Edgar Filing: HIGHLANDS BANKSHARES INC /VA/

f10qhbi033113.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 March 31, 2013

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

of the Securities Exchange Act of 1934

For the transition period from ____________ to _____________

Commission File Number: 0-27622

HIGHLANDS BANKSHARES, INC.

(Exact name of registrant as specified in its charter)

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

276-628-9181

(Registrant’s telephone number, including area code)

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

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

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

Large Accelerated Filer o	Accelerated Filer o
Non-Accelerated Filer o (Do not check if a smaller reporting company)	Smaller Reporting Company x

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

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

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

outstanding as of May 14, 2013

Index

Highlands Bankshares, Inc.

FORM 10-Q

For the Quarter Ended March 31, 2013

INDEX


PART I. FINANCIAL INFORMATION	PAGE

Item 1. Financial Statements

Consolidated Balance Sheets at March 31, 2013 (Unaudited) and December 31, 2012	3

Consolidated Statements of Income (Unaudited) for the Three Months Ended March 31, 2013 and 2012	4

Consolidated Statements of Comprehensive Income (Unaudited) for the Three Months Ended March 31, 2013 and 2012	5

Consolidated Statements of Cash Flows (Unaudited) for the Three Months Ended March 31, 2013 and 2012	6

Consolidated Statements of Changes in Stockholders’ Equity (Unaudited) for the Three Months Ended March 31, 2013 and 2012	7

Notes to Consolidated Financial Statements (Unaudited)	8-37

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations	38-44

Item 3. Quantitative and Qualitative Disclosures About Market Risk	44

Item 4. Controls and Procedures	44

PART II. OTHER INFORMATION

Item 1. Legal Proceedings	45

Item 1A. Risk Factors	45

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds	45

Item 3. Defaults Upon Senior Securities	45

Item 4. Mine Safety Disclosures	45

Item 5. Other Information	45

Item 6. Exhibits	46

SIGNATURES	47

Index

PART I. FINANCIAL INFORMATION

ITEM 1. Financial Statements

Consolidated Balance Sheets

(Amounts in thousands)

	(Unaudited) March 31, 2013			(Note 1) December 31, 2012
ASSETS
Cash and due from banks	$	12,929		$	15,220
Federal funds sold		70,411			65,988

Total Cash and Cash Equivalents		83,340			81,208

Investment securities available for sale (amortized cost $60,546 at March 31, 2013, $60,234 at December 31, 2012)		57,573			57,400
Other investments, at cost		4,710			4,930
Loans, net of allowance for loan losses of $7,435 at March 31, 2013, $7,449 at December 31, 2012		387,752			383,049
Premises and equipment, net		21,034			21,176
Deferred tax assets		8,232			8,298
Interest receivable		2,346			2,314
Bank owned life Insurance		13,802			13,689
Other real estate owned, net		15,593			16,639
Other assets		3,494			3,793

Total Assets	$	597,876		$	592,496

LIABILITIES AND STOCKHOLDERS’ EQUITY

LIABILITIES

Deposits:
Non-interest bearing	$	105,247		$	105,960
Interest bearing		384,945			379,380

Total Deposits		490,192			485,340

Interest, taxes and other liabilities		2,269			2,066
Other short-term borrowings		20,164			20,170
Long-term debt		51,258			51,298
Capital securities		3,150			3,150

Total Other Liabilities		76,841			76,684

Total Liabilities		567,033			562,024

STOCKHOLDERS’ EQUITY

Common stock (5,011 shares issued and outstanding)		3,132			3,132
Additional paid-in capital		7,783			7,783
Retained earnings		21,892			21,428
Accumulated other comprehensive income (loss)		(1,964	)		(1,871	)

Total Stockholders’ Equity		30,843			30,472

Total Liabilities and Stockholders’ Equity	$	597,876		$	592,496

See accompanying Notes to Consolidated Financial Statements

Index

Consolidated Statements of Income

(Amounts in thousands, except per share data)

(Unaudited)

	Three Months Ended March 31, 2013			Three Months Ended March 31, 2012
INTEREST INCOME
Loans receivable and fees on loans	$	5,403		$	5,930
Securities available for sale:
Taxable		203			234
Exempt from taxable income		141			200
Other investment income		30			21
Federal funds sold		40			42

Total Interest Income		5,817			6,427

INTEREST EXPENSE
Deposits		785			1,297
Other borrowed funds		715			845

Total Interest Expense		1,500			2,142

Net Interest Income		4,317			4,285

Provision for Loan Losses		219			505

Net Interest Income after Provision for Loan Losses		4,098			3,780

NON-INTEREST INCOME
Securities gains (losses), net		(4	)		3
Service charges on deposit accounts		499			491
Other service charges, commissions and fees		407			504
Other operating income		165			228
Other than temporary impairment charge		-			(167	)

Total Non-Interest Income		1,067			1,059

NON-INTEREST EXPENSE
Salaries and employee benefits		2,403			2,267
Occupancy expense of bank premises		303			277
Furniture and equipment expense		310			333
Other operating expense		1,351			1,263
Foreclosed Assets – Write-down and Operating Expenses		218			229

Total Non-Interest Expense		4,585			4,369

Income Before Income Taxes		580			470

Income Tax Expense (Note 3)		116			56

Net Income	$	464		$	414

Basic Earnings Per Common Share (Note 6)	$	0.09		$	0.08

Earnings Per Common Share – Assuming Dilution	$	0.09		$	0.08

Dividends Per Share	$	-		$	-

See accompanying Notes to Consolidated Financial Statements

Index

Consolidated Statements of Comprehensive Income

(Amounts in thousands)

(Unaudited)

	Three Months Ended March 31, 2013			Three Months Ended March 31, 2012


Net Income	$	464		$	414

Other Comprehensive Income
Unrealized gains (losses) on securities during the period		(142	)		579
Less: reclassification adjustment for (gains) losses included in net income		4			(3	)
Other Comprehensive Income, before tax		(138	)		576
Income tax expense (benefit) related to other comprehensive income		(45	)		196
Other Comprehensive Income (Loss)		(93	)		380
Comprehensive Income	$	371		$	794

See accompanying Notes to Consolidated Financial Statements

Index

Consolidated Statements of Cash Flows

(Amounts in thousands)

(Unaudited)

	Three Months Ended			Three Months Ended
	March 31, 2013			March 31, 2012
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income (loss)	$	464		$	414
Adjustments to reconcile net income (loss) to net cash provided by operating activities
Provision for loan losses		219			505
Depreciation and amortization		236			254
Net realized (gains) losses on available for sale securities		4			(3	)
Net amortization on securities		179			170
Other than temporary impairment charge		-			167
Amortization of Capital issue costs		1			1
Increase in interest receivable		(32	)		(16	)
Valuation adjustment of other real estate owned		61			-
Decrease in other assets		319			673
Increase (decrease) in interest, taxes and other liabilities		203			(294	)

Net cash provided by operating activities		1,654			1,871

CASH FLOWS FROM INVESTING ACTIVITIES:
Securities available for sale:
Proceeds from sale of securities		1,341			506
Proceeds from maturities of debt and equity securities		2,359			4,200
Purchase of debt and equity securities		(4,195	)		(1,650	)
Redemption of other investments		220			-
Net (increase) decrease in loans		(5,262	)		4,780
Proceeds from sales of other real estate owned		1,300			2,119
Premises and equipment expenditures		(91	)		(168	)

Net cash (used) provided by investing activities		(4,328	)		9,787

CASH FLOWS FROM FINANCING ACTIVITIES:
Net decrease in time deposits		(6,656	)		(22,671	)
Net increase in demand, savings and other deposits		11,508			13,320
Increase (decrease) in short-term borrowings		(6	)		1
Decrease in long-term debt		(40	)		(44	)

Net cash (used) provided by in financing activities		4,806			(9,394	)

Net increase in cash and cash equivalents		2,132			2,264
CASH AND CASH EQUIVALENTS AT BEGINNING OF YEAR		81,208			86,075

CASH AND CASH EQUIVALENTS AT END OF PERIOD	$	83,340		$	88,339

SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION
Cash paid during the year for:
Interest	$	1,504		$	1,973
Income taxes	$	-		$	-

SUPPLEMENTAL DISCLOSURE OF NONCASH TRANSACTIONS
Transfer of loans to other real estate owned	$	339		$	1,125
Loans originated from sales of other real estate owned	$	271		$	-

See accompanying Notes to Consolidated Financial Statements

Index

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, 2011		5,011	$	3,132	$	7,783	$	19,406	$	(2,059	)	$	28,262

Net income / (loss)		-		-		-		414		-			414

Other comprehensive income		-		-		-		-		380			380


Balance, March 31, 2012		5,011	$	3,132	$	7,783	$	19,820	$	(1,679	)	$	29,056

Balance, December 31, 2012		5,011	$	3,132	$	7,783	$	21,428	$	(1,871	)	$	30,472

Net income / (loss)		-		-		-		464		-			464

Other comprehensive income (loss)		-		-		-		-		(93	)		(93	)


Balance, March 31, 2013		5,011	$	3,132	$	7,783	$	21,892	$	(1,964	)	$	30,843

See accompanying Notes to Consolidated Financial Statements

Index

Notes to Consolidated Financial Statements

(Unaudited)

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

Note 1 - General

The consolidated financial statements of Highlands Bankshares, Inc. (the “Company”) conform to United States generally accepted accounting principles and to banking industry practices. The accompanying consolidated interim financial statements are unaudited. In the opinion of management, all adjustments necessary for a fair presentation of the consolidated financial statements have been included. All such adjustments are of a normal and recurring nature. The consolidated balance sheet as of December 31, 2012 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, 2012 (the “2012 Form 10-K”). The notes included herein should be read in conjunction with the notes to consolidated financial statements included in the 2012 Form 10-K. The results of operations for the three-month period ended March 31, 2013 are not necessarily indicative of the results to be expected for the full year.

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

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

The composition of net loans is as follows:

	March 31, 2013		December 31, 2012
Real Estate Secured:
Residential 1-4 family	$	168,238	$	167,777
Multifamily		18,030		17,348
Construction and Land Loans		19,479		19,161
Commercial, Owner Occupied		66,221		64,504
Commercial, Non-owner occupied		36,876		35,536
Second mortgages		8,811		9,298
Equity lines of credit		8,576		8,287
Farmland		12,522		11,180
		338,753		333,091

Secured (other) and unsecured
Personal		21,590		22,358
Commercial		31,636		31,927
Agricultural		3,541		3,372
		56,767		57,657

Overdrafts		219		297

		395,739		391,045
Less:
Allowance for loan losses		7,435		7,449
Net deferred fees		552		547
		7,987		7,996

Loans, net	$	387,752	$	383,049

Index

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 March 31, 2013:

	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	$	5,450	$	1,158	$	4,100	$	10,708	$	157,530	$	168,238	$	-
Equity lines of credit		-		-		271		271		8,305		8,576		-
Multifamily		-		-		-		-		18,030		18,030		-
Farmland		179		23		184		386		12,136		12,522		-
Construction, Land Development, Other Land Loans		556		25		1,942		2,523		16,956		19,479		-
Commercial Real Estate- Owner Occupied		2,540		311		2,888		5,739		60,482		66,221		-
Commercial Real Estate- Non Owner Occupied		391		535		1,873		2,799		34,077		36,876		-
Second Mortgages		335		5		206		546		8,265		8,811		-
Non Real Estate Secured
Personal		409		141		37		587		21,222		21,809		-
Business		289		69		744		1,102		30,534		31,636		-
Agricultural		2		-		-		2		3,539		3,541		-

Total	$	10,151	$	2,267	$	12,245	$	24,663	$	371,076	$	395,739	$	-

The following table is an analysis of past due loans as of December 31, 2012:

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

Real Estate Secured
Residential 1-4 family	$	4,894	$	956	$	4,029	$	9,879	$	157,898	$	167,777	$	-
Equity lines of credit		-		-		-		-		8,287		8,287		-
Multifamily		-		-		-		-		17,348		17,348		-
Farmland		133		28		129		290		10,890		11,180		-
Construction, Land Development, Other Land Loans		209		78		1,953		2,240		16,921		19,161		-
Commercial Real Estate- Owner Occupied		221		21		2,888		3,130		61,374		64,504		-
Commercial Real Estate- Non Owner Occupied		239		2,115		290		2,644		32,892		35,536		-
Second Mortgages		374		9		495		878		8,420		9,298		-
Non Real Estate Secured
Personal		307		155		56		518		22,137		22,655		6
Commercial		402		205		526		1,133		30,794		31,927		-
Agricultural		3		-		-		3		3,369		3,372		-

Total	$	6,782	$	3,567	$	10,366	$	20,715	$	370,330	$	391,045	$	6

Index

Notes to Consolidated Financial Statements

(Unaudited)

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

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

The following is a summary of non-accrual loans at March 31, 2013 and December 31, 2012:

	March 31, 2013		December 31, 2012
Real Estate Secured
Residential 1-4 Family	$	4,100	$	4,213
Multifamily		-		-
Construction and Land Loans		1,942		1,953
Commercial-Owner Occupied		2,888		2,888
Commercial- Non Owner Occupied		1,873		290
Second Mortgages		206		495
Equity Lines of Credit		271		-
Farmland		184		129
Secured (other) and Unsecured
Personal		37		50
Commercial		744		526
Agricultural		-		-

Total	$	12,245	$	10,544

Index

Notes to Consolidated Financial Statements

(Unaudited)

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

The following tables represent a summary of credit quality indicators of the Company’s loan portfolio at March 31, 2013 and December 31, 2012. 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 March 31, 2013

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

Quality		33,366		978		986		3,433		4,205		1,108
Satisfactory		81,795		12,672		4,617		6,468		25,787		15,719
Acceptable		36,308		3,093		6,414		6,251		20,668		10,484
Special Mention		2,945		883		8		1,613		5,562		4,567
Substandard		13,824		404		497		1,714		9,999		4,998
Doubtful		-		-		-		-		-		-

Total	$	168,238	$	18,030	$	12,522	$	19,479	$	66,221	$	36,876

Credit Risk Profile by Internally Assigned Grade as of December 31, 2012

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

Quality		34,201		994		1,001		3,768		5,016		1,168
Satisfactory		81,500		12,328		3,589		5,765		25,485		14,539
Acceptable		35,202		2,731		6,078		6,059		19,683		11,048
Special Mention		4,481		890		9		1,698		5,686		2,353
Substandard		12,393		405		503		1,871		8,634		6,428
Doubtful		-		-		-		-		-		-

Total	$	167,777	$	17,348	$	11,180	$	19,161	$	64,504	$	35,536

(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.

Index

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.

Index

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 March 31, 2013:

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

Performing	$	21,772	$	16,910	$	30,892	$	3,541
Nonperforming (>90 days past due)		37		477		744		-

Total	$	21,809	$	17,387	$	31,636	$	3,541

Credit Risk Profile based on payment activity as of December 31, 2012

	Consumer - Non Real Estate		Equity Line of Credit /Jr. liens		Commercial - Non Real Estate		Agricultural - Non Real Estate

Performing	$	22,599	$	17,090	$	31,401	$	3,372
Nonperforming (>90 days past due)		56		495		526		-

Total	$	22,655	$	17,585	$	31,927	$	3,372

Index

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 March 31, 2013:

	Recorded Investment		Unpaid Principal Balance		Related Allowance		Average Recorded Investment		Interest Income Recognized
With No Related Allowance
Real Estate Secured
Residential 1-4 family	$	5,977	$	5,977	$	-	$	6,268	$	42
Equity lines of credit		-		-		-		-		-
Multifamily		-		-		-		-		-
Farmland		295		295		-		297		3
Construction, Land Development, Other Land Loans		1,734		1,734		-		1,697		-
Commercial Real Estate- Owner Occupied		5,694		5,694		-		5,352		72
Commercial Real Estate- Non Owner Occupied		7,541		7,541		-		5,487		73
Second Mortgages		461		461		-		391		2
Non Real Estate Secured
Personal /Consumer		11		11		-		10		-
Business Commercial		141		141		-		105		1
Agricultural		20		20		-		20		-

Total	$	21,874	$	21,874	$	-	$	19,627	$	193

	Recorded Investment		Unpaid Principal Balance		Related Allowance		Average Recorded Investment		Interest Income Recognized
With an Allowance Recorded
Real Estate Secured
Residential 1-4 family	$	3,493	$	3,493	$	268	$	3,867	$	33
Equity lines of credit		-		-		-		-		-
Multifamily		-		-		-		203		-
Farmland		-		-		-		102		-
Construction, Land Development, Other Land Loans		104		104		64		52		-
Commercial Real Estate- Owner Occupied		2,698		2,698		323		2,698		-
Commercial Real Estate- Non Owner Occupied		3,801		3,801		814		3,398		4
Second Mortgages		199		199		33		100		-
Non Real Estate Secured
Personal /Consumer		82		82		66		52		1
Business Commercial		1,018		1,018		801		838		-
Agricultural		587		604		158		652		8

Total	$	11,982	$	11,982	$	2,527	$	11,962	$	46

Index

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, 2012:

	Recorded Investment		Unpaid Principal Balance		Related Allowance		Average Recorded Investment		Interest Income Recognized
12/31/12 With no Related Allowance
Real Estate Secured
Residential 1-4 family	$	6,559	$	6,559	$	-	$	7,797	$	237
Equity lines of credit		-		-		-		-		-
Multifamily		-		-		-		460		-
Farmland		299		299		-		291		15
Construction, Land Development, Other Land Loans		1,660		1,730		-		2,074		40
Commercial Real Estate- Owner Occupied		5,010		5,010		-		7,083		138
Commercial Real Estate- Non Owner Occupied		3,432		3,432		-		4,146		136
Second Mortgages		321		321		-		456		14
Non Real Estate Secured
Personal		9		9		-		20		1
Commercial		68		68		-		1,257		5
Agricultural		20		20		-		10		1

Total	$	17,378	$	17,448	$	-	$	23,594	$	587

	Recorded Investment		Unpaid Principal Balance		Related Allowance		Average Recorded Investment		Interest Income Recognized
12/31/12 With an Allowance Recorded
Real Estate Secured
Residential 1-4 family	$	4,486	$	4,486	$	491	$	4,146	$	165
Equity lines of credit		-		-		-		-		-
Multifamily		405		405		5		526		17
Farmland		203		203		2		255		13
Construction, Land Development, Other Land Loans		-		-		-		1,269		-
Commercial Real Estate- Owner Occupied		2,698		2,698		369		2,342		15
Commercial Real Estate- Non Owner Occupied		2,995		2,995		494		3,739		88
Second Mortgages		-		-		-		54		-
Non Real Estate Secured
Personal		22		22		1		48		2
Commercial		658		658		585		757		15
Agricultural		716		735		232		358		68

Total	$	12,183	$	12,202	$	2,179	$	13,494	$	383

Index

Notes to Consolidated Financial Statements

(Unaudited)

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

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

evaluation method as of March 31, 2013 and March 31, 2012.

Three months ended March 31, 2013	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, 2012	$	1,242		$	280	$	823		$	1,039		$	1,075	$	161	$	30	$	97	$	486	$	1,530	$	686			7,449
Provision for Credit Losses		(212	)		-		(130	)		(45	)		279		34		1		12		134		261		(115	)		219
Charge-offs		33			-		31			-			-		11		-		-		88		101		-			264
Recoveries		4			-		1			-			-		-		-		-		19		7		-			31
Net Charge-offs		29			-		30			-			-		11		-		-		69		94		-			233
Ending Balance March 31, 2013		1,001			280		663			994			1,354		184		31		109		551		1,697		571			7,435
Ending Balance: Individually evaluated for impairment		268			-		64			323			814		33		-		-		66		959		-			2,527
Ending Balance: Collectively Evaluated for Impairment		733			280		599			671			540		151		31		109		485		738		571			4,908
Loans:
Ending Balance: Individually Evaluated for Impairment		9,470			-		1,838			8,392			11,342		660		-		295		93		1,766		-			33,856
Ending Balance: Collectively Evaluated for Impairment		158,768			18,030		17,641			57,829			25,534		8,151		8,576		12,227		21,716		33,411		-			361,883
Ending Balance: March 31, 2013	$	168,238		$	18,030	$	19,479		$	66,221		$	36,876	$	8,811	$	8,576	$	12,522	$	21,809	$	35,177		-		$	395,739

Index

Notes to Consolidated Financial Statements

(Unaudited)

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

Three months ended March 31, 2012	Residential 1-4 Family			Multifamily		Construction and Land Loans			Commercial Owner Occupied		Commercial Non-Owner Occupied			Second Mortgages			Equity Line of Credit			Farmland			Personal and Overdrafts		Commercial and Agricultural			Unallocated		Total
Allowance for Credit Losses:
Beginning Balance December 31, 2011	$	1,618		$	477	$	1,746		$	1,209	$	400		$	371		$	69		$	336		$	764	$	1,620		$	414		9,024
Provision for Credit Losses		(257	)		194		(376	)		3		(76	)		(24	)		(18	)		(74	)		1		(122	)		1,254		505
Charge-offs		167			246		103			69		59			37			-			4			146		5			-		836
Recoveries		94			-		114			-		-			1			-			-			23		3			-		235
Net Charge-offs		73			246		(11	)		69		59			36			-			4			123		2			-		601
Ending Balance March 31, 2012		1,288			425		1,381			1,143		265			311			51			258			642		1,496			1,668		8,928
Ending Balance: Individually evaluated for impairment		373			-		345			439		188			8			-			5			5		732			-		2,095
Ending Balance: Collectively Evaluated for Impairment		915			425		1,036			704		77			303			51			253			637		764			1,668		6,833
Loans:
Ending Balance: Individually Evaluated for Impairment		16,798			1,324		1,194			13,966		10,772			357			-			656			126		2,318			-		47,511
Ending Balance: Collectively Evaluated for Impairment		152,039			15,523		18,564			54,115		26,899			10,888			8,793			11,620			23,018		32,871			-		354,330
Ending Balance: March 31, 2012	$	168,837		$	16,847	$	19,758		$	68,081	$	37,671		$	11,245		$	8,793		$	12,276		$	23,144	$	35,189			-	$	401,841

Index

Notes to Consolidated Financial Statements

(Unaudited)

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

A loan is considered impaired and an allowance for loan losses is established on loans for which it is probable that the full collection of principal and interest 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 March 31, 2013 and December 31, 2012, all of the total impaired loans were evaluated based on the fair value of the collateral. On a quarterly basis, the ALLL methodology begins with the determination of individually impaired loans. All loans that are rated “7” (Doubtful) are assessed as impaired based on the expectation that the full collection of principal and interest is in doubt. All loans that are rated “6” (Substandard) or are expected to be downgraded to “6”, require additional analysis 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 warrant further analysis before completing an assessment of 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 $17.09 million and $21.61 million of loans categorized as troubled debt restructurings as of March 31, 2013 and December 31, 2012, 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 probable.

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

The following tables summarize the troubled debt restructurings during the three months ended March 31, 2013 and 2012.

Index

Notes to Consolidated Financial Statements

(Unaudited)

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

Troubled Debt Restructurings –Three months ended March 31, 2013

Interest only

Number of Contracts

Pre- Modification Outstanding Recorded Investment

Post - Modification Recorded Investment

Real Estate Secured

Residential 1-4 family

Equity lines of credit

Multifamily

Farmland

Construction, Land Development, Other Land Loans

Commercial Real Estate- Owner Occupied

Commercial Real Estate- Non Owner Occupied

Second Mortgages

Non Real Estate Secured

Personal / Consumer

Business Commercial

Agricultural

Total

Troubled Debt Restructurings Below Market Rate	Number of Contracts		Pre- Modification Outstanding Recorded Investment		Post - Modification Recorded Investment
Real Estate Secured
Residential 1-4 family		1		875		874
Equity lines of credit		-		-		-
Multifamily		-		-		-
Farmland		-		-		-
Construction, Land Development, Other Land Loans		-		-		-
Commercial Real Estate- Owner Occupied		-		-		-
Commercial Real Estate- Non Owner Occupied		2		6,507		6,504
Second Mortgages		-		-		-
Non Real Estate Secured
Personal / Consumer		-		-		-
Business Commercial		-		-		-
Agricultural		-		-		-

Total		3		7,382		7,378

Index

Notes to Consolidated Financial Statements

(Unaudited)

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

Troubled Debt Restructurings Loan term extension	Number of Contracts		Pre- Modification Outstanding Recorded Investment		Post - Modification Recorded Investment
Real Estate Secured
Residential 1-4 family		2		308		308
Equity lines of credit		-		-		-
Multifamily		-		-		-
Farmland		-		-		-
Construction, Land Development, Other Land Loans		-		-		-
Commercial Real Estate- Owner Occupied		-		-		-
Commercial Real Estate- Non Owner Occupied		-		-		-
Second Mortgages		-		-		-
Non Real Estate Secured
Personal / Consumer		-		-		-
Business Commercial		1		71		71
Agricultural		1		129		129

Total		4		508		508

Troubled Debt Restructurings

All

Number of Contracts

Pre- Modification Outstanding Recorded Investment

Post - Modification Recorded Investment

Total Restructurings

7,890

7,886

Troubled Debt Restructurings

That subsequently defaulted

Number of Contracts

Pre- Modification Outstanding Recorded Investment

Post - Modification Recorded Investment

Real Estate Secured

Residential 1-4 family

Equity lines of credit

Multifamily

Farmland

Construction, Land Development, Other Land Loans

Commercial Real Estate- Owner Occupied

Commercial Real Estate- Non Owner Occupied

Second Mortgages

Non Real Estate Secured

Personal / Consumer

Business Commercial

Agricultural

Total

Index

Notes to Consolidated Financial Statements

(Unaudited)

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

Troubled Debt Restructurings – Three months ended March 31, 2012 Interest only	Number of Contracts		Pre- Modification Outstanding Recorded Investment		Post - Modification Recorded Investment
Real Estate Secured
Residential 1-4 family		1		729		729
Equity lines of credit		-		-		-
Multifamily		-		-		-
Farmland		-		-		-
Construction, Land Development, Other Land Loans		-		-		-
Commercial Real Estate- Owner Occupied		-		-		-
Commercial Real Estate- Non Owner Occupied		-		-		-
Second Mortgages		1		84		84
Non Real Estate Secured
Personal / Consumer		-		-		-
Business Commercial		-		-		-
Agricultural		-		-		-

Total		2		813		813

Troubled Debt Restructurings

Below Market Rate

Number of Contracts

Pre- Modification Outstanding Recorded Investment

Post - Modification Recorded Investment

Real Estate Secured

Residential 1-4 family

Equity lines of credit

Multifamily

Farmland

Construction, Land Development, Other Land Loans

Commercial Real Estate- Owner Occupied

Commercial Real Estate- Non Owner Occupied

Second Mortgages

Non Real Estate Secured

Personal / Consumer

Business Commercial

Agricultural

Total

Index

Notes to Consolidated Financial Statements

(Unaudited)

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

Troubled Debt Restructurings Loan term extension	Number of Contracts		Pre- Modification Outstanding Recorded Investment		Post - Modification Recorded Investment
Real Estate Secured
Residential 1-4 family		1		885		885
Equity lines of credit		-		-		-
Multifamily		1		410		410
Farmland		-		-		-
Construction, Land Development, Other Land Loans		-		-		-
Commercial Real Estate- Owner Occupied		2		3,002		3,002
Commercial Real Estate- Non Owner Occupied		2		5,949		5,949
Second Mortgages		-		-		-
Non Real Estate Secured
Personal / Consumer		-		-		-
Business Commercial		1		992		992
Agricultural		-		-		-

Total		7		11,238		11,238

Troubled Debt Restructurings

All

Number of Contracts

Pre- Modification Outstanding Recorded Investment

Post - Modification Recorded Investment

Total Restructurings

12,051

Troubled Debt Restructurings That subsequently defaulted	Number of Contracts		Pre- Modification Outstanding Recorded Investment		Post - Modification Recorded Investment
Real Estate Secured
Residential 1-4 family (interest only)		1		729		729
Equity lines of credit		-		-		-
Multifamily		-		-		-
Farmland		-		-		-
Construction, Land Development, Other Land Loans		-		-		-
Commercial Real Estate- Owner Occupied		-		-		-
Commercial Real Estate- Non Owner Occupied (loan term extension)		1		1,595		1,595
Second Mortgages (interest only)		1		84		84
Non Real Estate Secured
Personal / Consumer		-		-		-
Business Commercial		-		-		-
Agricultural		-		-		-

Total		3		2,408		2,408

Index

Notes to Consolidated Financial Statements

(Unaudited)

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

Overview of Loan Review and ALLL Processes

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

The segments of the Company’s loan portfolio are disaggregated to a level that allows management to monitor risk and performance. In reviewing risk, management has determined there to be several different risk categories within the loan portfolio. The allowance for loan losses consists of amounts applicable to: (i) the commercial loan portfolio; (ii) the commercial real estate loan portfolio; (iii) the construction loan portfolio; (iv) the consumer loan portfolio; and, (v) the residential loan portfolio. The commercial real estate (“CRE”) loan segment is further disaggregated into two classes. Non-owner occupied CRE loans, which include loans secured by non-owner occupied nonfarm nonresidential properties, generally have a greater risk profile than all other CRE loans, which include multifamily structures and owner-occupied commercial structures. The construction loan segment is further disaggregated into two classes. One-to-four family residential construction loans are generally made to individuals for the acquisition of and/or construction on a lot or lots on which a residential dwelling is to be built. Commercial construction loans are generally made to developers or investors for the purpose of acquiring, developing and constructing residential or commercial structures. Construction lending is generally considered to involve a higher degree of credit risk than long-term permanent financing.

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

On a quarterly basis, the ALLL methodology begins with the identification of loans subject to ASC 310. All loans that are rated “7” (Doubtful) are assessed as impaired based on the expectation that the full collection of principal and interest is in doubt. All loans that are rated “6” (Substandard) or are expected to be downgraded to “6”, require additional analysis to determine whether they may be impaired under ASC 310. All loans that are rated “5” (Special Mention) are presumed not to be impaired. However, “5” rated loans may warrant further analysis before completing an assessment of impairment.

Index

Notes to Consolidated Financial Statements

(Unaudited)

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

For ASC 310 loans that are individually evaluated and found to be impaired (primarily those designated as Substandard and Doubtful), the associated ALLL will be based upon one of the three impairment measurement methods specified within ASC 310:

(1)

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

(2)

Loan’s observable market price; or

(3)

Fair value of the collateral.

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

ASC 450 Loan Loss:

For all other loans, including individual loans determined not to be impaired under ASC 310, the associated ALLL is calculated in accordance with ASC 450 that provides for estimated credit losses likely to be realized on groups of loans with similar risk characteristics. The Bank uses standard call report categories to segregate loans into groups with similar risk characteristics. Estimated credit losses reflect significant factors that affect the collectability of the portfolio as of the evaluation date. Key factors that influence risk within the Bank’s loan portfolio are divided into three major categories:

(1)

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

(2)

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

National GDP Growth Rate

Local Unemployment Rates

The Prime Rate

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

(3)

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

Past-Due Loans.

Non-Accrual Loans

CRE Concentrations

Loan Volume Level

Level and Trend of Classified Loans

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

We maintain an unallocated component to cover uncertainties that could affect management’s estimate of probable losses. The unallocated component of the allowance reflects the margin of imprecision inherent in the underlying assumptions used in the methodologies for estimating specific and general losses in the portfolio. Once the quarterly ALLL is computed, the calculations are reviewed by the Company’s credit administration committee which is comprised of the CEO, CFO, and Senior Lending Officers, including Credit Review personnel. The Company’s controller also performs a detailed review of the computations, estimates, etc. included in the ALLL calculation. The ALLL is then reviewed and approved by the Board of Directors.

Index

Notes to Consolidated Financial Statements

(Unaudited)

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

Note 3 - Income Taxes

Income tax expense (benefit) for the three months ended March 31 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:

	2013			2012

Tax expense (benefit) at statutory rate	$	198		$	160
Reduction in taxes from:
Tax-exempt interest		(48	)		(68	)
Other, net		(34	)		(36	)

Income tax expense (benefit)	$	116		$	56

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.

March 31, 2013
Entity	Tier 1			Total Risk Based			Leverage

Highlands Bankshares, Inc.		7.97	%		9.22	%		5.25	%

Highlands Union Bank		8.94	%		10.19	%		5.90	%

December 31, 2012
Entity	Tier 1			Total Risk Based			Leverage

Highlands Bankshares, Inc.		7.85	%		9.11	%		5.18	%

Highlands Union Bank		8.79	%		10.05	%		5.80	%

Index

Notes to Consolidated Financial Statements

(Unaudited)

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

Note 5 - Capital Securities

The Company completed a $7.5 million capital issue of 9.25% 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. Effective April 15, 2010, the Company began deferring interest payments on the debt securities held by Highlands Capital Trust I. As a result, distribution payments to holders of the Capital Securities are also being deferred. The deferral period can last up to 5 years.

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 three months ended March 31, 2013 and March 31, 2012.

	Basic EPS		Weighted Average Number of Shares		Diluted EPS		Weighted Average Number of Shares
Quarter Ended:
March 31, 2013	$	0.09		5,011,152	$	0.09		5,011,152
March 31, 2012	$	0.08		5,011,152	$	0.08		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 March 31, 2013, these commitments included: standby letters of credit of $522 thousand; equity lines of credit of $8.80 million; credit card lines of credit of $6.01 million; commercial real estate, construction and land development commitments of $1.82 million; and other unused commitments to fund interest earning assets of $26.72 million.

Index

Notes to Consolidated Financial Statements

(Unaudited)

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

Note 8 – Fair Value

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

Fair Value Hierarchy

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

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

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

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

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

Index

Notes to Consolidated Financial Statements

(Unaudited)

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

Recurring - Investment Securities Available for Sale

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

As of March 31, 2013, we own approximately $3.86 million (amortized cost) in collateralized debt obligation securities (TRUP CDOs) that are backed by trust preferred securities issued by banks, thrifts, and insurance companies. The market for these and similar securities at March 31, 2013 is not active. The TRUP CDOs have been classified within Level 3 of the fair value hierarchy because we determined that significant adjustments are required for fair value assessment at the measurement date.

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

The following tables summarize the Company’s available for sale securities portfolio measured at fair value on a recurring basis as of March 31, 2013 and December 31, 2012, segregated by the level of the valuation inputs within the fair value hierarchy.

	March 31, 2013
	Level 1		Level 2		Level 3		Total Fair Value
Available for Sale Securities
State and Political Subdivisions	$	-	$	11,391	$	-	$	11,391
Mortgage Backed Securities	$	-	$	28,655	$	-	$	28,655
TRUP CDO’s	$	-	$	-	$	335	$	335
Single Issue Trust Preferred	$	-	$	891	$	-	$	891
SBA Pools	$	-	$	15,798	$	-	$	15,798
SLMA	$	-	$	503	$	-	$	503
Total AFS Securities	$	-	$	57,238	$	335	$	57,573

	December 31, 2012
	Level 1		Level 2		Level 3		Total Fair Value
Available for Sale Securities
State and Political Subdivisions	$	-	$	11,985	$	-	$	11,985
Mortgage Backed Securities	$	-	$	27,642	$	-	$	27,642
TRUP CDO’s	$	-	$	-	$	294	$	294
Single Issue Trust Preferred	$	-	$	886	$	-	$	886
SBA Pools	$	-	$	16,091	$	-	$	16,091
SLMA	$	-	$	502	$	-	$	502
Total AFS Securities	$	-	$	57,106	$	294	$	57,400

Index

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 March 31, 2013 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, 2012	$	294
Total losses included in net income		-
Included in other comprehensive income		41
Transfers in or out of Level 3		-
Ending balance, March 31, 2013	$	335

Loans

The Company does not record loans at fair value on a recurring basis. However, from time to time, a loan is considered impaired and an allowance for loan losses is established. Loans for which it is probable that payment of interest and principal will not be made in accordance with the contractual terms of the loan agreement are considered impaired. Once a loan is identified as individually impaired, management measures impairment using one of several methods, including collateral value, recent appraisal value and /or tax assessed value, liquidation value and discounted cash flows. At March 31, 2013 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 March 31, 2013 and December 31, 2012, segregated by the level of the valuation inputs within the fair value hierarchy for which a specific allowance has been allocated.

	March 31, 2013
	Level 1	Level 2		Level 3	Total Fair Value
Real Estate Secured
Residential 1-4 family		$	3,493		$	3,493
Farmland			-			-
Construction, Land Development, Other Land Loans			104			104
Commercial Real Estate – Owner Occupied			2,698			2,698
Commercial Real Estate – Non Owner Occupied			3,801			3,801
Second Mortgages			199			199
Non Real Estate Secured
Personal			82			82
Business / Commercial			1,018			1,018
Agricultural			587			587
Total		$	11,982		$	11,982

Index

Notes to Consolidated Financial Statements

(Unaudited)

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

	December 31, 2012
	Level 1	Level 2		Level 3	Total Fair Value
Real Estate Secured
Residential 1-4 family		$	4,486		$	4,486
Multifamily			405			405
Farmland			203			203
Construction, Land Development, Other Land Loans			-			-
Commercial Real Estate – Owner Occupied			2,698			2,698
Commercial Real Estate – Non Owner Occupied			2,995			2,995
Second Mortgages			-			-
Non Real Estate Secured
Personal			22			22
Business / Commercial			1,374			1,374
Total		$	12,183		$	12,183

Foreclosed Assets / Repossessions

Foreclosed assets and repossessions are adjusted to fair value upon transfer of the loans to foreclosed assets and repossessions. Subsequently, foreclosed assets and repossessions are carried at the lower of carrying value or fair value. Fair value is based upon independent market prices or appraised values of the collateral which the Company considers as nonrecurring Level 2. If additional specific write-downs have occurred, then the foreclosed asset balances are reclassified as non-recurring Level 3. The following tables summarize the Company’s foreclosed and repossessed assets at fair value on a non-recurring basis as of March 31, 2013 and December 31, 2012

	March 31, 2013
	Level 1		Level 2		Level 3		Total Fair Value
Repossessions/OREO, net		--	$	15,617		--	$	15,617

	December 31, 2012
	Level 1		Level 2		Level 3		Total Fair Value
Repossessions/OREO, net		--	$	16,661		--	$	16,661

Index

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 recurring or non-recurring basis.

Fair Value of Financial Instruments

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

Cash and Cash Equivalents

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

Securities Available for Sale

Fair values are determined in the manner as described above.

Other Investments

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

Loans

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

Deposits

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

Other Short-Term Borrowings

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

Index

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 March 31, 2013 and December 31, 2012 were as follows:

	March 31, 2013						December 31, 2012
	Carrying Amount			Fair Value			Carrying Amount			Fair Value
	Carrying Amount			Fair Value			Carrying Amount			Fair Value

Cash and cash equivalents	$	83,340		$	83,340		$	81,208		$	81,208
Securities available for sale		57,573			57,573			57,400			57,400
Other investments		4,710			4,710			4,930			4,930
Loans, net		387,752			387,120			383,049			383,173
Deposits		(490,192	)		(481,496	)		(485,340	)		(480,424	)
Other short-term borrowings		(20,164	)		(22,904	)		(20,170	)		(23,072	)
Long-term debt		(51,258	)		(56,608	)		(51,298	)		(57,145	)
Capital Securities		(3,150	)		(3,542	)		(3,150	)		(3,542	)

Index

Notes to Consolidated Financial Statements

(Unaudited)

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

Note 9. -Investment Securities Available For Sale

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

	March 31, 2013
	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses		Fair Value
	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses		Fair Value


State and political subdivisions	$	11,177		244		30	$	11,391
Mortgage backed securities		28,270		482		97		28,655
TRUP CDOs		3,864		-		3,529		335
Single Issue Trust Preferred		908		-		17		891
SBA Pools		15,827		26		55		15,798
SLMA		500		3		-		503
	$	60,546	$	755	$	3,728	$	57,573

	December 31, 2012
	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses		Fair Value
	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses		Fair Value


State and political subdivisions	$	11,708		302		25	$	11,985
Mortgage backed securities		27,120		531		9		27,642
TRUP CDOs		3,879		-		3,585		294
Single Issue Trust Preferred		908		-		22		886
SBA Pools		16,119		34		62		16,091
SLMA		500		2		-		502
	$	60,234	$	869	$	3,703	$	57,400

Investment securities available for sale with a carrying value of $39,520 and $41,994 at March 31, 2013 and December 31, 2012, respectively, and a market value of $40,113 and $42,718 at March 31, 2013 and December 31, 2012, respectively, were pledged as collateral on public deposits, FHLB advances and for other purposes as required or permitted by law.

Index

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:

	March 31, 2013
	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	$	987	$	30	$	-	$	-	$	987	$	30
Mortgage-backed securities		4,559		97		-		-		4,559		97
Pooled Trust Preferred Securities		-		-		335		3,529		335		3,529
Single Issue Trust Preferred		-		-		891		17		891		17
SBA Pools		7,452		44		2,107		11		9,559		55
SLMA		-		-		-		-		-		-

Total	$	12,998	$	171	$	3,333	$	3,557	$	16,331	$	3,728

	December 31, 2012
	Less Than 12 months				12 Months or More				Total
	Fair Value		Unrealized Losses		Fair Value		Unrealized Losses		Fair Value		Unrealized Losses

State and political subdivisions	$	1,352	$	25	$	-	$	-	$	1,352	$	25
Mortgage-backed securities		496		9		-		-		496		9
Pooled Trust Preferred Securities		-		-		294		3,585		294		3,585
Single Issue Trust Preferred		-		-		886		22		886		22
SBA Pools		9,073		59		1,707		3		10,780		62
SLMA		-		-		-		-		-		-

Total	$	10,921	$	93	$	2,887	$	3,610	$	13,808	$	3,703

Index

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 March 31, 2013, our TRUP CDOs book value totaled $3.86 million.

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

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

At March 31, 2013, the following assumptions were used in the cash flow projections:

·	Deferral / default ranges for 2013 – 1.00%.

·	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.

·	0% recovery on existing defaults

·	Cash flows are discounted at the effective interest rate.

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

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

Index

Notes to Consolidated Financial Statements

(Unaudited)

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

During the first quarter of 2013, the Company did not incur any credit-related OTTI charges on our TRUP CDOs. For the three months ended March 31, 2012, the Company incurred a total of $167 thousand of OTTI charges.

The Company also assesses other securities for OTTI quarterly by reviewing credit ratings, financial and regulatory reports as well as other pertinent published financial data. As of March 31, 2013 and December 31, 2012, 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 March 31, 2013 by contractual maturity are shown below. Expected maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.

	Amortized Cost		Approximate Market Value
Due in one year or less	$	-	$	-
Due after one year through five years		610		613
Due after five years through ten years		3,980		4,006
Due after ten years		27,686		24,299
		32,276		28,918

Mortgage-backed securities		28,270		28,655
	$	60,546	$	57,573

Note 10–Formal Written Agreement

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

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

strengthen credit risk management and administration;

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

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

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

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

maintain sufficient capital at the Company and the Bank;

establish a revised written contingency funding plan;

establish a revised written strategic and capital plan;

establish a revised investment policy;

improve the Bank’s earnings and overall condition;

revise the Bank’s information technology program;

establish a disaster recovery and business continuity program; and,

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

Index

Notes to Consolidated Financial Statements

(Unaudited)

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

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

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

Update No. 2013-02 -- Comprehensive Income (Topic 220): The update was issued to improve the reporting of reclassifications out of accumulated other comprehensive income. The amendments require an entity to provide information about the amounts reclassified out of accumulated other comprehensive income by component. In addition, an entity is required to present, either on the face of the statement where net income is presented or in the notes, significant amounts reclassified out of accumulated other comprehensive income by the respective line items of net income but only if the amount reclassified is required under U.S. GAAP to be reclassified to net income in its entirety in the same reporting period. For other amounts that are not required under U.S. GAAP to be reclassified in their entirety to net income, an entity is required to cross-reference to other disclosures required under U.S. GAAP that provide additional detail. The amendments do not change the current requirements for reporting net income or other comprehensive income in financial statements. For public entities, the amendments are effective prospectively for reporting periods beginning after December 15, 2012. Early adoption is permitted.

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.

Index

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, 2012.

Regulatory Economic Environment

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

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

Formal Written Agreement

As discussed in Footnote 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;

Index

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; and,

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

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

The following summarizes the Company’s progress to comply with the items in the Written Agreement as of March 31, 2013.

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. These are reviewed with the Board and forwarded to the Federal Reserve Bank on a quarterly basis;

Completed revising the written contingency funding plan;

Implemented stress testing of the loan portfolio;

Completed revising the investment policy;

Completed a three year capital plan targeted to improve the Company’s and Bank’s capital levels to include strategically reducing the risk weighted assets of the Company and improvement in earnings;

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

Formed a Directors’ compliance committee to monitor the progress of each item in the written agreement. The committee meets at least quarterly and files a report with the Federal Reserve Bank.

Results of Operations

Results of operations for the three-month periods ended March 31, 2013 and March 31, 2012 reflected net income of $464 thousand and $414 thousand, respectively. For the first three months of 2013, provisions for loan loss reserves decreased $286 thousand over the corresponding period in 2012 as the Company’s non-performing loans have decreased over the past 12 months.

Net interest income for the three-month period ended March 31, 2012 increased $32 thousand or .75% compared to the three months ended March 31, 2012, due to the rate on interest – bearing liabilities decreasing more than the yield on interest – earning assets.. Average interest-earning assets decreased $20.18 million from the three - month period ended March 31, 2012 to the current three-month period, while average interest-bearing liabilities decreased $32.55 million over the same period. The tax-equivalent yield on average interest-earning assets was 4.52% for the three-month period ended March 31, 2013 representing a decrease of 30 basis points from the same period in 2012. The Company has also reduced its non-accrual loans over the past year. The average balance of federal funds sold during the quarter was $67.47 million as a result of significant reductions in the loan portfolio. The average rate on federal funds sold was .23% during the quarter. The rate on average interest-bearing liabilities decreased 44 basis points to 1.31% for the three month period ended March 31, 2013 as compared to 1.75% for the same period in 2012.

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Total interest income for the three months ended March 31, 2013 was $610 thousand less than the comparable 2012 period due primarily to a reduction in loan 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 maintained a significant amount of cash and cash equivalents during 2012 and 2013.

The Company’s total interest expense decreased by $642 thousand for the three months ended March 31, 2013 as compared to the same period in 2012 due primarily to a reduction in time deposits and also due to new interest-bearing deposits recorded at lower rates and existing interest-bearing deposits re-pricing lower as they mature or re-price.

During the first three months of 2012, the Company’s non-interest income increased by $8 thousand over the corresponding period for 2012. OTTI write-downs for the first three months of 2013 were $0 compared to $167 thousand for the first three months of 2012. Other service charges, commissions and fees decreased by $97 thousand over the corresponding period in 2012.

Total non-interest expense for the three-month period ended March 31, 2013 increased $216 thousand over the comparable period in 2012. OREO expenses, write-downs, and losses on the sale of OREO and repossessions in the amount of $218 thousand decreased $11 thousand for the three month period ended March 31, 2013 as compared to the prior period. Salaries and employee benefits increased $136 thousand for the three months ended March 31, 2012 as compared to the prior year period primarily due to increased health and medical costs.

For the three months ended March 31, 2013, other operating expenses that exceeded 1% of total interest income and other operating income were FDIC premiums totaling $330 thousand, charges for other contracted services totaling $151 thousand, software licensing and maintenance costs totaling $196 thousand, legal expenses totaling $88 thousand, bank stock taxes totaling $75 thousand, and postage and freight charges totaling $95 thousand.

For the three months ended March 31, 2012, other operating expenses that exceeded 1% of total interest income and other operating income were FDIC premiums totaling $340 thousand, charges for other contracted services totaling $251 thousand, software licensing and maintenance costs totaling $184 thousand, and postage and freight charges totaling $69 thousand.

Operating results of the Company when measured as a percentage of average equity reveals an increase in return on average equity to 6.05% for the three-month period ended March 31, 2013 from 5.78% for the corresponding period in 2012. Return on average assets for the three months ended March 31, 2013 was 0.31% compared to 0.27% for the three months ended March 31, 2012.The provision for loan losses for the three-month period ended March 31, 2013 totaled $219 thousand, a $286 thousand decrease as compared to the corresponding period in 2012. This decreased provision was due to the improvement in the Company’s asset quality over the past 12 months, reduced charge-offs, and the continued reduction in the loan portfolio. 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 three months of 2013 were $233 thousand compared with $601 thousand for the first three months of 2012. Year–to–date net charge-offs were 0.06% and 0.15% of total loans for the periods ended March 31, 2013 and March 31, 2012, respectively. Loan loss reserves decreased 16.72% to $7.44 million at March 31, 2013 from March 31, 2012. The Company’s allowance for loan loss reserves at March 31, 2013 decreased to 1.88% of total loans versus 2.22% at March 31, 2012. At December 31, 2012, the allowance for loan loss reserve as a percentage of total loans was 1.91%.

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Financial Position

Total loans, net of deferred fees, decreased from $401.30 million at March 31, 2012 to $395.19 million at March 31, 2013. Total loans, net of fees, at December 31, 2012 were $390.50 million. Over the last few years, the Company has significantly reduced its construction loan and other land loan balances due to the economic downturn. Through the end of 2012, the Company has also been reducing its overall commercial real estate loan portfolio in an effort to increase its risk based capital ratios. The loan to deposit ratio increased from 79.31% at March 31, 2012 to 80.62% at March 31, 2013. The loan to deposit ratio at December 31, 2012 was 80.45%. Deposits at March 31, 2013 have decreased $15.82 million since March 31, 2012 but have increased $4.85 million since December 31, 2012. 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. Since March 31, 2012, interest bearing deposits (primarily time deposits) have decreased $15.13 million while non-interest bearing deposits have only decreased $684 thousand.

The Company also owns approximately $3.86 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 March 31, 2013 is not active and markets for similar securities are also not active. These securities are currently in non-accrual status. As of March 31, 2013, the unrealized loss in these securities totaled $3.53 million. Management feels that these losses are temporary and primarily a result of the current inactive market. The market discounts reflect the current illiquidity and the negative credit events within the banking sector. A deterioration of profits of banks nationally and the possibility of increased bank failures could result in changes in the Company’s outlook for these securities and require the Company to record additional OTTI charges on these securities. During the three months ended March 31, 2013, the Company did not incur any OTTI credit related impairment charges on its TRUP CDOs compared to $167 thousand during the three months ended March 31, 2012.

Below is a table of the Company’s remaining pooled trust preferred balances as of March 31, 2013.

(in thousands)

Description	Type	Class	Original Amount $		Book Value 3/31/13 $		Fair Value 3/31/13 $		Unrealized Gain/(Loss) $			Lowest Credit Rating

Pretsel 4-B	Pooled	Mezz B		700		85		68		(17	)	Ca
Prestel 11-B	Pooled	Mezz B		500		387		58		( 329	)	Ca
Prestel 12-B	Pooled	Mezz B		750		370		91		( 279	)	Ca
Prestel 13-B	Pooled	Mezz B		500		326		10		( 316	)	Ca
Prestel 15-B	Pooled	Mezz B		500		263		9		( 254	)	Ca
Prestel 18-C	Pooled	Mezz C		500		209		1		(208	)	Ca
Prestel 19-C	Pooled	Mezz C		500		255		1		( 254	)	Ca
Prestel 20-C	Pooled	Mezz C		500		11		1		( 10	)	Ca
Prestel 21-C	Pooled	Mezz C		500		294		13		(281	)	Ca
Prestel 22-C	Pooled	Mezz C		500		283		6		(277	)	Ca
Prestel 22-C	Pooled	Mezz C		500		317		6		( 311	)	Ca
Prestel 22-C	Pooled	Mezz C		500		316		6		(310	)	Ca
Prestel 23-C	Pooled	Mezz C		500		442		25		(417	)	C
Tropc CDO III	Pooled	Subordinate		1,000,000		306		40		(266	)	C

The Company currently has approximately $67.89 million in outstanding FHLB advances. No new advances were originated during the last 12 months. The Company secures all of its existing and future advances from the FHLB with a selected group of in-house residential and commercial real estate secured loans and a selected group of securities that are held in safekeeping by the FHLB.

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 is included. Non-performing assets were $28.20 million or 4.71% of total assets at March 31, 2013, compared with $27.50 million or 4.64% of total assets at December 31, 2012 and $30.19 million or 4.93% of total assets at March 31, 2012. The Company continues to focus its efforts on reducing its NPAs, primarily by reducing non accrual loans and selling OREO property.

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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 loan 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. The calculation for allowance for loan losses is reviewed by both the Credit Administration Committee and the Board of Directors.

At March 31, 2013 and December 31, 2012, 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 U.S. Generally Accepted Accounting Principles.

At March 31, 2013, OREO balances were $15,889 and consisted of 54 relationships. The following chart details each category type, number, and balance.

OREO Property at 3/31/13

OREO Description	Number		Balance at 3/31/13
			(in thousands)
Land Development - Vacant Land		22	$	4,175
1-4 Family		17		4,413
Multifamily		2		2,417
Commercial Real Estate		13		4,884

Total		54	$	15,889

At December, 2012, OREO balances were $17,139 and consisted of 54 relationships. The following chart details each category type, number, and balance.

OREO Property at 12/31/2012

OREO Description	Number		Balance at 12/31/12
			(in thousands)
Land Development - Vacant Land		21	$	4,208
1-4 Family		17		4,593
Multifamily		2		2,718
Commercial Real Estate		14		5,620

Total		54	$	17,139

One multifamily property, totaling $1,727, located outside the Sevierville, Tennessee area contains eighteen units. Another large relationship totals $1,604 and is a tract of land of developed lots and three completed condos also in the Sevierville, Tennessee market area. There has been greater deterioration in the Tennessee commercial real estate market compared to many other markets we serve. The Bank is actively marketing all of its property through its website, listing agents, and other marketing methods. The Company has 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.

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For each of the years ended December 31, 2012 and 2011, the Company also accrued a $500 thousand general valuation reserve due to the current real estate market conditions and in the expectation of receiving and accepting offers in the coming months that are lower than current appraised values. Management has allocated significant resources to facilitate sales of OREO to reduce the Company’s non-performing assets. At March 31, 2013, the valuation reserve totaled $296 thousand.

Investment securities and other investments totaled $62.28 million (market value) at March 31, 2013 which reflects a decrease of $47 thousand from the December 31, 2012 total of $62.33 million. Investment securities available for sale and other investments at March 31, 2013 were comprised of mortgage backed securities / CMOs (46.01% of the total securities portfolio), municipal issues (18.28%), corporate bonds (2.78%), and SBAs pools (25.36%). The Company’s entire securities portfolio was classified as available for sale at both March 31, 2013 and December 31, 2012.

Other investments include the Bank’s holdings of Federal Reserve, Federal Home Loan Bank, Pacific Coast Bankers Bank, Community Bankers Bank stock. These investments (carrying value of $4.46 million and 7.16% of the total) are considered to be restricted as the Company is required to hold these investments and the only market for these investments is the issuing agency. Also included in Other Investments is a certificate of deposit purchased from another FDIC insured institution. The balance of this CD was $250,000 at March 31, 2013 and December 31, 2012 respectively.

Liquidity and Capital Resources

Total stockholders’ equity of the Company was $30.84 million at March 31, 2013, representing an increase of $1.79 million or 6.15% from March 31, 2012. Total stockholders’ equity at December 31, 2012 was $30.47 million. The increase in stockholders’ equity from March 31, 2012 to March 31, 2013 is due to the net earnings achieved over the last 12 months.

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 Board of Directors and management are committed to increasing our capital 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 ($83.34 million as of March 31, 2013) and unrestricted investment securities available for sale ($17.12 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 certificates of deposit outside its market area by posting rates on the internet. The primary investors utilizing this network are credit unions. Unencumbered investment securities available for sale represent a secondary level of liquidity available for conversion to liquid funds in the event of extraordinary needs. The Company believes that it maintains sufficient liquidity to meet its current and projected requirements and needs.

On April 27, 2009, the Company announced that it entered into a $7,500,000 Loan Commitment Agreement with Community Bankers Bank (“CBB”), pursuant to which CBB agreed to extend to the Company an aggregate of $7,500,000 under a Revolving Line of Credit of up to $3,000,000 (“Loan A”) and a Closed-End Term Loan of up to $4,500,000 (“Loan B”) (collectively, the “Loans”). The Company pledged the stock of the Bank as collateral for the Loans. 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

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April 2014 and the Company deposited the monthly payments up to the balloon date into a reserve account held at CBB. The Closed – End Term Loan had a balance of $3,524,504 at March 31, 2013.

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;

Our inability to comply with servicing the Company’s Trust Preferred Securities,

Continued problems related to the national credit crisis and the sluggish recovery;

Unemployment continuing to rise;

Difficult market conditions in our industry;

Unprecedented levels of market volatility;

Effects of the soundness of other financial institutions;

Potential impact on us of recently enacted legislation;

Further deterioration in the housing market and collateral values;

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

The ability to continue to attract low cost core deposits

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

The successful management of interest rate risk;

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

Changes in interest rates and interest rate policies;

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

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

Demand, development and acceptance of new products and services;

Problems with technology utilized by the Company;

Changing trends in customer profiles and behavior; and

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

ITEM 3. Quantitative and Qualitative Disclosures About Market Risk

Not Applicable

ITEM 4. Controls and Procedures

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

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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 first quarter of 2013 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

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

Item 1A. Risk Factors

Not applicable

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

None

Item 3. Defaults Upon Senior Securities

None

Item 4. Mine Safety Disclosures

Not Applicable

Item 5. Other Information

None

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Item 6. Exhibits

	31.1	Rule 13a-14(a) Certification of Executive Vice President and Chief Executive Officer
	31.2	Rule 13a-14(a) Certification of Chief Financial Officer
	31.3	Rule 13a-14(a) Certification of Vice President of Accounting
	32.1	Certification Statement of Executive Vice President and Chief Executive Officer pursuant to 18 U.S.C. Section 1350.
	32.2	Certification Statement of Chief Financial Officer pursuant to 18 U.S.C. Section 1350.
	32.3	Certification Statement of Vice President of Accounting pursuant to 18 U.S.C. Section 1350
	101	The following materials from the Registrant’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2013, formatted in Extensible Business Reporting Language (XBRL), include: (i) the Consolidated Balance Sheets, (ii) the Consolidated Statements of Income, (iii) the Consolidated Statements of Comprehensive Income, (iv) Consolidated Statements of Cash Flows; (v) Consolidated Statements of Changes in Stockholders' Equity and (vi) related notes (furnished herewith).

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SIGNATURES

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

	HIGHLANDS BANKSHARES, INC.
		(Registrant)


Date: May 14, 2013	By:	/s/ Samuel L. Neese
		Samuel L. Neese
		Executive Vice President and
		Chief Executive Officer


Date: May 14, 2013	By:	/s/ Robert M.Little, Jr.
		Robert M.Little, Jr.
		Chief Financial Officer


Date: May 14, 2013	By:	/s/ James R. Edmondson
		James R. Edmondson
		Vice President -Accounting

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EXHIBIT INDEX

	Exhibit Number	Description
	31.1	Rule 13a-14(a) Certification of Executive Vice President and Chief Executive Officer
	31.2	Rule 13a-14(a) Certification of Chief Financial Officer
	31.3	Rule 13a-14(a) Certification of Vice President of Accounting
	32.1	Certification Statement of Executive Vice President and Chief Executive Officer pursuant to 18 U.S.C. Section 1350.
	32.2	Certification Statement of Chief Financial Officer pursuant to 18 U.S.C. Section 1350.
	32.3	Certification Statement of Vice President of Accounting pursuant to 18 U.S.C. Section 1350
	101	The following materials from the Registrant’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2013, formatted in Extensible Business Reporting Language (XBRL), include: (i) the Consolidated Balance Sheets, (ii) the Consolidated Statements of Income, (iii) the Consolidated Statements of Comprehensive Income, (iv) Consolidated Statements of Cash Flows; (v) Consolidated Statements of Changes in Stockholders' Equity and (vi) related notes (furnished herewith).