Edgar Filing: HIGHLANDS BANKSHARES INC /VA/

f10qhbi093013.htm

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

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

of the Securities Exchange Act of 1934

For the quarterly period ended September 30, 2013

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

of the Securities Exchange Act of 1934

For the transition period from ____________ to _____________

Commission File Number: 0-27622

HIGHLANDS BANKSHARES, INC.

(Exact name of registrant as specified in its charter)

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

276-628-9181

(Registrant’s telephone number, including area code)

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

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

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or smaller reporting company (See definition of “large accelerated filer, accelerated filer and smaller reporting company” in Rule 12b-2 of the Act). Large Accelerated Filer o Accelerated Filer o Non-Accelerated Filer o Smaller Reporting Company x

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

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

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

outstanding as of November 4, 2013

Highlands Bankshares, Inc.

FORM 10-Q

For the Quarter Ended September 30, 2013

INDEX


PART I. FINANCIAL INFORMATION	PAGE

Item 1. Financial Statements

Consolidated Balance Sheets at September 30, 2013 (Unaudited) and December 31, 2012	3

Consolidated Statements of Income (Unaudited) for the Three Months and Nine Months Ended September 30, 2013 and 2012	4

Consolidated Statements of Comprehensive Income (Unaudited) for the Three Months and Nine Months Ended September 30, 2013 and 2012	5
Consolidated Statements of Cash Flows (Unaudited) for the Nine Months Ended September 30, 2013 and 2012	6

Consolidated Statements of Changes in Stockholders’ Equity (Unaudited) for the Three Months and Nine Months Ended September 30, 2013 and 2012	7

Notes to Consolidated Financial Statements (Unaudited)	8-38

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations	39-47

Item 3. Quantitative and Qualitative Disclosures About Market Risk	47

Item 4. Controls and Procedures	47

PART II. OTHER INFORMATION

Item 1. Legal Proceedings	48

Item 1A. Risk Factors	48

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds	48

Item 3. Defaults Upon Senior Securities	48

Item 4. Mine Safety Disclosures	48

Item 5. Other Information	48

Item 6. Exhibits	48

SIGNATURES AND CERTIFICATIONS	49

PART I.

FINANCIAL INFORMATION

ITEM 1. Financial Statements

Consolidated Balance Sheets

(Amounts in thousands)

	(Unaudited) September 30, 2013			(Note 1) December 31, 2012
ASSETS
Cash and due from banks	$	17,657		$	15,220
Federal funds sold		58,578			65,988

Total Cash and Cash Equivalents		76,235			81,208

Investment securities available for sale (amortized cost $61,722 at Sept. 30, 2013, $60,234 at December 31, 2012)		57,353			57,400
Other investments, at cost		4,710			4,930
Loans, net of allowance for loan losses of $7,025 at Sept. 30, 2012, $7,449 at December 31, 2012		393,126			383,049
Premises and equipment, net		20,254			21,176
Land held for sale		1,106			-
Deferred tax assets		11,134			8,298
Interest receivable		2,312			2,314
Bank owned life Insurance		14,024			13,689
Other real estate owned, net		13,051			16,639
Other assets		3,341			3,793

Total Assets	$	596,646		$	592,496

LIABILITIES AND STOCKHOLDERS’ EQUITY

LIABILITIES
Deposits:
Non-interest bearing	$	107,958		$	105,960
Interest bearing		380,208			379,380

Total Deposits		488,166			485,340

Interest, taxes and other liabilities		2,446			2,066
Other short-term borrowings		23,525			20,170
Long-term debt		47,815			51,298
Capital securities		3,150			3,150

Total Other Liabilities		76,936			76,684

Total Liabilities		565,102			562,024

STOCKHOLDERS’ EQUITY

Common stock (5,011 shares issued and outstanding)		3,132			3,132
Additional paid-in capital		7,783			7,783
Retained earnings		23,514			21,428
Accumulated other comprehensive income (loss)		(2,885	)		(1,871	)

Total Stockholders’ Equity		31.544			30,472

Total Liabilities and Stockholders’ Equity	$	596,646		$	592,496

See accompanying Notes to Consolidated Financial Statements

Consolidated Statements of Income

(Amounts in thousands, except per share data)

(Unaudited)

	Nine Months Ended September 30, 2013			Nine Months Ended September 30, 2012			Three Months Ended September 30, 2013			Three Months Ended September 30, 2012
INTEREST INCOME
Loans receivable and fees on loans	$	16,186		$	17,712		$	5,384		$	5,728
Securities available for sale:
Taxable		534			679			173			210
Exempt from taxable income		418			532			138			155
Other investment income		122			73			31			29
Federal funds sold		110			109			35			33

Total Interest Income		17,370			19,105			5,761			6,155

INTEREST EXPENSE
Deposits		2,255			3,360			726			967
Other borrowed funds		2,178			2,529			727			824

Total Interest Expense		4,433			5,889			1,453			1,791

Net Interest Income		12,937			13,216			4,308			4,364

Provision for Loan Losses		1,120			857			552			236

Net Interest Income after Provision for Loan Losses		11,817			12,359			3,756			4,128

NON-INTEREST INCOME
Securities gains, losses, net		(4	)		663			-			458
Service charges on deposit accounts		1,545			1,516			533			516
Other service charges, commissions and fees		1,248			1,357			446			382
Other operating income		533			643			159			233
Other than temporary impairment		-			(167	)		--			--
Total Non-Interest Income		3,322			4,012			1,138			1,589

NON-INTEREST EXPENSE
Salaries and employee benefits		7,140			7,025			2,398			2,358
Occupancy expense of bank premises		902			896			301			300
Furniture and equipment expense		910			936			295			292
Other operating expense		4,034			4,106			1,378			1,303
Foreclosed Assets – Loss on Sale / Write-down /Expenses		2,381			1,039			1,632			410
Total Non-Interest Expense		15,367			14,002			6,004			4,663

Income (Loss) Before Income Taxes		(228	)		2,369			(1,110	)		1,054

Income Tax Expense (Benefit)		(2,314	)		519			(452	)		272

Net Income (Loss)	$	2,086		$	1,850		$	(658	)	$	782

Basic Earnings (Loss) Per Common Share – Weighted Average	$	0.42		$	0.37		$	(0.13	)	$	0.16

Earnings (Loss) Per Common Share – Assuming Dilution	$	0.42		$	0.37		$	(0.13	)	$	0.16

See accompanying Notes to Consolidated Financial Statements

Consolidated Statements of Comprehensive Income

(Amounts in thousands)

(Unaudited)

	Nine Months Ended September 30, 2013			Nine Months Ended September 30, 2012


Net Income	$	2,086		$	1,850

Other Comprehensive Income
Unrealized gains (losses) on securities during the period		(1,537	)		1,148
Less: reclassification adjustment for (gains) and losses included in net income		4			(663	)
Other Comprehensive Income (Loss), before tax		(1,533	)		485
Income tax expense (benefit) related to other comprehensive income		(519	)		165
Other Comprehensive Income (Loss)		(1,014	)		320
Comprehensive Income	$	1.072		$	2,170

	Three Months Ended September 30, 2013			Three Months Ended September 30, 2012


Net Income (Loss)	$	(658	)	$	782

Other Comprehensive Income
Unrealized gains (losses) on securities during the period		(156	)		205
Less: reclassification adjustment for (gains) included in net income		-			(458	)
Other Comprehensive Income (Loss), before tax		(156	)		(253	)
Income tax expense (benefit) related to other comprehensive income		(53	)		(86	)
Other Comprehensive Income (Loss)		(103	)		(167	)
Comprehensive Income	$	(761	)	$	615

See accompanying Notes to Consolidated Financial Statements

Consolidated Statements of Cash Flows

(Amounts in thousands)

(Unaudited)

	Nine Months Ended			Nine Months Ended
	September 30, 2013			September 30, 2012
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income	$	2,086		$	1,850
Adjustments to reconcile net income to net cash provided by operating activities
Provision for loan losses		1,120			857
Depreciation and amortization		676			744
Net realized (gains) losses on available for sale securities		4			(663	)
Net amortization on securities		586			536
Other than temporary impairment charge		-			167
Amortization of capital issue costs		4			4
(Increase) decrease in interest receivable		2			(100	)
Valuation adjustment of other real estate owned		1,645			243
Valuation adjustment of deferred tax assets		(2,000	)		-
Increase in other assets		(213	)		(234	)
Increase (decrease) in interest, taxes and other liabilities		380			(357	)

Net cash provided by operating activities		4,290			3,047

CASH FLOWS FROM INVESTING ACTIVITIES:
Securities available for sale:
Proceeds from sale of securities		1,321			11.557
Proceeds from maturities of debt and equity securities		8,366			17,737
Purchase of debt and equity securities		(11,765	)		(24.217	)
Redemption of other investments		220			377
Net (increase) decrease in loans		(14,769	)		1,387
Proceeds from sales of other real estate owned		5,514			4,970
Premises and equipment expenditures		(848	)		(263	)

Net cash provided by (used in) investing activities		(11,961	)		11,548

CASH FLOWS FROM FINANCING ACTIVITIES:
Net decrease in time deposits		(16,696	)		(43,984	)
Net increase in demand, savings and other deposits		19,522			20,257
Increase (decrease) in short-term borrowings		3,355			(37,501	)
Increase (decrease) in long-term debt		(3,483	)		37,372

Net cash provided by (used in) financing activities		2,698			(23,856	)

Net (decrease) in cash and cash equivalents		(4,973	)		(9,261	)
CASH AND CASH EQUIVALENTS AT BEGINNING OF YEAR		81,208			86,075

CASH AND CASH EQUIVALENTS AT END OF PERIOD	$	76,235		$	76,814

SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION
Cash paid during the year for:
Interest	$	4,303		$	5,807

SUPPLEMENTAL DISCLOSURE OF NONCASH TRANSACTIONS
Transfer of loans to other real estate owned	$	3,572		$	6,501
Loans originated from sales of other real estate owned	$	1,751		$	1,338

See accompanying Notes to Consolidated Financial Statements

Consolidated Statements of Changes in Stockholders’ Equity

(Amounts in thousands)

(Unaudited)

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

Balance, June 30, 2012		5,011	$	3,132	$	7,783	$	20,474		$	(1,572	)	$	29,817

Net income		-		-		-		782			-			782

Other comprehensive income (loss)		-		-		-		-			(167	)		(167	)

Balance, September 30, 2012		5,011	$	3,132	$	7,783	$	21,256		$	(1,739	)	$	30,432

Balance, June 30, 2013		5,011	$	3,132	$	7,783	$	24,172		$	(2,782	)	$	32,305

Net income / (loss)		-		-		-		(658	)		-			(658	)

Other comprehensive income (loss)		-		-		-		-			(103	)		(103	)


Balance, September 30, 2013		5,011	$	3,132	$	7,783	$	23,514		$	(2,885	)	$	31,544

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

Balance, December 31, 2011		5,011	$	3,132	$	7,783	$	19,406	$	(2,059	)	$	28,262

Net income		-		-		-		1,850		-			1,850

Other comprehensive income		-		-		-		-		320			320


Balance, September 30, 2012		5,011	$	3,132	$	7,783	$	21,256	$	(1,739	)	$	30,432

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

Net income		-		-		-		2,086		-			2,086

Other comprehensive income (loss)		-		-		-		-		(1,014	)		(1,014	)


Balance, September 30, 2013		5,011	$	3,132	$	7,783	$	23,514	$	(2,885	)	$	31,544

See accompanying Notes to Consolidated Financial Statements

Notes to Consolidated Financial Statements

(Unaudited)

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

Note 1 - General

The consolidated financial statements of Highlands Bankshares, Inc. (the “Company”) conform to United States generally accepted accounting principles and to banking industry practices. The accompanying consolidated interim financial statements are unaudited. In the opinion of management, all adjustments necessary for a fair presentation of the consolidated financial statements have been included. All such adjustments are of a normal and recurring nature. The consolidated balance sheet as of December 31, 2012 has been extracted from the audited financial statements included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2012 (the “2012 Form 10-K”). The notes included herein should be read in conjunction with the notes to consolidated financial statements included in the 2012 Form 10-K. The results of operations for the three month and nine month periods ended September 30, 2013 are not necessarily indicative of the results to be expected for the full year.

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

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

The composition of net loans is as follows:

	Sept. 30, 2013		December 31, 2012
Real Estate Secured:
Residential 1-4 family	$	174,971	$	167,777
Multifamily		19,768		17,348
Construction and Land Loans		17,620		19,161
Commercial, Owner Occupied		67,679		64,504
Commercial, Non-owner occupied		37,329		35,536
Second mortgages		8,200		9,298
Equity lines of credit		8,167		8,287
Farmland		10,728		11,180
		344,462		333,091

Secured (other) and unsecured
Personal		21,634		22,358
Commercial		31,454		31,927
Agricultural		2,964		3,372
		56,052		57,657

Overdrafts		213		297

		400,727		391,045
Less:
Allowance for loan losses		7,025		7,449
Net deferred fees		576		547
		7,601		7,996

Loans, net	$	393,126	$	383,049

Notes to Consolidated Financial Statements

(Unaudited)

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

The following table is an analysis of past due loans as of September 30, 2013:

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

Real Estate Secured
Residential 1-4 family	$	2,666	$	470	$	3,390	$	6,526	$	168,445	$	174,971	$	-
Equity lines of credit		-		12		282		294		7,873		8,167		-
Multifamily		-		-		-		-		19,768		19,768		-
Farmland		102		-		130		232		10,496		10,728		-
Construction, Land Development, Other Land Loans		184		94		1,576		1,854		15,766		17,620		-
Commercial Real Estate- Owner Occupied		-		938		1,610		2,548		65,131		67,679		-
Commercial Real Estate- Non Owner Occupied		921		375		262		1,558		35,771		37,329		-
Second Mortgages		99		276		50		425		7,775		8,200		-
Non Real Estate Secured
Personal		234		77		170		481		21,366		21,847		13
Commercial		193		175		412		780		30,674		31,454		-
Agricultural		-		-		-		-		2,964		2,964		-

Total	$	4,399	$	2,417	$	7,882	$	14,698	$	386,029	$	400,727	$	13

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

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

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

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

Notes to Consolidated Financial Statements

(Unaudited)

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

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

The following is a summary of non-accrual loans at September 30, 2013 and December 31, 2012:

	September 30, 2013		December 31, 2012
Real Estate Secured
Residential 1-4 Family	$	3,970	$	4,213
Multifamily		-		-
Construction and Land Loans		1,576		1,953
Commercial-Owner Occupied		1,844		2,888
Commercial- Non Owner Occupied		1,828		290
Second Mortgages		86		495
Equity Lines of Credit		282		-
Farmland		152		129
Secured (other) and Unsecured
Personal		158		50
Commercial		412		526
Agricultural		-		-

Total	$	10,308	$	10,544

The September 30, 2013 total above includes approximately $2.4 million of loans that are current and paying under the terms of their existing loan agreement but included in non-accrual per regulatory guidance.

Notes to Consolidated Financial Statements

(Unaudited)

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

The following tables represent a summary of credit quality indicators of the Company’s loan portfolio at September 30, 2013 and December 31, 2012. The grades are assigned and / or modified by the Company’s credit review and credit analysis departments based on the creditworthiness of the borrower and the overall strength of the loan.

Credit Risk Profile by Internally Assigned Grade as of September 30, 2013

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

Quality		33,415		-		762		3,313		4,736		1,580
Satisfactory		85,275		15,453		4,233		8,212		26,197		15,006
Acceptable		41,751		3,048		3,487		2,828		20,995		10,985
Special Mention		5,666		1,267		1,813		1,611		6,664		3,899
Substandard		8,864		-		433		1,656		9,087		5,859
Doubtful		-		-		-		-		-		-

Total	$	174,971	$	19,768	$	10,728	$	17,620	$	67,679	$	37,329

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

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

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

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

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

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

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

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

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

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

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

Notes to Consolidated Financial Statements

(Unaudited)

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

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

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

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

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

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

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

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

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

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

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

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

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

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

The weaknesses may include, but are not limited to:

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

Declining or inadequate liquidity

Improper loan structure or questionable repayment sources

Lack of well-defined secondary repayment source, and

Unfavorable competitive comparisons.

Notes to Consolidated Financial Statements

(Unaudited)

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

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

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

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

Injection of capital

Alternative financing

Liquidation of assets or the pledging of additional collateral.

Credit Risk Profile based on payment activity as of September 30, 2013:

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

Performing	$	21,676	$	15,999	$	31,043	$	2,964
Nonperforming (>90 days past due)		171		368		411		-

Total	$	21,847	$	16,367	$	31,454	$	2,964

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

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

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

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

Notes to Consolidated Financial Statements

(Unaudited)

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

The following tables reflect the Bank’s impaired loans at September 30, 2013:

	Recorded Investment		Unpaid Principal Balance		Related Allowance		Average Recorded Investment		Interest Income Recognized
With No Related Allowance
Real Estate Secured
Residential 1-4 family	$	6,805	$	6,805	$	-	$	6,682	$	138
Equity lines of credit		221		221		-		110		5
Multifamily		-		-		-		-		-
Farmland		231		231		-		265		4
Construction, Land Development, Other Land Loans		1,625		1,625		-		1,642		3
Commercial Real Estate- Owner Occupied		6,067		6,067		-		5,538		194
Commercial Real Estate- Non Owner Occupied		7,894		7,894		-		5,663		199
Second Mortgages		212		212		-		266		2
Non Real Estate Secured
Personal /Consumer		66		66		-		37		3
Business Commercial		409		409		-		238		21
Agricultural		600		600		-		310		3

Total	$	24,130	$	24,130	$	-	$	20,751	$	572

Notes to Consolidated Financial Statements

(Unaudited)

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

	Recorded Investment		Unpaid Principal Balance		Related Allowance		Average Recorded Investment		Interest Income Recognized
With an Allowance Recorded
Real Estate Secured
Residential 1-4 family	$	3,552	$	3,552	$	615	$	4,019	$	113
Equity lines of credit		13		13		13		7		-
Multifamily		-		-		-		203		-
Farmland		201		201		9		202		5
Construction, Land Development, Other Land Loans		-		-		-		-		-
Commercial Real Estate- Owner Occupied		2,854		2,854		339		2,776		100
Commercial Real Estate- Non Owner Occupied		4,220		4,220		1,185		3,607		44
Second Mortgages		49		49		38		27		-
Non Real Estate Secured
Personal /Consumer		173		173		116		97		7
Business Commercial		1,006		1,006		637		832		17
Agricultural		-		-		-		358		-

Total	$	12,068	$	12,068	$	2,952	$	12,128	$	286

The following tables reflect the Bank’s impaired loans at December 31, 2012:

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

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

Notes to Consolidated Financial Statements

(Unaudited)

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

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

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

Notes to Consolidated Financial Statements

(Unaudited)

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

The following tables present the balance in the allowance for loan losses and the recorded investment in loans by loan category and segregated by impairment evaluation method as of September 30, 2013 and September 30. 2012.

Nine months ended September 30, 2013	Residential 1-4 Family		Multifamily			Construction and Land Loans			Commercial Owner Occupied		Commercial Non-Owner Occupied		Second Mortgages		Equity Line of Credit		Farmland		Personal and Overdrafts		Commercial and Agricultural			Unallocated		Total
Allowance for Credit Losses:
Beginning Balance December 31, 2012	$	1,242	$	280		$	823		$	1,039	$	1,075	$	161	$	30	$	97	$	486	$	1,530		$	686		7,449
Provision for Credit Losses		329		(102	)		(404	)		161		376		150		1		17		348		(275	)		519		1,120
Charge-offs		333		-			127			408		52		134		3		41		331		193			-		1,622
Recoveries		6		-			3			-		-		-		-		-		39		30			-		78
Net Charge-offs		327		-			124			408		52		134		3		41		292		163			-		1,544
Ending Balance September 30, 2013		1,244		178			295			792		1,399		177		28		73		542		1,092			1,205		7,025
Ending Balance: Individually evaluated for impairment		615		-			-			339		1,185		38		13		9		116		637			-		2,952
Ending Balance: Collectively Evaluated for Impairment		629		178			295			453		214		139		15		64		426		455			1,205		4,073
Loans:
Ending Balance: Individually Evaluated for Impairment		10,357		-			1,625			8,921		12,114		261		234		432		239		2,015			-		36,198
Ending Balance: Collectively Evaluated for Impairment		164,614		19,768			15,995			58,758		25,215		7,939		7,933		10,296		21,608		32,403			-		364,529
Ending Balance: September 30, 2013	$	174,971	$	19,768		$	17,620		$	67,679	$	37,329	$	8,200	$	8,167	$	10,728	$	21,847	$	34,418			-	$	400,727

Notes to Consolidated Financial Statements

(Unaudited)

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

Nine months ended September 30, 2012	Residential 1-4 Family			Multifamily		Construction and Land Loans			Commercial Owner Occupied			Commercial Non-Owner Occupied		Second Mortgages			Equity Line of Credit		Farmland			Personal and Overdrafts		Commercial and Agricultural		Unallocated		Total
Allowance for Credit Losses:
Beginning Balance December 31, 2011	$	1,618		$	477	$	1,746		$	1,209		$	400	$	371		$	69	$	336		$	764	$	1,620	$	414		9,024
Provision for Credit Losses		(235	)		139		(889	)		(193	)		822		(65	)		7		(164	)		94		450		891		857
Charge-offs		313			246		448			183			686		68			23		4			309		566		-		2,846
Recoveries		158			-		452			-			5		2			-		2			63		132		-		814
Net Charge-offs		155			246		(4	)		183			681		66			23		2			246		434		-		2,032
Ending Balance Sept. 30, 2012		1,228			370		861			833			541		240			53		170			612		1,636		1,305		7,849
Ending Balance: Individually evaluated for impairment		416			7		43			212			167		3			-		3			18		647		-		1,516
Ending Balance: Collectively Evaluated for Impairment		812			363		818			621			374		237			53		167			594		989		1,305		6,333
Loans:
Ending Balance: Individually Evaluated for Impairment		13,427			1,305		1,765			11,031			10,775		326			-		475			91		1,899		-		41,094
Ending Balance: Collectively Evaluated for Impairment		155,905			16,027		18,236			54,825			26,111		9,711			8,452		10,421			23,278		34,377		-		357,343
Ending Balance: Sept. 30, 2012	$	169,332		$	17,332	$	20,001		$	65,856		$	36,886	$	10,037		$	8,452	$	10,896		$	23,369	$	36,276		-	$	398,437

Notes to Consolidated Financial Statements

(Unaudited)

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

A loan is considered impaired and an allowance for loan losses is established on loans for which it is probable that the full collection of principal and interest is in doubt. Once a loan is identified as individually impaired, management measures impairment using one of several methods, including collateral value based on recent appraisal and /or tax assessment value, liquidation value and/or discounted cash flows. Those impaired loans not requiring an allowance represent loans for which the fair value of the expected repayments or collateral exceed the recorded investments in such loans. At September 30, 2013 and December 31, 2012, all of the total impaired loans were evaluated based on the fair value of the collateral. On a quarterly basis, the ALLL methodology begins with the determination of individually impaired loans. All loans that are rated “7” (Doubtful) are assessed as impaired based on the expectation that the full collection of principal and interest is in doubt. All loans that are rated “6” (Substandard) or are expected to be downgraded to “6”, require additional analysis to determine whether they may be impaired. All loans that are rated “5” (Special Mention) are presumed not to be impaired. However, “5” rated loans with the following characteristics warrant further analysis before completing an assessment of impairment:

•

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

•

A loan is presently in an unapproved over advanced position;

•

A loan is newly modified; or

•

A loan is expected to be modified.

The Company’s credit administration personnel and senior financial officers are responsible for tracking, coding, and monitoring loans that become Troubled Debt Restructurings. Concessions are made to existing borrowers in the form of modified interest rates and / or payment terms. The loans are segregated for regulatory and external reporting. Each specific TDR is reviewed to determine if the accrual of interest should be discontinued and also reviewed for impairment. The Company’s senior credit administration officer performs this analysis on a quarterly basis in addition to determining any other loans that are impaired within the loan portfolio. The Company had a total of $17.86 million and $21.61 million of loans categorized as troubled debt restructurings as of September 30, 2013 and December 31, 2012, respectively. Interest is accrued on TDRs if the loan is otherwise not impaired and the full collection of principal and interest under the modified terms is still deemed probable.

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

The following tables summarize the troubled debt restructurings during the nine months ended September 30, 2013 and 2012.

Notes to Consolidated Financial Statements

(Unaudited)

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

Nine months ended September 30, 2013

Troubled Debt Restructurings Interest only	Number of Contracts		Pre- Modification Outstanding Recorded Investment		Post ModificationRecorded Investment
Real Estate Secured
Residential 1-4 family		-		-		-
Equity lines of credit		-		-		-
Multifamily		-		-		-
Farmland		-		-		-
Construction, Land Development, Other Land Loans		-		-		-
Commercial Real Estate- Owner Occupied		1		1,395		1,395
Commercial Real Estate- Non Owner Occupied		-		-		-
Second Mortgages		-		-		-
Non Real Estate Secured
Personal / Consumer		-		-		-
Business Commercial		-		-		-
Agricultural		-		-		-
		-		-		-
Total		1		1,395		1,395

Troubled Debt Restructurings Below Market Rate	Number of Contracts		Pre- Modification Outstanding Recorded Investment		Post Modification Recorded Investment
Real Estate Secured
Residential 1-4 family		2		1,264		1,264
Equity lines of credit		-		-		-
Multifamily		-		-		-
Farmland		-		-		-
Construction, Land Development, Other Land Loans		-		-		-
Commercial Real Estate- Owner Occupied		-		-		-
Commercial Real Estate- Non Owner Occupied		5		8,687		8,687
Second Mortgages		-		-		-
Non Real Estate Secured
Personal / Consumer		-		-		-
Business Commercial		-		-		-
Agricultural		-		-		-

Total		7		9,951		9,951

Notes to Consolidated Financial Statements

(Unaudited)

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

Troubled Debt Restructurings Loan term extension	Number of Contracts		Pre- Modification Outstanding Recorded Investment		Post Modification Recorded Investment
Real Estate Secured
Residential 1-4 family		3		500		500
Equity lines of credit		-		-		-
Multifamily		-		-		-
Farmland		-		-		-
Construction, Land Development, Other Land Loans		1		55		55
Commercial Real Estate- Owner Occupied		-		-		-
Commercial Real Estate- Non Owner Occupied		-		-		-
Second Mortgages		1		36		36
Non Real Estate Secured
Personal / Consumer		-		-		-
Business Commercial		1		71		71
Agricultural		3		755		755

Total		9		1,417		1,417
Troubled Debt Restructurings All	Number of Contracts		Pre- Modification Outstanding Recorded Investment		Post Modification Recorded Investment
Total Restructurings		17		12,763		12,763

Troubled Debt Restructurings

That subsequently defaulted

Number of Contracts

Pre- Modification Outstanding Recorded Investment

Post Modification Recorded Investment

Real Estate Secured

Residential 1-4 family

Equity lines of credit

Multifamily

Farmland

Construction, Land Development, Other Land Loans

Commercial Real Estate- Owner Occupied

Commercial Real Estate- Non Owner Occupied

Second Mortgages

Non Real Estate Secured

Personal / Consumer

Business Commercial

Agricultural

Total

Notes to Consolidated Financial Statements

(Unaudited)

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

Nine months ended September 30, 2012

Troubled Debt Restructurings Below Market Rate	Number of Contracts		Pre- Modification Outstanding Recorded Investment		Post Modification Recorded Investment
Real Estate Secured				-		-
Residential 1-4 family		1		885		881
Equity lines of credit		-		-		-
Multifamily		-		-		-
Farmland		-		-		-
Construction, Land Development, Other Land Loans		-		-		-
Commercial Real Estate- Owner Occupied		1		2,270		2,248
Commercial Real Estate- Non Owner Occupied		4		8,031		7,968
Second Mortgages		-		-		-
Non Real Estate Secured		-		-		-
Personal / Consumer		-		-		-
Business Commercial		-		-		-
Agricultural		-		-		-
		-		-		-
Total		6		11,186		11,094

Troubled Debt Restructurings Interest Only	Number of Contracts		Pre- Modification Outstanding Recorded Investment		Post Modification Recorded Investment
Real Estate Secured
Residential 1-4 family		1		729		729
Equity lines of credit
Multifamily
Farmland		1		138		138
Construction, Land Development, Other Land Loans
Commercial Real Estate- Owner Occupied
Commercial Real Estate- Non Owner Occupied
Second Mortgages		1		84		84
Non Real Estate Secured
Personal / Consumer
Business Commercial
Agricultural

Total		3		951		951

Notes to Consolidated Financial Statements

(Unaudited)

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

Troubled Debt Restructurings Loan term extension	Number of Contracts		Pre- Modification Outstanding Recorded Investment		Post Modification Recorded Investment
Real Estate Secured
Residential 1-4 family		1		111		111
Equity lines of credit
Multifamily
Farmland
Construction, Land Development, Other Land Loans
Commercial Real Estate- Owner Occupied		2		1,017		1,003
Commercial Real Estate- Non Owner Occupied
Second Mortgages
Non Real Estate Secured
Personal / Consumer		1		28		28
Business Commercial
Agricultural		1		129		129

Total		6		1,696		1,678
Troubled Debt Restructurings All	Number of Contracts		Pre- Modification Outstanding Recorded Investment		Post Modification Recorded Investment
Total Restructurings		15		13,833		13,723

Troubled Debt Restructurings That subsequently defaulted	Number of Contracts		Pre- Modification Outstanding Recorded Investment		Post Modification Recorded Investment
Real Estate Secured
Residential 1-4 family (Loan Term Extension)		1		111		111
Commercial Real Estate- Owner Occupied (Loan Term Extension)		1		285		278

Total		2		396		389

Notes to Consolidated Financial Statements

(Unaudited)

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

Overview of Loan Review and ALLL Processes

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

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

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

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

Notes to Consolidated Financial Statements

(Unaudited)

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

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

(1)

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

(2)

Loan’s observable market price; or

(3)

Fair value of the collateral.

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

ASC 450 Loan Loss:

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

(1)

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

(2)

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

National GDP Growth Rate

Local Unemployment Rates

The Prime Rate

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

(3)

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

Past-Due Loans.

Non-Accrual Loans

CRE Concentrations

Loan Volume Level

Level and Trend of Classified Loans

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

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

Notes to Consolidated Financial Statements

(Unaudited)

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

Note 3 - Income Taxes

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

	2013			2012

Tax expense (benefit) at statutory rate	$	(77	)	$	806
Reduction in taxes from:
Tax-exempt interest		(142	)		(181	)
Valuation adjustment for deferred tax assets		(2,000	)		-
Other, net		(95	)		(106	)

Income tax expense (benefit)	$	(2,314	)	$	519

In the second quarter of 2013, responsive to the improvement in earnings and asset quality,the Company reversed a significant portion of the valuation allowance that was established against the deferred tax assets (“DTA”) during the fourth quarter of 2011. The valuation allowance was established during 2011 due to uncertainty at the time regarding the ability to generate sufficient future taxable income to fully realize the benefit of the net DTA. In assessing the deferred tax assets (“DTA”), management considers whether it is more likely than not that some portion or all of the DTA will not be realized. The Company evaluates the carrying amount of its DTA on a quarterly basis in accordance with the guidance provided in FASB ASC Topic 740 (“ASC 740”), in particular, applying the criteria set forth therein to determine whether it is more likely than not (i.e., a likelihood of more than 50%) that some portion, or all, of the DTA will not be realized within its life cycle, based on the weight of available evidence. In most cases, the realization of the DTA is dependent upon the Company generating a sufficient level of taxable income in future periods, which can be difficult to predict. If the Company’s forecast of taxable income within the carry forward periods available under applicable law is not sufficient to cover the amount of net deferred assets, such assets may be impaired. Management considers the reversal of deferred tax liabilities (including the impact of available carry-back and carry-forward periods), projected future taxable income and tax-planning strategies in making this assessment.

Note 4 - Capital Requirements

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

Notes to Consolidated Financial Statements

(Unaudited)

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

September 30, 2013
Entity	Tier 1			Total Risk Based			Leverage

Highlands Bankshares, Inc.		7.84	%		9.09	%		5.18	%

Highlands Union Bank		8.87	%		10.13	%		5.87	%

December 31, 2012
Entity	Tier 1			Total Risk Based			Leverage

Highlands Bankshares, Inc.		7.85	%		9.11	%		5.18	%

Highlands Union Bank		8.79	%		10.05	%		5.80	%

As of December 31, 2012, the most recent notification from the Federal Reserve Bank of Richmond categorized the Bank as well-capitalized under the regulatory framework for prompt corrective action.

Note 5 - Capital Securities

The Company completed a $7.5 million capital issue of 9.25% Preferred Securities (the “Trust Preferred Securities”) on January 23, 1998. These Trust Preferred Securities were issued by Highlands Capital Trust I, a wholly owned subsidiary of the Company.

On January 15, 2008, after receiving regulatory approval, Highlands Bankshares, Inc. (the “Company”) redeemed $3.862 million in principal amount of its Junior Subordinated Debt Securities due January 15, 2028 (the “Debt Securities”). All of the Debt Securities are held by Highlands Capital Trust I (the “Trust”), the Company’s subsidiary.

Subject to certain exceptions and limitations, the Company may elect from time to time to defer interest payments on the debt securities, which would result in a deferral of distribution payments on the related Capital Securities. Effective April 15, 2010, the Company began deferring interest payments on the debt securities held by Highlands Capital Trust I. As a result, distribution payments to holders of the Capital Securities are also being deferred. The deferral period can last up to 5 years.

Note 6 – Per Share Amounts

The following table contains information regarding the Company’s computation of basic earnings per share and diluted earnings per share for the nine and three months ended September 30, 2013 and 2012.

	Nine Months Ended September 30,				Three Months Ended September 30,
	2013		2012		2013			2012

Basic Earnings per Share	$	0.42	$	0.37	$	( 0.13	)	$	0.16

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

Diluted Earnings per Share	$	0.42	$	0.37	$	( 0.13	)	$	0.16

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

Notes to Consolidated Financial Statements

(Unaudited)

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

Note 7 – Commitments and Contingencies

The Bank is a party to various financial instruments with off-balance sheet risk arising in the normal course of business to meet the financing needs of its customers. Those financial instruments include commitments to extend credit and standby letters of credit. At September 30, 2013, these commitments included: standby letters of credit of $537 thousand; equity lines of credit of $8.66 million; credit card lines of credit of $6.05 million; real estate, construction and land development commitments of $2.64 million; and other unused commitments to fund interest earning assets of $28.52 million.

Note 8 – Fair Value

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

Fair Value Hierarchy

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

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

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

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

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

Notes to Consolidated Financial Statements

(Unaudited)

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

Recurring - Investment Securities Available for Sale

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

As of September 30, 2013, we own approximately $3.83 million (amortized cost) in collateralized debt obligation securities (TRUP CDOs) that are backed primarily by trust preferred securities issued by banks, thrifts, and insurance companies. The market for these and similar securities at September 30, 2013 is not active. The TRUP CDOs have been classified within Level 3 of the fair value hierarchy because we determined that significant adjustments are required for fair value assessment at the measurement date.

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

The following tables summarize the Company’s available for sale securities portfolio measured at fair value on a recurring basis as of September 30, 2013 and December 31, 2012, segregated by the level of the valuation inputs within the fair value hierarchy.

September 30, 2013
	Level 1		Level 2		Level 3		Total Fair Value
Available for Sale Securities
State and Political Subdivisions	$	-	$	10,627	$	-	$	10,627
Mortgage Backed Securities	$	-		30,663	$	-		30,663
TRUP CDO’s	$	-		-	$	413		413
Single Issue Trust Preferred	$	-		877	$	-		877
SBA Pools	$	-		14,272	$	-		14,272
SLMA	$	-		501	$	-		501
Total AFS Securities	$	-	$	56,940	$	413	$	57,353

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

Notes to Consolidated Financial Statements

(Unaudited)

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

Pursuant to ASC Topic 820, the following table shows a reconciliation of the beginning and ending balance at September 30, 2013 for Level 3 assets measured on a recurring basis using significant unobservable inputs. Level 3 assets represent the Company’s TRUP CDOs.

Investment Securities Available for Sale

Beginning balance, December 31, 2012	$	294
Total losses included in net income		-
Included in other comprehensive income		119
Transfers in or out of Level 3		-
Ending balance, September 30, 2013	$	413

Loans

The Company does not record loans at fair value on a recurring basis. However, from time to time, a loan is considered impaired and an allowance for loan losses is established. Loans for which it is probable that payment of interest and principal will not be made in accordance with the contractual terms of the loan agreement are considered impaired. Once a loan is identified as individually impaired, management measures impairment using one of several methods, including collateral value, recent appraisal value and /or tax assessed value, liquidation value and discounted cash flows. At September 30, 2013 impaired loans were evaluated based on the fair value of the collateral. Fair value is based upon independent market prices or appraised values of the collateral which the Company considers as nonrecurring Level 2. The following tables summarize the Company’s impaired loans by loan category at fair value on a non - recurring basis as of September 30, 2013 and December 31, 2012, segregated by the level of the valuation inputs within the fair value hierarchy for which a specific allowance has been allocated.

September 30, 2013
	Level 1	Level 2		Level 3	Total Fair Value
Real Estate Secured
Residential 1-4 family		$	3,552		$	3,552
Equity Lines of Credit			13			13
Farmland			201			201
Construction, Land Development, Other Land Loans			-			-
Commercial Real Estate – Owner Occupied			2,854			2,854
Commercial Real Estate – Non Owner Occupied			4,220			4,220
Second Mortgages			49			49
Non Real Estate Secured
Personal			173			173
Business / Commercial			1,006			1,006
Agricultural			-			-
Total		$	12,068		$	12,068

Notes to Consolidated Financial Statements

(Unaudited)

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

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

Foreclosed Assets / Repossessions

Foreclosed assets and repossessions are adjusted to fair value upon transfer of the loans to foreclosed assets and repossessions. Subsequently, foreclosed assets and repossessions are carried at the lower of carrying value or fair value. Fair value is based upon independent market prices or appraised values of the collateral which the Company considers as nonrecurring Level 2. If additional specific write-downs have occurred, then the foreclosed asset balances are reclassified as non-recurring Level 3. The following tables summarize the Company’s foreclosed and repossessed assets at fair value on a non-recurring basis as of September 30, 2013 and December 31, 2012

September 30, 2013
	Level 1		Level 2		Level 3		Total Fair Value
Repossessions/OREO, net		--	$	13,075		--	$	13,075

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

Notes to Consolidated Financial Statements

(Unaudited)

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

General

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

Fair Value of Financial Instruments

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

Cash and Cash Equivalents

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

Securities Available for Sale

Fair values are determined in the manner as described above.

Other Investments

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

Loans

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

Deposits

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

Other Short-Term Borrowings

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

Notes to Consolidated Financial Statements

(Unaudited)

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

Long-term Debt and Capital Securities

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

Off-Balance Sheet Instruments

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

The carrying amounts and fair values of the Company's financial instruments at September 30, 2013 and December 31, 2012 were as follows:

	September 30, 2013						December 31, 2012
	Carrying			Fair Value			Carrying			Fair Value
	Amount						Amount

Cash and cash equivalents	$	76,235		$	76,235		$	81,208		$	81,208
Securities available for sale		57,353			57,353			57,400			57,400
Other investments		4,710			4,710			4,930			4,930
Loans, net		393,126			390,860			383,049			383,173
Deposits		(488,166	)		(468,994	)		(485,340	)		(480,424	)
Other short-term borrowings		(23,525	)		(25,748	)		(20,170	)		(23,072	)
Long-term debt		(47,815	)		(51,462	)		(51,298	)		(57,145	)
Capital Securities		(3,150	)		(3,542	)		(3,150	)		(3,542	)

Notes to Consolidated Financial Statements

(Unaudited)

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

Note 9. -Investment Securities Available For Sale

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

	September 30, 2013
	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses		Fair Value


State and political subdivisions	$	10,802		84		259	$	10,627
Mortgage backed securities		30,700		232		269		30,663
TRUP CDOs		3,833		-		3,420		413
Single Issue Trust Preferred		908		-		31		877
SBA Pools		14,979		35		742		14,272
SLMA		500		1		-		501
	$	61,722	$	352	$	4,721	$	57,353

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


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

Investment securities available for sale with a carrying value of $43,336 and $41,994 at September 30, 2013 and December 31, 2012, respectively, and a market value of $42,697 and $42,718 at September 30, 2013 and December 31, 2012, respectively, were pledged as collateral on public deposits, FHLB advances and for other purposes as required or permitted by law.

Notes to Consolidated Financial Statements

(Unaudited)

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

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

	September 30, 2013
	Less Than 12 months				12 Months or More				Total
	Fair Value		Unrealized Losses		Fair Value		Unrealized Losses		Fair Value		Unrealized Losses

States and political subdivisions	$	4,359	$	259	$	-	$	-	$	4,359	$	259
Mortgage-backed securities		14,449		247		425		22		14,874		269
Pooled Trust Preferred Securities		-		-		413		3,420		413		3,420
Single Issue Trust Preferred		-		-		887		31		887		31
SBA Pools		8,238		500		4,442		242		12,680		742
SLMA		-		-		-		-		-		-

Total	$	27,046	$	1,006	$	6,167	$	3,715	$	33,213	$	4,721

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

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

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

Notes to Consolidated Financial Statements

(Unaudited)

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

The segment of the portfolio that contains the largest unrealized loss is the pooled trust preferred securities (TRUP CDOs) that are backed primarily by trust preferred securities issued by banks, thrifts, and insurance companies. As of September 30, 2013, the TRUP CDOs book value totaled $3.83 million.

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

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

At September 30, 2013, the following assumptions were used in the cash flow projections:

Deferral / default ranges for 2013 – 1.00%.

· Deferral / default rate for 2014 – 0.25% to 0.36%.

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

· Prepayments - 1% annually, 100% at maturity

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

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

· 0% recovery on existing defaults

· Cash flows are discounted at the effective interest rate.

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

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

Notes to Consolidated Financial Statements

(Unaudited)

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

During the first nine months of 2013, the Company did not incur any credit-related OTTI charges on its TRUP CDOs. For the nine months ended September 30, 2012, the Company incurred a total of $167 thousand of OTTI charges.

The Company also assesses other securities for OTTI quarterly by reviewing credit ratings, financial and regulatory reports as well as other pertinent published financial data. As of September 30, 2013 and December 31, 2012, the Company's assessment revealed no impairment other than that deemed temporary on those securities.

The amortized cost and estimated fair value of securities available for sale at September 30, 2013 by contractual maturity are shown below. Expected maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.

	Amortized Cost		Approximate Market Value
Due in one year or less	$	500	$	501
Due after one year through five years		125		127
Due after five years through ten years		3,641		3,642
Due after ten years		26,756		22,420
		31,022		26,690

Mortgage-backed securities		30,700		30,663
	$	61,722	$	57,353

Note 10–Formal Written Agreement

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

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

strengthen credit risk management and administration;

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

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

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

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

maintain sufficient capital at the Company and the Bank;

establish a revised written contingency funding plan;

establish a revised written strategic and capital plan;

establish a revised investment policy;

improve the Bank’s earnings and overall condition;

revise the Bank’s information technology program;

establish a disaster recovery and business continuity program; and,

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

Notes to Consolidated Financial Statements

(Unaudited)

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

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

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

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

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

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

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

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

Critical Accounting Policy

The financial condition and results of operations presented in the Consolidated Financial Statements, accompanying Notes to Consolidated Financial Statements and management’s discussion and analysis are, to a large degree, dependent upon the accounting policies of the Company. The selection and application of these accounting policies involve judgments, estimates, and uncertainties that are susceptible to change. For a discussion of the Company’s critical accounting policies related to its allowance for loan losses and other than temporary impairment, see the Company’s Annual Report on Form 10-K for the year ended December 31, 2012.

Regulatory Economic Environment

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

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

Formal Written Agreement

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

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

strengthen credit risk management and administration;

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

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

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

maintain sufficient capital at the Company and the Bank;

establish a revised written contingency funding plan;

establish a revised written strategic and capital plan;

establish a revised investment policy;

improve the Bank’s earnings and overall condition;

revise the Bank’s information technology program;

establish a disaster recovery and business continuity program; and,

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

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

The following summarizes the Company’s progress to comply with the items in the Written Agreement as of September 30, 2013.

A new board oversight policy has been approved and implemented;

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

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

Completed revising the written contingency funding plan;

Completed revising the investment policy;

Completed revising the strategic and capital plan;

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

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

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

Results of Operations

Results of operations for the three month and nine month periods ended September 30, 2013 reflect a net loss of $658 thousand and earnings of $2.09 million, respectively, compared to earnings of $782 thousand and $1.85 million for the corresponding periods in 2012. The increase for the nine months ended September 30, 2013 is primarily due to a partial reversal made by the Company in the second quarter of 2013 of its valuation allowance related to deferred tax assets. See Note 3 in our Consolidated Financial Statements for further discussion concerning the Company’s deferred tax asset valuation. The primary reason for the loss incurred for the three months ended September 30, 2013 is an increase in OREO write-downs and losses on the sale of OREO related to contracts to sell approximately $5 million of various OREO properties during September, of which approximately $1 million closed in September. Management took a more aggressive approach to reduce OREO, including conducting on-site auctions of selected properties. The Company recorded any losses related to these sales during the third quarter. However, the reduction related to the net proceeds of approximately

$3 million is not reflected in the Company’s OREO balance as of September 30, 2013 due to the transactions actually closing in October. Subsequent to September 30, 2013, the Company has contracted to sell additional OREO properties, the proceeds of which are expected to reduce the Company’s OREO balance an additional $1.3 million when these transactions close during the fourth quarter.

Net interest income for the three-month period ended September 30, 2013 decreased $56 thousand or 1.28% compared to the three months ended September 30, 2012. For the nine-month period ended September 30, 2013 net interest income decreased $279 thousand or 2.11% as compared to the nine month period ended September 30, 2012. Average interest-earning assets decreased $4.48 million from the nine month period ended September 30, 2012 to the current nine month period, while average interest-bearing liabilities decreased $14.33 million over the same period. The tax-equivalent yield on average interest-earning assets was 4.44% for the nine month period ended September 30, 2013 representing a decrease of 42 basis points from the same period in 2012. The average balance of federal funds sold during the third quarter was $64.27 million. The average yield on federal funds sold for the nine month period ended September 30, 2013 was .23%. The rate on average interest-bearing liabilities decreased 37 basis points to 1.30% for the nine month period ended September 30, 2013 as compared to 1.67% for the same period in 2012.

Total interest income for the three and nine months ended September 30, 2013 was $394 thousand and $1.74 million less than the comparable 2012 periods due primarily to new loan and investment securities being booked at lower rates, and existing adjustable rate loans and investment securities re-pricing at lower rates. Yields on typical investment securities during the current economic cycle have decreased significantly; therefore, management has intentionally decreased its security portfolio and maintained a significant amount of cash and cash equivalents during the last four years.

The Company’s total interest expense decreased by $338 thousand for the three months and $1.46 million for the nine months from the same periods in 2012, due in part to the overall reduction in time deposit balances. Also new interest-bearing deposits are continuing to be recorded at lower rates and existing interest-bearing deposits and other liabilities are re-pricing lower as they renew.

Additionally, during the third quarter of 2012, the Bank restructured $47.50 million of its $67.86 million of Federal Home Loan Bank (FHLB) borrowings. This restructuring resulted in a decrease in the weighted average borrowing rate by approximately 100 basis points or approximately $480,000 in reduced interest expense annually. It also extended the average maturity dates on these borrowings by approximately 2.5 years.

During the first nine months of 2013, the Company’s non-interest income decreased by $690 thousand over the corresponding period for 2012. Total non-interest income for the three months ended September 30, 2013 decreased $451 thousand over the three month period ended September 30, 2012 due primarily to a decrease in security gains of $458 thousand.

Total non-interest expense for the nine month period ended September 30, 2013 increased $1.36 million as compared to the nine month period ended September 30, 2012. The increase is primarily due to the Company’s more aggressive approach pertaining to the sale of OREO properties, primarily through on-site auctions. FDIC insurance premiums totaled $990 thousand and for the nine months ended September 30, 2013 and September 30, 2012. OREO expenses, write-downs and losses on the sale of OREO and repossessions in the amount of $2.38 million increased $1.34 million for the nine month period ended September 30, 2013 as compared to the prior period. Salaries and employee benefits increased $115 thousand for the nine months ended September 30, 2013 as compared to the prior year period primarily due to an increase in medical insurance costs. Total non-interest expense for the three month period ended September 30, 2013 increased $1.34 million compared to the three month period ended September 30, 2012, primarily as a result of the OREO reduction discussed above.

In addition to FDIC insurance premiums, for the nine months ended September 30, 2013, other operating expenses that exceeded 1% of total interest income and other operating income were charges for other contracted services totaling $486 thousand, software licensing and maintenance costs totaling $507 thousand, legal expenses totaling $299 thousand, bank franchise taxes totaling $225 thousand and postage and freight expenses totaling $272 thousand.

In addition to FDIC insurance premiums, for the nine months ended September 30, 2012, other operating expenses that exceeded 1% of total interest income and other operating income were charges for other contracted services totaling $608 thousand, software licensing and maintenance costs totaling $558 thousand, legal expenses totaling $300 thousand and postage and freight expenses totaling $211 thousand.

For the three month period ended September 30, 2013, other operating expenses that exceeded 1% of total interest income and other operating income were charges for FDIC insurance totaling $330 thousand, legal expenses totaling $126 thousand, other contracted services totaling $163 thousand, software licensing and maintenance totaling $158 thousand, bank franchise taxes totaling $75 thousand and postage and freight expenses totaling $95 thousand.

For the three month period ended September 30, 2012, other operating expenses that exceeded 1% of total interest income and other operating income were charges for FDIC insurance totaling $330 thousand, legal expenses totaling $79 thousand, other contracted services totaling $152 thousand and software licensing and maintenance totaling $171 thousand.

Operating results of the Company when measured as a percentage of average equity reveals an increase in return on average equity to 8.87% for the nine-month period ended September 30, 2013 from 8.40% for the corresponding period in 2012. Return on average assets for the nine months ended September 30, 2013 was 0.46% compared to 0.41% for the nine months ended September 30, 2012.The provision for loan losses for the three-month and nine-month periods ended September 30, 2013 totaled $552 thousand and $1.12 million, respectively, a $316 thousand increase and $263 thousand increase as compared to the corresponding periods in 2012. Net charge-offs (inclusive of recoveries) for the first nine months of 2013 were $1.54 million compared with $2.03 million for the first nine months of 2012. Year–to–date net charge-offs were 0.39% and 0.51% of total loans for the periods ended September 30, 2013 and September 30, 2012, respectively. The Company continually monitors the loan portfolio for signs of credit weaknesses or developing collection problems. Loan loss provisions for each period are determined after evaluating the loan portfolio and determining the level necessary to absorb current charge-offs and maintain the reserve at adequate levels. Loan loss reserves decreased 10.50% to $7.03 million at September 30, 2013 from $7.85 million at September 30, 2012. The Company’s allowance for loan loss reserves at September 30, 2013 decreased to 1.76% of total loans versus 1.97% at September 30, 2012. At December 31, 2012, the allowance for loan loss reserve as a percentage of total loans was 1.91%.

In the second quarter of 2013, the Company reversed 50% of the $4 million valuation allowance that was established against our deferred tax assets (“DTA”) during the fourth quarter of 2011. The valuation allowance was established during 2011 due to uncertainty at the time regarding our ability to generate sufficient future taxable income to fully realize the benefit of our net DTA. The quarter ended June 30, 2013 marked our ninth consecutive quarter of profitability, exclusive of the above mentioned DTA write-down during the fourth quarter of 2011. Based on the improved earnings performance trend, improvements in our financial condition, asset quality and capital ratios, and the expectation of continued profitability, the Company determined that it was more likely than not that a significant portion of our net DTA would be realized in future years. As discussed above, during the quarter ended September 30 , 2013, the Company auctioned or sold several properties included in Other Real Estate Owned in an effort to reduce non-performing assets which resulted in losses on the properties and ultimately a loss for the quarter. The large scale auction process is believed to be a non-recurring event and in managemnent’s opinion does not indicate a reversal of the positive earnings trends experienced since 2011.

In assessing the realizability of deferred tax assets (“DTA”), management considers whether it is more likely than not that some portion or all of the DTA will not be realized. The Company evaluates the carrying amount of its DTA on a quarterly basis in accordance with the guidance provided in FASB ASC Topic 740 (“ASC 740”), in particular, applying the criteria set forth therein to determine whether it is more likely than not (i.e., a likelihood of more than 50%) that some portion, or all, of the DTA will not be realized within its life cycle, based on the weight of available evidence. In most cases, the realization of the DTA is dependent upon the Company generating a sufficient level of taxable income in future periods, which can be difficult to predict. If the Company’s forecast of taxable income within the carry

forward periods available under applicable law is not sufficient to cover the amount of net deferred assets, such assets may be impaired. Management considers the reversal of deferred tax liabilities (including the impact of available carry-back and carry-forward periods), projected future taxable income and tax-planning strategies in making this assessment.

As provided by ASC 740, the Company considers certain prudent and feasible tax-planning strategies that, if implemented, could prevent an operating loss or tax credit carry forward from expiring unused and could result in realization of the existing DTA. The Company currently expects that these tax-planning strategies could generate pre-tax profitability at levels sufficient to fully absorb the existing DTA. However, the Company has no present intention to implement such strategies.

Based on the weight of available evidence, including the continued improvement in earnings, the Company has determined that it is more likely than not that it will be able to realize the existing net deferred tax asset totaling $11.1 million. Specifically, the negative evidence is tempered by the unusual and temporary circumstances created by the significant economic downturn and significant changes in the Company’s lending practices, management, growth strategy, risk tolerance, and operating practices. The implementation of such changes has already led to improved asset quality measures since the first quarter of 2011. Further, the positive evidence currently indicates that the Company has opportunities through various means to generate income at a sufficient enough level to absorb the DTA.

Management, in conjunction with the board of directors, will continue to evaluate the carrying value of the Company’s DTA on a quarterly basis, in accordance with ASC 740, and will determine any need for a valuation allowance based upon circumstances and expectations then in existence.

The Company does not expect to recognize any income tax expense until the first quarter of 2014 as a portion of the remaining deferred tax asset valuation allowance is expected to offset income tax expense for the remainder of 2013. The net impact of reversing the valuation allowance and recording the provision for income tax expense was a net income tax benefit of $2 million. As of September 30, 2013, the remaining valuation allowance on our DTA totaled $2.0 million. Net of this valuation allowance, as of September 30, 2013, the Company’s DTA totaled $11.1 million, compared to a DTA of $8.3 million as of December 31, 2012 as reflected on our consolidated balance sheets.

Financial Position

Total loans increased from $397.88 million at September 30, 2012 to $400.15 million at September 30, 2013. Total loans at December 31, 2012 were $390.50 million. Over the last few years, the Company has significantly decreased its construction portfolio as a result of the economic downturn. The Company’s current focus is to moderately increase its 1-4 family residential loan portfolio. The loan to deposit ratio slightly increased from 80.93% at September 30, 2012 to 81.97% at September 30, 2013. The loan to deposit ratio at December 31, 2012 was 80.45%. Deposits at September 30, 2013 have decreased $3.47 million since September 30, 2012 and have increased $2.83 million since December 31, 2012. During the last 48 months, the Company has continued to lower the interest rates paid on time deposits in a continuing effort to reduce its cost of funds.

The Company owns approximately $3.83 million (book value) in collateralized debt obligation securities that are backed by trust preferred securities issued by banks, thrifts, and insurance companies (TRUP CDOs). The market for these securities at September 30, 2013 is mostly illiquid and markets for similar securities are also not active. These securities are currently in non-accrual status. As of September 30, 2013, the unrealized loss in these securities totaled $3.42 million. Management feels that these losses are temporary and primarily a result of the current inactive market. The market discounts reflect the current illiquidity and the negative credit events within the banking sector. Future deterioration of profits of banks nationally and the possibility of increased bank failures could result in changes in the Company’s outlook for these securities and cause the Company to consider recording additional OTTI charges on these securities. During the nine months ended September 30, 2013, the Company did not incur any OTTI credit related impairment charges on its TRUP CDOs compared to $167 thousand during the nine months ended September 30, 2012.

Below is a table of the Company’s remaining pooled trust preferred balances as of September 30, 2013.

(in thousands)

Description	Type	Class	Original Amount $		Book Value 9/30/13 $		Fair Value 9/30/13 $		Unrealized Gain/(Loss) $			Lowest Credit Rating

Pretsel 4-B	Pooled	Mezz B		700		85		76		(9	)	Ca
Prestel 11-B	Pooled	Mezz B		500		382		78		( 304	)	Ca
Prestel 12-B	Pooled	Mezz B		750		360		100		( 260	)	Ca
Prestel 13-B	Pooled	Mezz B		500		309		32		( 277	)	Ca
Prestel 15-B	Pooled	Mezz B		500		263		16		( 247	)	Ca
Prestel 18-C	Pooled	Mezz C		500		209		1		(208	)	Ca
Prestel 19-C	Pooled	Mezz C		500		255		1		( 254	)	Ca
Prestel 20-C	Pooled	Mezz C		500		11		1		( 10	)	Ca
Prestel 21-C	Pooled	Mezz C		500		294		18		(276	)	Ca
Prestel 22-C	Pooled	Mezz C		500		283		11		(272	)	Ca
Prestel 22-C	Pooled	Mezz C		500		317		11		( 306	)	Ca
Prestel 22-C	Pooled	Mezz C		500		316		11		(305	)	Ca
Prestel 23-C	Pooled	Mezz C		500		442		15		(427	)	C
Tropc CDO III	Pooled	Subordinate		1,000		307		42		(265	)	C

The Company currently has approximately $67.86 million in outstanding FHLB advances. No new advances were originated during the last 24 months. The Company secures all of its existing and future advances from the FHLB with a selected group of in-house residential and commercial real estate secured loans and a selected group of securities that are held in safekeeping by the FHLB.

Non-performing assets are comprised of loans on non-accrual status, loans contractually past due 90 days or more and still accruing interest, other real estate owned and repossessions. In addition, the market value of any securities available for sale placed in non-accrual status is included. Non-performing assets were $23.81 million or 3.99% of total assets at September 30, 2013, compared with $27.50 million or 4.59% of total assets at December 31, 2012 and $29.39 million or 4.91% of total assets at September 30, 2012. The Company continues to focus its efforts on reducing its NPAs, primarily by reducing non accrual loans and selling OREO property.

The adequacy of the allowance for loan losses is based on management's judgment and analysis of current and historical loss experience, risk characteristics of the loan portfolio, concentrations of credit and asset quality, as well as other internal and external factors, such as general economic conditions. The internal credit review department performs pre-approval analyses of large credits and also conducts credit review activities that provide management with an early warning of loan deterioration. The senior credit administration officer prepares quarterly analyses of the adequacy of the allowance for loan losses. These analyses include individual loans considered impaired for direct exposure. In addition, potential losses on loan pools and pool allocations are based upon historical losses and other factors, as adjusted, for various loan types. The calculation of the allowance for loan losses is reviewed by both the Credit Administration Committee and the Board of Directors.

At September 30, 2013 and December 31, 2012, the internal credit review department as well as management determined that the Company's allowance for loan losses is sufficient and is appropriate based on the requirements of U.S. Generally Accepted Accounting Principles.

At September 30, 2013, OREO balances were $13,051 and consisted of 47 relationships. The following chart details each category type, number, and balance.

OREO Property at 9/30/13

OREO Description	Number		Balance at 9/30/13
			(in thousands)
Land Development - Vacant Land		17	$	2,220
1-4 Family		14		4,483
Multifamily		3		1,985
Commercial Real Estate		13		4,363

Total		47	$	13,051

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

OREO Property at 12/31/2012

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

Total		54	$	17,139

During the third quarter, the Company initiated a more aggressive approach to sell OREO, including conducting on-site auctions on several OREO properties. As of September 30, 2013, the Company had approximately $4 million of OREO property under contract with closings scheduled in the month of October. Losses of approximately $1 million related to these sales were recorded in September. The reduction in the Company’s OREO balance related to the net proceeds of approximately $3 million is not reflected as of September 30, 2013 due to the closings occurring in October. Subsequent to September 30, 2013, the Company has contracted to sell additional OREO properties, the proceeds of which are expected to reduce the Company’s OREO balance an additional $1.3 million when these transactions close during the fourth quarter. The Company will continue to make a concerted effort to continue to reduce its NPAs. There has been greater deterioration in the Tennessee commercial real estate market compared to many other markets we serve. The Bank is actively marketing all of its property through its website, listing agents, and other marketing methods. The Company has formed a special assets committee to focus directly on selling OREO properties and reducing other non-performing assets. The committee is comprised of lending officers from all of the Bank’s three market areas. The ability to sell OREO has been negatively affected by the current economic climate. Therefore, the continued reduction of non-performing assets, will to a large degree, depend on how quickly specific market areas rebound from the recession.

The Company also has contracted to sell properties in Bristol, Tennessee and Boone, North Carolina that it had purchased for future branch expansion. If both of these sales occur as expected in November 2013, the Company will experience a gain of approximately $450 thousand.

Investment securities and other investments totaled $62.06 million (market value) at September 30, 2013 which reflects a decrease of $267 thousand from the December 31, 2012 total of $62.33 million. Investment securities available for sale and other investments at September 30, 2013 were comprised of mortgage backed securities / CMOs (49.40% of the total securities portfolio), municipal issues (17.12%), corporate bonds (2.89%), and SBAs pools (23.00%). The Company’s entire securities portfolio was classified as available for sale at both September 30, 2013 and December 31, 2012.

Other investments include the Bank’s holdings of Federal Reserve, Federal Home Loan Bank, Pacific Coast Bankers Bank, Community Bankers Bank stock. These investments (carrying value of $4.71 million and 7.59% of the total) are considered to be restricted as the Company is required to hold these investments and the only market for these investments is the issuing agency. Also included in Other Investments is a certificate of deposit purchased from another FDIC insured institution. The balance of this CD was $250,000 at September 30, 2013 and December 31, 2012 respectively.

Liquidity and Capital Resources

Total stockholders’ equity of the Company was $31.54 million at September 30, 2013, representing an increase of $1.11 million or 3.66% from September 30, 2012. Total stockholders’ equity at December 31, 2012 was $30.47 million. The increase in stockholders’ equity from September 30, 2012 to September 30, 2013 is due to the net earnings achieved over the last 12 months.

Quantitative measures established by regulation to ensure capital adequacy require the Company and the Bank to maintain minimum amounts and ratios of total risk-based capital and Tier I capital to risk-weighted assets (as defined in the regulations), and Tier I capital to adjusted total assets (as defined). See Footnote 4 for a more detailed discussion of the Company’s and Bank’s regulatory capital ratios. The Board of Directors and management are committed to increasing our capital levels and we are continuing to explore options for raising additional capital.

Liquidity is the ability to provide sufficient cash levels to meet financial commitments and to fund loan demand and deposit withdrawals. The Company and subsidiary Bank maintain a significant level of liquidity in the form of cash and cash equivalents ($76.24 million as of September 30, 2013) and unrestricted investment securities available for sale ($14.21 million). Cash and cash equivalents are immediately available for satisfaction of deposit withdrawals, customer credit needs, and operations of the Bank. The Bank also maintains a significant amount of available credit with both the Federal Home Loan Bank and a correspondent financial institution. The Bank also has the ability to attract certificates of deposit outside its market area by posting rates on the internet. The primary investors utilizing this network are credit unions. Unencumbered investment securities available for sale represent a secondary level of liquidity available for conversion to liquid funds in the event of extraordinary needs. The Company believes that it maintains sufficient liquidity to meet its current and projected requirements and needs.

On April 27, 2009, the Company announced that it entered into a $7,500,000 Loan Commitment Agreement with Community Bankers Bank (“CBB”), pursuant to which CBB agreed to extend to the Company an aggregate of $7,500,000 under a Revolving Line of Credit of up to $3,000,000 (“Loan A”) and a Closed-End Term Loan of up to $4,500,000 (“Loan B”) (collectively, the “Loans”). The Company pledged the stock of the Bank as collateral for the Loans. Proceeds of the loans of $3,200,000 were down-streamed into the Bank as additional Tier 1 capital with the remaining proceeds of $2,300,000 held in cash by the Company. Subsequently, during the second quarter of 2011, the Company requested and CBB agreed to modify the closed-end loan to extend the amortization period of the loan for a new 20-year period. The Company simultaneously paid off the Revolving Line of Credit. The Closed – End Term Loan has a balloon maturity in April 2014 and the Company deposited the monthly payments up to the balloon date into a reserve account held at CBB. The Closed – End Term Loan had a balance of $3,475,577 at September 30, 2013.

Caution About Forward-Looking Statements

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

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

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

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

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

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

Continued problems pertaining to a slower than normal economic recovery;

Unemployment continuing at elevated levels;

Difficult market conditions in our industry;

Unprecedented levels of market volatility;

Effects of the soundness of other financial institutions;

Potential impact on us of recently enacted legislation;

Further deterioration in the housing market and collateral values;

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

The ability to continue to attract low cost core deposits;

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

The successful management of interest rate risk;

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

Changes in interest rates and interest rate policies;

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

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

Demand, development and acceptance of new products and services;

Problems with technology utilized by the Company;

Changing trends in customer profiles and behavior; and,

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

ITEM 3. Quantitative and Qualitative Disclosures About Market Risk

Not Applicable

ITEM 4. Controls and Procedures

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

There have not been any changes in the Company’s internal controls over financial reporting during the third quarter of 2013 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

PART II. OTHER INFORMATION

Item 1. Legal Proceedings

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

Item 1A. Risk Factors

Not applicable

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

None

Item 3. Defaults Upon Senior Securities

None

Item 4. Mine Safety Disclosures

Not Applicable

Item 5. Other Information

None

Item 6. Exhibits

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

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

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

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

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

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

101	The following materials from the Registrant’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2013, formatted in Extensible Business Reporting Language (XBRL), include: (i) the Consolidated Balance Sheets, (ii) the Consolidated Statements of Income, (iii) the Consolidated Statements of Comprehensive Income, (iv) Consolidated Statements of Cash Flows; (v) Consolidated Statements of Changes in Stockholders' Equity and (vi) related notes (furnished herewith).

SIGNATURES

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

	HIGHLANDS BANKSHARES, INC.
		(Registrant)


Date: November 4, 2013	/s/ Samuel L. Neese
	Samuel L. Neese
	Executive Vice President and
	Chief Executive Officer


Date: November 4, 2013	/s/ Robert M. Little, Jr.
	Robert M. Little, Jr.
	Chief Financial Officer


Date: November 4, 2013	/s/ James R. Edmundson
	James R. Edmondson
	Vice President -Accounting

Exhibits Index

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

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

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

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

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

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

101	The following materials from the Registrant’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2013, formatted in Extensible Business Reporting Language (XBRL), include: (i) the Consolidated Balance Sheets, (ii) the Consolidated Statements of Income, (iii) the Consolidated Statements of Comprehensive Income, (iv) Consolidated Statements of Cash Flows; (v) Consolidated Statements of Changes in Stockholders' Equity and (vi) related notes (furnished herewith).