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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D. C. 20549
FORM 10-Q
(Mark One)
[X ] Quarterly Report Pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934
[ ] Transition Report Pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934
For the quarterly period ended September 30, 2004
Commission File No. 0-16761
HIGHLANDS BANKSHARES, INC.
(Exact name of registrant as specified in its charter)
West Virginia 55-0650793
- ----------------------------------- --------------------
(State or Other Jurisdiction of (I.R.S. Employer
Incorporation or Organization) Identification No.)
P. O. Box 929
Petersburg, West Virginia 26847
(Address of Principal Executive Offices, Including Zip Code)
(304) 257-4111
(Registrant's Telephone Number, Including Area Code)
Indicate by check mark whether the registrant (1) filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act
of 1934 during the past 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to
such filing requirement for the past 90 days. Yes X No
--- ------
Indicate by check mark whether the issuer is an accelerated filer (as
defined in Rule 12b-2 of the Act). Yes No X
---- -----
State the number of shares outstanding of each of the issuer's classes of
common equity, as of the latest practicable date. As of October 31, 2004:
1,436,874 shares of Common Stock, $5 Par Value
1
HIGHLANDS BANKSHARES, INC.
INDEX
Page
PART I FINANCIAL INFORMATION
Item 1. Financial Statements
Unaudited Consolidated Statements of Income - Nine Months
Ended September 30, 2004 and 2003 2
Unaudited Consolidated Statements of Income - Three Months
Ended September 30, 2004 and 2003 3
Unaudited Consolidated Balance Sheet - September 30, 2004 and
Audited Consolidated Balance Sheet--December 31, 2003 4
Unaudited Consolidated Statements of Changes in Stockholders'
Equity - Nine Months Ended September 30, 2004 and 2003 5
Unaudited Consolidated Statements of Cash Flows - Nine Months
Ended September 30, 2004 and 2003 6
Notes to Consolidated Financial Statements 7
Item 2. Management's Discussion and Analysis of
Financial Condition and Results of Operations 10
Item 3. Quantitative and Qualitative Disclosures about Market Risk 23
Item 4. Controls and Procedures 25
PART II OTHER INFORMATION
Item 1. Legal Proceedings 26
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds 26
Item 3. Defaults upon Senior Securities 26
Item 4. Submission of Matters to a Vote of Security Holders 26
Item 5. Other Information 26
Item 6. Exhibits and Reports on Form 8K 26
SIGNATURES 27
2
Part I Financial Information
Item 1 Financial Statements
HIGHLANDS BANKSHARES, INC.
CONSOLIDATED STATEMENTS OF INCOME
(In Thousands of Dollars Except Per Share Amounts)
(Unaudited)
Nine Months Ended
September 30
2004 2003
Interest Income
Interest and fees on loans $ 12,417 $12,795
Interest on federal funds sold 128 170
Interest on time deposits 13 44
Interest and dividends on investment securities 607 801
------- ------
Total Interest Income 13,165 13,810
Interest Expense
Interest on deposits 3,354 4,793
Interest on borrowed money 197 175
------- ------
Total Interest Expense 3,551 4,968
Net Interest Income 9,614 8,842
Provision for Loan Losses 600 995
------- ------
Net Interest Income After Provision for Loan Losses 9,014 7,847
------- ------
Noninterest Income
Service charges 597 454
Insurance Income 194 159
Other 404 417
------- ------
Total Noninterest Income 1,195 1,030
Noninterest Expense
Salaries and employee benefits 3,553 3,251
Equipment and occupancy expense 905 851
Data processing 508 441
Legal and professional fees 268 197
Directors fees 267 213
Other 1,135 1,051
------- ------
Total Noninterest Expense 6,636 6,004
------- ------
Income Before Income Taxes 3,573 2,873
Provision for Income Taxes 1,189 927
------- ------
Net Income $ 2,384 $ 1,946
======= ======
Per Share Data
Net Income $ 1.66 $ 1.35
======= ======
Cash Dividends $ .45 $ .42
======= ======
Weighted Average Common Shares Outstanding 1,436,874 1,436,874
========= =========
The accompanying notes are an integral part of these statements.
3
HIGHLANDS BANKSHARES, INC.
CONSOLIDATED STATEMENTS OF INCOME
(In Thousands of Dollars Except Per Share Amounts)
(Unaudited)
Three Months Ended
September 30
2004 2003
Interest Income
Interest and fees on loans $ 4,189 $ 4,289
Interest on federal funds sold 45 48
Interest on time deposits 6 14
Interest and dividends on investment securities 195 253
------- --------
Total Interest Income 4,435 4,604
Interest Expense
Interest on deposits 1,073 1,476
Interest on borrowed money 69 67
------- ------
Total Interest Expense 1,142 1,543
------- ------
Net Interest Income 3,293 3,061
Provision for Loan Losses 195 240
------- ------
Net Interest Income After Provision for Loan Losses 3,098 2,821
------- ------
Noninterest Income
Service charges 214 166
Insurance Income 76 52
Other income 161 130
------- ------
Total Noninterest Income 451 348
Noninterest Expense
Salaries and employee benefits 1,210 1,110
Equipment and occupancy expense 314 285
Data processing expense 164 156
Legal and professional fees 89 82
Directors fees 88 82
Other 377 361
------- ------
Total Noninterest Expense 2,242 2,076
------- ------
Income Before Income Taxes 1,307 1,093
Provision for Income Taxes 432 363
------- ------
Net Income $ 875 $ 730
======= ======
Per Share Data
Net Income $ .61 $ .51
======= ======
Cash Dividends $ .15 $ .14
======= ======
Weighted Average Common Shares Outstanding 1,436,874 1,436,874
========= =========
The accompanying notes are an integral part of these statements.
4
HIGHLANDS BANKSHARES, INC.
CONSOLIDATED BALANCE SHEETS
(In Thousands of Dollars)
September 30, December 31,
2004 2003
(unaudited) (audited)
ASSETS
Cash and due from banks - noninterest bearing $ 6,571 $ 7,214
Time deposits in other banks 727 1,187
Federal funds sold 5,672 16,718
Securities held to maturity (note 2) 1,162 1,366
Securities available for sale (note 2) 25,006 32,631
Other investments (note 3) 963 933
Loans (note 4) 242,504 226,635
Allowance for loan losses (note 5) (2,363) (2,463)
Bank premises and equipment 6,883 7,210
Interest receivable 1,513 1,718
Investments in insurance contracts (note 6) 5,729 5,559
Other assets 2,105 2,460
------- -------
Total Assets $296,472 $301,168
======= =======
LIABILITIES
Deposits:
Noninterest bearing demand deposits $ 37,693 $ 32,936
Interest bearing
Money market and checking 24,359 22,958
Money market savings 16,163 16,953
Savings 35,530 32,187
Time deposits (note 7) 142,022 157,651
------- -------
Total Deposits 255,767 262,685
Borrowed money 5,691 5,295
Accrued expenses and other liabilities 3,821 3,639
------- -------
Total Liabilities 265,279 271,619
------- -------
STOCKHOLDERS' EQUITY
Common stock ($5 par value, 3,000,000 shares
authorized) 7,184 7,184
Surplus 1,662 1,662
Retained earnings 22,464 20,727
Accumulated other comprehensive loss (117) (24)
-------- --------
Total Stockholders' Equity 31,193 29,549
------- -------
Total Liabilities and Stockholders' Equity $296,472 $301,168
======= =======
The accompanying notes are an integral part of these statements.
5
HIGHLANDS BANKSHARES, INC.
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY
(In Thousands of Dollars)
(Unaudited)
Accumulated
Other
Common Retained Comprehensive
Stock Surplus Earnings Income Total
Balance December 31, 2003 $ 7,184 $1,662 $20,727 $ (24) $29,549
Comprehensive Income
Net income 2,384 2,384
Net change in unrealized
depreciation on
investment
securities available
for sale
net of taxes of $53 (93) (93)
----- ----- ------ ------ -----
Total Comprehensive Income $ 2,291
Dividends paid in cash (647) (647)
----- ----- ------ ------ ------
Balances September 30, 2004 $ 7,184 $1,662 $22,464 $ (117) $31,193
======= ======= ======= ======= ======
Accumulated
Other
Common Retained Comprehensive
Stock Surplus Earnings Income Total
Balance December 31, 2002 $ 7,184 $1,662 $19,850 $ 220 $28,916
Comprehensive Income
Net income 1,946 1,946
Net change in unrealized
Appreciation on
investment
securities available
for sale
net of taxes of $81 (138) (138)
----- ----- ------ ------ -----
Total Comprehensive Income $1,808
Dividends paid in cash (604) (604)
----- ----- ------ ------ -----
Balances September 30, 2003 $ 7,184 $1,662 $21,192 $ 82 $30,120
======= ======== ======= ===== =======
The accompanying notes are an integral part of these statements.
6
HIGHLANDS BANKSHARES, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(In Thousands of Dollars)
(Unaudited)
Nine Months Ended
September 30
2004 2003
Cash Flows from Operating Activities:
Net income $ 2,384 $ 1,946
Adjustments to reconcile net income to net
cash provided by operating activities:
Depreciation 500 460
Net securities amortization 208 321
Provision for loan losses 600 995
Income from insurance investments (170) (143)
Decrease (increase) in interest receivable 205 (7)
Decrease in other assets 408 28
Increase in accrued expenses 182 139
------- ------
Net Cash Provided by Operating Activities 4,317 3,741
------- ------
Cash Flows from Investing Activities:
Net change in time deposits in other banks 460 (1,309)
Net change in federal funds sold 11,046 (4,098)
Proceeds from maturities of securities
available for sale 14,267 12,459
Proceeds from maturities of securities held
to maturity 201 1
Purchase of securities available for sale (6,994) (22,124)
Purchase of other investments (30) (290)
Net change in loans (16,569) (1,383)
Purchase of property and equipment (172) (199)
-------- ------
Net Cash Provided by (Used in) Investing Activities 2,209 (16,943)
------- -------
Cash Flows from Financing Activities:
Net change in time deposits (15,629) 4,792
Net change in other deposits 8,711 5,705
Dividends paid in cash (647) (604)
Repayment of borrowed money (604) (421)
Additional borrowed money 1,000 1,785
------- ------
Net Cash Provided by (Used in) Financing Activities (7,169) 11,257
-------- ------
Net Decrease in Cash and Cash Equivalents (643) (1,945)
Cash and Cash Equivalents, Beginning of Period 7,214 8,226
------- ------
Cash and Cash Equivalents, End of Period $ 6,571 $ 6,281
======= ======
Supplemental Disclosures:
Cash Paid For:
Income taxes $ 696 $ 1,050
Interest 3,757 5,030
The accompanying notes are an integral part of these statements.
7
HIGHLANDS BANKSHARES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1 ACCOUNTING PRINCIPLES:
The consolidated financial statements conform to U. S. generally
accepted accounting principles and to general industry practices. In
the opinion of management, the accompanying unaudited consolidated
financial statements contain all adjustments necessary to present
fairly the financial position as of September 30, 2004 and the results
of operations for the three month and nine month periods ended
September 30, 2004 and 2003.
The notes included herein should be read in conjunction with the notes
to financial statements included in the 2003 annual report on Form
10-K.
NOTE 2 SECURITIES:
The amortized cost and market value of securities held to maturity as
of September 30, 2004 and December 31, 2003, are as follows (in
thousands):
2004 2003
---- ----
Amortized Market Amortized Market
Cost Value Cost Value
Mortgage-backed
securities $ 1 $ 1 $ 2 $ 2
Obligations of states and
political subdivisions 1,161 1,201 1,364 1,435
------ ------ ----- ------
Total $ 1,162 $ 1,202 $1,366 $ 1,437
====== ====== ===== ======
The amortized cost and fair value of securities available for sale as
of September 30, 2004 and December 31, 2003 are as follows (in
thousands):
2004 2003
----- -----
Amortized Market Amortized Market
Cost Value Cost Value
US Treasury securities and
obligations of US Government
corporations and agencies $ 17,785 $ 17,793 $ 23,132 $ 23,240
Mortgage-backed securities 5,136 5,180 6,686 6,758
Obligations of states and
political subdivisions 1,985 2,005 2,567 2,604
Other investments 32 28 32 29
------ ------ ----- -----
Total $ 24,938 $ 25,006 $ 32,417 $ 32,631
====== ====== ====== ======
8
HIGHLANDS BANKSHARES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 2 SECURITIES (continued):
Taxable and non-taxable interest and dividends on investment
securities for the three month and nine month periods ended September
30, 2004 and 2003 are as follows (in thousands):
Nine Months Ended Three Months Ended
September 30, September 30,
2004 2003 2004 2003
---- ----- ----- ------
Taxable $ 511 $ 681 $ 166 $ 213
Non-taxable 96 120 29 40
------ ------- ------- -----
Total $ 607 $ 801 $ 195 $ 253
===== ===== ===== =====
NOTE 3 OTHER INVESTMENTS:
Other investments totaling $ 963,000 as of September 30, 2004 include
investments in the Federal Home Loan Bank and other governmental
entities whose transferability is restricted.
NOTE 4 LOANS:
A summary of loans outstanding as of September 30, 2004 and December
31, 2003 is as follows (in thousands):
2004 2003
Commercial $ 50,231 $ 42,911
Real estate - construction 9,304 7,552
- mortgages 137,715 129,670
Consumer 45,254 46,502
------- -------
Net loans outstanding $242,504 $226,635
======= =======
In addition to loans to fund construction and traditional mortgage
loans, portions of the portfolio identified as commercial are also
secured by real estate.
NOTE 5 ALLOWANCE FOR LOAN LOSSES:
A summary of transactions in the allowance for loan losses for the
nine months ended September 30, 2004 and 2003 follows:
2004 2003
Balance, beginning of period $ 2,463 $ 1,793
Provisions charged to operating expenses 600 995
Loan recoveries 256 206
Loan charge-offs (956) (580)
-------- -------
Balance, end of period $ 2,363 $ 2,414
======= =======
9
HIGHLANDS BANKSHARES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 6 INVESTMENT IN INSURANCE CONTRACTS:
Investment in insurance contracts consist of single premium insurance
contracts which have the dual purposes of providing a rate of return
to the Company which approximately equals the Company's average cost
of funds and providing life insurance and retirement benefits to
certain executives. The carrying value of these investments was
$5,729,000 at September 30, 2004 and $5,559,000 at December 31, 2003.
NOTE 7 DEPOSITS:
Balances of time deposits over $100,000 and time deposits less than
$100,000 at September 30, 2004 and December 31, 2003 are set forth
below (in thousands):
2004 2003
------ ------
Time deposits over $100,000 $ 39,812 $ 47,345
All other time deposits 102,210 110,306
------- -------
Total Time Deposits $142,022 $157,651
======= =======
Interest expense for time deposits over $100,000 for the nine month
and three month periods ended September 30, 2004 and September 30,
2003 are set forth below (in thousands):
Nine Months Three Months
Ended September 30 Ended September 30
2004 2003 2004 2003
------ ----- ----- -----
$ 943 $1,321 $ 304 $ 379
The following is a summary of the maturity distribution of all time
deposits of $100,000 or more as of September 30, 2004 (in thousands):
Amount
1-90 Days $ 5,762
91-365 Days 15,532
1-3 Years 13,548
3-5 Years 4,970
------
Total $39,812
======
10
Item 2 Management's Discussion and Analysis of Financial Condition and
Results of Operations
Introduction
The following discussion focuses on significant results of the Company's
operations and significant changes in our financial condition or results of
operations for the periods indicated in the discussion. This discussion should
be read in conjunction with our audited financial statements and Report on Form
10-K for the period ended December 31, 2003.
Critical Accounting Policies
The Company's financial statements are prepared in accordance with accounting
principles generally accepted in the United States ("GAAP"). The financial
statements contained within these statements are, to a significant extent,
financial information that is based on measures of the financial effects of
transactions and events that have already occurred. A variety of factors could
affect the ultimate value that is obtained either when earning income,
recognizing an expense, recovering an asset or relieving a liability. In
addition, GAAP itself may change from one previously acceptable method to
another method. Although the economics of these transactions would be the same,
the timing of events that would impact these transactions could change.
The allowance for loan losses is an estimate of the losses that may be sustained
in the loan portfolio. The allowance is based on two basic principles of
accounting: (i) SFAS No. 5, Accounting for Contingencies, which requires that
losses be accrued when they are probable of occurring and estimable and (ii)
SFAS No. 114, Accounting by Creditors for Impairment of a Loan, which requires
that losses be accrued based on the differences between the value of collateral,
present value of future cash flows or values that are observable in the
secondary market and the loan balance.
The Company has invested in and owns life insurance polices on certain officers.
The policies are designed so that the company recovers the interest expenses
associated with carrying the polices and the officer will, at the time of
retirement, receive any earnings in excess of these expenses. The Company
recognizes as an asset the net amount that could be realized under the insurance
contract as of the balance sheet date. This amount represents the cash surrender
value of the policies less applicable surrender charges. The portion of the
benefits which will be received by the executives at the time of their
retirement is considered, when taken collectively, to constitute a retirement
plan. Therefore the Company accounts for these policies using guidance found in
Statement of Financial Accounting Standards No. 106, "Employers' Accounting for
Post Retirement Benefits Other Than Pensions."
SFAS No. 106 requires that an employers' obligation under a deferred
compensation agreement be accrued over the expected service life of the employee
through their normal retirement date. Assumptions are used in estimating the
present value of amounts due officers after their normal retirement date. These
assumptions include the estimated income to be derived from the investments and
an estimate of the Company's cost of funds in these future periods. In addition,
the discount rate used in the present value calculation will change in future
years based on market conditions.
Recent Accounting Pronouncements
No recent accounting pronouncements had a material impact on the Company's
consolidated financial statements.
11
Item 2 Management's Discussion and Analysis of Financial Condition
and Results of Operations (continued)
Prior Period Adjustment
During the fourth quarter of 2003, the Company, based on new information and
regulatory guidance, made changes to the way it accounts for the life insurance
policies owned by the Company on key officers. These adjustments applied solely
to periods prior to the first quarter of 2003. Beginning balances of certain
financial statements and certain tabular data contained in the Management's
Discussion and Analysis of Financial Condition and Results of Operations in this
quarterly filing on Form 10-Q may have been restated based on these adjustments
as compared to certain previous quarterly filings on Form 10-Q. Information
contained herein should be read in conjunction with the notes to financial
statements included in the 2003 annual report on Form 10-K.
Forward Looking Statements
Certain statements in this report may constitute "forward-looking statements"
within the meaning of the Private Securities Litigation Reform Act of 1995.
Forward-looking statements are statements that include projections, predictions,
expectations or beliefs about future events or results or otherwise are not
statements of historical fact. Such statements are often characterized by the
use of qualified words (and their derivatives) such as "expect," "believe,"
"estimate," "plan," "project," "anticipate" or other similar words. Although the
Company believes that its expectations with respect to certain forward-looking
statements are based upon reasonable assumptions within the bounds of its
existing knowledge of its business and operations, there can be no assurance
that actual results, performance or achievements of the Company will not differ
materially from any future results, performance or achievements expressed or
implied by such forward-looking statements. Actual future results and trends may
differ materially from historical results or those anticipated depending on a
variety of factors, including, but not limited to, the effects of and changes
in: general economic conditions, the interest rate environment, legislative and
regulatory requirements, competitive pressures, new products and delivery
systems, inflation, changes in the stock and bond markets, technology, downturns
in the trucking and timber industries, effects of mergers and/or downsizing in
the poultry industry in Hardy County, and consumer spending and savings habits.
Additionally, actual future results and trends may differ from historical or
anticipated results to the extent: (1) any significant downturn in certain
industries, particularly the trucking and timber industries are experienced; (2)
loan demand decreases from prior periods; (3) the Company may incur additional
loan loss provision due to negative credit quality trends in the future that may
lead to a deterioration of asset quality; (4) the Company may not continue to
experience significant recoveries of previously charged-off loans or loans
resulting in foreclosure; and (5) the Company is unable to control costs and
expenses as anticipated. The Company does not update any forward-looking
statements that may be made from time to time by or on behalf of the Company.
Overview
Continued improvements in asset quality and asset liability management were
significant factors in a 22.51% increase in income for the nine month period
ended September 30, 2004 as compared to the same period in 2003. During 2003,
rises in delinquencies and net charge-offs of loans prompted a provision for
loan losses of $995,000. During 2004, although net charge-offs remain above the
Company's historical average, improved loan quality and falling delinquency
rates, among other factors, allowed for a significantly smaller provision for
loan losses. Increases in average loan balances and closer management of deposit
costs were key contributors to an 8.73% increase in net interest income.
12
Item 2 Management's Discussion and Analysis of Financial Condition and Results
of Operations (continued)
Overview (continued)
Total assets have declined over recent periods as Management has attempted to
better manage its Asset/Liability position. The Company has historically paid
above available market rates for deposits in order to fund loan growth. In
recent quarters, as a result of a lesser need for monies to fund loan growth and
because of lower yields on assets alternative to loans, the Company has not
encountered a need to pay above market rates to obtain deposits. In many
instances, has been able to maintain rates below that of other local and
regional banking institutions. As a result of this approach, balances of time
deposits have fallen over the duration of 2004. Because of the historically low
yield on fed funds sold and securities, Management chose to fund the reductions
in time deposits through reductions in balances of these lower yielding assets.
Loan balances increased 7.00% from December 31, 2003 to September 30, 2004.
These new loans were also funded primarily through reductions in balances of
lower yielding assets, with the net result being a decline in total assets
largely attributable to lower balances of fed funds sold, deposits in other
banks, and securities.
Income year to date through September 30, 2004 provided an annualized return on
average assets (ROAA) of 1.06% and an annualized return on average equity (ROAE)
of 10.38% compared to an ROAA of .85% and an ROAE of 8.75% during the same
period in 2003.
Net Interest Income
Year To Date
Net interest income through the first nine months of 2004 increased 8.73% as
compared to the same period in 2003.
Although three recent rate increases by the Federal Reserve Board ("The Fed")
for the target Fed Funds rate have caused market rates for both earning assets
and interest bearing liabilities to begin to increase, average rates for 2004
continued to decline as compared to 2003. As payments continue to occur on older
loans and new loans are written at lower rates, average yields on loans fell as
compared to 2003. And as older, more expensive, time deposits continue to mature
and were either re-written at lower rates or depositors moved monies to other
institutions paying higher rates, the Company has seen a continued decline in
average rates paid on deposit liabilities as compared to previous periods.
Interest income decreased 4.67% as compared to 2003 as average rates on earning
assets fell 15 basis points and average balances of earning assets fell by over
$7 million. Average loan balances increased 2.27%, but this increase was offset
by a decrease in average rates earned on loans. Because of the comparatively low
yield on earning assets alternative to loans such as fed funds sold, securities
and deposits in other banks, Management has chosen in recent periods to fund
loan growth and deposit reductions through reductions in these alternative
investments. The combined average balances of fed funds sold, interest bearing
deposits and securities fell 20.27% as compared to average balances in 2003.
13
Item 2 Management's Discussion and Analysis of Financial Condition and Results
of Operations (continued)
Net Interest Income (continued)
For most of the nine month period ended September 30, 2004, the Company found
itself in a favorable short-term liquidity position as average balances of fed
funds sold topped $16.5 million during the first nine months of 2004. As a
result, the Company has not seen a need for additional deposit balances and has
been able to remain at or often below competitors rates paid on deposits. Rates
paid on deposits during the first nine months of 2004 compared to 2003 fell 72
basis points and average balances of interest bearing deposits during the first
nine months of 2004 fell 4.87% compared to 2003. The largest declines were the
result of reductions in time deposits. This led to a reduction of 30.02% in
interest expense paid on deposits.
As the quarter ended September 30, 2004 drew to a close, the Company saw a large
increase in new loans. As such, as of September 30, 2004, the liquidity position
for the Company is not as favorable as it was throughout most of the year to
date. Balances of fed funds sold fell to $5.7 million at September 30, 2004 as
compared to the year to date average of $16.5 million and balances of interest
bearing deposits and securities were also lower at September 30, 2004 than at
December 31, 2003. As a result, the Company may, in the coming periods, be
required to increase rates to gain new deposits to fund future loan growth or
may borrow additional funds for this purpose. These actions might, under certain
circumstances, have the effect of lowering net interest margin.
A summary of the Company's net interest margin and average balance sheet for the
nine month periods ended September 30, 2004 and September 30, 2003 can be found
on page 14.
Quarter Ended September 30
Net interest income for the quarter ended September 30, 2004 increased 7.58%
over the same period a year ago. The net interest margin for the quarter was
4.73%, 45 basis points greater than the same quarter in 2003.
Interest income decreased 3.76% as average balances of earning assets declined
$10.1 million despite an increase in average loan balances of 3.68%. Average
rates on earning assets fell 6 basis points from 2003 to 2004.
The decrease in interest income was more than offset by a 25.99% decrease in
interest expense. Average rates paid on deposits fell 56 basis points and
average balances of interest bearing deposits declined 6.35%. The most dramatic
drop in deposit balances occurred in time deposits, which typically bear higher
average rates than interest bearing transaction accounts. Average balances of
time deposits for the quarter ended September 30, 2004 fell $22.7 million
compared to average balances for the same quarter in 2003, a decline of 13.72%.
As the Company's need for liquidity diminished, the Company opted to keep rates
on time deposits at or below those of local competitors. Because of this, it
appears that some depositors have shifted monies to other financial institutions
that are paying higher rates. Balances of interest bearing and noninterest
bearing transaction accounts have increased as customers appear reluctant to
commit to longer term deposits due to the low interest rate environment and have
chosen instead to hold monies in transaction accounts in anticipation of future
rate increases.
A summary of the Company's net interest margin and average balance sheet for the
three month periods ended September 30, 2004 and September 30, 2003 can be found
on page 15.
14
Item 2 Management's Discussion and Analysis of Financial Condition and Results
of Operations (continued)
Net Interest Income (continued)
HIGHLANDS BANKSHARES, INC.
NET INTEREST MARGIN FOR THE NINE MONTH PERIODS ENDED
SEPTEMBER 30, 2004 AND 2003
(Dollar Amounts in Thousands)
September 30, 2004 September 30, 2003
------------------------- --------------------------
Average Income/ Average Income/
Balance Expense Rate Balance Expense Rate
Interest Earning Assets
Loans 1,3 $231,218 $12,417 7.17% $226,095 $12,795 7.57%
Federal funds sold 16,521 128 1.03% 21,219 170 1.07%
Interest bearing
deposits 1,469 13 1.18% 5,952 44 .99%
Investments
Taxable 4 26,632 511 2.56% 29,044 681 3.14%
Tax exempt 2,4 3,366 152 6.03% 3,974 188 6.33%
----- ----- ---- ----- ----- -----
Total Earning Assets 279,206 13,221 6.33% 286,284 13,878 6.48%
------- ------ ----- ------- ------ -----
Noninterest Earning Assets
Cash and due from
banks 6,715 7,306
Premises and equipment 7,053 6,726
Allowance for loan
losses (2,395) (2,062)
Other assets 9,307 7,152
------- -------
Total Nonearning
Assets 20,680 19,122
-------- ------
Total Assets $ 299,886 $ 305,406
========= =========
Interest Bearing Liabilities
Money markets 23,361 64 .37% $ 21,186 113 .71%
Savings 52,597 219 .56% 47,937 313 .87%
Time deposits 147,286 3,071 2.79% 165,560 4,367 3.53%
Other borrowed money 5,578 197 4.72% 4,589 175 5.10%
------- ------ ----- -------- ----- ----
Total Interest Bearing
Liabilities 228,822 3,551 2.07% $ 239,272 4,968 2.78%
------- ----- ----- ------ ----- ----
Non Interest Bearing Liabilities
Demand deposits 37,054 34,267
Other Liabilities 3,319 2,201
Shareholder's Equity 30,691 29,666
-------- --------
Total Liabilities and
Shareholder's Equity $299,886 $305,406
======== ========
Net Interest Income $ 9,670 $ 8,910
===== =====
Net Yield on Interest Earning
Assets 4.62% 4.16%
==== =====
1 Interest income on loans includes loan fees.
2 On a taxable equivalent basis based on a tax rate of 37%.
3 Average Balances include non-accrual loans
4 Average balance information is reflective of historical cost and has not been
adjusted for changes in market value.
15
Item 2 Management's Discussion and Analysis of Financial Condition and Results
of Operations (continued)
Net Interest Income (continued)
HIGHLANDS BANKSHARES, INC.
NET INTEREST MARGIN FOR THE THREE MONTH PERIODS ENDED
SEPTEMBER 30, 2004 AND 2003
(Dollar Amounts in Thousands)
September 30, 2004 September 30, 2003
-------------------------- --------------------------
Average Income/ Average Income/
Balance Expense Rate Balance Expense Rate
Interest Earning Assets
Loans 1,3 $ 235,163 $4,189 7.09% $ 226,810 $4,289 7.56%
Federal funds sold 13,119 45 1.36% 20,565 48 .93%
Interest bearing
deposits 1,477 5 1.35% 6,263 15 .96%
Investments
Taxable 4 25,242 166 2.62% 30,624 213 2.79%
Tax exempt 2,4 3,201 46 5.72% 4,043 60 5.89%
----- ----- ---- ----- ----- -----
Total Earning
Assets 278,202 4,451 6.36% 288,305 4,625 6.42%
--------- ----- ------ ------ ----- ----
Non Interest Earning Assets
Cash 6,867 6,399
Premises and
equipment 6,940 6,650
Allowance for
loan losses (2,369) (2,372)
Other Assets 7,877 8,338
----- -----
Total Nonearning
assets 19,315 19,015
------- ------
Total Assets $ 297,517 $ 307,320
Interest Bearing Liabilities
Money markets 23,550 25 .42% 21,110 24 .45%
Savings 53,555 78 .58% 48,211 73 .61%
Time deposits 142,567 970 2.71% 165,244 1,379 3.34%
Other borrowed
money 5,791 69 4.74% 5,366 67 4.99%
------- ----- ----- -------- ----- ------
Total Interest Bearing
Liabilities 225,463 1,142 2.01% 239,931 1,543 2.57%
------- ----- ----- ------ ---- ------
Non Interest Bearing Liabilities
Demand deposits 37,786 35,645
Other Liabilities 3,290 1,717
Shareholder's Equity 30,978 30,027
------- ------
Total Liabilities and
Shareholder's
Equity $ 297,517 $ 307,320
========== ========
Net Interest Income 3,309 3,082
===== =====
Net Yield on
Interest Earning
Assets 4.73% 4.28%
==== =====
1 Interest income on loans includes loan fees.
2 On a taxable equivalent basis based on a tax rate of 37%.
3 Average Balances include non-accrual loans
4 Average balance information is reflective of historical cost and has not been
adjusted for changes in market value.
16
Item 2 Management's Discussion and Analysis of Financial Condition
and Results of Operations (continued)
Loan Portfolio
The Company is an active residential mortgage and construction lender and
generally extends commercial loans to small and medium sized businesses within
its primary service area. The Company's commercial lending activity extends
across its primary service areas of Grant, Hardy, Hampshire, Mineral, Randolph,
and northern Pendleton counties in West Virginia and Frederick County, Virginia.
Consistent with its focus on providing community-based financial services, the
Company does not attempt to diversify its loan portfolio geographically by
making significant amounts of loans to borrowers outside of its primary service
area.
Credit Quality
Balances of non-performing loans decreased 69.51% from December 31, 2003 to
September 30, 2004. Nonperforming loans include nonaccrual loans, loans 90 days
or more past due and restructured loans. Nonaccrual loans are loans on which
interest accruals have been suspended or discontinued permanently. Restructured
loans are loans on which the original interest rate or repayment terms have been
changed due to financial hardship of the borrower.
The following table summarizes the company's non-performing loans as of
September 30, 2004 and December 31, 2003.
September30,December 31,
(in thousands) 2004 2003
---- ----
Non-accrual loans $ 653 $ 1,664
Restructured Loans 631
Loans past due 90 days or more and
still accruing interest 534 1,598
------ -----
Total $ 1,187 $ 3,893
======== ========
At December 31, 2003, loans 30 days or more delinquent plus non-accrual loans
were 4.73% of gross loan balances and at September 30, 2004, these loans
represented 3.37% of gross loans. Restructured loans at December 31, 2003 were
comprised of two commercial loans on which refinancing was necessary in order to
recoup timely payment of principal. In neither case were any principal amounts
forgiven. As of September 30, 2004, these loans which had previously been
classified as restructured had timely payments for more than a twelve month
period and terms were not better than those that would be offered in a
competitive environment. For this reason, they were no longer classified as
restructured.
Loans are typically placed on non-accrual status once they have reached certain
levels of delinquency, depending on loan type, and it is no longer reasonable to
expect collection of principal and interest because collateral is insufficient
to cover both the principal and interest due. After loans are placed on
non-accrual status, they are returned to accrual status if the obligation is
brought current by the borrower, or they are charged off if payment is not made
and management believes that collection of the amounts due is doubtful.
Charged-off loans are charged against the allowance for loan losses. Any
subsequent collection or sale of repossessed collateral is added to the
allowance as a recovery.
The carrying value of foreclosed property at September 30, 2004 was $415,000.
All foreclosed property held as of September 30, 2004 was in the Company's
primary service area. The Company's practice is to value real estate acquired
through foreclosure at the lower of (i) an independent current appraisal or
market analysis less anticipated costs of disposal, or (ii) the existing loan
balance. The Company is actively marketing all foreclosed real estate and does
not anticipate material write-downs in value before disposition.
17
Item 2 Management's Discussion and Analysis of Financial Condition
and Results of Operations (continued)
Credit Quality (continued)
An inherent risk in the lending of money is that the borrower will not be able
to repay the loan under the terms of the original agreement. The allowance for
loan losses (see subsequent section) provides for this risk and is reviewed
periodically for adequacy. This review also considers concentrations of loans in
terms of geography, business type or level of risk. While lending is
geographically diversified within the service area, the Company does have some
concentration of loans in the area of agriculture (primarily poultry farming),
timber and related industries. Management recognizes these concentrations and
considers them when structuring its loan portfolio.
As of September 30, 2004, the Company had one potential problem loan as defined
in SEC Industry Guide III that would require disclosure. In July, the Company
received notice that a large commercial loan customer had filed for Chapter 11
bankruptcy protection. Terms of the bankruptcy proceedings have not been
finalized. Depending upon the outcome of the bankruptcy proceedings, the Company
may be forced to reclassify the loans made to this customer, which total
approximately $1.4 million, to non-accrual status. If these loans are
reclassified to non-accrual, this will have a negative impact on interest
revenue and net income. The loans to this customer are deemed by Management to
be well secured, and if a foreclosure is required, the Company expects there to
be no loss on the sale of the collateral. Since the bankruptcy filing, this
customer has continued to make payments of both principal and interest, and
though remaining moderately delinquent, these payments have been sufficient to
consistently keep the customer less than 60 days past due.
Because of its large impact on the local economy, Management continues to
monitor the economic health of the poultry industry. The Company has direct
loans to poultry growers and the industry is a large employer in the Company's
trade area. During the spring of 2004, Pilgrim's Pride Corporation announced the
pending closure of its turkey processing facilities near Harrisonburg, VA. This
closure would have impacted the local economy because turkey growers contracted
with Pilgrim's Pride would either be forced to cease growing operations or turn
to alternative contractual arrangements. The number of direct grower loans held
by the Company and which would have been impacted by this potential closure is
small. Since the announcement of the pending closure, some of the growers
impacted by the closure who have loans with the Company have contracted with
another poultry integrator. The remainder have joined a cooperative organization
that will re-open the processing plant in late November. As of this filing, this
cooperative has begun placing birds with growers in preparation for future
processing. Management will monitor the activities of this cooperative but
expects no adverse impact relating to the transitions involved with the poultry
processing facility and its related operations.
In recent periods, the Company's loan portfolio has also begun to reflect a
concentration in loans collateralized by heavy equipment, particularly in the
trucking and timber industries. In part because of rising fuel costs, and
because of continued stagnant economic conditions, the trucking sector has
experienced a recent downturn. However, the Company has experienced no material
losses related to foreclosures of loans collateralized by heavy equipment. While
close monitoring of this sector is necessary, management expects no significant
losses in the foreseeable future.
Allowance For Loan Losses
The allowance for loan losses is an estimate of the losses in the current loan
portfolio. The allowance is based on two principles of accounting: (i) SFAS No.
5, Accounting for Contingencies which requires that losses be accrued when they
are probable of occurring and estimable and (ii) SFAS No. 114, Accounting by
Creditors for Impairment of a Loan, which requires that loans be identified
which have characteristics of impairment as individual risks, (e.g. the
collateral, present value of cash flows or observable market values are less
than the loan balance).
18
Item 2 Management's Discussion and Analysis of Financial Condition
and Results of Operations (continued)
Allowance For Loan Losses (continued)
Each of Company's banking subsidiaries, Capon Valley Bank and The Grant County
Bank, determines the adequacy of its allowance for loan losses independently.
Although the loan portfolios of the two banks are similar to each other, some
differences exist which result in divergent risk patterns and different
charge-off rates amongst the functional areas of the banks' portfolio. Each bank
pays particular attention to individual loan performance, collateral values,
borrower financial condition and economic conditions. The determination of an
adequate allowance at each bank is done in a three step process. The first step
is to identify problem loans above a certain threshold and estimated losses are
calculated based on collateral values and projected cash flows. The second step
is to identify loans above a certain threshold which are problem loans due to
the borrowers' payment history or deteriorating financial condition. Losses in
this category are determined based on historical loss rates adjusted for current
economic conditions. The final step is to calculate a loss for the remainder of
the portfolio using historical loss information for each type of loan
classification. The determination of specific allowances and weighting is
somewhat subjective and actual losses may be greater or less than the amount of
the allowance. However, Management believes that the allowance represents a fair
assessment of the losses that exist in the current loan portfolio.
An analysis of the components of net charge-offs for the nine month periods
ended September 30, 2004 and September 30, 2003 and for the quarters ended
September 30, 2004 and September 30, 2003 is set forth in the following table
(in thousands):
Quarter Ended Nine Months Ended
September 30, September 30,
2004 2003 2004 2003
Components of net charge-offs:
Real estate $ (121) $ $ (386) $ (6)
Commercial (26) (51) (92) (92)
Installment (23) (151) (222) (194)
------ -------- ------- ---------
Total $ (170) $ (202) $ (700) $ (292)
======= ====== ======= ======
The following table shows the allocation of loans in the loan portfolio and the
corresponding amounts of the allowance allocated by loan types as of September
30, 2004 and December 31, 2003:
September 30, 2004 December 31, 2003
------------------ ----------------
Allowance Percentage Allowance Percentage
Loan Type Allocation of Loans Allocation of Loans
--------- ---------- ---------- ---------- ---------
Commercial $ 816 20% $ 779 19%
Mortgage 668 61% 725 61%
Consumer 760 19% 819 20%
Unallocated 119 140
---- ------ ----- ---
Totals $2,363 100% $2,463 100%
===== === ===== ===
As of December 31, 2003, the Company's Allowance For Loan Losses represented
1.09% of total loan balances. As of September 30, 2004, this percentage had
fallen to .97%. During 2003 and year to date in 2004, the Company has reduced
the level of severely delinquent loans. The charge off of a large number of
poorly performing loans has contributed to the declining delinquency rates and
has led to a decreased allowance requirement. Management believes that the
credit quality of the current loan portfolio is significantly improved and that
in the coming periods net charge-offs will decline compared to those seen in
2003 and year to date in 2004. Management believes losses will more closely
reflect historical charge-off rates, or may fall below historical averages. The
table below summarizes the Company's charge-offs by loan type for the four years
previous to 2004 and year to date 2004 (in thousands):
19
Item 2 Management's Discussion and Analysis of Financial Condition and
Results of Operations (continued)
Allowance For Loan Losses (continued)
Year
To Date
2000 2001 2002 2003 2004
-----------------------------------------------
Charge-Offs:
Commercial $ 172 $ 239 $ 246 $ 557 $ 97
Real Estate 128 92 110 65 422
Consumer 215 369 424 839 437
Recoveries:
Commercial 2 57 10 75 5
Real Estate 30 12 68 54 36
Consumer 71 141 72 182 215
Net Charge-Offs:
Commercial 170 182 236 482 92
Real Estate 98 80 42 11 386
Consumer 144 228 352 657 222
-------- ------- ------- ------- -------
Total Net Charge-Offs: $ 412 $ 490 $ 630 $1,150 $ 700
===== ===== ===== ===== =====
Percent of net charge-offs
to average net loans
during the period (1) .23% .25% .29% .51% .40%
(1) Year to date percentage of net charge-offs to average net loans is
presented on an annualized basis.
In addition to Management's belief that the recent volume of charge-offs has
reduced the risk of loss in the portfolio, the quality of the Company's loan
portfolio has experienced an improvement from the past years as the percentage
of loans secured by real estate has increased. In the year 2000, consumer loans
made up 24% of the Company's portfolio. The portion of the portfolio made up by
consumer loans has declined steadily, and at September 30, 2004, represented 19%
of the total loan portfolio. In 2000, mortgage loans comprised 56% of the total
loan portfolio and 61% at September 30, 2004. Losses as a percentage of loans
have historically been significantly higher in the consumer portion of the
portfolio than with loans secured by real estate. This shift from consumer loans
to loans secured by real estate has also contributed to the reduction in the
balance of the allowance for loan losses as a percentage of total loans
outstanding.
Discontinuation of Trust Operations
During the fourth quarter of 2003, the Board of Directors of Highlands
Bankshares, Inc. (HBI) decided to close Highlands Bankshares Trust Company, Inc.
(HBTI).The demand for trust services in the Company's primary and secondary
service areas had been less than anticipated. As of May 31, 2004, Highlands
Bankshares Trust Company, a wholly owned subsidiary of Highlands Bankshares,
Inc. ceased operations.
On an unconsolidated basis, at the time of it's closing, HBTI had an accumulated
net loss of $3,217. This loss, in combination with an initial capital
contribution by HBI of $2,143,576, resulted in a net investment by HBI at the
time of closing of $2,140,359. Upon the cessation of operations of HBTI, this
capital investment was returned to Highlands Bankshares, Inc. in the form of
cash. At its regularly scheduled meeting in July, the Highlands Board of
Directors voted to invest this capital, less amounts used to pay second quarter
shareholder dividends, in the two subsidiary banks.
20
Item 2 Management's Discussion and Analysis of Financial Condition and
Results of Operations (continued)
Discontinuation of Trust Operations (continued)
The distribution of this available capital as investment in the subsidiary banks
was as follows (in thousands):
Capital
Subsidiary Bank Investment
----------------- ----------
Capon Valley Bank $ 703
The Grant County Bank 1,157
-------
Total $ 1,860
Non Interest Income
Income from service charges increased 31.50% for the nine months of 2004 as
compared to 2003 and 28.92% for the third quarter of 2004 as compared to the
third quarter of 2003. In both instances, the increase was largely due to an
increase in the rate on insufficient funds transactions charged to checking
account customers as opposed to an increase in the volume of transactions.
The declining volume of new consumer installment loans has impacted insurance
earnings. As credit life and accident and health insurance are sold primarily to
these loan customers, the volume of new insurance business has also decreased.
In spite of declines in sales of credit life and accident insurance, insurance
earnings have increased year to date and for the quarter ended September 30,
2004 as compared to the same periods in 2003. As new policies are written, there
are requirements that portions of the premiums be held in reserve in
anticipation of future claims. Throughout 2004, as the volume of new insurance
business has fallen, older policies have matured without claims. As a result of
this, required balances of these reserves has been reduced and this has
positively impacted the income of HBI Life Insurance Company.
Because of the closing of the trust subsidiary, trust fees fell $28,000 during
the first nine months of 2004 as compared to 2003. There were no trust fees
earned during the quarter ended September 2004 as compared to $12,000 during the
same quarter in 2003.
Non Interest Expense
The costs of salaries and benefits for the first nine months of 2004 were
$302,000 higher than the same period in 2003 and $100,000 higher during the
third quarter of 2004 as compared to the same period in 2003. The largest
contributions to these increases were higher costs of health insurance and
higher pension expenses.
Occupancy and equipment expense increased due mainly to higher costs associated
with the implementation of new operating equipment. The volume of transaction
accounts continues to increase and the Company has embarked on new services to
make operations more efficient (these include check imaging and telephone
banking). The combination of these new or expanded services resulted in an
increase in data processing expense of 15.30% for the first nine months of 2004
when compared to the same period in 2003. Increases in these costs have
stabilized as the aforementioned improvement projects have become fully
implemented. For this reason, increases in data processing costs were more
modest during the quarter ended September 30, 2004 as compared to the year to
date 2004 increases.
21
Item 2 Management's Discussion and Analysis of Financial Condition and
Results of Operations (continued)
Non Interest Expense (continued)
Legal and professional fees rose due to expanded internal audit procedures.
Management expects that since these increased procedures commenced during the
latter parts of 2003 and are continuing, that the year over year increase will
stabilize in the future quarters. Legal and professional fees for the nine month
period ended September 30, 2004 were 35.61% higher than those experienced in the
same period in 2003. The increase had declined to 8.54% for the quarter ended
September 30, 2004.
At its meeting in April of 2003, the Company's Board of Directors approved an
increase in directors fees for the directors of both the Company and its
subsidiaries. This increase, coupled with an increase in the number of directors
at the subsidiary banks, caused directors fees for the first nine months of 2004
to rise 25.29% and 7.14% for the quarter ended September 30, 2004.
Borrowed Money
The Company periodically borrows money from the Federal Home Loan Bank (FHLB).
These borrowings are typically used to fund loan growth but have also been used
to fund the renovation of the Capon Valley Bank's main office building.
Throughout most of 2004, the Company has found itself in a favorable liquidity
position such that new loans could be funded through the decline in balances of
more liquid, lower earning assets such as fed funds sold. The Company during
2003 and 2004 chose to fund certain larger fixed rate commercial loans by
borrowing from the Federal Home Loan Bank (FHLB). In matching the maturity of
FHLB borrowings with larger commercial loans, the Company has attempted to
minimize future interest rate risk.
Liquidity
Operating liquidity is the ability to meet present and future financial
obligations. Short term liquidity is provided primarily through cash balances,
deposits with other financial institutions, federal funds sold, non-pledged
securities and loans maturing within one year. Additional sources of liquidity
available to the Company include, but are not limited to, loan repayments, the
ability to obtain deposits through the adjustment of interest rates and the
purchasing of federal funds. To further meet its liquidity needs, the Company
also maintains lines of credit with correspondent financial institutions, the
Federal Reserve Bank of Richmond and the Federal Home Loan Bank of Pittsburgh.
Historically, the Company's primary need for additional levels of operational
liquidity has been to fund increases in loan balances. The Company has normally
funded increases in loans by increasing deposits and decreases in secondary
liquidity sources such as balances of fed funds sold and balances of securities.
During the latter weeks of the quarter ended September 30, 2004, the Company saw
a significant increase in new loans. These loans were funded primarily through
secondary liquidity sources. Deposit balances have also decreased in recent
periods. Should the Company continue to experience significant loan growth, it
may be necessary to raise rates on deposits above current market levels in order
to attract new deposits. The Company may also utilize the available lines of
credit with correspondent financial institutions to fund loan growth.
The parent Company's operating funds, funds with which to pay shareholder
dividends and funds for the exploration of new business ventures have been
supplied primarily through dividends paid by the Company's subsidiary banks,
Capon Valley Bank (CVB) and The Grant County Bank (GCB). The various regulatory
authorities impose restrictions on dividends paid by a state bank. A state bank
cannot pay dividends without the consent of the relevant banking authorities in
excess of the total net profits of the current year and the combined retained
profits of the previous two years. As of October 1, 2004, the subsidiary banks
could pay dividends to Highlands Bankshares, Inc. of approximately $4,048,000
without permission of the regulatory authorities.
22
Item 2 Management's Discussion and Analysis of Financial Condition and
Results of Operations (continued)
Liquidity (continued)
A summary of the amounts available follows (in thousands):
Total
2002 2003 2004 Available
---- ---- ---- for
Income Dividend Income Dividend Income Dividend Dividends
CVB $ 1,076 975 $ 475 $ -- $ 874 $ 316 $1,134
GCB 1,627 975 1,801 905 1,582 216 $2,914
Capital
The Company seeks to maintain a strong capital base to expand facilities,
promote public confidence, support current operations and grow at a manageable
level. As of September 30, 2004 the Company was above the regulatory minimum
levels of capital. The table below summarizes the capital ratios for the Company
and its subsidiary banks as of September 30, 2004 and December 31, 2003:
September 30, 2004 December 31, 2003
Actual Regulatory Actual Regulatory
Ratio Minimum Ratio Minimum
Total Risk Based Capital Ratio
Highlands Bankshares 14.68% 8.00% 14.55% 8.00%
Capon Valley Bank 12.57% 8.00% 11.93% 8.00%
The Grant County Bank 15.48% 8.00% 13.89% 8.00%
Tier 1 Leverage Ratio
Highlands Bankshares 10.17% 3.00% 9.42% 3.00%
Capon Valley Bank 8.48% 3.00% 7.31% 3.00%
The Grant County Bank 10.72% 3.00% 9.05% 3.00%
Tier 1 Risk Based Capital Ratio
Highlands Bankshares 13.62% 4.00% 13.40% 4.00%
Capon Valley Bank 10.36% 4.00% 10.68% 4.00%
The Grant County Bank 14.52% 4.00% 12.81% 4.00%
Effects of Inflation
Inflation primarily affects industries having high levels of property, plant and
equipment or inventories. Although the Company is not significantly affected in
these areas, inflation does have an impact on the growth of assets. As assets
grow rapidly, it becomes necessary to increase equity capital at proportionate
levels to maintain the appropriate equity to asset ratios. Traditionally, the
Company's earnings and high capital retention levels have enabled the Company to
meet these needs.
The Company's reported earnings results have been minimally affected by
inflation. The different types of income and expense are affected in various
ways. Interest rates are affected by inflation, but the timing and magnitude of
the changes may not coincide with changes in the consumer price index.
Management actively monitors interest rate sensitivity, as illustrated by the
gap analysis shown under the section titled Interest Rate Sensitivity, in order
to minimize the effects of inflationary trends on interest rates. Other areas of
noninterest expenses may be more directly affected by inflation.
23
Item 2 Management's Discussion and Analysis of Financial Condition and
Results of Operations (continued)
Securities and Exchange Commission Web Site
The Securities and Exchange Commission maintains a Web site that contains
reports, proxy and information statements and other information regarding
registrants that file electronically with the Commission, including Highlands
Bankshares, Inc., and the address is (http://www.sec.gov).
Item 3 Quantitative and Qualitative Disclosures About Market Risk
The greatest portion of the Company's net income is derived from net interest
income. As such, the greatest component of market risk is interest rate
volatility. In conjunction with maintaining a satisfactory level of liquidity,
management must also control the degree of interest rate risk assumed on the
balance sheet. Managing this risk involves regular monitoring of the interest
sensitive assets relative to interest sensitive liabilities over specific time
intervals. Early withdrawal of deposits, greater than expected balances of new
deposits, prepayments of loans and loan delinquencies are some of the factors
that could affect actual versus expected cash flows. In addition, changes in
rates on interest sensitive assets and liabilities may not be equal, which could
result in a change in net interest margin. While the Company does not match each
of its interest sensitive assets against specific interest sensitive
liabilities, it does review its positions regularly and takes actions to
reposition itself when necessary. With the largest amount of interest sensitive
assets and liabilities repricing within one year, the Company believes it is in
an excellent position to respond quickly to rapid market rate changes.
Interest rate market conditions may also affect portfolio composition of both
assets and liabilities. Traditionally, the Company's subsidiary banks have
primarily offered one year adjustable rate mortgages (ARMs) to its mortgage loan
customers. However, the low interest rate environment has created intense
competition, especially from larger banking institutions and finance companies
offering long term fixed rate mortgages. As a result, the Company in recent
periods has begun to write more mortgage loans with adjustable rates and
maturities greater than one year. The increase in new ARM loans with two, three
and five year adjustable rates has caused a shift in the maturity composition of
the loan portfolio. As of September 30, 2003, 64.80% of the Company's loan
portfolio repriced within one year. As of September 30, 2004, 53.24% of the
Company's loan portfolio repriced within one year.
Also as a result of the low interest rate environment, depositors seem reluctant
to commit to longer term time deposits and in many instances appear to be
holding monies temporarily in interest bearing transaction accounts in
anticipation of rising rates in the coming periods. As of September 30, 2003,
balances of interest bearing transaction and savings accounts were $69,257,000.
These balances had grown to $76,052,000 by September 30, 2004. Were interest
rates to rise sharply in the coming periods, some of the monies now in interest
bearing transaction and savings accounts may shift to time deposits, causing a
rise in the Company's cost of funds. Alternatively, these balances may be
transferred by customers to other financial institutions offering higher deposit
rates, and requiring the Company to match such rates. Increased deposit
incentives may also be required if the loan demand grows at a rate whereby
current sources of funds will not be sufficient to support loan funding.
24
Item 3 Quantitative and Qualitative Disclosures About Market Risk (continued)
The following table illustrates the Company's sensitivity to interest rate
changes as of September 30, 2004 (in thousands):
HIGHLANDS BANKSHARES, INC.
INTEREST RATE SENSITIVITY ANALYSIS
SEPTEMBER 30, 2004
(In Thousands of Dollars)
More than
5 Years
1 - 90 91 - 365 1 to 3 3 to 5 or no
Days Days Years Years Maturity Total
EARNING ASSETS
Loans $36,647 $92,458 $81,359 $16,612 $15,428 $242,504
Fed funds sold 5,672 5,672
Securities 8,964 7,398 9,777 264 728 27,131
Time deposits in other
banks 427 300 727
------ ------ ------ ------ ----- ------
Total 51,710 99,856 91,436 16,876 16,156 276,034
-------- ------- ------ ------ ------ -------
INTEREST BEARING LIABILITIES
Interest bearing
transaction 24,359 24,359
Savings accounts 51,693 51,693
Time deposits 22,836 64,343 40,006 14,837 142,022
Other borrowed money 146 442 1,222 1,289 2,592 5,691
------ ------ ------ ------ ----- ------
Total 99,034 64,785 41,228 16,126 2,592 223,765
-------- ------- ------ ------ ------ -------
Rate sensitivity GAP (47,324) 35,071 50,208 750 13,564 52,269
Cumulative GAP (47,324) (12,253) 37,955 38,705 52,269
Ratio of cumulative
interest sensitive
assets to
cumulative interest
sensitive liabilities 52.21% 92.52% 118.51% 117.50% 123.36%
Assumes all transaction, money market and savings deposit accounts reprice
within 90 days.
25
Item 4 Controls and Procedures
Evaluation of Disclosure Controls and Procedures
As a result of the enactment of the Sarbanes-Oxley Act of 2002, issuers such as
Highlands Bankshares, Inc. that file periodic reports under the Securities
Exchange Act of 1934 (the "Act") are now required to include in those reports
certain information concerning the issuer's controls and procedures for
complying with the disclosure requirements of the federal securities laws. These
disclosure controls and procedures include, without limitation, controls and
procedures designed to ensure that information required to be disclosed by an
issuer in the reports it files or submits under the Act, is communicated to the
issuer's management, including its principal executive officer or officers and
principal financial officer or officers, or persons performing similar
functions, as appropriate to allow timely decisions regarding required
disclosure.
We have established our disclosure controls and procedures to attempt to ensure
that material information related to Highlands Bankshares, Inc. is made known to
our principal executive officers and principal finance officer on a regular
basis, in particular during the periods in which our quarterly and annual
reports are being prepared. These disclosure controls and procedures consist
principally of communications between and among the Chief Executive Officer and
Chief Financial Officer, and the other executive officers of Highlands
Bankshares, Inc. and its subsidiaries to identify any new transactions, events,
trends, contingencies or other matters that may be material to the Company's
operations. As required, we will evaluate the effectiveness of these disclosure
controls and procedures on a quarterly basis, and most recently did so as of the
end of the period covered by this report.
The Company's chief executive officer and chief financial officer, based on
their evaluation as of the end of the period covered by this Annual Report of
the Company's disclosure controls and procedures (as defined in Rule 13(a)-14(e)
of the Securities Exchange Act of 1934), have concluded that the Company's
disclosure controls and procedures are adequate and effective for purposes of
Rule 13(a)-14(c) and timely, alerting them to financial information relating to
the Company required to be included in the Company's filings with the Securities
and Exchange Commission under the Securities Exchange Act of 1934.
Changes in Internal Controls
During the period reported upon, there were no significant changes in the
internal controls of Highlands Bankshares, Inc. pertaining to its financial
reporting and control of its assets or any other factors that could
significantly affect these controls.
Due to the nature of the Company's business as stewards of assets of customers,
internal controls are of the utmost importance. The company has established
procedures undertaken during the normal course of business in an attempt to
reasonably ensure that fraudulent activity of either an amount material to these
results or in any amount is not occurring. In addition to these controls and
review by executive officers, the Company retains the services of Yount, Hyde &
Barbour, P.C., a public accounting firm, to complete regular internal audits to
examine the processes and procedures of the Company and its subsidiary banks to
ensure that these processes are both reasonably effective to prevent fraud, both
internal and external, and that these processes comply with regulatory
guidelines of all relevant banking authorities. The findings of Yount, Hyde &
Barbour are presented both to Management of the subsidiary banks and to the
Audit Committee for review.
26
Part II Other Information
Item 1 Legal Proceedings--Not Applicable
Item 2 Unregistered Sales of Equity Securities and Use of Proceeds--Not
Applicable
Item 3 Defaults Upon Senior Securities--Not Applicable
Item 4 Submission of Matters to a Vote of Security Holders - Not Applicable
Item 5 Other Information --Not Applicable
Item 6 Exhibits and Reports on 8-K -
(a) Exhibits
3 (i) Articles of Incorporation of Highlands Bankshares, Inc. are
incorporated by reference to Appendix C to Highlands Bankshares, Inc.'s
Form S-4 filed October 20, 1986.
3 (ii) Bylaws of Highlands Bankshares, Inc. are incorporated by reference to
Exhibit 3(ii) to Highland Bankshares, Inc.'s Form 10-Q filed May 15,
2003.
31.1 Certification by Chief Executive Officer pursuant to Rule 13a-14(a)
under the Securities Exchange Act of 1934, as adopted pursuant to
Section 302 of the Sarbanes-Oxley Act of 2002
31.2 Certification by Chief Financial Officer pursuant to Rule 13a-14(a)
under the Securities Exchange Act of 1934, as adopted pursuant to
Section 302 of the Sarbanes-Oxley Act of 2002
32.1 Certification by Chief Executive Officer and Chief Financial Officer
pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906
of the Sarbanes-Oxley Act of 2002
(b) Reports on Form 8-K filed during the three months ended September
30, 2004
None
27
Signature
Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
HIGHLANDS BANKSHARES, INC.
/s/ C.E. PORTER
---------------------------
C.E. Porter
President & Chief Executive Officer
/s/ R. ALAN MILLER
---------------------------
R. Alan Miller
Chief Financial Officer
Date: November 12, 2004