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EX-31.1 - EXHIBIT 31.1 - HIGHLANDS BANKSHARES INC /WV/ex31_1.htm
EX-32.2 - EXHIBIT 32.2 - HIGHLANDS BANKSHARES INC /WV/ex32_2.htm
EX-32.1 - EXHIBIT 32.1 - HIGHLANDS BANKSHARES INC /WV/ex32_1.htm
EX-31.2 - EXHIBIT 31.2 - HIGHLANDS BANKSHARES INC /WV/ex31_2.htm


UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549


FORM 10-Q

(Mark One)
T  QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended March 31, 2011.

£  TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

Commission File Number:  0-16761

HIGHLANDS BANKSHARES, INC.
(Exact name of registrant as specified in its charter)

West Virginia
 
55-0650793
(State or Other Jurisdiction of Incorporation or Organization)
 
(IRS Employer Identification No.)

P.O. Box 929
Petersburg, WV 26847
(Address of Principal Executive Offices, Including Zip Code)

304-257-4111
(Registrant’s Telephone Number, Including Area Code)

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

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

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

Large Accelerated Filer £
 
Accelerated Filer £
Non-accelerated filer £ (Do not check if a smaller reporting company) 
 
Smaller reporting company T

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

Indicate the number of shares outstanding of each of the issuer’s classes of common stock as of the latest practicable date. As of May 16, 2011:  1,336,873 shares of Common Stock, $5 Par Value
 


 
 

 
 
HIGHLANDS BANKSHARES, INC.
Quarterly Report on Form 10-Q For The Period Ended March 31, 2011
         
   
INDEX
   
       
Page
PART I
     
         
Item 1.
     
         
       
     
3
         
       
     
4
         
       
     
5
         
       
     
6
         
     
7
         
Item 2.
     
     
20
         
Item 3.
   
32
         
Item 4.
   
32
         
PART II
 
OTHER INFORMATION
   
         
Item 1.
   
32
         
Item 1A.
   
32
         
Item 2.
   
32
         
Item 3.
   
32
         
Item 4.
   
33
         
Item 5.
   
33
         
Item 6.
   
33
         
 
   34
 
 
2


PART I.
Item 1. Financial Statements

HIGHLANDS BANKSHARES, INC.
CONSOLIDATED STATEMENTS OF INCOME
(In Thousands of Dollars, Except Per Share Data)


   
Three Months Ended March 31
 
   
2011
   
2010
 
   
(unaudited)
   
(unaudited)
 
Interest Income
           
Interest and fees on loans
  $ 5,156     $ 5,482  
Interest on federal funds sold
    4       5  
Interest on deposits in other banks
    1       3  
Interest and dividends on securities
    139       187  
Total Interest Income
    5,300       5,677  
                 
Interest Expense
               
Interest on deposits
    1,161       1,606  
Interest on borrowed money
    108       115  
Total Interest Expense
    1,269       1,721  
                 
Net Interest Income
    4,031       3,956  
                 
Provision for Loan Losses
    585       1,092  
                 
Net Interest Income After Provision for Loan Losses
    3,446       2,864  
                 
Non-interest Income
               
Service charges
    345       357  
Life insurance investment income
    66       66  
Gains on securities transactions
    0       33  
Gains on sale of foreclosed property
    14       4  
Other non-interest income
    81       87  
Total Non-interest Income
    506       547  
                 
Non-interest Expense
               
Salaries and employee benefits
    1,662       1,720  
Occupancy and equipment expense
    381       368  
Data processing expense
    300       271  
Directors fees
    101       99  
Legal and professional fees
    124       182  
Office supplies and postage and freight expense
    92       121  
FDIC premium
    166       162  
Loan and foreclosed asset expense
    135       48  
Other non-interest expense
    173       227  
Total Non-interest Expense
    3,134       3,198  
                 
Income Before Provision For Income Taxes
    818       213  
                 
Provision for Income Taxes
    266       52  
                 
Net Income
  $ 552     $ 161  
                 
Per Share Data
               
Net Income
  $ 0.41     $ 0.12  
Cash Dividends
  $ 0.25     $ 0.27  
Weighted Average Common Shares Outstanding
    1,336,873       1,336,873  

The accompanying notes are an integral part of these financial statements.

 
3


HIGHLANDS BANKSHARES, INC.
CONSOLIDATED BALANCE SHEETS
(In thousands of dollars)

   
March 31, 2011
   
December 31, 2010
 
   
(unaudited)
   
(audited)
 
ASSETS
           
Cash and due from banks
  $ 7,131     $ 8,282  
Interest bearing deposits in banks
    2,657       3,532  
Federal funds sold
    9,091       5,836  
Investment securities available for sale
    30,702       25,324  
Restricted investments
    1,993       2,087  
Loans
    325,459       329,336  
Allowance for loan losses
    (5,729 )     (5,407 )
Bank premises and equipment, net of depreciation
    9,776       9,901  
Interest receivable
    1,645       1,791  
Investment in life insurance contracts
    7,097       7,031  
Foreclosed assets
    5,353       4,700  
Goodwill
    1,534       1,534  
Other intangible assets
    784       830  
Other assets
    4,966       5,123  
Total Assets
  $ 402,459     $ 399,900  
                 
LIABILITIES
               
Deposits
               
Non-interest bearing deposits
  $ 56,212     $ 54,693  
Interest bearing transaction and savings accounts
    80,012       77,392  
Time deposits over $100,000
    74,304       75,003  
All other time deposits
    134,609       135,724  
Total Deposits
    345,137       342,812  
                 
Long term debt instruments
    9,272       9,393  
Accrued expenses and other liabilities
    6,459       6,327  
Total Liabilities
    360,868       358,532  
                 
STOCKHOLDERS’ EQUITY
               
Common Stock, $5 par value, 3,000,000 shares
               
authorized, 1,436,874 shares  issued
    7,184       7,184  
Surplus
    1,662       1,662  
Treasury stock (100,001 shares, at cost)
    (3,372 )     (3,372 )
Retained earnings
    37,383       37,165  
Other accumulated comprehensive loss
    (1,266 )     (1,271 )
Total Stockholders’ Equity
    41,591       41,368  
                 
Total Liabilities and Stockholders’ Equity
  $ 402,459     $ 399,900  

The accompanying notes are an integral part of these financial statements

 
4


HIGHLANDS BANKSHARES, INC.
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY
Three Months Ended March 31, 2011 and 2010
(In Thousands of Dollars)

   
Common Stock
   
Surplus
   
Treasury Stock
   
Retained Earnings
   
Accumulated Other Comprehensive Income (Loss)
   
Total
 
                                     
Balances at December 31, 2009
  $ 7,184     $ 1,662     $ (3,372 )   $ 36,963     $ (1,015 )   $ 41,422  
                                                 
Other Comprehensive Income:
                                               
Net Income
                            161               161  
Change in other comprehensive income
for unrealized gains or losses on
investment securities available for sales
                                    (41 )     (41 )
Total Comprehensive Income
                                            120  
                                                 
Dividends Paid
                            (361 )             (361 )
                                                 
Balances March 31, 2010
  $ 7,184     $ 1,662     $ (3,372 )   $ 36,763     $ (1,056 )   $ 41,181  
                                                 
                                                 
                                                 
                                                 
Balances at December 31, 2010
  $ 7,184     $ 1,662     $ (3,372 )   $ 37,165     $ (1,271 )   $ 41,368  
                                                 
Other Comprehensive Income:
                                               
Net Income
                            552               552  
Change in other comprehensive income
for unrealized gains or losses on
investment securities available for sales
                                    5       5  
Total Comprehensive Income
                                            557  
                                                 
Dividends Paid
                            (334 )             (334 )
                                                 
Balances March 31, 2011
  $ 7,184     $ 1,662     $ (3,372 )   $ 37,383     $ (1,266 )   $ 41,591  

The accompanying notes are an integral part of these financial statements

 
5

 
CONSOLIDATED STATEMENTS OF CASH FLOWS
(In Thousands of Dollars)

   
Three Months Ended March 31
 
   
2011
   
2010
 
   
(unaudited)
   
(unaudited)
 
Cash Flows From Operating Activities
           
Net Income
  $ 552     $ 161  
Adjustments to reconcile net income to net
               
cash provided by operating activities
               
(Gain) on securities transactions
    0       (33 )
(Gain) loss on sale of foreclosed assets
    14       (4 )
Depreciation
    196       182  
Income from life insurance contracts
    (132 )     (66 )
Net amortization of securities premiums
    48       31  
Provision for loan losses
    585       1,092  
Write-down on foreclosed assets
    65       18  
Amortization of intangibles
    46       49  
Decrease in interest receivable
    146       110  
Decrease in other assets
    157       344  
Increase in accrued expenses
    198       223  
Net Cash Provided by Operating Activities
    1,875       2,107  
                 
Cash Flows From Investing Activities
               
Proceeds from sale of foreclosed assets and fixed assets
    155       63  
Proceeds from maturity of securities available for sales
    1,652       1,442  
Purchase of securities available for sale
    (7,073 )     (2,640 )
Net change in other investments
    94       0  
Net change in interest bearing deposits in other banks
    875       (827 )
Net change in federal funds sold
    (3,255 )     (3,620 )
Net decrease in loans
    2,727       453  
Purchase of property and equipment
    (71 )     (283 )
Net Cash (Used in) Investing Activities
    (4,896 )     (5,412 )
                 
Cash Flows From Financing Activities
               
Net change in time deposits
    (1,814 )     (904 )
Net change in other deposit accounts
    4,139       3,722  
Repayment of long term borrowings
    (121 )     (116 )
Dividends paid in cash
    (334 )     (361 )
Net Cash Provided by Financing Activities
    1,870       2,341  
Net (decrease)  in Cash and Cash Equivalents
    (1,151 )     (964 )
Cash and Cash Equivalents, Beginning of Period
    8,282       7,062  
Cash and Cash Equivalents, End of Period
  $ 7,131     $ 6,098  
                 
Supplemental Disclosures
               
Cash paid for income taxes
  $ 125     $ 0  
Cash paid for interest
  $ 113     $ 1,733  
Noncash Investing and Financing Activities for other
               
real estate acquired in settlement of loans
  $ 883     $ 415  

The accompanying notes are an integral part of these financial statements.

 
6


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE ONE:
ACCOUNTING PRINCIPLES

The consolidated financial statements conform to U. S. generally accepted accounting principles and to general industry practices.  In the opinion of management, the accompanying unaudited consolidated financial statements contain all adjustments, consisting solely of normal recurring adjustments, necessary to present fairly the financial position as of March 31, 2011 and the results of operations for the three month periods ended March 31, 2011 and 2010.

The results of operations for the three month periods ended March 31, 2011 and 2010 are not necessarily indicative of the results to be expected for the full year.

The notes included herein should be read in conjunction with the notes to financial statements included in the Company’s 2010 annual report on Form 10-K.

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

NOTE TWO:
LOANS

A summary of loans outstanding as of March 31, 2011 and December 31, 2010 is shown in the table below (in thousands of dollars):

   
March 31, 2011
   
December 31, 2010
 
Commercial Mortgage
  $ 145,731     $ 142,896  
Commercial Other
  $ 14,337     $ 15,037  
Consumer Mortgage
  $ 139,373     $ 142,505  
Consumer Other
  $ 26,018     $ 28,898  
    $ 325,459     $ 329,336  

At March 31, 2011, the total balance of loans in the portfolio secured by real estate was $282,425,000.

The following is a summary of information pertaining to impaired loans by portfolio segment at March 31, 2011 and December 31, 2010 (in thousands of dollars):

Impaired Loans
 
As of March 31, 2011
 
   
Recorded
Investment
   
Unpaid
Principal
Balance
   
Related
Allowance
   
Average
Recorded
Investment
   
Interest
Income
Recognized
 
                               
With no related allowance recorded:
                   
Commercial Mortgage
  $ 20,112     $ 20,112     $ 0     $ 22,222     $ 221  
Commercial Other
    160       160       0       177       4  
Consumer Mortgage
    31       31       0       31       0  
Sub-total
  $ 20,303     $ 20,303     $ 0     $ 22,430     $ 225  
With an allowance recorded:
                         
Commercial Mortgage
    6,625       6,625       1,351       7,505       71  
Commercial Other
    313       313       84       441       9  
Consumer Mortgage
    577       577       59       581       4  
Sub-total
  $ 7,515     $ 7,515     $ 1,494     $ 8,527     $ 84  
Total
                         
Commercial Mortgage
    26,737       26,737       1,351       29,727       292  
Commercial Other
    473       473       84       618       13  
Consumer Mortgage
    608       608       59       612       4  
Total
  $ 27,818     $ 27,818     $ 1,494     $ 30,957     $ 309  

 
7


Impaired Loans
 
As of December 31, 2010
 
   
Recorded
Investment
   
Unpaid
Principal
Balance
   
Related
Allowance
   
Average
Recorded
Investment
   
Interest
Income
Recognized
 
                               
With no related allowance recorded:
                   
Commercial Mortgage
  $ 18,455     $ 18,455     $ 0     $ 26,557     $ 137  
Commercial Other
    840       840       0       1,159       13  
Consumer Mortgage
    253       253       0       256       2  
Sub-total
  $ 19,548     $ 19,548     $ 0     $ 27,972     $ 152  
With an allowance recorded:
                         
Commercial Mortgage
    5,692       5,692       904       6,871       272  
Commercial Other
    148       148       21       203       19  
Sub-total
  $ 5,840     $ 5,840     $ 925     $ 7,074     $ 291  
Total
                         
Commercial Mortgage
    24,147       24,147       904       33,428       409  
Commercial Other
    988       988       21       1,362       32  
Consumer Mortgage
    253       253       0       256       2  
Total
  $ 25,388     $ 25,388     $ 925     $ 35,046     $ 443  
                                         
No loans were identified as impaired with potential loss as of March 31, 2011 or December 31, 2010 for which an allowance was not provided. The table above includes troubled debt restructurings (TDR).  Loans are identified as TDR if concessions are made related to the terms of the loan beyond regular lending practices in response to a borrower’s financial condition.  Restructured loans performing in accordance with modified terms consist of four commercial mortgages and three consumer mortgages.  Restructured loans not performing in accordance with modified terms consist of one consumer mortgage.  These loans were modified to reduce interest rates or provide for interest-only payment periods.  These loans did not have any additional commitments to extend credit at March 31, 2011.

Balances of non-accrual loans at March 31, 2011 and December 31, 2010 are shown below (in thousands of dollars):

             
   
March 31, 2011
   
December 31, 2010
 
Loans on non-accrual status
           
Commercial Mortgage
  $ 4,828     $ 2,215  
Commercial Other
    131       139  
Consumer Mortgage
    3,768       4,240  
Consumer Other
    136       385  
Total non-accrual loans
  $ 8,863     $ 6,979  
 
 
8


Certain loans identified as impaired are placed into non-accrual status, based upon the loan’s performance compared with contractual terms. Not all loans identified as impaired are placed into non-accrual status. The interest on loans identified as impaired and also placed into non-accrual status and not recognized as income throughout the year (foregone interest) was $175,000 for the period ended March 31, 2011.  Foregone interest in 2010 totaled $427,000.

The following table presents the contractual aging of the recorded investment in past due loans by class as of March 31, 2011 and December 31, 2010 (in thousands of dollars):
 
Age Analysis of Past Due Financing Receivables
 
As of March 31, 2011
 
   
30-59
Days
Past Due
   
60-89
Days
Past Due
   
Greater
Than 90
Days
   
Total
Past Due
   
Current
   
Total
Financing
Receivables
   
Recorded
Investment
> 90 Days
and
Accruing
 
                                           
Commercial - Mortgage
  $ 2,384     $ 378     $ 4,220     $ 6,982     $ 138,749     $ 145,731     $ 320  
Commercial -Other
    571       186       0       757       13,580       14,337       0  
Consumer - Mortgage
    3,399       1,117       2,724       7,240       132,133       139,373       253  
Consumer - Other
    683       199       54       936       25,082       26,018       23  
Total
  $ 7,037     $ 1,880     $ 6,998     $ 15,915     $ 309,544     $ 325,459     $ 596  
                                                         
Age Analysis of Past Due Financing Receivables
 
As of December 31, 2010
 
   
30-59
Days
Past Due
   
60-89
Days
Past Due
   
Greater
Than 90
Days
   
Total
Past Due
   
Current
   
Total
Financing
Receivables
   
Recorded
Investment
> 90 Days
and
Accruing
 
                                                         
Commercial - Mortgage
  $ 3,691     $ 663     $ 2,188     $ 6,542     $ 136,354     $ 142,896     $ 301  
Commercial -Other
    234       396       46       676       14,361       15,037       46  
Consumer - Mortgage
    5,391       2,952       4,089       12,432       130,073       142,505       397  
Consumer - Other
    917       580       171       1,668       27,230       28,898       122  
Total
  $ 10,233     $ 4,591     $ 6,494     $ 21,318     $ 308,018     $ 329,336     $ 866  
 
 
9

 
NOTE THREE:
ALLOWANCE FOR LOAN LOSSES

A summary of the transactions in the allowance for loan losses for the three month periods ended March 31, 2011 and December 31, 2010 is shown below (in thousands of dollars):

Allowance for Credit Losses and Recorded Investment in Financing Receivables
 
As of and For the Three Month Period Ended March 31, 2011
 
   
Commercial 
Mortgage
   
Commercial 
Other
   
Consumer 
Mortgage
   
Consumer 
Other
   
Unallocated
   
Total
 
                                     
Allowance for Credit Losses:
                                   
Beginning Balance 12/31/2010
  $ 1,345     $ 887     $ 1,662     $ 968     $ 545     $ 5,407  
Charge-offs
    31       0       307       122        0       460  
Recoveries
    106       21       10       60        0       197  
Provision
    1,322       (294 )     115       (265 )     (293 )     585  
Ending Balance 3/31/2011
  $ 2,742     $ 614     $ 1,480     $ 641     $ 252     $ 5,729  
Ending Balance: individually evaluated for impairment
    1,351       84       59       0       0       1,494  
Ending Balance:  collectively evaluated for impairment
    1,391       530       1,421       641       252       4,235  
                                                 
Financing Receivables:
                                               
Ending Balance
    145,731       14,337       139,373       26,018       0       325,459  
Ending Balance: individually evaluated for impairment
    26,737       473       608       0       0       27,818  
Ending Balance:  collectively evaluated for impairment
  $ 118,994     $ 13,864     $ 138,765     $ 26,018     $ 0     $ 297,641  

 
10


Allowance for Credit Losses and Recorded Investment in Financing Receivables
 
As of and For the Year Ended December 31, 2010
 
   
Commercial 
Mortgage
   
Commercial 
Other
   
Consumer 
Mortgage
   
Consumer 
Other
   
Unallocated
   
Total
 
                                     
Allowance for Credit Losses:
                                   
Ending Balance 12/31/2010
  $ 1,345     $ 887     $ 1,662     $ 968     $ 545     $ 5,407  
Ending Balance: individually evaluated for impairment
    904       21       0       0       0       925  
Ending Balance:  collectively evaluated for impairment
    441       866       1,662       968       545       4,482  
                                                 
Financing Receivables:
                                               
Ending Balance
    142,896       15,037       142,505       28,898       0       329,336  
Ending Balance: individually evaluated for impairment
    24,147       988       253       0       0       25,388  
Ending Balance:  collectively evaluated for impairment
  $ 118,749     $ 14,049     $ 142,252     $ 28,898     $ 0     $ 303,948  
                                                 

 
11


The following table presents the company’s loans by internally assigned grades and by loan type (in thousands of dollars).

Credit Quality Indicators
 
As of March 31, 2011
 
                           
Credit Risk Profile by Internally Assigned Grade
                   
                               
   
Commercial
   
Commercial
   
Consumer
   
Consumer
   
Total
 
   
Mortgage
   
Other
   
Mortgage
   
Other
       
Grade:
                             
 Excellent
  $ 1,519     $ 1,379     $ 2,891     $ 2,878     $ 8,667  
Very Good
    13,236       1,528       28,597       4,767       48,128  
Pass
    85,500       9,886       86,491       16,375       198,252  
Pass-Watch
    7,596       552       3,445       122       11,715  
Special Mention
    9,349       211       4,896       1,212       15,668  
Substandard
    26,783       639       8,361       545       36,328  
Doubtful
    0       0       0       0       0  
Loss
    0       0       0       0       0  
Total
  $ 143,983     $ 14,195     $ 134,681     $ 25,899     $ 318,758  
                                         
Credit Quality Indicators
 
As of December 31, 2010
 
                                         
Credit Risk Profile by Internally Assigned Grade
                         
                                         
   
Commercial
   
Commercial
   
Consumer
   
Consumer
   
Total
 
   
Mortgage
   
Other
   
Mortgage
   
Other
         
Grade:
                                       
 Excellent
  $ 1,573     $ 968     $ 2,964     $ 2,793     $ 8,298  
Very Good
    16,509       1,648       28,611       5,765       52,533  
Pass
    88,366       8,610       91,889       18,104       206,969  
Pass-Watch
    3,160       619       1,228       120       5,127  
Special Mention
    7,262       1,876       6,050       1,526       16,714  
Substandard
    24,194       1,025       6,747       450       32,416  
Doubtful
    0       0       0       0       0  
Loss
    0       0       129       0       129  
Total
  $ 141,064     $ 14,746     $ 137,618     $ 28,758     $ 322,186  

Loans classified as “special mention” have potential weaknesses that deserve management’s close attention.  Loans classified as “substandard” have been determined to be inadequately protected by the current collateral pledged, if any, and the cash flow and/or the net worth of the borrower.  “Doubtful” loans have all the weaknesses inherent in substandard loans, with 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.  Loans classified as “loss” are loans with expected loss of the entire principal balance.  The loan may be carried in this classified status if circumstances indicate a remote possibility that the amount will be repaid, however, the principal balance is included in the impairment calculation

 
12


and carried in the allowance for loan losses. Loans not categorized as special mention, substandard, or doubtful are classified as “pass”, “very good” or “excellent” loans and are considered to exhibit acceptable risk.  Additionally, the company classifies certain loans as “pass-watch” loans.  This category includes satisfactory borrowing relationships that require close monitoring because of complexity, information deficiencies, or emerging signs of weakness.

NOTE FOUR:
INVESTMENT IN INSURANCE CONTRACTS

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

NOTE FIVE:
SECURITIES AND RESTRICTED INVESTMENTS

The Company’s securities portfolio serves several purposes. Portions of the portfolio secure certain public and trust deposits while the remaining portions are held as investments or used to assist the Company in liquidity and asset/liability management.

The amortized cost and market value of securities as of March 31, 2011 and December 31, 2010 is shown in the table below (in thousands of dollars). All of the securities on the Company’s balance sheet are classified as available for sale.


   
Available For Sale Securities
 
   
As of March 31, 2011
 
         
Gross
   
Gross
       
   
Amortized
   
Unrealized
   
Unrealized
   
Market
 
   
Cost
   
Gains
   
Losses
   
Value
 
                         
                         
U.S. Treasuries and Agencies
  $ 13,720     $ 132     $ 5     $ 13,847  
                                 
Mortgage backed securities
    5,017       139       4       5,152  
                                 
Collateralized mortgage obligations
    3,038       8       0       3,046  
                                 
States and municipalities
    2,122       37       0       2,159  
                                 
Certificates of deposit
    6,442       31       4       6,469  
                                 
Marketable equities
    15       14       0       29  
                                 
Total Available For Sale Securities
  $ 30,354     $ 361     $ 13     $ 30,702  

 
13


   
Available For Sale Securities
 
   
As of December 31, 2010
 
         
Gross
   
Gross
       
   
Amortized
   
Unrealized
   
Unrealized
   
Market
 
   
Cost
   
Gains
   
Losses
   
Value
 
                         
                         
U.S. Treasuries and Agencies
  $ 9,132     $ 133     $ 7     $ 9,258  
                                 
Mortgage backed securities
    5,505       153       7       5,651  
                                 
Collateralized mortgage obligations
    1,764       0       0       1,764  
                                 
States and municipalities
    2,123       34       0       2,157  
                                 
Certificates of deposit
    6,442       25       2       6,465  
                                 
Marketable equities
    15       14       0       29  
                                 
Total Available For Sale Securities
  $ 24,981     $ 359     $ 16     $ 25,324  
                                 
Information pertaining to securities with gross unrealized losses at March 31, 2011 and December 31, 2010, aggregated by investment category and length of time that individual securities have been in a continuous loss position is shown in the table below (in thousands of dollars):
 
As of March 31, 2011
 
Total
   
Less than 12 Months
   
12 Months or Greater
 
   
Fair Value
   
Gross Unrealized Losses
   
Fair Value
   
Gross Unrealized Losses
   
Fair Value
   
Gross Unrealized Losses
 
                                     
Investment Category
                                   
U.S. Treasuries and Agencies
  $ 1,497     $ (5 )   $ 1,497     $ (5 )   $ 0     $ 0  
Mortgage backed securities
    1,160       (4 )     1,160       (4 )     0       0  
Collateralized mortgage obligations
    0       0       0       0       0       0  
Certificates of deposit
    492       (4 )     492       (4 )     0       0  
Total
  $ 3,149     $ (13 )   $ 3,149     $ (13 )   $ 0     $ 0  

 
14


As of December 31, 2010
 
Total
   
Less than 12 Months
   
12 Months or Greater
 
   
Fair Value
   
Gross Unrealized Losses
   
Fair Value
   
Gross Unrealized Losses
   
Fair Value
   
Gross Unrealized Losses
 
                                     
Investment Category
                                   
U.S. Treasuries and Agencies
  $ 993     $ (7 )   $ 993     $ (7 )   $ 0     $ 0  
Mortgage backed securities
    2,283       (7 )     2,283       (7 )     0       0  
Collateralized mortgage obligations
    827       0       827       0       0       0  
Certificates of deposit
    494       (2 )     494       (2 )     0       0  
Total
  $ 4,597     $ (16 )   $ 4,597     $ (16 )   $ 0     $ 0  

Restricted investments consist of investments in the Federal Home Loan Bank, the Federal Reserve Bank and West Virginia Bankers’ Title Insurance Company.  Restricted investments are carried at face value and the level of investment is dictated by the level of participation with each institution.  Amounts are restricted as to transferability. Investments in the Federal Home Loan Bank act as collateral against the outstanding borrowings from that institution.
 
NOTE SIX:
EARNINGS PER SHARE

Earnings per share represent income available to common stockholders divided by the weighted average number of common shares outstanding during the period.  During 2011 and 2010, there were no changes to the outstanding shares of common stock.

NOTE SEVEN:
DEBT INSTRUMENTS

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

The borrowings with long term maturities may have either single payment maturities or amortize. The interest rates on the various long term borrowings at March 31, 2011 range from 3.94% to 5.96%. The weighted average interest rate on the borrowings at March 31, 2011 was 4.58%.

In addition to utilization of the FHLB for borrowings of long term debt, the Company also can utilize the FHLB for overnight and other short term borrowings. At March 31, 2011 and December 31, 2010, the Company had no overnight or other short term borrowings.
 
NOTE EIGHT:
INTANGIBLE ASSETS
 
The Company’s balance sheet contains several components of intangible assets. At March 31, 2011, the total balance of intangible assets was comprised of Goodwill and Core Deposit Intangible Assets acquired as a result of the acquisition of other banks and also an intangible asset related to the purchased naming rights for a performing arts center located within the Company’s primary business area. The Company performs an impairment test on an annual basis for goodwill.  No impairment has been recorded to date.  Other intangible assets are amortized based upon the estimated economic benefits received.

 
15

 
NOTE NINE:
EMPLOYEE BENEFITS

The Company's two subsidiary banks each have separate retirement and profit sharing plans which cover substantially all full time employees at each bank.

Capon Valley Bank has a defined contribution pension plan with 401(k) features that is funded with discretionary contributions by the Bank.  The bank matches on a limited basis the contributions of the employees.  Investment of employee balances is done through the direction of each employee.  Employer contributions are vested over a six year period.

The Grant County Bank is a member of the West Virginia Bankers' Association Retirement Plan.  Benefits under the plan are based on compensation and years of service with 100% vesting after seven years of service.  The Bank has recognized a liability of $1,844,000 at March 31, 2011 for the unfunded portion of the plan. The following table provides the components of the net periodic benefit cost for the plan for the three month periods ended March 31, 2011 and 2010 (in thousands of dollars):

      2011        2010   
Service cost
  $ 51     $ 47  
Interest cost
    81       76  
Expected return on plan assets
    (88 )     (84 )
Recognized net actuarial loss
    38       24  
Amortization of unrecognized prior service costs
    0       0  
Net periodic expense
  $ 82     $ 63  


NOTE TEN:
FAIR VALUE MEASUREMENTS

ASC 820, Fair Value Measurements and Disclosures (previously SFAS No. 157, Fair Value Measurements), defines fair value, establishes a framework for measuring fair value, establishes a three-level valuation hierarchy for disclosure of fair value measurement and enhances disclosure requirements for fair value measurements. The valuation hierarchy is based upon the transparency of inputs to the valuation of an asset or liability as of the measurement date. The three levels are defined as follows:
 
·
Level One: Inputs to the valuation methodology are quoted prices (unadjusted) for identical assets or liabilities in active markets.
 
·
Level Two: Inputs to the valuation methodology include quoted prices for similar assets and liabilities in active markets, and inputs that are observable for the asset or liability, either directly or indirectly, for substantially the full term of the financial instrument.
 
·
Level Three: Inputs to the valuation methodology are unobservable and significant to the fair value measurement.
Following is a description of the valuation methodologies used for instruments measured at fair value on the Company’s balance sheet, as well as the general classification of such instruments pursuant to the valuation hierarchy:

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

Impaired Loans
The fair value measurement guidance applies to loans measured for impairment using the practical expedients permitted by authoritative accounting guidance, including impaired loans measured at an observable market price (if available), or at the fair value of the loan’s collateral (if the loan is collateral dependent). Fair value of the loan’s collateral, when the loan is dependent on collateral, is determined by appraisals or independent valuation which is then adjusted for the cost related to liquidation of the collateral. At March 31, 2011, the Company had impaired loans of $27,818,000 of which $7,515,000 required an allowance of $1,494,000.  (see Note Two).

 
16


Other Real Estate Owned
Certain assets such as other real estate owned (OREO) are measured at fair value. Real estate acquired through foreclosure is recorded at an estimated fair value less cost to sell. At or near the time of foreclosure, a real estate appraisal is obtained on the properties.  In the event that a sales agreement is in place at the time of valuation, the fair value of the collateral is determined to be the agreed-upon sale price (Level 1).  In the absence of a sales agreement, the real estate is then valued at the lesser of the appraised value or the loan balance, including interest receivable, at the time of foreclosure less an estimate of costs to sell the property.  Appraised values are typically determined utilizing an income or market valuation approach based on an appraisal conducted by an independent, licensed appraiser (Level 2).  If the acquired property is a house or building in the process of construction or if an appraisal of the real estate property is over twelve months old, the fair value is considered Level 3.  The estimate of costs to sell the property is based on historical transactions of similar holdings.

The Company, at March 31, 2011 and December 31, 2010 had no liabilities subject to fair value reporting requirements. The table below summarizes assets at March 31, 2011 and December 31, 2010 measured at fair value on a recurring basis (in thousands of dollars):

March 31, 2011
 
Level 1
   
Level 2
   
Level 3
   
Total Fair Value
Measurements
 
U.S. Treasuries and Agencies
  $ 0     $ 13,847     $ 0     $ 13,847  
Mortgage backed securities
    0       5,152       0       5,152  
Collateralized mortgage obligations
    0       3,046       0       3,046  
States and municipalities
    0       2,159       0       2,159  
Certificates of deposit
    0       6,469       0       6,469  
Marketable equities
    0       29       0       29  
Total Available For Sale Securities
  $ 0     $ 30,702     $ 0     $ 30,702  
                                 
December 31, 2010
 
Level 1
   
Level 2
   
Level 3
   
Total Fair Value
Measurements
 
U.S. Treasuries and Agencies
  $ 0     $ 9,258     $ 0     $ 9,258  
Mortgage backed securities
    0       5,651       0       5,651  
Collateralized mortgage obligations
    0       1,764       0       1,764  
States and municipalities
    0       2,157       0       2,157  
Certificates of deposit
    0       6,465       0       6,465  
Marketable equities
    0       29       0       29  
Total Available For Sale Securities
  $ 0     $ 25,324     $ 0     $ 25,324  

 
17


The table below summarizes assets at March 31, 2011, measured at fair value on a non recurring basis (in thousands of dollars):
 
   
Level 1
   
Level 2
   
Level 3
   
Total Fair
Value
Measurements
   
Three Months
Ended 
March 31, 2011 
Total gains/(losses)
 
                               
Other real estate owned
  $ 0     $ 2,153     $ 3,200     $ 5,353     $ (65 )
Impaired Loans
    0       1,290       4,731       6,021       0  
Total
  $ 0     $ 3,443     $ 7,931     $ 11,374     $ (65 )
                                         
The information above discusses financial instruments carried on the Company’s balance sheet at fair value. Other financial instruments on the Company’s balance sheet, while not carried at fair value, do have fair values which may differ from the carrying value. GAAP requires disclosure relating to these fair values. The following information shows the carrying values and estimated fair values of financial instruments and discusses the methods and assumptions used in determining these fair values.

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

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

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

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

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

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

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

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

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

 
18


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

Life Insurance
The carrying amount of life insurance contracts is assumed to be a reasonable fair value. Life insurance contracts are carried on the balance sheet at their redemption value as of March 31, 2011.  This redemption value is based on existing market conditions and therefore represents the fair value of the contract.

Off-Balance-Sheet Items
The carrying amount and estimated fair value of off-balance-sheet items were not material at March 31, 2011 or December 31, 2010.

The carrying amount and estimated fair values of financial instruments as of March 31, 2011 and December 31, 2010 are shown in the table below (in thousands of dollars):
   
March 31, 2011
   
December 31, 2010
 
   
Carrying
   
Estimated
   
Carrying
   
Estimated
 
 
Amount
   
Fair Value
   
Amount
   
Fair Value
 
Financial Assets:
           
Cash and due from banks
  $ 7,131     $ 7,131     $ 8,282     $ 8,282  
Interest bearing deposits
    2,657       2,657       3,532       3,532  
Federal funds sold
    9,091       9,091       5,836       5,836  
Securities available for sale
    30,702       30,702       25,324       25,324  
Restricted investments
    1,993       1,993       2,087       2,087  
Loans, net
    319,730       320,483       323,929       324,780  
Interest receivable
    1,645       1,645       1,791       1,791  
Life insurance contracts
    7,097       7,097       7,031       7,031  
                                 
Financial Liabilities:
                               
Demand and savings deposits
    136,224       136,224       132,085       132,085  
Time deposits
    208,913       209,656       210,727       211,590  
Long term debt instruments
    9,272       10,012       9,393       10,142  
Interest payable
    483       483       488       488  


NOTE ELEVEN:   SUBSEQUENT EVENTS

The Company evaluates subsequent events that have occurred after the balance sheet, but before the financial statements are issued.  There are two types of subsequent events:  (1) recognized, or those that provide additional evidence about conditions that existed at the date of the balance sheet, including the estimates inherent in the process of preparing financial statements, and (2) non-recognized, or those that provide evidence about conditions that did not exist at the date of the balance sheet but arose after that date.

Based on management’s evaluation through the date these financial statements were issued, the Company did not identify any recognized or non-recognized subsequent events that would have required adjustment or disclosure in the consolidated financial statements.

 
19


Management’s Discussion and Analysis of Financial Condition and Results of Operations

Introduction

The following discussion focuses on significant results of the Company’s operations and significant changes in our financial condition or results of operations for the periods indicated in the discussion. This discussion should be read in conjunction with the preceding financial statements and related notes, as well as the Company’s Annual Report on Form 10-K for the period ended December 31, 2010.  Current performance does not guarantee, and may not be indicative of, similar performance in the future.

Forward Looking Statements

Certain statements in this report may constitute “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995.  Forward-looking statements are statements that include projections, predictions, expectations or beliefs about future events or results or otherwise are not statements of historical fact.  Such statements are often characterized by the use of qualified words (and their derivatives) such as “expect,” “believe,” “estimate,” “plan,” “project,” “anticipate” or other similar words.  Although the Company believes that its expectations with respect to certain forward-looking statements are based upon reasonable assumptions within the bounds of its existing knowledge of its business and operations, there can be no assurance that actual results, performance or achievements of the Company will not differ materially from any future results, performance or achievements expressed or implied by such forward-looking statements.  Actual future results and trends may differ materially from historical results or those anticipated depending on a variety of factors, including, but not limited to, the effects of and changes in:  general economic conditions, the interest rate environment, legislative and regulatory requirements, competitive pressures, new products and delivery systems, inflation, changes in the stock and bond markets, technology, downturns in the trucking, mining, and timber industries, downturns in the housing market affecting manufacturers of household cabinetry and thus, employment, effects of mergers and/or downsizing in the poultry industry in Hardy County, continued challenges in the current economic environment affecting our financial condition and results of operations, continued deterioration in the financial condition of the U.S. banking system impacting the valuations of investments the Company has made in the securities of other financial institutions, and consumer spending and savings habits, particularly in the current economic environment.  Additionally, actual future results and trends may differ from historical or anticipated results to the extent: (1) any significant downturn in certain industries, particularly the trucking and timber industries are experienced; (2) loan demand decreases from prior periods; (3) the Company may make additional loan loss provisions due to negative credit quality trends in the future that may lead to a deterioration of asset quality; (4) the Company may not continue to experience significant recoveries of previously charged-off loans or loans resulting in foreclosure; (5) the Company is unable to control costs and expenses as anticipated, (6) legislative and regulatory changes could increase expenses (including changes as a result of rules and regulations adopted under the Dodd-Frank Wall Street Reform and Consumer Protection Act); and (7) any additional assessments imposed by the FDIC. Additionally, consideration should be given to the cautionary language contained elsewhere in this Form 10-Q.  The Company does not update any forward-looking statements that may be made from time to time by or on behalf of the Company.

Critical Accounting Policies

The Company’s financial statements are prepared in accordance with accounting principles generally accepted in the United States (“GAAP”). The financial statements contained within these statements are, to a significant extent, financial information that is based on measures of the financial effects of transactions and events that have already occurred. A variety of factors could affect the ultimate value that is obtained either when earning income, recognizing an expense, recovering an asset or relieving a liability. In addition, GAAP itself may change from one previously acceptable method to another method. Although the economics of these transactions would be the same, the timing of events that would impact these transactions could change.

Disclosure of the Company’s significant accounting policies are included in Note Two to the Consolidated Financial Statements of the Company’s Annual Report on Form 10-K for the period ended December 31, 2010. Some of the policies are particularly sensitive, requiring significant judgments, estimates and assumptions by management.

Allowance for Loan Losses

The allowance for loan losses is an estimate of the losses that may be sustained in the loan portfolio. The allowance is based on two basic principles of accounting: (i) ASC 450, Contingencies, which requires that losses be accrued when they are probable of occurring and estimable and (ii) ASC 310, Loans and Debt Securities Acquired with Deteriorated Credit Quality (previously Statement of Financial Accounting Standards No. 114, Accounting by Creditors for Impairment of a Loan), which requires that losses be accrued based on the differences between the value of collateral, present value of future cash flows or values that are observable in the secondary market and the loan balance.

 
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The allowance consists of specific, general and unallocated components.  The specific component relates to loans that are determined to be impaired.  For such loans, an allowance is established when the discounted cash flows (or collateral value or observable market price) of the impaired loan is lower than the carrying value of that loan.

The general component covers non-impaired loans and is based on management’s internal risk ratings as well as historical loss experience adjusted for qualitative factors.  The following risk factors relevant to the loan portfolio are reviewed and evaluated:

 
·
Changes in lending policies and procedures, including changes in underwriting standards or collection, charge-off and recovery practices.
 
·
Changes in national, regional, and local economic and business conditions and developments that affect the collectability of the portfolio, including unemployment trends and GDP and other leading economic indicators.
 
·
Changes in the nature and volume of the portfolio.
 
·
Changes in the experience, ability and depth of lending management and staff.
 
·
Changes in the volume and severity of past due and classified loans, the volume of nonaccrual loans, troubled debt restructurings and other loan modifications.
 
·
Changes in the quality of the Banks’ loan review systems.
 
·
The existence and effect of any concentrations of credit, and the changes in the level of such concentrations.
 
·
Changes in the value of underlying collateral.
 
·
The effect of other external factors such as competition and legal and regulatory requirements on the level of estimated credit losses in the existing portfolio.

An unallocated component is maintained 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.

A loan is considered impaired when, based on current information and events, it is probable that the Company will be unable to collect the scheduled payment of principal or interest when due according to the contractual terms of the loan agreement.  Factors considered by management in determining impairment include payment status, collateral value, and the probability of collecting scheduled principal and interest payments when due.  Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired.  Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the borrower’s prior payment record, and the amount of the shortfall in relation to the principal and interest owed.

Impairment is measured on a loan by loan basis for commercial loans by either the present value of expected future cash flows discounted at the loan’s effective interest rate, the loan’s obtainable market price, or the fair value of the collateral if the loan is collateral dependent.

Large groups of smaller balance homogeneous loans are collectively evaluated for impairment.  Accordingly, the Banks do not separately identify individual consumer and residential loans for impairment disclosures, unless the loans are the subject of a restructuring agreement.

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

All other loans, including individually evaluated loans determined not to be impaired, are included in a group of loans that are measured under ASC 450 to provide for estimated credit losses that have been incurred on groups of loans with similar risk characteristics. The methodology for measuring estimated credit losses on groups of loans with similar risk characteristics in accordance with ASC 450 is based on each group’s historical net charge-off rate, adjusted for the effects of the qualitative or environmental factors that are likely to cause estimated credit losses as of the evaluation date to differ from the group’s historical loss experience.

Intangible Assets

The Company carries intangible assets related to the purchase of two banks. Amounts paid to purchase these banks were allocated as intangible assets. Generally accepted accounting principles were applied to allocate the intangible components of the purchases. The excess was allocated between identifiable intangibles (core deposit intangibles) and unidentified intangibles (goodwill). Goodwill is required to be evaluated for impairment on an annual basis, and the value

 
21


of the goodwill adjusted accordingly, should impairment be found.  As of December 31, 2010, the Company did not identify an impairment of this intangible. In addition to the intangible assets associated with the purchases of banks, the company also carries intangible assets relating to the purchase of naming rights to certain features of a performing arts center in Petersburg, WV. Intangible assets other than goodwill, which are determined to have finite lives, are amortized based upon the estimated economic benefits received.

Post Retirement Benefits and Life Insurance Investments

The Company has invested in and owns life insurance policies on key officers. The policies are designed so that the company recovers the interest expenses associated with carrying the policies and the officer will, at the time of retirement, receive any earnings in excess of the amounts earned by the Company. The Company recognizes as an asset the net amount that could be realized under the insurance contract as of the balance sheet date. This amount represents the cash surrender value of the policies less applicable surrender charges. The portion of the benefits, which will be received by the executives at the time of their retirement, is considered, when taken collectively, to constitute a retirement plan. Therefore the Company accounts for these policies using guidance found in ASC 715, Compensation –Retirement Benefits.  ASC 715 requires that an employer’s obligation under a deferred compensation agreement be accrued over the expected service life of the employee through their normal retirement date. Assumptions are used in estimating the present value of amounts due officers after their normal retirement date.  These assumptions include the estimated income to be derived from the investments and an estimate of the 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.

Adoption of New Accounting Standards

In January 2010, the FASB issued ASU No. 2010-06, Fair Value Measurements and Disclosures (Topic 820): Improving Disclosures about Fair Value Measurements. ASU 2010-06 amends Subtopic 820-10 to clarify existing disclosures, require new disclosures, and includes conforming amendments to guidance on employers’ disclosures about postretirement benefit plan assets. ASU 2010-06 is effective for interim and annual periods beginning after December 15, 2009, except for disclosures about purchases, sales, issuances, and settlements in the roll forward of activity in Level 3 fair value measurements. Those disclosures are effective for fiscal years beginning after December 15, 2010 and for interim periods within those fiscal years.  The adoption of the new guidance did not have a material impact on the Company’s consolidated financial statements.

In July 2010, the FASB issued ASU 2010-20, “Disclosures about the Credit Quality of Financing Receivables and the Allowance for Credit Losses.”  The new disclosure guidance will significantly expand the existing requirements and will lead to greater transparency into a company’s exposure to credit losses from lending arrangements.  The extensive new disclosures of information as of the end of a reporting period will become effective for both interim and annual reporting periods ending on or after December 15, 2010.  Specific disclosures regarding activity that occurred before the issuance of the ASU, such as the allowance roll forward and modification disclosures, will be required for periods beginning or after December 15, 2010.  The Company has included the required disclosures in its consolidated financial statements.

In December 2010, the FASB issued ASU 2010-29, “Disclosure of Supplementary Pro Forma Information for Business Combinations.”  The guidance requires pro forma disclosure for business combinations that occurred in the current reporting period as though the acquisition date for all business combinations that occurred during the year had been as of the beginning of the annual reporting period.  If comparative financial statements are presented, the pro forma information should be reported as though the acquisition date for all business combinations that occurred during the current year had been as of the beginning of the comparable prior annual reporting period.  ASU 2010-29 is effective for business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2010.  Early adoption is permitted.  The adoption of the new guidance did not have a material impact on the Company’s consolidated financial statements.

In December 2010, the FASB issued ASU 2010-28, “When to Perform Step 2 of the Goodwill Impairment Test for Reporting Units with Zero or Negative Carrying Amounts.”  The amendments in this ASU modify Step 1 of the goodwill impairment test for reporting units with zero or negative carrying amounts. For those reporting units, an entity is required to perform Step 2 of the goodwill impairment test if it is more likely than not that a goodwill impairment exists.  The amendments in this Update are effective for fiscal years, and interim periods within those years, beginning after December 15, 2010. Early adoption is not permitted.  The adoption of the new guidance did not have a material impact on the Company’s consolidated financial statements

The Securities Exchange Commission (SEC) has issued Final Rule No. 33-9002, “Interactive Data to Improve Financial Reporting, which requires companies to submit financial statements in XBRL (extensible business reporting language) format with their SEC filings on a phased-in schedule.  Large accelerated filers and foreign large accelerated filers using U.S. GAAP were required to provide interactive data reports starting with their first quarterly report for fiscal periods

 
22


ending on or after June 15, 2010.  All remaining filers are required to provide interactive data reports starting with their first quarterly report for fiscal periods ending on or after June 15, 2011.

In March 2011, the SEC issued Staff Accounting Bulletin (SAB) 114.  This SAB revises or rescinds portions of the interpretive guidance included in the codification of the Staff Accounting Bulletin Series.  This update is intended to make the relevant interpretive guidance consistent with current authoritative accounting guidance issued as a part of the FASB’s Codification.  The principal changes involve revision or removal of accounting guidance references and other conforming changes to ensure consistency of referencing through the SAB Series.  The effective date for SAB 114 is March 28, 2011.   The adoption of the new guidance did not have a material impact on the Company’s consolidated financial statements.

In April 2011, the FASB issued ASU 2011-02, “A Creditor’s Determination of Whether a Restructuring Is a Troubled Debt Restructuring.”  The amendments in this ASU clarify the guidance on a creditor’s evaluation of whether it has granted a concession to a debtor.  They also clarify the guidance on a creditor’s evaluation of whether a debtor is experiencing financial difficulty.  The amendments in this Update are effective for the first interim or annual period beginning on or after June 15, 2011.  Early adoption is permitted.  Retrospective application to the beginning of the annual period of adoption for modifications occurring on or after the beginning of the annual adoption period is required.  As a result of applying these amendments, an entity may identify receivables that are newly considered to be impaired.  For purposes of measuring impairment of those receivables, an entity should apply the amendments prospectively for the first interim or annual period beginning on or after June 15, 2011. The Company is currently assessing the impact that ASU 2011-02 will have on its consolidated financial statements. 

Overview of First Three Months Results

Net income for the first three months of 2011, as compared to the same period in 2010, increased 242.9%.  This increase was driven primarily by the decrease in the provision for loan loss expense during the first three months of 2011 compared to the same period in 2010.

Total assets increased 0.6% from December 31, 2010 to March 31, 2011 with gross loan balances decreasing 1.18% during the same period. Average balances of earning assets and interest bearing liabilities, for the first three months of 2011, decreased 2.14% and 3.9%, respectively.  Interest income on earning assets decreased 6.8%, on a fully tax equivalent basis, which was more than offset by the decrease in interest expense on interest bearing liabilities of 26.3% on a fully taxable equivalent basis.  The change in interest bearing assets and liabilities coupled with the change in income and expenses are driving the increase in total taxable equivalent interest income of 1.69%.

The Company’s allowance for loan losses increased to 1.76% of total gross loans during the first three months of 2011 as compared to 1.64% at December 31, 2010.  The increase is driven by the changes in loan loss experience factors which have increased as a result of the current economic conditions.

Non-interest income decreased $41,000 in the first three months of 2011 as compared to the same period in 2010 driven primarily by the gain on security transactions reported in the first three months of 2010 not recurring in the first three months of 2011.

Non-interest expense decreased $64,000 in the first three months of 2011 as compared to the same period in 2010 primarily due to reductions in employee related costs and legal expenses.

Performance Measures

The following table compares selected commonly used measures of bank performance for the three month periods ended March 31, 2011 and 2010:

   
Three months ended March 31,
 
   
2011
   
2010
 
Annualized return on average assets
    0.55 %     0.16 %
Annualized return on average equity
    5.44 %     1.57 %
Net interest margin (1)
    4.39 %     4.23 %
Efficiency Ratio (2)
    69.08 %     71.02 %
Earnings per share (3)
  $ 0.41     $ 0.12  

 
(1)
On a fully taxable equivalent basis and including loan origination fees.
 
(2)
Non-interest expenses for the period indicated divided by the sum of net interest income and non-interest income for the period indicated.

 
23


 
(3)
Per weighted average shares of common stock outstanding for the period indicated.

Securities Portfolio

The Company's securities portfolio serves several purposes.  Portions of the portfolio are used to secure certain public and trust deposits.  The remaining portfolio is held as investments or used to assist the Company in liquidity and asset liability management.  Total securities, including restricted securities, represented 8.12% of total assets and 78.61% of total shareholders’ equity at March 31, 2011.

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

The Company identifies at the time of acquisition those securities that are available for sale. These securities are valued at their market value with any difference in market value and amortized cost shown as an adjustment in stockholders' equity.  Changes in market values of securities which are considered temporary changes due to changes in the market rate of interest are reflected as changes in other comprehensive income, net of the deferred tax effect.  Any changes in market values of securities deemed by management to be attributable to reasons other than changes in market rates of interest would be recorded through results of operations.   As of March 31, 2011, management determined that all securities with fair values less than the amortized cost, are related to increases in the current interest rates for similar issues of securities, and that no other than temporary impairment for any securities in the portfolio exists because of downgrades of the securities or as a result of a change in the financial condition of any of the issuers. A summary of the length of time of unrealized losses for all securities held at March 31, 2011 can be found in Note Five to the financial statements. Management reviews all securities with unrealized losses, and all securities in the portfolio on a regular basis to determine whether the potential for other than temporary impairment exists.

Loan Portfolio

The Company is an active residential mortgage and construction lender and generally extends commercial loans to small and medium sized businesses within its primary service area.  The Company's commercial lending activity extends across its primary service areas of Grant, Hardy, Hampshire, Mineral, Randolph, Tucker, and northern Pendleton counties in West Virginia, Frederick County, Virginia and Garrett County, Maryland.  Consistent with its focus on providing community-based financial services, the Company does not attempt to diversify its loan portfolio geographically by making significant amounts of loans to borrowers outside of its primary service area.

Credit Quality and Allowance for Loan Losses

Non-performing loans increased 20.6% from December 31, 2010 to March 31, 2011 primarily as a result of increases in non-accrual loans somewhat offset by a decrease in loans past due in excess of 90 days.  Non-accrual loans have increased as a result of the deterioration of loan performance due to the current economic conditions.  As a result of the decline of property values, management has chosen to be more conservative in its evaluation of potential non-performing loans.  Non-performing loans represented as a percentage of total loans increased to 2.91% during the first three months of 2011, as compared to 2.38% of total loans at December 31, 2010, due to the increase in non-accrual loans mentioned above.  The allowance for loan losses as a percentage of total loans increased from the December 31, 2010 level of 1.64% to 1.76%.  As noted in Note Two to the unaudited consolidated financial statements, the carrying value of impaired loans increased from $24.5 million at December 31, 2010 to $26.3 million at March 31, 2011.

Restructured loans performing in accordance with modified terms consist of four commercial mortgages and three consumer mortgages.  Restructured loans not performing in accordance with modified terms consist of one consumer mortgage.  Based on Management’s analysis, $59,000 is included in the allowance related to two restructured loans.  The remaining six restructured loans are well secured and no losses are anticipated; therefore, no additional allowance was provided.

Each of the Company’s banking subsidiaries determines the adequacy of its allowance for loan losses independently using the same allowance for loan loss methodology.  The allowance is calculated quarterly and adjusted prior to the issuance of the quarterly financial statements.  All loan losses charged to the allowance are approved by the boards of directors of

 
24


each bank at their regular meetings.  The allowance is reviewed for adequacy after considering historical loss rates, current economic conditions (both locally and nationally) and any known credit problems that have not been considered elsewhere in the calculation.  Although the loan portfolios of the two banks are similar to each other, some differences exist which result in divergent risk patterns and different historical charge-off rates amongst the functional areas of the banks’ loan portfolios.  Each bank pays particular attention to the individual loan performance, collateral values, borrower financial condition and economic conditions.  A committee, with representatives from both subsidiary banks, meets to discuss the overall economic conditions that impact both subsidiary banks in the same fashion.

The determination of an adequate allowance at each bank is done in a four step process.  The first step is to identify impaired loans.  Impaired loans are problem loans above a certain threshold which are not expected to perform in accordance with the original loan agreement.  Impaired loans and their resulting valuation allowance are disclosed in Note Two to the Company’s unaudited consolidated financial statements.  The second step is to identify loans above a certain threshold which are problem loans due to the borrower’s payment history or deteriorating financial condition.  Losses in this category are determined based on historical loss rates of loans in the category over the prior 12 months.  The third step is to calculate a loss for the remainder of the portfolio using historical loss information for each loan category.  The final step is to calculate the potential impact of the economic environment on future loan performance.  The determination of specific allowances and weighting is subjective and actual losses may be greater or less than the current amount of the allowance.  However, management believes the current level of the allowance for loan losses represents a fair assessment of the losses inherent in the loan portfolio.

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

   
March 31, 2011
   
December 31, 2010
 
Allowance for loan losses as a percentage of gross loans
    1.76 %     1.64 %
Non performing loans as a percentage of gross loans
    2.91 %     2.38 %
Ratio of allowance for loan losses to non-performing loans
    0.61       0.69  

Non-performing loans include non-accrual loans and loans 90 days or more past due (including non-performing restructured loans).  Non-accrual loans are loans on which interest accruals have been suspended.  Loans are typically placed on non-accrual status once they have reached certain delinquency status, depending on loan type, and it is no longer reasonable to expect collection of principal and interest because collateral is insufficient to cover both the principal and interest due.  After loans are placed on non-accrual status, they are returned to accrual status if the obligation is brought current by the borrower, or they are charged off if payment is not made.

The following table summarizes the Company’s non-performing loans at March 31, 2011 and December 31, 2010 (in thousands of dollars):
 
   
March 31, 2011
   
December 31, 2010
 
Loans accounted for on a non-accrual basis
           
Commercial Mortgage
  $ 4,828     $ 2,215  
Commercial Other
    131       139  
Consumer Mortgage
    3,768       4,240  
Consumer Other
    136       385  
Total non-accrual loans
  $ 8,863     $ 6,979  
                 
Loans delinquent 90 days or more and still accruing
         
Commercial Mortgage
  $ 320     $ 301  
Commercial Other
    0       46  
Consumer Mortgage
    253       397  
Consumer Other
    23       122  
Total delinquent loans
  $ 596     $ 866  
                 
Total Non-Performing Loans
  $ 9,459     $ 7,845  
                 
Restructured loans are loans on which the original interest rate or repayment terms have been changed due to financial hardship of the borrower.  Restructured loans that are performing in accordance with modified terms are $5,345,000 and

 
25


$6,740,000 at March 31, 2011 and December 31, 2010, respectively.  The decrease was primarily driven by the removal of one commercial mortgage loan which no longer meets the criteria of restructured loans.

The following table summarizes the Company’s net charge-offs by loan type for the three month periods ended March 31, 2011 and 2010 (in thousands of dollars):

   
2011
   
2010
 
Charge-offs
           
Commercial Mortgage
  $ (31 )   $ (225 )
Commercial Other
    0       (154 )
Consumer Mortgage
    (307 )     (88 )
Consumer Other
    (122 )     (227 )
Total Charge-offs
  $ (460 )   $ (694 )
                 
Recoveries
               
Commercial Mortgage
  $ 106     $ 0  
Commercial Other
    21       0  
Consumer Mortgage
    10       0  
Consumer Other
    60       93  
Total Recoveries
  $ 197     $ 93  
                 
Total Net Charge-offs
  $ (263 )   $ (601 )

Management believes that the allowance is to be taken as a whole, and the allocation between loan types is an estimation of potential losses within each type given information known at the time.  The following table shows the allocation for loans in the loan portfolio and the corresponding amounts of the allowance allocated by loan type as of March 31, 2011 and December 31, 2010 (in thousands of dollars):

   
March 31, 2011
   
December 31, 2010
 
   
Amount
   
Percent
of Loans
   
Amount
   
Percent
of Loans
 
Loan Type
                       
Commercial Mortgage
  $ 2,742       45 %   $ 1,345       43 %
Commercial Other
    614       4 %     887       5 %
Consumer Mortgage
    1,480       43 %     1,662       43 %
Consumer Other
    641       8 %     968       9 %
Unallocated
    252               545          
Totals
  $ 5,729       100 %   $ 5,407       100 %

Because of its large impact on the local economy, management continues to monitor the economic health of the poultry industry. The Company has direct loans to poultry growers and the industry is a large employer in the Company’s trade area. In addition, multiple manufacturers of household cabinetry are large employers in the Company’s primary trade area. Due to the downturn in the housing market nationally, there have been indications that the demand for cabinetry has decreased, impacting the performance of these manufacturers. Because of the impact on the local economy, management has begun to monitor the performance of this industry as it relates to local employment trends. Additionally, the Company’s loan portfolio contains a segment of loans collateralized by heavy equipment, particularly in the trucking, mining and timber industries. Because of the impact of the slowing economic conditions on the housing market, the timber sector has experienced a recent downturn. The Company has experienced losses related to the downturn in this industry.

Net Interest Income

The Company’s net interest income, on a fully taxable equivalent basis, increased 1.69% for the first three months of 2011 as compared to the same period in 2010.  The increase in net interest income was driven by changes in average rates earned on assets and paid on interest bearing liabilities and by changes in the relative mix of earning assets and interest bearing liabilities.

 
26


For the three month period ended March 31, 2011, the Company’s average earning assets decreased 2.14% compared to the same period in 2010 offset by a decrease in average interest bearing liabilities, comparing the same periods, of 3.90%.  The average balances of time deposits and long-term debt, both comparatively more expensive interest bearing liabilities, decreased 6.27%. These changes in the relative mix of earning assets and interest bearing liabilities and the change in the average yields somewhat offset, resulting in the slight increase of the Company’s net interest income.

The Company believes that its deposits will be sufficient to fund the current and expected loan demand.  Should the loan demand increase beyond the Company’s current expectations, the Company may be required to fund these loans with borrowings which could result in a reduction of net interest margin.  However, management believes total net interest income would not be adversely affected.

Also, balances of non-performing loans and other real estate acquired through foreclosure have increased from December 31, 2010 to March 31, 2011. Increases in balances of non-accrual loans and other real estate acquired through foreclosure often have adverse effects on net interest income. Should balances of non-accrual loans and other real estate acquired through foreclosure continue to increase, net interest margin may decrease accordingly.

The table below illustrates the effects on net interest income, on a fully taxable equivalent basis, for the first three months of 2011 compared to the same period in 2010, of changes in average volumes of interest bearing liabilities and earning assets from 2010 to 2011 and changes in average rates on interest bearing liabilities and earning assets from 2010 to 2011 (in thousands of dollars):

EFFECT OF RATE-VOLUME CHANGES ON NET INTEREST INCOME
 
                   
Increase (Decrease) Three Months Ended March 31, 2011 compared to Three Months Ended March 31, 2010
 
   
Due to change in:
       
   
Average
Volume
   
Average
Rate
   
Total
Change
 
Interest Income
                 
Loans
  $ (104 )   $ (222 )   $ (326 )
Federal funds sold
    (1 )     0       (1 )
Interest bearing deposits
    0       (2 )     (2 )
Taxable investment securities
    6       (28 )     (22 )
Nontaxable investment securities
    (15 )     (19 )     (34 )
Total Interest Income
    (114 )     (271 )     (385 )
                         
Interest Expense
                       
Demand deposits
    0       0       0  
Savings deposits
    2       (14 )     (12 )
Time deposits
    (70 )     (363 )     (433 )
Borrowings
    (17 )     10       (7 )
Total Interest Expense
    (85 )     (367 )     (452 )
                         
Net Interest Income
  $ (29 )   $ 96     $ 67  


 
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The table below sets forth an analysis of net interest income for the three month periods ended March 31, 2011 and 2010 (Average balances and interest/expense shown in thousands of dollars):

   
2011
   
2010
 
   
Average
   
Income/
         
Average
   
Income/
       
   
Balance
   
Expense
   
Rate
   
Balance
   
Expense
   
Rate
 
Earning Assets
                                   
Loans
  $ 327,633     $ 5,156       6.29 %   $ 334,232     $ 5,482       6.56 %
Taxable investment securities
    24,863       126       2.03 %     23,684       148       2.51 %
Non-taxable investment securities
    2,148       19       3.54 %     3,871       53       5.49 %
Interest bearing deposits
    3,988       1       0.10 %     2,144       3       0.48 %
Federal funds sold
    8,792       4       0.18 %     11,515       5       0.18 %
Total Earning Assets
  $ 367,424     $ 5,306       5.79 %   $ 375,446     $ 5,691       6.06 %
                                                 
Allowance for loan losses
    (5,574 )                     (3,954 )                
Other non-earning assets
    41,506                       38,143                  
Total Assets
  $ 403,356                     $ 409,635                  
                                                 
Interest Bearing Liabilities
                                               
Demand deposits
  $ 23,062     $ 7       0.13 %   $ 23,000     $ 7       0.12 %
Savings deposits
    54,253       34       0.25 %     51,668       46       0.36 %
Time deposits
    210,987       1,120       2.12 %     224,235       1,553       2.77 %
Long-term debt
    9,335       108       4.63 %     10,813       115       4.26 %
Total Interest Bearing Liabilities
  $ 297,637     $ 1,269       1.71 %   $ 309,716     $ 1,721       2.22 %
                                                 
                                                 
Demand deposits
    56,872                       52,484                  
Other liabilities
    8,251                       6,439                  
Stockholders’ equity
    40,596                       40,996                  
Total liabilities and stockholders’ equity
  $ 403,356                     $ 409,635                  
                                                 
Net Interest Income
          $ 4,037                     $ 3,970          
Net Yield on Earning Assets
                    4.39 %                     4.23 %

Notes:
Yields are computed on a taxable equivalent basis using a 30% tax rate
Average balances are based upon daily balances
Includes loans in non-accrual status
Income on loans includes fees

 
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Non-interest Income

Non-interest income decreased $41,000, or 7.5%, during the first three months of 2011 compared to the same period in 2010 driven primarily by the gains on security transactions reported in the first three months of 2010 not recurring in the first three months of 2011.

Service charges on deposit accounts decreased 3.36%. The largest portion of these charges is non-sufficient funds fees on non-interest bearing transaction accounts. The subsidiary banks continued to see decreases in service charges associated with the program commonly referred to as the “courtesy overdraft” program.  This is the result of customer’s choice not to participate in the subsidiary bank’s automatic overdraft protection coupled with better management, by customers, of their accounts.

Life insurance investment income was the same during the first three months of 2011 compared to the same period in 2010.

Non-interest Expense

Non-interest expense decreased 2.0% for the first three months of 2011 as compared to the same period in 2010.

Changes in salary and benefits expense

The following table compares the components of salary and benefits expense for the three month periods ended March 31, 2011 and 2010 (in thousands of dollars):

Salary and Benefits Expense
                 
   
2011
   
2010
   
Increase
(Decrease)
 
                   
Employee salaries
  $ 1,104     $ 1,097     $ 7  
Employee benefit insurance
    320       271       49  
Payroll taxes
    70       101       (31 )
Non-recurring post retirement adjustment
    (70 )     0       (70 )
Post retirement plans
    238       251       (13 )
Total
  $ 1,662     $ 1,720     $ (58 )
 
Changes in data processing expense

Data processing expense increased $29,000 or 10.70% for the first three months of 2011 compared to the same period in 2010.  The increase was driven by a credit received from the Company’s core system vendor during the first three months of 2010 for an error in billing during the system conversion in the fall of 2009.

Changes in occupancy and equipment expense

The following table illustrates the components of occupancy and equipment expense for the three month periods ended March 31, 2011 and 2010 (in thousands of dollars):

   
2011
   
2010
   
Increase
(Decrease)
 
Depreciation of buildings and equipment
  $ 196     $ 183     $ 13  
Maintenance expense on buildings and equipment
    84       102       (18 )
Utilities expense
    47       40       7  
Real estate and personal property tax
    29       21       8  
Other expense related to occupancy and equipment
    25       22       3  
Total occupancy and equipment expense
  $ 381     $ 368     $ 13  

 
29


The increases in occupancy and equipment expenses during the first three months of 2011 are related to a new subsidiary bank branch opened during the third quarter of 2010.
 
Changes in miscellaneous non-interest expense
 
Office supplies and postage and freight expenses decreased 23.97% or $29,000 during the first three months of 2011 compared to the same period in 2010, largely driven by the reduction of courier services between branches.

FDIC premium expense increased 2.47% or $4,000 during the first three months of 2011 compared to the same period in 2010 driven by rate changes.

Loan and foreclosed asset expenses increased 181.25% or $87,000 during the first three months of 2011 compared to the same period in 2010 due to the increased number of foreclosures.

Other non-interest expense decreased $54,000 or 23.79% during the first three months of 2011 compared to the same period in 2010.

The table below illustrates components of other non-interest expense for the three month periods ended March 31, 2011 and 2010 (in thousands of dollars). Significant individual components of other non-interest expense are itemized.

   
2011
   
2010
   
Increase
(Decrease)
 
ATM expense
    (25 )     (12 )     (13 )
Amortization of intangible assets
    46       49       (3 )
Advertising and marketing expense
    34       37       (3 )
Miscellaneous components of other non interest expense
    118       153       (35 )
Total
  $ 173     $ 227     $ (54 )


Borrowed Funds

The Company borrows funds from the Federal Home Loan Bank (“FHLB”) to reduce market rate risks or to provide operating liquidity.  Management typically will initiate these borrowings in response to a specific need for managing market risks or for a specific liquidity need and will attempt to match features of these borrowings to best suit the specific need. Therefore, the borrowings on the Company’s balance sheet as of March 31, 2011 and throughout the periods ended March 31, 2011 and December 31, 2010 have varying features of amortization or single payment with periodic, regular interest payments and also have interest rates which vary based on the terms and on the features of the specific borrowing.

Liquidity

Operating liquidity is the ability to meet present and future financial obligations. Short term liquidity is provided primarily through cash balances, deposits with other financial institutions, federal funds sold, non-pledged securities and loans maturing within one year. Additional sources of liquidity available to the Company include, but are not limited to, loan repayments, the ability to obtain deposits through the adjustment of interest rates and the purchasing of federal funds.  To further meet its liquidity needs, the Company also maintains lines of credit with correspondent financial institutions, the Federal Reserve Bank of Richmond and the Federal Home Loan Bank of Pittsburgh.

Historically, the Company’s primary need for additional levels of operational liquidity has been to fund increases in loan balances. The Company has normally funded increases in loans by increasing deposits and with decreases in liquid assets such as balances of federal funds sold and balances of securities. The Company also utilizes existing borrowing facilities for additional levels of operating liquidity. In choosing which sources of operating liquidity to utilize, management evaluates the implications of each liquidity source and its impact on profitability, balance sheet stability and potential future liquidity needs.

The parent Company’s operating funds, funds with which to pay shareholder dividends and funds for the exploration of new business ventures have been supplied primarily through dividends paid by the Company’s subsidiary banks Capon Valley Bank (CVB) and The Grant County Bank (GCB).  The various regulatory authorities impose restrictions on dividends paid by a state bank.  A state bank cannot pay dividends without the consent of the relevant banking authorities in excess of the total net profits of the current year and the combined retained profits of the previous two years.  As of March 31, 2011, the subsidiary banks could pay dividends to Highlands Bankshares, Inc. of approximately $1,880,000 without permission of the regulatory authorities.

 
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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 March 31, 2011, 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 March 31, 2011 and December 31, 2010:

   
March 31, 2011
   
December 31, 2010
 
   
Actual
   
Regulatory
   
Actual
   
Regulatory
 
   
Ratio
   
Minimum
   
Ratio
   
Minimum
 
Total Risk Based Capital Ratio
                       
Highlands Bankshares
    14.65 %     8.00 %     14.49 %     8.00 %
Capon Valley Bank
    12.68 %     8.00 %     12.50 %     8.00 %
The Grant County Bank
    14.66 %     8.00 %     14.58 %     8.00 %
                                 
Tier 1 Leverage Ratio
                               
Highlands Bankshares
    10.11 %     4.00 %     9.91 %     4.00 %
Capon Valley Bank
    8.44 %     4.00 %     8.33 %     4.00 %
The Grant County Bank
    10.29 %     4.00 %     10.26 %     4.00 %
                                 
Tier 1 Risk Based Capital Ratio
                               
Highlands Bankshares
    13.40 %     4.00 %     13.24 %     4.00 %
Capon Valley Bank
    11.41 %     4.00 %     11.24 %     4.00 %
The Grant County Bank
    13.41 %     4.00 %     13.32 %     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 in order to minimize the effects of inflationary trends on interest rates. Other areas of non-interest expenses may be more directly affected by inflation.

 
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Recent Developments

Dodd-Frank Wall Street Reform and Consumer Protection Act

On July 21, 2010, President Obama signed into law the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Act”).  The Act will result in sweeping financial regulatory reform aimed at strengthening the nation’s financial services sector.

The Act’s provisions that have received the most public attention generally have been those applying to larger institutions or institutions that engage in practices in which we do not engage.  These provisions include growth restrictions, credit exposure limits, higher prudential standards, prohibitions on proprietary trading, and prohibitions on sponsoring and investing in hedge funds and private equity funds.

However, the Act contains numerous other provisions that likely will directly impact us and our banking subsidiaries.  These include increased fees payable by banks to regulatory agencies, new capital guidelines for banks and bank holding companies, permanently increasing the FDIC insurance coverage from $100,000 to $250,000 per depositor, new liquidation procedures for banks, new regulations affecting consumer financial products, new corporate governance disclosures and requirements, and the increased cost of supervision and compliance more generally.  Many aspects of the law are subject to rulemaking by various government agencies and will take effect over several years.  This time table, combined with the Act’s significant deference to future rulemaking by various regulatory agencies, makes it difficult for us to anticipate the Act’s overall financial, competitive and regulatory impact on us, our customers, and the financial industry more generally.

Item 3. 
Quantitative and Qualitative Disclosures About Market Risk                                                                                                           

Not required for smaller reporting companies.

Controls and Procedures

The Company’s management, with the participation of the Company’s Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of the Company’s disclosure controls and procedures as of March 31, 2011. Based on this evaluation, the Company’s Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures are effective as of March 31, 2011. The Company has established procedures undertaken during the normal course of business in an effort to reasonably ensure that fraudulent activity of either an amount material to these results or in any amount is not occurring.

Changes in Internal Controls

During the period reported upon, there were no significant changes in internal controls of Highlands Bankshares, Inc. pertaining to its financial reporting and control of its assets or in other factors that materially affected or are reasonably likely to materially affect such control.


PART IIOTHER INFORMATION

Legal Proceedings

Management is not aware of any material pending or threatened litigation in which the Company or its subsidiaries may be involved as a defendant.  In the normal course of business, the banks periodically must initiate suits against borrowers as a final course of action in collecting past due loans. In addition, to management’s knowledge, no governmental authorities have initiated or contemplated legal action against the Company.

Risk Factors

Not required for smaller reporting companies.

Unregistered Sales of Equity Securities and Use of Proceeds.

None

 
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Defaults Upon Senior Securities

None

(Removed and Reserved)

None

Item 5.
Other Information

None

Item 6.
Exhibits

EXHIBIT INDEX
Exhibit
Number
 
Description
3(i)
 
Articles of Incorporation of Highlands Bankshares, Inc., as restated, are hereby incorporated by reference to Exhibit 3(i) to Highlands Bankshares Inc.’s Form 10-Q filed November 13, 2007.
3(ii)
 
Amended Bylaws of Highlands Bankshares, Inc. are incorporated by reference to Exhibit 3(ii) to Highlands Bankshares Inc.’s Report on Form 8-K filed January 9, 2008.
 
Certification of Chief Executive Officer Pursuant to section 302 of the Sarbanes-Oxley  Act  of
2002 Chapter 63, Title 18 USC Section 1350 (A) and (B).
 
Certification of Chief Financial Officer  Pursuant to section 302 of the Sarbanes-Oxley  Act of
2002 Chapter 63, Title 18 USC Section 1350 (A) and (B).
 
Statement of Chief Executive Officer Pursuant to 18  U.S.C. §1350.
 
Statement of Chief Financial Officer Pursuant to 18 U.S.C. §1350.

 
33

 
Signatures

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

 
HIGHLANDS BANKSHARES, INC.
   
 
/s/ C.E. Porter
 
C.E. Porter
 
President & Chief Executive Officer
   
 
/s/ Jeffrey B. Reedy
 
Jeffrey B. Reedy
 
Chief Financial Officer
May 16, 2011
 
 
 
34