

Foreclosed Assets (Other Real Estate Owned)

(dollar amounts in thousands)

At June 30, 2011 OREO balances were $16,917 and consisted of 38 relationships. The following chart details each category type, number of accounts and balance.

OREO Property at 6/30/2011

OREO Description	Number		Balance at 6/30/2011
			(in thousands)
Land Development - Vacant Land		13	$	4,215
1-4 Family		19		6,477
Multifamily		1		3,128
Commercial Real Estate		5		3,097

Total		38	$	16,917

The one multifamily property totaling $3.1 million contains twenty – nine residential units outside the Sevierville, Tennessee area. The second largest property totals $2.08 million and is a tract of land of partially developed lots and vacant land also in the Sevierville, Tennessee market area. There has been increased deterioration in the Tennessee commercial real estate market compared to other markets. The Bank is actively marketing all of its property through its website, listing agents, and other marketing methods. The Company has recently formed a special assets committee to focus directly on selling OREO properties and reducing other non-performing assets. The committee is comprised of lending officers from all of the Bank’s three market areas. The ability to sell OREO has been negatively affected by the current economic climate and the reduction of non-performing assets, will to a large degree, depend on how quickly specific market areas rebound from the recession.

Investment securities and other investments totaled $72.09 million (market value) at June 30, 2011 which reflects an increase of $9.96 million or 16.03% from the December 31, 2010 total of $62.13 million. Investment securities available for sale and other investments at June 30, 2011 were comprised of mortgage backed securities (43.36% of the total securities portfolio), municipal issues (25.83%), collateralized mortgage obligations (1.12%), corporate bonds (3.45%), SBAs pools (9.96%), and US Treasuries (8.40%). The Company’s entire securities portfolio was classified as available for sale at both June 30, 2011 and December 31, 2010.

Other investments include the Bank’s holdings of Federal Reserve, Federal Home Loan Bank, Pacific Coast Bankers Bank and Community Bankers Bank stock. These investments (carrying value of $5.67 million and 7.87% of the total) are considered to be restricted as the Company is required to hold these investments and the only market for these investments is the issuing agency.

Liquidity and Capital Resources

Total stockholders’ equity of the Company was $31.65 million at June 30, 2011, representing a decrease of $4.37 million or 12.12% from June 30, 2010. Total stockholders’ equity at December 31, 2010 was $32.88 million. The decrease in stockholders’ equity from June 30, 2010 to June 30, 2011 is primarily due to the net loss with the additional loan loss provision recorded over the last 12 months. The Company’s other than temporary impairment losses recorded over the last 12 months did not negatively impact stockholders equity since these losses were already included in stockholders equity directly through Accumulated Other Comprehensive Income.

Quantitative measures established by regulation to ensure capital adequacy require the Company and the Bank to maintain minimum amounts and ratios of total risk-based capital and Tier I capital to risk-weighted assets (as defined in the regulations), and Tier I capital to adjusted total assets (as defined). See Footnote 4 for a more detailed discussion of the Company’s and Bank’s regulatory capital ratios.

The Company plans to continue to reduce its higher risk weighted assets (primarily commercial real estate loans and non –performing assets) as well as the overall asset size of the Bank over the next 12 months in an effort to improve its regulatory capital ratios. Additionally, the Board of Directors and management are committed to regain “well-capitalized” status at all levels, and we are continuing to explore options for raising additional capital.

Liquidity is the ability to provide sufficient cash levels to meet financial commitments and to fund loan demand and deposit withdrawals. The Company and subsidiary Bank maintain a significant level of liquidity in the form of cash and cash equivalents ($71.21 million as of June 30, 2011) and unrestricted investment securities available for sale ($10.48 million). Cash and cash equivalents are immediately available for satisfaction of deposit withdrawals, customer credit needs, and operations of the Bank. The Bank also maintains a significant amount of available credit with both the Federal Home Loan Bank and a correspondent financial institution. The Bank also has the ability to attract non-brokered certificates of deposit outside its market area by posting rates on the internet. The primary investors utilizing this network are credit unions. Unencumbered investment securities available for sale represent a secondary level of liquidity available for conversion to liquid funds in the event of extraordinary needs. The Company believes that it maintains sufficient liquidity to meet its current and projected requirements and needs.

Caution About Forward-Looking Statements

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

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

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

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

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

·	Continued problems related to the national credit crisis and deepening recession;

·	Unemployment continuing to rise;

·	Difficult market conditions in our industry;

·	Unprecedented levels of market volatility;

·	Effects of the soundness of other financial institutions;

·	Potential impact on us of recently enacted legislation;

·	Further deterioration in the housing market and collateral values;

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

·	The ability to continue to attract low cost core deposits

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

·	The successful management of interest rate risk;

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

·	Changes in interest rates and interest rate policies;

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

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

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

·	Problems with technology utilized by the Company;

·	Changing trends in customer profiles and behavior; and

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

ITEM 3. Quantitative and Qualitative Disclosures About Market Risk

N/ A

ITEM 4. Controls and Procedures

We have carried out an evaluation, under the supervision and the participation of our management, including our Chief Executive Officer, Chief Financial Officer and Vice President of Accounting, of the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rule 13a-15(e) under the Exchange Act) as of the end of the period covered by this report. Based upon that evaluation, our Chief Executive Officer, Chief Financial Officer and Vice President of Accounting concluded that our disclosure controls and procedures are effective in providing reasonable assurance that (a) the information required to be disclosed by us in the reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and (b) such information is accumulated and communicated to our management, including our Chief Executive Officer, Chief Financial Officer and Vice President of Accounting, as appropriate to allow timely decisions regarding required disclosure.

There have not been any changes in the Company’s internal controls over financial reporting during the second quarter of 2011 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

PART II. OTHER INFORMATION

Item 1. Legal Proceedings

There have been no material developments to the Company’s legal proceedings during the quarter ended June 30, 2011. For a description of the Company’s legal proceedings, see the Quarterly Report on Form 10-Q for the period ended March 31, 2011.

Item 1A. Risk Factors

Not applicable

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

None

Item 3. Defaults Upon Senior Securities

None

Item 4. Removed and Reserved

Item 5. Other Information

None

Item 6. Exhibits

31.1

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

31.2

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

31.3

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

32.1

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

32.2

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

32.3

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

101

The following materials from the Highlands Bankshares, Inc. Quarterly Report on Form 10-Q for the quarter ended June 30, 2011 formatted in Extensible Business Reporting Language (XBRL): (i) Consolidated Balance Sheets, (ii) Consolidated Statements of Income, (iii) Consolidated Statements of Cash Flows, (iv) Consolidated Statements of Changes in Stockholders Equity and (v) Notes to Consolidated Financial Statements.

SIGNATURES

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

	HIGHLANDS BANKSHARES, INC. (Registrant)

Date: August 12, 2011	By:	/s/ Samuel L. Neese
		Samuel L. Neese
		Chief Executive Officer


Date: August 12, 2011	By:	/s/ Robert M. Little, Jr.
		Robert M. Little, Jr.
		Chief Financial Officer


Date: August 12, 2011	By:	/s/ James R. Edmondson
		James R. Edmondson
		Vice President of Accounting

Exhibits Index

31.1

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

31.2

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

31.3

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

32.1

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

32.2

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

32.3

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

101