UNITED
      STATESSECURITIES
      AND EXCHANGE COMMISSIONWashington,
      DC 20549
 
 
 FORM
10-Q
 
 (Mark
One)
 [X]  QUARTERLY
REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
1934
 For the
quarterly period ended September 30, 2008.
 
 [  ]  TRANSITION
REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
1934
 
 Commission
File Number:  0-16761
 
 HIGHLANDS
BANKSHARES, INC.
 (Exact
name of registrant as specified in its charter)
 
 West
      Virginia
              55-0650793(State
      or Other Jurisdiction of Incorporation or Organization)
              (IRS
      Employer Identification No.)
 
 P.O. Box
929
 Petersburg,
WV 26847
 (Address
of Principal Executive Offices, Including Zip Code)
 
 304-257-4111
 (Registrant’s
Telephone Number, Including Area Code)
 
 Indicate by check mark whether the
registrant (1) has filed all reports required to be filed by Section 13 or 15(d)
of the Securities Exchange Act of 1934 during the preceding 12 months (or for
such shorter period that the registrant was required to file such reports), and
(2) has been subject to such filing requirements for the past 90
days.  Yes [X] No [  ]
 
 Indicate by check mark whether the
registrant is a large accelerated filer, an accelerated filed, a non-accelerated
filer, or a smaller reporting company.  See the definitions of “large
accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule
12b-2 of the Exchange Act.
 
 Large
      Accelerated Filer [  ]
              Accelerated
      Filer                  [   ]Non-accelerated
      filer     [  ] (Do not check if a smaller
      reporting company)
              Smaller
      reporting company [X]
 
 Indicate
by check mark whether the registrant is a shell company (as defined in Rule
12b-2 of the Exchange Act).   [  ] Yes  [X]
No
 
 Indicate
the number of shares outstanding of each of the issuer’s classes of common stock
as of the latest practicable date. As of July 31, 2008:  1,336,873
shares of Common Stock, $5 Par Value
   
  
 HIGHLANDS BANKSHARES, INC.Quarterly
      Report on Form 10Q For The Period Ended September 30,
  2008INDEXPagePART I
              FINANCIAL INFORMATIONItem 1.
              Financial StatementsUnaudited Consolidated Statements of Income Nine Months Ended
      September 30, 2008 and 2007
              2Unaudited Consolidated Statements of Income Three Months Ended
      September 30, 2008 and 2007
              3Unaudited Consolidated Balance Sheet for September 30, 2008 and
      Audited Consolidated Balance Sheet for December 31,
    2007
              4Unaudited Consolidated Statements of Changes in Stockholders’
      Equity for the Nine Months Ended September 30, 2008 and
      2007
              5Unaudited Consolidated Statements of Cash Flows for the Nine
      Months Ended September 30, 2008 and 2007
              6Notes to Consolidated Financial Statements
              7Item 2.
              Management’ Discussion and Analysis of Financial Condition and
      Results of Operations
              12Item 3.
              Quantitative and Qualitative Disclosures About Market
      Risk
              25Item 4.
              Controls and Procedures
              26PART II
              OTHER INFORMATIONItem 1.
              Legal Proceedings
              26Item 1A.
              Risk Factors
              26Item 2.
              Unregistered Sales of Equity Securities and Use of
      Proceeds
              26Item 3.
              Defaults Upon Senior Securities
              27Item 4.
              Submission of Matters to a Vote of Security
      Holders
              27Item 5.
              Other Information
              27Item 6.
              Exhibits
              27SIGNATURES
              
              27
 
 
 
 Index
 
 
 Page
      Two
 PART
I                           FINANCIAL
INFORMATION
 Item
1.                 Financial
Statements
 
 HIGHLANDS BANKSHARES, INC.CONSOLIDATED
      STATEMENTS OF INCOME(In
      Thousands of Dollars, Except Per Share Data)Nine
      Months Ended September 302008
              
              
              2007(unaudited)
              
              
              (unaudited)Interest
      IncomeInterest
      and fees on loans
              
              $
              18,774
              
              
              $
              18,830Interest
      on federal funds sold
              
              
              231
              
              
              
              600Interest
      on deposits in other banks
              
              
              38
              
              
              
              100Interest
      and dividends on securities
              
              
              835
              
              
              
              1,033Total
      Interest Income
              
              
              19,878
              
              
              
              20,563Interest
      ExpenseInterest
      on deposits
              
              
              6,467
              
              
              
              7,458Interest
      on federal funds purchased
              
              
              10
              
              
              
              0Interest
      on borrowed money
              
              
              363
              
              
              
              447Total
      Interest Expense
              
              
              6,840
              
              
              
              7,905Net
      Interest Income
              
              
              13,038
              
              
              
              12,658Provision
      for Loan Losses
              
              
              636
              
              
              
              486Net
      Interest Income After Provision for Loan Losses
              
              
              12,402
              
              
              
              12,172Non-interest
      IncomeService
      Charges
              
              
              1,286
              
              
              
              979Investment
      in insurance contracts
              
              
              208
              
              
              
              173Gains
      on securities
              
              
              109
              
              
              
              0Gains
      on sale of fixed assets
              
              
              32
              
              
              
              0Other
      non-interest income
              
              
              389
              
              
              
              355Total
      Non-interest Income
              
              
              2,024
              
              
              
              1,507Non-interest
      ExpenseSalaries
      and employee benefits
              
              
              4,740
              
              
              
              4,467Equipment
      and occupancy expense
              
              
              1,020
              
              
              
              1,043Data
      processing expense
              
              
              616
              
              
              
              649Legal
      and professional fees
              
              
              413
              
              
              
              430Other
      non-interest expense
              
              
              1,782
              
              
              
              1,728Total
      Non-interest Expense
              
              
              8,571
              
              
              
              8,317Income
      Before Provision For Income Taxes
              
              
              5,855
              
              
              
              5,362Provision
      for Income Taxes
              
              
              2,096
              
              
              
              1,985Net
      Income
              
              $
              3,759
              
              
              $
              3,377Per
      Share DataNet
      Income
              
              $
              2.69
              
              
              $
              2.35Cash
      Dividends
              
              $
              .81
              
              
              $
              .75Weighted
      Average Common Shares Outstanding
              
              
              1,398,773
              
              
              
              1,436,874The
      accompanying notes are an integral part of these
    statements.
  Index
  
 Page
      Three
 
 HIGHLANDSBANKSHARES, INC.CONSOLIDATED
      STATEMENTS OF INCOME(In
      Thousands of Dollars, Except Per Share Data)Three
      Months Ended September 302008
              
              
              2007(unaudited)
              
              
              (unaudited)Interest
      IncomeInterest
      and fees on loans
              
              $
              6,162
              
              
              $
              6,471Interest
      on federal funds sold
              
              
              8
              
              
              
              195Interest
      on deposits in other banks
              
              
              7
              
              
              
              30Interest
      and dividends on securities
              
              
              294
              
              
              
              383Total
      Interest Income
              
              
              6,471
              
              
              
              7,079Interest
      ExpenseInterest
      on deposits
              
              
              1,916
              
              
              
              2,652Interest
      on federal funds purchased
              
              
              10
              
              
              
              0Interest
      on borrowed money
              
              
              128
              
              
              
              144Total
      Interest Expense
              
              
              2,054
              
              
              
              2,796Net
      Interest Income
              
              
              4,417
              
              
              
              4,283Provision
      for Loan Losses
              
              
              238
              
              
              
              145Net
      Interest Income After Provision for Loan Losses
              
              
              4,179
              
              
              
              4,138Non-interest
      IncomeService
      Charges
              
              
              467
              
              
              
              347Investment
      in insurance contracts
              
              
              89
              
              
              
              57Gain
      on sale of fixed assets
              
              
              7
              
              
              
              0Other
      non-interest income
              
              
              124
              
              
              
              138Total
      Non-interest Income
              
              
              687
              
              
              
              542Non-interest
      ExpenseSalaries
      and employee benefits
              
              
              1,599
              
              
              
              1,504Equipment
      and occupancy expense
              
              
              341
              
              
              
              352Data
      processing expense
              
              
              200
              
              
              
              221Legal
      and professional fees
              
              
              148
              
              
              
              153Other
      non-interest expense
              
              
              622
              
              
              
              627Total
      Non-interest Expense
              
              
              2,910
              
              
              
              2,857Income
      Before Provision For Income Taxes
              
              
              1,956
              
              
              
              1,823Provision
      for Income Taxes
              
              
              656
              
              
              
              690Net
      Income
              
              $
              1,300
              
              
              $
              1,133Per
      Share DataNet
      Income
              
              $
              .97
              
              
              $
              .79Cash
      Dividends
              
              $
              .27
              
              
              $
              .25Weighted
      Average Common Shares Outstanding
              
              
              1,337,311
              
              
              
              1,436,874The
      accompanying notes are an integral part of these
    statements.
 
 
 Index
 
 Page
      Four
 
 HIGHLANDS
      BANKSHARES, INC.CONSOLIDATED
      BALANCE SHEETS(In
      Thousands of Dollars)September
      30, 2008
              
              
              December
      31, 2007(unaudited)
              
              
              (audited)ASSETSCash
      and due from banks—non-interest bearing
              
              $
              6,774
              
              
              $
              7,935Deposits
      in other banks—interest bearing
              
              
              492
              
              
              
              1,853Federal
      funds sold
              
              
              828
              
              
              
              14,246Securities
      available for sale, at market value
              
              
              23,398
              
              
              
              26,090Restricted
      investments
              
              
              1,873
              
              
              
              1,498Loans
              
              
              315,315
              
              
              
              310,199Allowance
      for loan losses
              
              
              (3,651
              )
              
              
              (3,577
              )Bank
      premises and equipment, net of depreciation
              
              
              8,085
              
              
              
              8,104Interest
      receivable
              
              
              2,149
              
              
              
              2,273Investment
      in life insurance contracts
              
              
              6,427
              
              
              
              6,300Goodwill
              
              
              1,534
              
              
              
              1,534Other
      intangible assets
              
              
              1,264
              
              
              
              1,572Other
      Assets
              
              
              3,585
              
              
              
              2,909Total
      Assets
              
              $
              368,073
              
              
              $
              380,936LIABILITIESNon-interest
      bearing deposits
              
              $
              49,011
              
              
              $
              48,605Savings
      and interest bearing demand deposits
              
              
              69,364
              
              
              
              73,736Time
      deposits
              
              
              192,707
              
              
              
              201,397Total
      Deposits
              
              
              311,082
              
              
              
              323,738Long
      term debt
              
              
              11,450
              
              
              
              11,819Federal
      funds purchased
              
              
              775
              
              
              
              0Accrued
      expenses and other liabilities
              
              
              5,323
              
              
              
              4,786Total
      Liabilities
              
              
              328,630
              
              
              
              340,343STOCKHOLDERS’
      EQUITYCommon
      stock ($5 par value, 3,000,000 shares authorized, 1,436,874 shares
      issued)
              
              
              7,184
              
              
              
              7,184Surplus
              
              
              1,662
              
              
              
              1,662Retained
      earnings
              
              
              34,308
              
              
              
              32,032Other
      accumulated comprehensive loss
              
              
              (339
              )
              
              
              (285
              )Treasury
      stock
                (at
      cost, 100,001 shares at September 30, 2008)
              
              
              (3,372
              )
              
              
              0Total
      Stockholders’ Equity
              
              
              39,443
              
              
              
              40,593Total
      Liabilities and Stockholders’ Equity
              
              $
              368,073
              
              
              $
              380,936The
      accompanying notes are an integral part of these
    statements.
 
  Index
  
 Page
      Five
 
 HIGHLANDS
      BANKSHARES, INCCONSOLIDATED
      STATEMENTS OF CHANGES IN STOCKHOLDERS’
    EQUITY(In
      Thousands of Dollars)Common
                Stock
              
              
              Surplus
              
              
              Treasury
                Stock
              
              
              Retained
                Earnings
              
              
              Accumulated
                Other
                Comprehensive
                Income
              
              
              TotalBalances
      at December 31, 2006
              
              $
              7,184
              
              
              $
              1,662
              
              
              $
              0
              
              
              $
              28,816
              
              
              $
              (586
              )
              
              $
              37,076Net
      Income
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              3,377
              
              
              
              
              
              
              
              3,377Change
      in other comprehensive income
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              95
              
              
              
              95Total
      Comprehensive Income
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              3,472Dividends
      Paid
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              (1,078
              )
              
              
              
              
              
              
              (1,078
              )Balances
      at September 30, 2007
              
              $
              7,184
              
              
              $
              1,662
              
              
              $
              0
              
              
              $
              31,115
              
              
              $
              (491
              )
              
              $
              39,470
 
 
 
 Common
                Stock
              
              
              Surplus
              
              
              Treasury
                Stock
              
              
              Retained
                Earnings
              
              
              Accumulated
                Other
                Comprehensive
                Income
              
              
              TotalBalances
      at December 31, 2007
              
              $
              7,184
              
              
              $
              1,662
              
              
              $
              0
              
              
              $
              32,032
              
              
              $
              (285
              )
              
              $
              40,593Net
      Income
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              3,759
              
              
              
              
              
              
              
              3,759Change
      in other comprehensive income
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              (54
              )
              
              
              (54
              )Cumulative
      effect adjustment to retained earnings for change in accounting
      principle
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              (348
              )
              
              
              
              
              
              
              (348
              )Total
      comprehensive Income
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              3,357Treasury
      stock repurchased
              
              
              
              
              
              
              
              
              
              
              (3,372
              )
              
              
              
              
              
              
              
              
              
              
              (3,372
              )Dividends
      paid
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              (1,135
              )
              
              
              
              
              
              
              (1,135
              )Balances
      at September 30, 2008
              
              $
              7,184
              
              
              $
              1,662
              
              
              $
              (3,372
              )
              
              $
              34,308
              
              
              $
              (339
              )
              
              $
              39,443
 
 
 
 
  Index
  
 Page
      Six
 
 HIGHLANDS
      BANKSHARES, INC.CONSOLIDATED
      STATEMENTS OF CASH FLOWS(In
      Thousands of Dollars)Nine
      Months Ended September 30,2008
              
              
              2007(unaudited)
              
              
              (unaudited)Cash
      Flows From Operating ActivitiesNet
      Income
              
              $
              3,759
              
              
              $
              3,377Adjustments
      to reconcile net income to netcash
      provided by operating activities(Gain)
      on investment securities
              
              
              (109
              )
              
              
              0(Gain)
      on sale of fixed asset
              
              
              (32
              )
              
              
              0Other
      (Gain)/Loss
              
              
              22
              
              
              
              0Depreciation
              
              
              512
              
              
              
              519Income
      from insurance contracts
              
              
              (209
              )
              
              
              (173
              )Net
      amortization of securities
              
              
              3
              
              
              
              (163
              )Provision
      for loan losses
              
              
              636
              
              
              
              486Deferred
      income tax benefit
              
              
              (14
              )
              
              
              0Amortization
      of intangibles
              
              
              133
              
              
              
              132Net
      purchase of intangibles
              
              
              175Decrease
      (increase) in interest receivable
              
              
              124
              
              
              
              (361
              )Decrease
      (increase) in other assets
              
              
              (685
              )
              
              
              (429
              )Increase
      (decrease) in accrued expenses and other liabilities
              
              
              189
              
              
              
              325Net
      Cash Provided by Operating Activities
              
              
              4,504
              
              
              
              3,713Cash
      Flows From Investing ActivitiesIncrease
      (decrease) in federal funds sold
              
              
              13,418
              
              
              
              (342
              )Settlement
      on insurance contract
              
              
              82
              
              
              
              0Proceeds
      from maturities of securities available for sale
              
              
              15,282
              
              
              
              6,479Purchase
      of securities available for sale
              
              
              (12,537
              )
              
              
              (10,827
              )Decrease
      (increase) in restricted investments
              
              
              (375
              )
              
              
              71Decrease
      (increase) in interest bearing deposits in other banks
              
              
              1,361
              
              
              
              (1,759
              )Purchase
      of property and equipment
              
              
              (461
              )
              
              
              (428
              )Net
      Increase in Loans
              
              
              (5,678
              )
              
              
              (15,476
              )Net
      Cash Provided by (Used in) Investing Activities
              
              
              11,092
              
              
              
              (22,282
              )Cash
      Flows From Financing ActivitiesNet
      change in deposits
              
              
              (12,656
              )
              
              
              23,088Federal
      funds purchased
              
              
              775
              
              
              
              0Additional
      long term debt
              
              
              1,500
              
              
              
              0Repayment
      of long term debt
              
              
              (1,869
              )
              
              
              (2,727
              )Purchase
      of treasury stock
              
              
              (3,372
              )
              
              
              0Dividends
      paid in cash
              
              
              (1,135
              )
              
              
              (1,078
              )Net
      Cash Provided (Used in) by Financing Activities
              
              
              (16,757
              )
              
              
              19,283Net
      Increase (decrease) in Cash and Cash Equivalents
              
              
              (1,161
              )
              
              
              714Cash
      and Cash Equivalents, Beginning of Period
              
              
              7,935
              
              
              
              7,111Cash
      and Cash Equivalents, End of Period
              
              $
              6,774
              
              
              $
              7,825Supplemental
      DisclosuresCash
      paid for income taxes
              
              $
              1,997
              
              
              $
              2,315Cash
      paid for interest
              
              $
              6,746
              
              
              $
              7,745The
      accompanying notes are an integral part of these
    statements.
 
  Index
  
 Page
      Seven
 
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 
 NOTE
      1
              ACCOUNTING
      PRINCIPLES
 
 These
consolidated financial statements conform to U. S. generally accepted accounting
principles and to general industry practices.  In the opinion of
management, the accompanying unaudited consolidated financial statements contain
all adjustments, consisting solely of normal recurring adjustments, necessary to
present fairly the financial position as of September 30, 2008 and the results
of operations for the three and nine month periods ended September 30, 2008 and
2007.
 
 The
results of operations for the three and nine month periods ended September 30,
2008 and 2007 are not necessarily indicative of the results to be expected for
the full year.
 
 The notes
included herein should be read in conjunction with the notes to financial
statements included in the Company’s 2007 annual report on Form
10-K.
 
 Certain
reclassifications have been made to prior period balances to conform to the
current year’s presentation format.
 
 
 NOTE
      2
              LOANS
 
 A summary
of loans outstanding as of September 30, 2008 and December 31, 2007 is shown in
the table below (in thousands of dollars):
 
 September
      30,
              
              
              December
      31,2008
              
              
              2007Loan
      TypeCommercial
              
              $
              89,156
              
              
              $
              79,892Real
      Estate construction
              
              
              24,948
              
              
              
              15,560Real
      Estate mortgage
              
              
              155,578
              
              
              
              169,122Consumer
      installment
              
              
              45,633
              
              
              
              45,625Total
      Loans
              
              $
              315,315
              
              
              $
              310,199
 
 In
addition to loans to fund construction and traditional mortgage loans, portions
of the portfolio identified as commercial are also secured by real
estate.  At September 30, 2008, the total balance of loans in the
portfolio secured by real estate was $248,980,000.
 
 
 NOTE
      3
              INVESTMENT
      IN INSURANCE CONTRACTS
 
 Investment
in insurance contracts consist of single premium insurance contracts which have
the dual purposes of providing a rate of return to the Company which
approximately equals the Company’s average cost of funds and of providing life
insurance and retirement benefits to certain executives.
 
 A summary
of the changes to the balance of investments in insurance contracts from
December 31, 2007 to September 30, 2008 is shown in the table below (in
thousands of dollars):
 
 Balance
      December 31, 2007
              
              $
              6,300Increases
      in value of policies
              
              
              179Settlement
      payout
              
              
              (52
              )Balance
      September 30, 2008
              
              $
              6,427
 
 
 
  Index
  
 
 Page
      Eight
 
 
 NOTE
      4
              SECURITIES
      AND RESTRICTED INVESTMENTS
 
 The
Company’s securities portfolio serves several purposes. Portions of the
portfolio secure certain public and trust deposits while the remaining portions
are held as investments or used to assist the Company in liquidity and
asset/liability management.
 
 The
amortized cost and market value of securities as of September 30, 2008 and
December 31, 2007 is shown in the table below (in thousands of dollars). All of
the securities on the Company’s balance sheet are classified as available for
sale.
 
 September
      30, 2008
              
              
              December
      31, 2007Amortized
              
              
              Market
              
              
              Amortized
              
              
              MarketCost
              
              
              Value
              
              
              Cost
              
              
              ValueAvailable For Sale
      SecuritiesU.S.
      Treasuries and Agencies
              
              $
              8,704
              
              
              $
              8,826
              
              
              $
              15,040
              
              
              $
              15,245Mortgage
      backed securities
              
              
              10,785
              
              
              
              10,839
              
              
              
              7,718
              
              
              
              7,784Obligations
      of states and municipalities
              
              
              3,696
              
              
              
              3,711
              
              
              
              3,034
              
              
              
              3,039Marketable
      equities
              
              
              28
              
              
              
              22
              
              
              
              28
              
              
              
              22Total
      Available For Sale Securities
              
              $
              23,213
              
              
              $
              23,398
              
              
              $
              25,820
              
              
              $
              26,090
 
 
 Information
pertaining to securities with gross unrealized losses at December 31, 2007 and
September 30, 2007, aggregated by investment category and length of time that
individual securities have been in a continuous loss position is shown in the
table below (in thousands of dollars):
 
 Total
              
              
              Less
      than 12 Months
              
              
              12
      Months or GreaterFair
      Value
              
              
              Gross
                Unrealized
                Losses
              
              
              Fair
      Value
              
              
              Gross
                Unrealized
                Losses
              
              
              Fair
                Value
              
              
              Gross
                Unrealized
                LossesSeptember 30,
      2008Investment
      CategoryMortgage
      backed securities
              
              
              5,794
              
              
              
              (40
              )
              
              
              5,723
              
              
              
              (39
              )
              
              
              71
              
              
              
              (1
              )State
      and municipals
              
              
              1,547
              
              
              
              (10
              )
              
              
              1,547
              
              
              
              (10
              )
              
              
              0
              
              
              
              0Other
      equity securities
              
              
              22
              
              
              
              (6
              )
              
              
              0
              
              
              
              0
              
              
              
              22
              
              
              
              (6
              )Total
              
              $
              7,363
              
              
              $
              (56
              )
              
              $
              7,270
              
              
              $
              (49
              )
              
              $
              93
              
              
              $
              (7
              )December 31,
      2007Investment
      CategoryU.S.
      Treasury and Agency
              
              $
              1,497
              
              
              $
              (2
              )
              
              $
              0
              
              
              $
              0
              
              
              $
              1,497
              
              
              $
              (2
              )Mortgage
      backed securities
              
              
              2,574
              
              
              
              (8
              )
              
              
              1,005
              
              
              
              (1
              )
              
              
              1,569
              
              
              
              (7
              )State
      and municipals
              
              
              575
              
              
              
              (3
              )
              
              
              0
              
              
              
              0
              
              
              
              575
              
              
              
              (3
              )Other
      equity securities
              
              
              22
              
              
              
              (6
              )
              
              
              22
              
              
              
              (6
              )
              
              
              0
              
              
              
              0Total
              
              $
              4,668
              
              
              $
              (19
              )
              
              $
              1,027
              
              
              $
              (7
              )
              
              $
              3,641
              
              
              $
              (12
              )
 
 
 Restricted
investments consist of investments in the Federal Home Loan Bank, the Federal
Reserve Bank and West Virginia Bankers’ Title Insurance
Company.  Investments are carried at face value and the level of
investment is dictated by the level of participation with each
institution.  Amounts are restricted as to transferability.
Investments in the Federal Home Loan Bank act as a collateral against the
outstanding borrowings from that institution.
 
 
  Index
  
 
 Page
      Nine
 
 
 NOTE
      5
              ALLOWANCE
      FOR LOAN LOSSES
 
 A summary
of the transactions in the allowance for loan losses for the nine month periods
ended September 30, 2008 and 2007 is shown below (in thousands of
dollars):
 
 2008
              
              
              2007Balance,
      beginning of period
              
              $
              3,577
              
              
              $
              3,482Provisions
      charged to operations
              
              
              636
              
              
              
              486Loan
      recoveries
              
              
              102
              
              
              
              283Loan
      charge-offs
              
              
              (664
              )
              
              
              (540
              )Balance,
      end of period
              
              $
              3,651
              
              
              $
              3,711
 
 
 NOTE
      6
              DEPOSITS
 
 Balances
of time deposits over $100,000 and of all other time deposits at September 30,
2008 and December 31, 2007 are shown below (in thousands of
dollars):
 
 September
      30,
              
              
              December
      31,2008
              
              
              2007Time
      deposits over $100,000
              
              $
              61,993
              
              
              $
              65,486All
      other time deposits
              
              
              130,714
              
              
              
              135,911Total
      Time Deposits
              
              $
              192,707
              
              
              $
              201,397
 
 Interest
expense for time deposits over $100,000 and for all other time deposits for the
nine month and three month periods ended September 30, 2008 and 2007 is shown
below (in thousands of dollars):
 
 
 Nine
      months ended
                September
      30,
              
              
              Three
      months ended
                September
      30,2008
              
              
              2007
              
              
              2008
              
              
              2007Time
      deposits over $100,000
              
              $
              2,072
              
              
              $
              2,243
              
              
              $
              609
              
              
              $
              818All
      other time deposits
              
              
              3,982
              
              
              
              4,540
              
              
              
              1,213
              
              
              
              1,587Total
      interest paid on time deposits
              
              $
              6,054
              
              
              $
              6,783
              
              
              $
              1,822
              
              
              $
              2,405
 
 
 NOTE
      8
              DEBT
      INSTRUMENTS
 
 As it
becomes necessary, the Company borrows money from the Federal Home Loan Bank of
Pittsburgh (FHLB) to meet specificfunding
needs.  The interest rates of the long term notes payable as of September 30, 2008 range from
3.94% to 5.96%.  The weighted average interest rate was 4.62% at
September 30, 2008. The debt is secured by the general assets of the
Banks.
 
 On
multiple instances during the third quarter of 2008, the subsidiary banks of
Highlands Bankshares, due to a need for liquid funds, utilized overnight
borrowing facilities available to each of the subsidiary banks. The average
balance of overnight and other short term borrowings during the third quarter
was $1,478,000.
 
 
 
 
  Index
  
 
 Page
      Ten
 
 NOTE
      7
              EMPLOYEE
      BENEFITS
 
 The
Company's two subsidiary banks each have separate retirement and profit sharing
plans which cover substantially all full time employees at each
bank.
 
 Capon
Valley Bank has a defined contribution pension plan with 401(k) features that is
funded with discretionary contributions by the Bank.  The bank matches
on a limited basis the contributions of the employees.  Investment of
employee balances is done through the direction of each
employee.  Employer contributions are vested over a six year
period.
 
 The Grant
County Bank is a member of the West Virginia Bankers' Association Retirement
Plan.  Benefits under the plan are based on compensation and years of
service with 100% vesting after seven years of service.  The bank was
required to make contributions to the plan in 2007 and made a contribution to
the plan during the first quarter of 2008.  The Bank has recognized
liabilities of $206,000 at September 30, 2008 as a result of this
shortfall.  The following table provides the components of the net periodic
benefit cost for the plan for the nine month periods ended September 30, 2008
and 2007 (in thousands of dollars):
 
 2008
              
              
              2007Service
      cost
              
              $
              127
              
              
              $
              100Interest
      cost
              
              
              201
              
              
              
              160Expected
      return on plan assets
              
              
              (244
              )
              
              
              (170
              )Amortization
      of unrecognized prior service costs
              
              
              3
              
              
              
              8Recognized
      net actuarial loss
              
              
              40
              
              
              
              48Net
      periodic expense
              
              $
              127
              
              
              $
              146
 
 
 NOTE
      9
              EARNINGS
      PER SHARE
 
 During
the first nine months of 2007, there were no changes to the outstanding shares
of common stock. During the second and third quarters of 2008, the Company
purchased, at varying intervals, 100,001 shares of outstanding common stock. The
weighted average shares, upon which earnings per share calculations for the
three and nine month periods ended September 30, 2008, were calculated based
upon the date repurchased and the number of shares repurchased on that date, as
a percentage of the total period represented.
 
 NOTE
      10
              INTANGIBLE
      ASSETS
 
 The
Company’s balance sheet contains several components of intangible assets. At
September 30, 2008, the total balance of intangible assets was comprised of
Goodwill and Core Deposit Intangible Assets acquired as a result of the
acquisition of other banks and also an intangible asset related to the purchased
naming rights for a performing arts center located within the Company’s primary
business area.
 
 During
the fourth quarter of 2007, The Grant County Bank entered into an agreement to
contribute $250,000 toward the erection of a performing arts center located
within the Company’s primary business area. In return, the bank has been granted
naming rights for this performing arts center. During the second quarter of
2008, the performing arts center reached an agreement with another party for the
same rights but at better terms and cancelled the contractual agreement with The
Grant County Bank. The $250,000 paid to the performing arts center was
subsequently returned during the third quarter of 2008. After the cancellation
of the original contract, the performing arts center and The Grant County Bank
reached another agreement whereby a contribution of $75,000 was made in return
for naming rights to only a portion of the same arts center.
 
 A summary
of the changes to the balance of goodwill and other intangible assets from
December 31, 2007 to September 30, 2008 is shown below (in thousands of
dollars):
 
 Balance
      December 31, 2007
              
              $
              3,106Amortization
      of intangibles other than goodwill
              
              
              (133
              )Cancellation
      of original naming rights contract
              
              
              (250
              )Purchase
      of new naming rights contract
              
              
              75Balance
      September 30, 2008
              
              $
              2,798
 
  Index
  
 Page
      Eleven
 
 
 NOTE
      11
              ADJUSTMENT
      TO RETAINED EARNINGS FOR CHANGE IN ACCOUNTING
  PRINCIPLE
 
 In 2006,
the FASB issued EITF 06-04 and EITF 06-10. These EITF pronouncements require
that companies which own life insurance policies insuring employees and for
which the employees receive a portion of the death benefits of the policies
(commonly referred to as “split dollar” policies) and for which these death
benefits to the employee continue post retirement record a liability for the
present value of the cost of these post retirement death benefits. These EITF
pronouncements became effective for Highlands Bankshares on January 1,
2008.
 
 These
EITF pronouncements provided an option for affected companies to record the
resulting liability as a cumulative effect adjustment to retained earnings at
the beginning of the period in which recorded or to record through retrospective
application to prior periods. Highlands Bankshares opted to record the liability
as a cumulative effect adjustment to prior period retained earnings and as such
recorded a liability and corresponding reduction of prior period retained
earnings of $348,000. There is no corresponding deferred tax consequence
relating to this liability. The recording of the cumulative effect adjustment to
prior period retained earnings is reflected in the June 30, 2008 balance of
retained earnings and is shown as an adjustment to retained earnings in the
Consolidated Statement of Changes in Stockholders’ Equity.
 
 
 NOTE
      12
              FAIR
      VALUE MEASUREMENTS
  SFAS
No. 157, Fair Value
Measurements, defines fair value, establishes a framework for measuring
fair value, establishes a three-level valuation hierarchy for disclosure of fair
value measurement and enhances disclosure requirements for fair value
measurements. The valuation hierarchy is based upon the transparency of inputs
to the valuation of an asset or liability as of the measurement date. The three
levels are defined as follow:
 
 ·
              Level One:Inputs to the valuation
      methodology are quoted prices (unadjusted) for identical assets or
      liabilities in active markets.
 ·
              Level Two: Inputs to the valuation
      methodology include quoted prices for similar assets and liabilities in
      active markets, and inputs that are observable for the asset or liability,
      either directly or indirectly, for substantially the full term of the
      financial instrument.
 ·
              Level Three:
      Inputs to the valuation methodology are unobservable and significant to
      the fair value measurement.
  Following
is a description of the valuation methodologies used for instruments measured at
fair value on the Company’s balance sheet, as well as the general classification
of such instruments pursuant to the valuation hierarchy:
  Securities
  Where
quoted prices are available in an active market, securities are classified
within level 1 of the valuation hierarchy. Level 1 securities would include
highly liquid government bonds, mortgage products and exchange traded equities.
If quoted market prices are not available, then fair values are estimated by
using pricing models, quoted prices of securities with similar characteristics,
or discounted cash flow. Level 2 securities would include U.S. agency
securities, mortgage-backed agency securities, obligations of states and
political subdivisions and certain corporate, asset backed and other securities.
In certain cases where there is limited activity or less transparency around
inputs to the valuation, securities are classified within level 3 of the
valuation hierarchy.  Currently, all of the Company’s securities are
considered to be Level 2 securities.
  Impaired
Loans
  SFAS No.
157 applies to loans measured for impairment using the practical expedients
permitted by SFAS No. 114, Accounting by Creditors for
Impairment of a Loan, including impaired loans measured at an observable
market price (if available), or at the fair value of the loan’s collateral (if
the loan is collateral dependent). Fair value of the loan’s collateral, when the
loan is dependent on collateral, is determined by appraisals or independent
valuation which is then adjusted for the cost related to liquidation of the
collateral.
  Other Real Estate
Owned
  Certain
assets such as other real estate owned (OREO) are measured at fair value less
cost to sell. We believe that the fair value component in its valuation follows
the provisions of SFAS No. 157.
  Index
  
 Page
      Twelve
 
 Item 2.Management’s
Discussion and Analysis of Financial Condition and Results of
Operations
 
 Introduction
 
 The
following discussion focuses on significant results of the Company’s operations
and significant changes in our financial condition or results of operations for
the periods indicated in the discussion. This discussion should be read in
conjunction with the preceding financial statements and related notes, as well
as the Company’s Annual Report on Form 10-K for the period ended December 31,
2007.  Current performance does not guarantee, and may not be
indicative of, similar performance in the future.
 
 Critical Accounting
Policies
 
 The
Company’s financial statements are prepared in accordance with accounting
principles generally accepted in the United States (“GAAP”). The financial
statements contained within these statements are, to a significant extent,
financial information that is based on measures of the financial effects of
transactions and events that have already occurred. A variety of factors could
affect the ultimate value that is obtained either when earning income,
recognizing an expense, recovering an asset or relieving a liability. In
addition, GAAP itself may change from one previously acceptable method to
another method. Although the economics of these transactions would be the same,
the timing of events that would impact these transactions could
change.
 
 Disclosure
of the Company’s significant accounting policies is included in Note Two to the
Consolidated Financial Statements of the Company’s Annual Report on Form 10-K
for the period ended December 31, 2007. Some of the policies are particularly
sensitive, requiring significant judgments, estimates and assumptions by
management.
 
 Allowance for Loan
Losses
 
 The
allowance for loan losses is an estimate of the losses that may be sustained in
the loan portfolio. The allowance is based on two basic principles of
accounting: (i) Statement of Financial Accounting Standards No. 5, Accounting for Contingencies(SFAS 5), which
requires that losses be accrued when they are probable of occurring and
estimable, and (ii) Statement of Financial Accounting Standards No. 114, Accounting by Creditors for
Impairment of a Loan(SFAS 114), which requires that losses
be accrued based on the differences between the value of collateral, present
value of future cash flows or values that are observable in the secondary market
and the loan balance.
 
 The
allowance for loan losses includes two basic components: estimated credit losses
on individually evaluated loans that are determined to be impaired, and
estimated credit losses inherent in the remainder of the loan portfolio. Under
SFAS 114, an individual loan is impaired when, based on current information and
events, it is probable that a creditor will be unable to collect all amounts due
according to the contractual terms of the loan agreement. An individually
evaluated loan that is determined not to be impaired under SFAS 114 is evaluated
under SFAS 5 when specific characteristics of the loan indicate that it is
probable there would be estimated credit losses in a group of loans with those
characteristics.
 
 SFAS 114
does not specify how an institution should identify loans that are to be
evaluated for collectibility, nor does it specify how an institution should
determine that a loan is impaired. Each subsidiary of Highlands Bankshares uses
its standard loan review procedures in making those judgments so that allowance
estimates are based on a comprehensive analysis of the loan portfolio. For loans
within the scope of SFAS 114 that are individually evaluated and found to be
impaired, the associated allowance is based on upon the estimated fair value,
less costs to sell, of any collateral securing the loan as compared to the
existing balance of the loan as of the date of analysis.
 
 All other
loans, including individually evaluated loans determined not to be impaired
under SFAS 114, are included in a group of loans that are measured under SFAS 5
to provide for estimated credit losses that have been incurred on groups of
loans with similar risk characteristics. The methodology for measuring estimated
credit losses on groups of loans with similar risk characteristics in accordance
with SFAS 5 is based on each group’s historical net charge-off rate, adjusted
for the effects of the qualitative or environmental factors that are likely to
cause estimated credit losses as of the evaluation date to differ from the
group’s historical loss experience.
  Index
  
 Page
      Thirteen
 
 Investment in Life Insurance
Policies
 
 The
Company has invested in and owns life insurance policies on certain officers.
The policies are designed so that the company recovers the interest expenses
associated with carrying the policies and the officer will, at the time of
retirement, receive any earnings in excess of the amounts earned by the Company.
The Company recognizes as an asset the net amount that could be realized under
the insurance contract as of the balance sheet date. This amount represents the
cash surrender value of the policies less applicable surrender charges. The
portion of the benefits which will be received by the executives at the time of
their retirement is considered, when taken collectively, to constitute a
retirement plan. Therefore the Company accounts for these policies using
guidance found in Statement of Financial Accounting Standards No. 106,
"Employers' Accounting for Post Retirement Benefits Other Than Pensions.” SFAS
No. 106 requires that an employers' obligation under a deferred compensation
agreement be accrued over the expected service life of the employee through
their normal retirement date. Assumptions are used in estimating the present
value of amounts due officers after their normal retirement
date.  These assumptions include the estimated income to be derived
from the investments and an estimate of the Company’s cost of funds in these
future periods.  In addition, the discount rate used in the present
value calculation will change in future years based on market
conditions.
 
 Intangible
Assets
 
 In accordance with provisions of SFAS
No. 142, "Goodwill and Other
Intangible Assets",
goodwill is not amortized over an estimated useful life, but rather will be
tested at least annually for impairment. Core deposit and other intangible
assets include premiums paid for acquisitions of core deposits (core deposit
intangibles) and other identifiable intangible assets.  Intangible
assets other than goodwill, which are determined to have finite lives, are
amortized based upon the estimated economic benefits
received.
 
 Recent Accounting
Pronouncements
 
 In
September 2006, the Financial Accounting Standards Board (FASB) issued
Statement of Financial Accounting Standards No. 157, “Fair Value
Measurements” (SFAS 157).  SFAS 157 defines fair value, establishes a
framework for measuring fair value in generally accepted accounting principles,
and expands disclosures about fair value measurements.  SFAS 157 does not
require any new fair value measurements, but provides enhanced guidance to other
pronouncements that require or permit assets or liabilities to be measured at
fair value.  This Statement is effective for financial statements issued
for fiscal years beginning after November 15, 2007 and interim periods
within those years.  As of December 1, 2007, the FASB has proposed a
one-year deferral for the implementation of the Statement for nonfinancial
assets and nonfinancial liabilities that are recognized or disclosed at fair
value in the financial statements on a nonrecurring basis.  SFAS 157 had no
material impact on the Company’s September 30, 2008 financial statements.
Additional disclosure information required by this pronouncement is included as
a footnote to the financial statements.
 
 In 2006,
the FASB issued EITF 06-04 and 06-10. These EITF pronouncements require that
companies which own life insurance policies insuring employees and for which the
employees receive a portion of the death benefits of the policies (commonly
referred to as “split dollar” policies) and for which these death benefits to
the employee continue post retirement record a liability for the present value
of the cost of these post retirement death benefits. These EITF pronouncements
became effective for Highlands Bankshares on January 1, 2008. These EITF
pronouncements provided an option for affected companies to record the resulting
liability as a cumulative effect adjustment to retained earnings at the
beginning of the period in which recorded or to record through retrospective
application to prior periods. Highlands Bankshares opted to record the liability
as a cumulative effect adjustment to prior period retained earnings and as such
recorded a liability and corresponding reduction of prior period retained
earnings of $348,000. There is no corresponding deferred tax consequence
relating to this liability.
 
 No other
recent accounting pronouncements had a material impact on the Company’s
consolidated financial statements, and it is believed that none will have a
material impact on the Company’s operations in future years.
 
 
  Index
  
 Page
      Fourteen
 
 Forward Looking
Statements
 
 Certain
statements in this report may constitute “forward-looking statements” within the
meaning of the Private Securities Litigation Reform Act of
1995.  Forward-looking statements are statements that include
projections, predictions, expectations or beliefs about future events or results
or otherwise are not statements of historical fact.  Such statements
are often characterized by the use of qualified words (and their derivatives)
such as “expect,” “believe,” “estimate,” “plan,” “project,” “anticipate” or
other similar words.  Although the Company believes that its
expectations with respect to certain forward-looking statements are based upon
reasonable assumptions within the bounds of its existing knowledge of its
business and operations, there can be no assurance that actual results,
performance or achievements of the Company will not differ materially from any
future results, performance or achievements expressed or implied by such
forward-looking statements.  Actual future results and trends may
differ materially from historical results or those anticipated depending on a
variety of factors, including, but not limited to, the effects of and changes
in:  general economic conditions, the interest rate environment,
legislative and regulatory requirements, competitive pressures, new products and
delivery systems, inflation, changes in the stock and bond markets, technology,
downturns in the trucking and timber industries, effects of mergers and/or
downsizing in the poultry industry in Hardy County, and consumer spending and
savings habits.  Additionally, actual future results and trends may
differ from historical or anticipated results to the extent: (1) any significant
downturn in certain industries, particularly the trucking and timber industries
are experienced; (2) loan demand decreases from prior periods; (3) the Company
may make additional loan loss provisions due to negative credit quality trends
in the future that may lead to a deterioration of asset quality; (4) the Company
may not continue to experience significant recoveries of previously charged-off
loans or loans resulting in foreclosure; and (5) the Company is unable to
control costs and expenses as anticipated. The Company does not update any
forward-looking statements that may be made from time to time by or on behalf of
the Company.
 
 Overview
 
 Income
for the first nine months of 2008 increased 11.31% compared to the first nine
months of 2007. For the same nine month periods, earnings per weighted average
share outstanding (EPS) increased 14.47%. The Company’s increase in net income
was due largely to continued increases in net interest income and increases in
other non interest income, offset slightly by increases in operational expenses.
Loan growth has slowed compared to recent years, however, balances of loans were
1.65% greater at September 30, 2008 than at December 31, 2007. This slowing loan
growth and changes in relative rates of earning assets and liabilities prompted
certain measures of balance sheet management by the Company, namely a reduction
in time deposits, which allowed net interest income, before provision for loan
loss, to increase 3.00% in spite of the slowing loan demand.
 
 Income
for the three months ended September 30, 2008 increased 14.74% as compared to
the third quarter of 2007. For the same three month periods, EPS increased
22.78%
 
 The
increase in EPS for each of the comparative periods indicated above is larger
than the increase in net income for the same periods due to a reduction in
shares outstanding as the result of the Company’s repurchase of 100,001 shares
during the second and third quarters of 2008.This share repurchase also had the
effect of increasing the Company’s Return on Average Equity, as the effect of
the share repurchase was to reduce shareholders’ equity by
$3,372,000.
 
 The
Company’s assets at September 30, 2008 as compared to December 31, 2007
decreased by 3.38%. This reduction in assets came as a result of both the share
repurchase program referenced above and also as a result of management efforts
to maintain net interest income margins through closer management of earning
assets and liabilities which is discussed further under the heading “Net
Interest Income.”
 
 
  Index
  
 Page
      Fifteen
 
 
 Performance
Measures
 
 The table
below compares selected commonly used measures of bank performance for the three
and nine month periods ended September 30, 2007 and 2008:
 
 Three
      months ended September 30,
              
              
              Nine
      months ended September 30,2008
              
              
              2007
              
              
              2008
              
              
              2007Annualized
      return on average assets
              
              
              1.41
              %
              
              
              1.20
              %
              
              
              1.33
              %
              
              
              1.21
              %Annualized
      return on average equity
              
              
              12.46
              %
              
              
              11.76
              %
              
              
              13.38
              %
              
              
              11.80
              %Net
      interest margin (1)
              
              
              5.16
              %
              
              
              4.88
              %
              
              
              4.97
              %
              
              
              4.90
              %Efficiency
      Ratio (2)
              
              
              57.02
              %
              
              
              59.21
              %
              
              
              56.91
              %
              
              
              58.72
              %Earnings
      per share (3)
              
              $
              .97
              
              
              $
              .79
              
              
              $
              2.69
              
              
              $
              2.35
  (1)
      On a fully taxable equivalent basis and including loan origination
      fees(2)
      Non-interest expenses for the period indicated divided by the sum of net
      interest income and non-interest income for the period
      indicated(3)
      Per weighted average shares of common stock outstanding for the period
      indicated. Earnings per share for the three and nine month periods ended
      September 30, 2008 reflect share repurchase of 100,001 shares during the
      second and third quarters of 2008.
 
 
 Loan
Portfolio
 
 The
Company is an active residential mortgage and construction lender and generally
extends commercial loans to small and medium sized businesses within its primary
service area.  The Company's commercial lending activity extends
across its primary service areas of Grant, Hardy, Hampshire, Mineral, Randolph,
Tucker, and northern Pendleton counties in West Virginia, Frederick County,
Virginia and Garrett County, Maryland.  Consistent with its focus on
providing community-based financial services, the Company does not attempt to
diversify its loan portfolio geographically by making significant amounts of
loans to borrowers outside of its primary service area.
 
 
 Securities
Portfolio
 
 The
Company's securities portfolio serves several purposes.  Portions of
the portfolio are used to secure certain public and trust
deposits.  The remaining portfolio is held as investments or used to
assist the Company in liquidity and asset liability management.  Total
securities, including restricted securities, represented 6.87% of total assets
and 64.07% of total shareholders’ equity at September 20, 2008.
 
 The
securities portfolio typically will consist of three
components:  securities held to maturity, securities available for
sale and restricted securities.  Securities are classified as held to
maturity when management has the intent and the Company has the ability at the
time of purchase to hold the securities to maturity.  Held to maturity
securities are carried at cost, adjusted for amortization of premiums and
accretion of discounts. Securities to be held for indefinite periods of time are
classified as available for sale and accounted for at market
value.  Securities available for sale include securities that may be
sold in response to changes in market interest rates, changes in the security's
prepayment risk, increases in loan demand, general liquidity needs and other
similar factors.  Restricted securities are those investments
purchased as a requirement of membership in certain governmental lending
institutions and cannot be transferred without the issuer’s
permission.  The Company's purchases of securities have generally been
limited to securities of high credit quality with short to medium term
maturities.
  Index
  
 Page
      Sixteen
 
 
 
 The
Company identifies at the time of acquisition those securities that are
available for sale. These securities are valued at their market value with any
difference in market value and amortized cost shown as an adjustment in
stockholders' equity.  Changes in market values of securities which
are considered temporary changes due to changes in the market rate of interest
are reflected as changes in other comprehensive income, net of the deferred tax
effect.  Any changes in market values of securities deemed by
management to be attributable to reasons other than changes in market rates of
interest would be recorded through results of operations  It is
management’s determination that all securities held at September 30, 2008 which
have fair values less than the amortized cost, have these gross unrealized
losses related to increases in the current interest rates for similar issues of
securities, and that no material impairment for any securities in the portfolio
exists because of downgrades of the securities or as a result of a change in the
financial condition of any of the issuers. A summary of the length of time of
unrealized losses for all securities held at September 30, 2008 can be found in
the footnotes to the financial statements. Management reviews all securities
with unrealized losses, and all securities in the portfolio on a regular basis
to determine whether the potential for other than temporary impairment exists.
One of the criteria for making this determination is the rating given to each
bond by the major ratings agencies Moodys and Standard & Poors. A summary of
the Company’s securities portfolio at September 30, 2008, based on the ratings
of the securities in the portfolio given by these ratings agencies is shown
below (in thousands of dollars):
 
 Amortized
                Cost
              
              
              Gross
      Unrealized
                Gains
              
              
              Gross
      Unrealized
                Losses
              
              
              Market
                ValueRatings
      Provided by Ratings AgenciesMoody’s
              
              
              S&PU.S. Treasuries and
      AgenciesAaa
              
              
              AAA
              
              
              $
              8,704
              
              
              $
              122
              
              
              $
              0
              
              
              $
              8,826Mortgage Backed
      SecuritiesAaa
              
              
              AAA
              
              
              $
              10,785
              
              
              $
              94
              
              
              $
              40
              
              
              $
              10,839State and
      MunicipalsAaa
              
              
              AAA
              
              
              $
              1,618
              
              
              $
              14
              
              
              $
              9
              
              
              $
              1,623Aa2
              
              
              AA
              
              
              
              608
              
              
              
              5
              
              
              
              0
              
              
              
              613Aa3
              
              
              AA-
              
              
              
              514
              
              
              
              0
              
              
              
              3
              
              
              
              512A2
              
              
              A
              
              
              
              205
              
              
              
              1
              
              
              
              0
              
              
              
              206A3
              
              
              A-
              
              
              
              140
              
              
              
              2
              
              
              
              0
              
              
              
              142Baa1
              
              
              BBB+
              
              
              
              155
              
              
              
              0
              
              
              
              0
              
              
              
              155No
      Rating
              
              
              
              456
              
              
              
              4
              
              
              
              0
              
              
              
              460Marketable
      EquitiesNo
      Rating
              
              
              $
              28
              
              
              $
              0
              
              
              $
              6
              
              
              $
              22
 
 
  Index
  
 Page
      Seventeen
 
 Credit Quality and Allowance
for Loan Losses
 
 The
following table illustrates certain ratios related to quality of the Company’s
loan portfolio:
 
 September
      30,
                2008
              
              
              December
      31,
                2007Allowance
      for loan losses as a percentage of gross loans
              
              
              1.16
              %
              
              
              1.15
              %Non
      performing loans as a percentage of gross loans
              
              
              0.93
              %
              
              
              1.08
              %Ratio
      of allowance for loan losses to non-performing loans
              
              
              1.25
              
              
              
              1.07
 
 The
following table summarizes the Company’s non-performing loans at September 30,
2008 and December 31, 2007 (in thousands of dollars):
 
 September
      30,
              
              
              December
      31,2008
              
              
              2007Non-accrual
      loans
              
              $
              659
              
              
              $
              916Loans
      past due 90 days and still accruing interest
              
              
              1,560
              
              
              
              2,244Restructured
      loans
              
              
              705
              
              
              
              198Total
      non-performing loans
              
              $
              2,924
              
              
              $
              3,358
 
 
 Management
has analyzed the potential risk of loss on the Company's loan portfolio given
the loan balances and the value of the underlying collateral and has recognized
losses where appropriate. Non-performing loans are closely monitored on an
ongoing basis as part of the Company's loan review process.   The
required level of the allowance for loan losses is computed quarterly and the
allowance adjusted prior to the issuance of the quarterly financial
statements.  The allowance is reviewed for adequacy after considering
historical loss rates, current economic conditions (both locally and nationally)
and any known credit problems that have not been considered under the above
formula.
 
 The
following table shows the allocation for loans in the loan portfolio and the
corresponding amounts of the allowance allocated by loan type as of September
30, 2008 and December 31, 2007 (in thousands of dollars):
 
 September
      30, 2008
              
              
              December
      31, 2007Percent
      of
              
              
              
              
              
              Percent
      ofAmount
              
              
              Loans
              
              
              Amount
              
              
              LoansLoan
      TypeCommercial
              
              $
              1,301
              
              
              
              28
              %
              
              $
              1,140
              
              
              
              26
              %Mortgage
      and construction
              
              
              864
              
              
              
              57
              %
              
              
              1,200
              
              
              
              59
              %Consumer
              
              
              1,311
              
              
              
              15
              %
              
              
              1,172
              
              
              
              15
              %Unallocated
              
              
              175
              
              
              
              
              
              
              
              65Totals
              
              $
              3,651
              
              
              
              
              
              
              $
              3,577
 
 As
certain loans identified as impaired are paid current, collateral values
increase or loans are removed from watch lists for other reasons, and as other
loans become identified as impaired, and because delinquency levels within each
of the portfolios change, the allocation of the allowance among the loan types
may change. Management feels that the allowance is a fair representation of the
losses present in the portfolio given historical loss trends, economic
conditions and any known credit problems as of a given date. Management believes
that the allowance is to be taken as a whole, and allocation between loan types
is an estimation of potential losses within each type given information known at
the time. Due to concerns by management regarding deterioration of the economy
and the potential effects of this deterioration on the quality of the loan
portfolio, it was deemed appropriate by management that a larger unallocated
portion of the allowance exist.
  Index
  
 Page
      Eighteen
 
 The
following table summarizes the Company’s net charge-offs by loan type for the
nine month periods ended September 30, 2008 and 2007 (in thousands of
dollars):
 
 2008
              
              
              2007Charge-offsCommercial
              
              $
              (170
              )
              
              $
              (141
              )Mortgage
      and construction
              
              
              (155
              )
              
              
              (38
              )Consumer
              
              
              (339
              )
              
              
              (361
              )Total
      Charge-offs
              
              
              (664
              )
              
              
              (540
              )RecoveriesCommercial
              
              
              19
              
              
              
              50Mortgage
              
              
              2
              
              
              
              4Consumer
              
              
              81
              
              
              
              229Total
      Recoveries
              
              
              102
              
              
              
              283Total
      Net Charge-offs
              
              $
              (562
              )
              
              $
              (257
              )
 
 Year to
date in 2008, the Company has experienced a significant increase in net
charge-offs as compared to 2007. The recoveries experienced during 2007 on
previously charged off loans was greater than the organization has typically
historically experienced, with the result being that net charge-off rates for
the nine month period ended September 30, 2007 were lower than often
historically experienced by the Company.
 
 Because
of the large impact on the local economy, Management continuously monitors the
economic health of the poultry industry.  The Company has direct loans
to poultry growers and the industry is a large employer in the Company’s trade
area.  In recent periods, the Company’s loan portfolio has begun to
reflect a concentration in loans collateralized by heavy equipment, particularly
in the trucking, timber and coal extraction industries. In part because of
rising fuel costs, and because of continued slow economic growth, the trucking
and timber sectors have experienced recent downturns, and profitability growth
within this sector still appears to be sluggish. While close monitoring of this
sector is necessary, management expects no significant losses in the foreseeable
future.
 
 
 Net Interest
Income
 
 Net
interest income for the first nine months of 2008, on a fully taxable equivalent
basis, increased 3.05% as compared to the same period in 2007.
 
 The
Company’s loan demand, as compared to recent years, has slowed. Although demand
is slowing compared to recent periods, the call for new loans in the Company’s
market area has still been enough to maintain modest growth in loan balances and
average loan balances during the first nine months of 2008 were 4.15% higher
than during the same period in 2007 and total loan balances increased 2.20%
(annualized) from December 31, 2007 to September 30, 2008.
 
 Due do
the slowing loan demand and to reductions in the relative earnings potential of
other earning assets like federal funds sold as compared to costs of new
deposits, management, during the second and third quarters of 2008 maintained
rates on deposit products less than the rates offered by local competition for
similar products. The effect of this action was a reduction in balances of
deposits, mainly time deposits. Although average balances of time deposits
during the first nine months of 2008 were higher than during the same period in
2007, the Company’s total balances of time deposits have decreased 4.31% from
December 31, 2007 to September 30, 2008 and a corresponding effect of lowered
balances of lesser earning assets such as federal funds sold, interest bearing
deposits in other banks, and, to a lesser degree, securities available for
sale.
  Index
  
 Page
      Nineteen
 
 Management’s
efforts to increase the relative weight of loans, a higher earning asset, to
total average balances of earning assets through the reduction of assets earning
a lower rate of interest and reduction of interest costs through the reduction
of balances of time deposits contributed to increases in the Company’s net
interest margin for the first nine months and for the third quarter of 2008 as
compared to the same periods in 2007.
 
 During
the latter parts of the third quarter, reduction in deposits also required the
Company to begin short term borrowing of overnight federal funds purchased.
Historically, management of Highlands has not frequently utilized short term
borrowing facilities. However, the relative opportunity cost of these sources of
funding as compared to deposits or longer term debt vehicles made this an
attractive funding option given current trends in rates on both earning assets
and interest bearing liabilities and trends in the Company’s loan growth.
Although not considered a permanent funding option by the Company, management
will continue to evaluate the relative cost of funding options as compared to
growth opportunities for earning assets and will utilize overnight borrowings as
feasible.
 
 The table
below illustrates the effects on net interest income, on a fully taxable
equivalent basis, and for the first nine months of each year, of changes in
average volumes of interest bearing liabilities and earning assets from 2007 to
2008 and changes in average rates on interest bearing liabilities and earning
assets from 2007 to 2008 (in thousands of dollars):
 
 
 EFFECT
      OF RATE-VOLUME CHANGES ON NET INTEREST INCOME(On
      a fully taxable equivalent basis)(In
      thousands of dollars)Increase
      (Decrease) Nine Months Ended September 30, 2008 Compared to
                Nine
      Months Ended September 30, 2007Due
      to change in:Average Volume
              
              
              Average Rate
              
              
              Total ChangeInterest
      IncomeLoans
              
              $
              781
              
              
              $
              (837
              )
              
              $
              (56
              )Federal
      funds sold
              
              
              (136
              )
              
              
              (233
              )
              
              
              (369
              )Interest
      bearing deposits
              
              
              (30
              )
              
              
              (32
              )
              
              
              (62
              )Taxable
      investment securities
              
              
              (115
              )
              
              
              (91
              )
              
              
              (206
              )Nontaxable
      investment securities
              
              
              14
              
              
              
              0
              
              
              
              14Total
      Interest Income
              
              
              514
              
              
              
              (1,193
              )
              
              
              (679
              )Interest
      ExpenseDemand
      deposits
              
              
              (12
              )
              
              
              (83
              )
              
              
              (95
              )Savings
      deposits
              
              
              25
              
              
              
              (193
              )
              
              
              (168
              )Time
      deposits
              
              
              76
              
              
              
              (804
              )
              
              
              (728
              )Federal
      funds purchased
              
              
              10
              
              
              
              0
              
              
              
              10Borrowed
      money
              
              
              (57
              )
              
              
              (27
              )
              
              
              (84
              )Total
      Interest Expense
              
              
              42
              
              
              
              (1,107
              )
              
              
              (1,065
              )Net
      Interest Income
              
              $
              472
              
              
              $
              (86
              )
              
              $
              386
  Index
  
 Page
      Twenty
 
 The table
below sets forth an analysis of net interest income for the nine month periods
ended September 30, 2008 and 2007 (Average balances and interest/expense shown
in thousands of dollars):
 
 2008
              
              
              2007Average
              
              
              Income/
              
              
              
              
              
              Average
              
              
              Income/Balance
              
              
              Expense
              
              
              Rate
              
              
              Balance
              
              
              Expense
              
              
              RateInterest
      IncomeLoans1,2
              
              $
              313,392
              
              
              $
              18,774
              
              
              
              7.99
              %
              
              $
              300,905
              
              
              $
              18,830
              
              
              
              8.34
              %Federal
      funds sold
              
              
              12,157
              
              
              
              231
              
              
              
              2.53
              %
              
              
              15,715
              
              
              
              600
              
              
              
              5.09
              %Interest
      bearing deposits
              
              
              1,747
              
              
              
              38
              
              
              
              2.90
              %
              
              
              2,490
              
              
              
              100
              
              
              
              5.35
              %Taxable
      investment securities
              
              
              20,717
              
              
              
              742
              
              
              
              4.78
              %
              
              
              23,581
              
              
              
              948
              
              
              
              5.36
              %Nontaxable
      investment securities3
              
              
              3,239
              
              
              
              148
              
              
              
              6.09
              %
              
              
              2,927
              
              
              
              134
              
              
              
              6.10
              %Total
      Earning Assets
              
              
              351,252
              
              
              
              19,933
              
              
              
              7.57
              %
              
              
              345,618
              
              
              
              20,612
              
              
              
              7.95
              %Cash
      and cash equivalents
              
              
              7,339
              
              
              
              
              
              
              
              
              
              
              
              8,006Allowance
      for loan losses
              
              
              (3,605
              )
              
              
              
              
              
              
              
              
              
              
              (3,626
              )Insurance
      contracts
              
              
              6,368
              
              
              
              
              
              
              
              
              
              
              
              6,151Non-earning
      assets
              
              
              16,337
              
              
              
              
              
              
              
              
              
              
              
              15,535Total
      Assets
              
              $
              377,692
              
              
              
              
              
              
              
              
              
              
              $
              371,684Interest
      ExpenseInterest
      bearing demand deposits
              
              $
              23,700
              
              
              $
              73
              
              
              
              0.41
              %
              
              $
              25,528
              
              
              $
              168
              
              
              
              0.88
              %Savings
      and money markets
              
              
              50,144
              
              
              
              339
              
              
              
              0.90
              %
              
              
              47,744
              
              
              
              507
              
              
              
              1.42
              %Time
      deposits
              
              
              196,328
              
              
              
              6,055
              
              
              
              4.11
              %
              
              
              194,156
              
              
              
              6,783
              
              
              
              4.66
              %Long
      term debt
              
              
              11,217
              
              
              
              363
              
              
              
              4.31
              %
              
              
              12,841
              
              
              
              447
              
              
              
              4.64
              %Short
      term borrowings
              
              
              496
              
              
              
              10
              
              
              
              2.69
              %
              
              
              0
              
              
              
              0Total
      Interest Bearing Liabilities
              
              
              281,885
              
              
              
              6,840
              
              
              
              3.24
              %
              
              
              280,269
              
              
              
              7,905
              
              
              
              3.76
              %Demand
      deposits
              
              
              50,020
              
              
              
              
              
              
              
              
              
              
              
              48,249Other
      liabilities
              
              
              5,499
              
              
              
              
              
              
              
              
              
              
              
              4,923Stockholders’
      equity
              
              
              40,288
              
              
              
              
              
              
              
              
              
              
              
              38,243Total
      liabilities and stockholders’ equity
              
              $
              377,692
              
              
              
              
              
              
              
              
              
              
              $
              371,684Net
      Interest Income
              
              
              
              
              
              $
              13,094
              
              
              
              
              
              
              
              
              
              
              $
              12,707Net
      Yield on Earning Assets3
              
              
              
              
              
              
              
              
              
              
              4.97
              %
              
              
              
              
              
              
              
              
              
              
              4.90
              %
 
 1Balances
of loans include loans in non accrual status
 2Interest
income on loans includes fees
 3Yields
are on a fully taxable equivalent basis
 
 
 
  Index
  
 Page
      Twenty One
 
 The table
below sets forth an analysis of net interest income for the three month periods
ended September 30, 2008 and 2007 (Average balances and interest/expense shown
in thousands of dollars):
 
 2008
              
              
              2007Average
              
              
              Income/
              
              
              
              
              
              Average
              
              
              Income/Balance
              
              
              Expense
              
              
              Rate
              
              
              Balance
              
              
              Expense
              
              
              RateInterest
      IncomeLoans1,2
              
              $
              316,627
              
              
              $
              6,162
              
              
              
              7.78
              %
              
              $
              305,542
              
              
              $
              6,471
              
              
              
              8.47
              %Federal
      funds sold
              
              
              1,383
              
              
              
              8
              
              
              
              2.31
              %
              
              
              15,449
              
              
              
              195
              
              
              
              5.05
              %Interest
      bearing deposits
              
              
              773
              
              
              
              7
              
              
              
              3.63
              %
              
              
              2,660
              
              
              
              30
              
              
              
              4.51
              %Taxable
      investment securities
              
              
              21,669
              
              
              
              257
              
              
              
              4.74
              %
              
              
              25,792
              
              
              
              354
              
              
              
              5.49
              %Nontaxable
      investment securities3
              
              
              3,535
              
              
              
              57
              
              
              
              6.45
              %
              
              
              2,860
              
              
              
              46
              
              
              
              6.43
              %Total
      Earning Assets
              
              
              343,987
              
              
              
              6,491
              
              
              
              7.55
              %
              
              
              352,303
              
              
              
              7,096
              
              
              
              8.06
              %Cash
      and cash equivalents
              
              
              7,260
              
              
              
              
              
              
              
              
              
              
              
              7,950Allowance
      for loan losses
              
              
              (3,698
              )
              
              
              
              
              
              
              
              
              
              
              (3,693
              )Insurance
      contracts
              
              
              6,423
              
              
              
              
              
              
              
              
              
              
              
              6,205Non-earning
      assets
              
              
              16,749
              
              
              
              
              
              
              
              
              
              
              
              16,518Total
      Assets
              
              $
              370,721
              
              
              
              
              
              
              
              
              
              
              $
              379,283Interest
      ExpenseInterest
      bearing demand deposits
              
              $
              22,878
              
              
              $
              19
              
              
              
              0.33
              %
              
              $
              24,538
              
              
              $
              55
              
              
              
              0.90
              %Savings
      and money markets
              
              
              49,300
              
              
              
              88
              
              
              
              0.71
              %
              
              
              49,278
              
              
              
              191
              
              
              
              1.55
              %Time
      deposits
              
              
              191,463
              
              
              
              1,809
              
              
              
              3.78
              %
              
              
              201,223
              
              
              
              2,406
              
              
              
              4.78
              %Long
      term debt
              
              
              11,283
              
              
              
              128
              
              
              
              4.54
              %
              
              
              12,416
              
              
              
              144
              
              
              
              4.64
              %Short
      term borrowings
              
              
              1,478
              
              
              
              10
              
              
              
              2.71
              %
              
              
              0
              
              
              
              0Total
      Interest Bearing Liabilities
              
              
              276,402
              
              
              
              2,054
              
              
              
              2.97
              %
              
              
              287,275
              
              
              
              2,796
              
              
              
              3.89
              %Demand
      deposits
              
              
              49,832
              
              
              
              
              
              
              
              
              
              
              
              47,435Other
      liabilities
              
              
              5,410
              
              
              
              
              
              
              
              
              
              
              
              5,550Stockholders’
      equity
              
              
              39,077
              
              
              
              
              
              
              
              
              
              
              
              39,023Total
      liabilities and stockholders’ equity
              
              $
              370,721
              
              
              
              
              
              
              
              
              
              
              $
              379,283Net
      Interest Income
              
              
              
              
              
              $
              4,437
              
              
              
              
              
              
              
              
              
              
              $
              4,300Net
      Yield on Earning Assets3
              
              
              
              
              
              
              
              
              
              
              5.16
              %
              
              
              
              
              
              
              
              
              
              
              4.88
              %
 
 1Balances
of loans include loans in non accrual status
 2Interest
income on loans includes fees
 3Yields
are on a fully taxable equivalent basis
 
 
 
  Index
  
 
 
 Page
      Twenty Two
 
 Non-interest
Income
 
 Non-interest
income increased 34.31% for the first nine months of 2008 as compared to the
same period in 2007.
 
 Income
received from customer deposit account service charges increased $307,000 due to
continued growth in balances of demand deposits, a large source of these
charges, and also to the implementation by The Grant County Bank, during the
last quarter of 2007, of a courtesy overdraft program, which resulted in an
increase in non-sufficient funds fees collected by that bank.
 
 Non
interest income was also impacted by $177,000 in non recurring gains. The table
below summarizes the components of non-recurring income recorded during the
first nine months of 2008:
 
 Description of
      non-recurring income
              
              AmountGains
      recorded on called securities available for sale
              
              $
              109Gain
      on life insurance settlement
              
              
              30Gain
      on sale of fixed assets
              
              
              30Gain
      on sale of other real estate owned
              
              
              8
 
 
 Non-interest
Expense
 
 Non-interest
expense increased 3.05% for the first nine months of 2008 as compared to
2007.
 
 Salary and benefits
expense
 
 The
following table compares the components of salary and benefits expense for the
nine month periods ended September 30, 2007 and 2008 (in thousands of
dollars):
 
 Salary
      and Benefits ExpenseNine
      month periods
                ended
      September 30,2008
              
              
              2007
              
              
              Increase
                (Decrease)Employee
      salaries
              
              $
              3,159
              
              
              $
              2,986
              
              
              $
              173Employee
      benefit insurance
              
              
              683
              
              
              
              640
              
              
              
              43Payroll
      taxes
              
              
              232
              
              
              
              209
              
              
              
              23Post
      retirement plans
              
              
              666
              
              
              
              632
              
              
              
              34Total
              
              $
              4,740
              
              
              $
              4,467
              
              
              $
              273
 
 The table
below illustrates the change in salary expense between the first nine months of
2008 compared to salary expense for the same period in 2007 occurring because of
increases in average pay per employee and increases in the average number of
full time employees (in thousands of dollars):
 
 AmountChanges
      due to increase in average salary per full time equivalent
      employee
              
              $
              142Changes
      due to increase in the average full time equivalent employees for the
      periods
              
              
              31Total
      increase in salary expense
              
              $
              173
 
 
 Data processing
expense
 
 Data
processing expense decreased 5.08%. As the company has moved toward increased
electronic transfer of information between branch locations and centralized data
processing locations, data processing costs have been reduced.
 
 
 
 
  Index
  
 
 Page
      Twenty Three
 
 
 Occupancy and equipment
expense
 
 The
following table illustrates the components of occupancy and equipment expense
for the nine month periods ended September 30, 2008 and 2007 (in thousands of
dollars):
 
 2008
              
              
              2007
              
              
              Increase
                (Decrease)Depreciation
      of buildings and equipment
              
              $
              512
              
              
              $
              519
              
              
              $
              (7
              )Maintenance
      expense on buildings and equipment
              
              
              316
              
              
              
              327
              
              
              
              (11
              )Utilities
      expense
              
              
              67
              
              
              
              73
              
              
              
              (6
              )Real
      estate and personal property tax
              
              
              62
              
              
              
              62
              
              
              
              0Other
      expense related to occupancy and equipment
              
              
              63
              
              
              
              62
              
              
              
              1Total
      occupancy and equipment expense
              
              $
              1,020
              
              
              $
              1,043
              
              
              $
              (23
              )
 
 Other non interest
expense
 
 Other non
interest expense remained comparatively flat for the first three quarters of
2008 as compared to the same period in 2007. The typical increases in costs
associated with inflation and the increasing size of the organization were
offset by decreases in state franchise tax expense as a result of a reduction in
the effective rate of this tax and also decreases in advertising and marketing
expense and a slight decline in legal and professional fees.
 
 The table
below illustrates components of other non interest expense for the nine month
periods ended September 30, 2008 and 2007 (in thousands of dollars). All
components of other non interest expense comprising over 5% of the total are
itemized.
 
 2008
              
              
              2007
              
              
              Increase
                (Decrease)Legal
      and professional fees
              
              $
              413
              
              
              $
              430
              
              
              $
              (17
              )Directors
      fees
              
              
              274
              
              
              
              283
              
              
              
              (9
              )Amortization
      of intangible assets
              
              
              134
              
              
              
              132
              
              
              
              2Office
      supplies and postage
              
              
              382
              
              
              
              370
              
              
              
              12ATM
      expense
              
              
              146
              
              
              
              141
              
              
              
              5Advertising
      and marketing expense
              
              
              134
              
              
              
              154
              
              
              
              (20
              )State
      franchise tax expense
              
              
              79
              
              
              
              108
              
              
              
              (29
              )Miscellaneous
      components of other non interest expense
              
              
              633
              
              
              
              540
              
              
              
              93Total
              
              $
              2,195
              
              
              $
              2,158
              
              
              $
              37
 
 .
 Borrowed
Funds
 
 The
Company borrows funds from the Federal Home Loan Bank (“FHLB”) to reduce market
rate risks or to provide operating liquidity.  Management typically
will initiate these borrowings in response to a specific need for managing
market risks or for a specific liquidity need and will attempt to match features
of these borrowings to best suit the specific need. Therefore, the borrowings on
the Company’s balance sheet as of September 30, 2008 and throughout the three
and nine month periods ended September 30, 2008 have varying features of
amortization or single payment with periodic, regular interest payment and also
have interest rates which vary based on the terms and on the features of the
specific borrowing.
 
 Liquidity
 
 Operating
liquidity is the ability to meet present and future financial obligations. Short
term liquidity is provided primarily through cash balances, deposits with other
financial institutions, federal funds sold, non-pledged securities and loans
maturing within one year. Additional sources of liquidity available to the
Company include, but are not limited to, loan repayments, the ability to obtain
deposits through the adjustment of interest rates and the purchasing of federal
funds.  To further meet its liquidity needs, the Company also
maintains lines of credit with correspondent financial institutions, the Federal
Reserve Bank of Richmond and the Federal Home Loan Bank of
Pittsburgh.
  Index
  
 Page
      Twenty Four
 
 Historically,
the Company’s primary need for additional levels of operational liquidity has
been to fund increases in loan balances. The Company has normally funded
increases in loans by increasing deposits and with decreases in liquid assets
such as balances of federal funds sold and balances of securities. The Company
also utilizes existing borrowing facilities for additional levels of operating
liquidity. In choosing which sources of operating liquidity to utilize,
management evaluates the implications of each liquidity source and its impact on
profitability, balance sheet stability and potential future liquidity
needs.
 
 The
parent Company’s operating funds, funds with which to pay shareholder dividends
and funds for the exploration of new business ventures have been supplied
primarily through dividends paid by the Company’s subsidiary banks Capon Valley
Bank (CVB) and The Grant County Bank (GCB).  The various regulatory
authorities impose restrictions on dividends paid by a state bank.  A
state bank cannot pay dividends without the consent of the relevant banking
authorities in excess of the total net profits of the current year and the
combined retained profits of the previous two years.  As of October 1,
2008, the subsidiary banks could pay dividends to Highlands Bankshares, Inc. of
approximately $5,723,000 without permission of the regulatory
authorities.
 
 
 Capital
 
 The
Company seeks to maintain a strong capital base to expand facilities, promote
public confidence, support current operations and grow at a manageable
level.  As of September 30, 2008, the Company was above the regulatory
minimum levels of capital. The table below summarizes the capital ratios for the
Company and its subsidiary banks as of September 30, 2008 and December 31,
2007:
 
 September
      30, 2008
              
              
              December
      31, 2007Actual
              
              
              Regulatory
              
              
              Actual
              
              
              RegulatoryRatio
              
              
              Minimum
              
              
              Ratio
              
              
              MinimumTotal
      Risk Based Capital RatioHighlands
      Bankshares
              
              
              14.24
              %
              
              
              8.00
              %
              
              
              14.53
              %
              
              
              8.00
              %Capon
      Valley Bank
              
              
              13.10
              %
              
              
              8.00
              %
              
              
              14.78
              %
              
              
              8.00
              %The
      Grant County Bank
              
              
              13.98
              %
              
              
              8.00
              %
              
              
              13.23
              %
              
              
              8.00
              %Tier
      1 Leverage RatioHighlands
      Bankshares
              
              
              10.05
              %
              
              
              4.00
              %
              
              
              9.95
              %
              
              
              4.00
              %Capon
      Valley Bank
              
              
              9.07
              %
              
              
              4.00
              %
              
              
              10.00
              %
              
              
              4.00
              %The
      Grant County Bank
              
              
              9.85
              %
              
              
              4.00
              %
              
              
              9.09
              %
              
              
              4.00
              %Tier
      1 Risk Based Capital RatioHighlands
      Bankshares
              
              
              13.00
              %
              
              
              4.00
              %
              
              
              13.28
              %
              
              
              4.00
              %Capon
      Valley Bank
              
              
              11.85
              %
              
              
              4.00
              %
              
              
              13.53
              %
              
              
              4.00
              %The
      Grant County Bank
              
              
              12.75
              %
              
              
              4.00
              %
              
              
              12.09
              %
              
              
              4.00
              %
 
 
 In April
of 2008, Highlands Bankshares announced that its Board of Directors had
authorized the Company’s management to repurchase up to 100,000 shares of the
Company’s outstanding common stock and in early July of 2008 announced that the
repurchase of 100,000 shares had been completed.  This repurchase of
the Company’s common stock outstanding has had the effect of lowering capital.
Management and the board of directors feels that the Company and both subsidiary
banks’ current levels of capitalization as compared to regulatory minimums are
such that the effects on capital of this repurchase program have not reduced
capital to an extent that any type of regulatory action will occur as a result
of lowered capital levels.
 
 
 
 
 
  Index
  
 
 Page
      Twenty Five
 
 
 Subsequent
to September 30, 2008, U.S. Treasury announced a Troubled Asset Relief Program
(“TARP”) which includes provisions whereby the US Treasury could infuse capital
into qualifying banks via a capital purchase program. The amount of capital
available under TARP is limited to a minimum of 1% of risk weighted assets and a
maximum of 3% of risk weighted assets and would be available to qualifying banks
via sale of senior preferred stock, in combination with warrants on common
stock, to the United States Treasury.  After careful consideration of
the potential outcomes relating to participating in this capital purchase
program versus not participating, Management and the Board of Directors of
Highlands Bankshares have decided not to participate in the capital purchase
program.
 
 
 Effects of
Inflation
 
 Inflation
primarily affects industries having high levels of property, plant and equipment
or inventories. Although the Company is not significantly affected in these
areas, inflation does have an impact on the growth of assets.  As
assets grow rapidly, it becomes necessary to increase equity capital at
proportionate levels to maintain the appropriate equity to asset
ratios.  Traditionally, the Company's earnings and high capital
retention levels have enabled the Company to meet these needs. The Company's
reported earnings results have been minimally affected by
inflation.  The different types of income and expense are affected in
various ways.  Interest rates are affected by inflation, but the
timing and magnitude of the changes may not coincide with changes in the
consumer price index.  Management actively monitors interest rate
sensitivity in order to minimize the effects of inflationary trends on interest
rates. Other areas of non-interest expenses may be more directly affected by
inflation.
 
 
 
 Item 3.Quantitative and Qualitative Disclosures About Market Risk
 
 There
have been no material changes in Quantitative and Qualitative Disclosures about
Market Risk as reported in the Company’s Annual Report on Form 10-K for the
period ended December 31, 2007.
  Index
  
 Page
      Twenty Six
 
 Item 4. Controls and Procedures
 
 The
Company’s management, with the participation of the Company’s Chief Executive
Officer and Chief Financial Officer, has evaluated the effectiveness of the
Company’s disclosure controls and procedures as of September 30, 2008. Based on
this evaluation, the Company’s Chief Executive Officer and Chief Financial
Officer concluded that the Company’s disclosure controls and procedures are
effective as of September 30, 2008. The company has established procedures
undertaken during the normal course of business in an effort to reasonably
ensure that fraudulent activity of either an amount material to these results or
in any amount is not occurring.
 
 Changes in Internal
Controls
 
 During
the period reported upon, there were no significant changes in internal controls
of Highlands Bankshares, Inc. pertaining to its financial reporting and control
of its assets or in other factors that materially affected or are reasonably
likely to materially affect such control.
 
 
 
 PART
II OTHER INFORMATION
 
 Item
1.   Legal Proceedings
 
 Management
is not aware of any material pending or threatened litigation in which the
Company or its subsidiaries may be involved as a defendant.  In the
normal course of business, the banks periodically must initiate suits against
borrowers as a final course of action in collecting past due loans. In addition,
to management’s knowledge, no governmental authorities have initiated or
contemplated legal action against the Company.
 
 Item
1A. Risk Factors
 
 There
have been no material changes to the Company’s risk factors since these factors
were previously disclosed in the Company’s Annual Report on Form 10-K for the
period ended December 31, 2007.
 
 Item
2.  Unregistered Sales of Equity Securities and Use of
Proceeds.
 
 (a)  None
 
 (b)
None
 
 (c)  On
April 8, 2008 the Company announced a share repurchase plan whereby Management
was authorized by the Board of Directors to repurchase up to 100,000 shares of
the Company’s Common Stock, $5 par value, through open market transactions. On
July 8, 2008 the Company announced that it had successfully completed the share
repurchase plan at a total cost of $3,372,000 to repurchase 100,001 shares of
the Company’s shares of common stock outstanding. The table below summarizes the
shares purchased from the announcement date through September 30,
2008.
 
 
 Period
              
              Total
      Number of
                Shares
                Purchased
              
              
              Average
      Price
                Paid
      Per
                Share
              
              
              Total
      Number
                of
      Shares
                Purchased
      as
                Part
      of
                Publicly
                Announced
                Plan
              
              
              Maximum
                Number
      of
                Shares
      that May
                Yet
      Be
                Purchased
                Under the PlanApril
      9, 2008—April 30, 2008
              
              
              3,100
              
              
              $
              29.07
              
              
              
              3,100
              
              
              
              96,900May
      1, 2008—May 31, 2008
              
              
              4,631
              
              
              $
              31.21
              
              
              
              4,631
              
              
              
              92,269June
      1, 2008—June 30, 2008
              
              
              68,710
              
              
              $
              33.70
              
              
              
              68,710
              
              
              
              23,559July 1, 2008—July 31, 2008
              
              
              23,560
              
              
              $
              34.88
              
              
              
              23,560
              
              
              
              0Total
              
              
              100,001
              
              
              $
              33.72
              
              
              
              100,001
              
              
              
              0
  Index
  
 Page
      Twenty Seven
 
 
 Item
3.                      Defaults Upon Senior Securities
 
 None
 
 Item
4.                      Submission of Matters to a Vote of Security Holders
 
 None
 
 Item
5.                      Other Information
 
 None
 
 Item
6.                      Exhibits
 
 EXHIBIT
      INDEXExhibit
                Number
              Description3(i)
              Articles
      of Incorporation of Highlands Bankshares, Inc., as restated, are hereby
      incorporated by reference to Exhibit 3(i) to Highlands Bankshares Inc.’s
      Form 10-Q filed November 13, 2007 .3(ii)
              Amended
      Bylaws of Highlands Bankshares, Inc. are incorporated by reference to
      Exhibit 3(ii) to Highlands Bankshares Inc.’s Report on Form 8-K filed
      January 9, 2008.31.1
              Certification
      of Chief Executive Officer Pursuant to section 302 of the
      Sarbanes-Oxley  Act  of
                2002
      Chapter 63, Title 18 USC Section 1350 (A) and (B).31.2
              Certification
      of Chief Financial Officer  Pursuant to section 302 of the
      Sarbanes-Oxley  Act of
                2002
      Chapter 63, Title 18 USC Section 1350 (A) and (B).32.1
              Statement
      of Chief Executive Officer Pursuant to 18  U.S.C.
      §1350.32.2
              Statement
      of Chief Financial Officer Pursuant to 18 U.S.C.
  §1350.
 
 
 
 
 
 
 
 Signatures
 
 Pursuant to the requirements of the
Securities Exchange Act of 1934, the Registrant has duly caused this report to
be signed on its behalf by the undersigned thereunto duly
authorized.
 
 HIGHLANDS
      BANKSHARES, INC./s/ C.E.
      PorterC.E.
      PorterPresident
      & Chief Executive Officer/s/ R. Alan
      MillerR.
      Alan MillerPrincipal
      Financial OfficerNovember
      12, 2008