UNITED
      STATESSECURITIES
      AND EXCHANGE COMMISSIONWashington,
      DC 20549
 
 
 FORM
10-Q
 
 (Mark
One)
 ý  QUARTERLY
REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
1934
 For the
quarterly period ended March 31, 2009
 
 o  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 ý No o
 
 Indicate
by check mark whether the registrant has submitted electronically and posted on
its corporate Web site, if any, every Interactive Date File required to be
submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this
Chapter) during the preceding 12 months (or for such shorter period that
the registrant was required to submit and post such files).  Yes o No o
 
 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 o
              Accelerated
      Filer            
           oNon-accelerated
      filero (Do not check if a
      smaller reporting company)
              Smaller
      reporting company ý
 
 Indicate
by check mark whether the registrant is a shell company (as defined in Rule
12b-2 of the Exchange Act).   o
Yes   ý 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 April 30, 2009:  1,336,873
shares of Common Stock, $5 Par Value
  
  
 
 HIGHLANDS
      BANKSHARES, INC.Quarterly
      Report on Form 10Q For The Period Ended March 31, 2009INDEXPagePART I
                    FINANCIAL INFORMATIONItem 1.
                    Financial StatementsUnaudited Consolidated Statements of Income Three Months Ended
      March 31, 2009 and 2008
                    1Unaudited Consolidated Balance Sheet for March 31, 2009 and
      Audited Consolidated Balance Sheet for December 31,
    2008
                    2Unaudited Consolidated Statements of Changes in Stockholders’
      Equity for the Three Months Ended March 31, 2009 and
    2008
                    3Unaudited Consolidated Statements of Cash Flows for the Three
      Months Ended March 31, 2009 and 2008
                    4Notes to Consolidated Financial Statements
                    5Item 2.
                    Management’ Discussion and Analysis of Financial
      Condition  and Results of Operations
                    10Item 3.
                    Quantitative and Qualitative Disclosures About Market
      Risk
                    22Item 4.
                    Controls and Procedures
                    22PART II
                    OTHER INFORMATIONItem 1.
                    Legal Proceedings
                    22Item 1A.
                    Risk Factors
                    22Item 2.
                    Unregistered Sales of Equity Securities and Use of
      Proceeds
                    22Item 3.
                    Defaults Upon Senior Securities
                    22Item 4.
                    Submission of Matters to a Vote of Security
      Holders
                    23Item 5.
                    Other Information
                    23Item 6.
                    Exhibits
                    23SIGNATURES
                    23
 
  Index
  
 Page
      One
 
 PART I.
 Item 1.
              Financial
      Statements
 
 HIGHLANDS BANKSHARES, INC.CONSOLIDATED
      STATEMENTS OF INCOME(In
      Thousands of Dollars, Except Per Share Data)Three
      Months Ended March, 312009
                  
                  
                  2008(unaudited)
                  
                  
                  (unaudited)Interest
      IncomeInterest
      and fees on loans
                  
                  $
                  5,890
                  
                  
                  $
                  6,390Interest
      on federal funds sold
                  
                  
                  5
                  
                  
                  
                  148Interest
      on deposits in other banks
                  
                  
                  3
                  
                  
                  
                  17Interest
      and dividends on securities
                  
                  
                  227
                  
                  
                  
                  282Total
      Interest Income
                  
                  
                  6,125
                  
                  
                  
                  6,837Interest
      ExpenseInterest
      on deposits
                  
                  
                  1,838
                  
                  
                  
                  2,448Interest
      on borrowed money
                  
                  
                  137
                  
                  
                  
                  134Total
      Interest Expense
                  
                  
                  1,975
                  
                  
                  
                  2,582Net
      Interest Income
                  
                  
                  4,150
                  
                  
                  
                  4,255Provision
      for Loan Losses
                  
                  
                  284
                  
                  
                  
                  179Net
      Interest Income After Provision for Loan Losses
                  
                  
                  3,866
                  
                  
                  
                  4,076Non-interest
      IncomeService
      charges
                  
                  
                  367
                  
                  
                  
                  379Gains
      on securities
                  
                  
                  (13
                  )
                  
                  
                  87Other
      non-interest income
                  
                  
                  175
                  
                  
                  
                  191Total
      Non-interest Income
                  
                  
                  529
                  
                  
                  
                  657Non-interest
      ExpenseSalaries
      and employee benefits
                  
                  
                  1,661
                  
                  
                  
                  1,560Equipment
      and occupancy expense
                  
                  
                  329
                  
                  
                  
                  350Data
      processing expense
                  
                  
                  169
                  
                  
                  
                  208Directors
      fees
                  
                  
                  103
                  
                  
                  
                  96Legal
      and professional fees
                  
                  
                  123
                  
                  
                  
                  137Other
      non-interest expense
                  
                  
                  505
                  
                  
                  
                  435Total
      Non-interest Expense
                  
                  
                  2,890
                  
                  
                  
                  2,786Income
      Before Provision For Income Taxes
                  
                  
                  1,505
                  
                  
                  
                  1,947Provision
      for Income Taxes
                  
                  
                  542
                  
                  
                  
                  709Net
      Income
                  
                  $
                  963
                  
                  
                  $
                  1,238Per
      Share DataNet
      Income
                  
                  $
                  .72
                  
                  
                  $
                  .86Cash
      Dividends
                  
                  $
                  .29
                  
                  
                  $
                  .27Weighted
      Average Common Shares Outstanding
                  
                  
                  1,336,873
                  
                  
                  
                  1,436,874The
      accompanying notes are an integral part of these
    statements.
 
  Index
  
 Page
      Two
 
 
 HIGHLANDS BANKSHARES, INC.CONSOLIDATED
      BALANCE SHEETS(In
      thousands of dollars)March 31, 2009
                    
                    
                    December 31, 2008(unaudited)
                    
                    
                    (audited)ASSETSCash
      and due from banks
                    
                    $
                    7,038
                    
                    
                    $
                    7,589Interest
      bearing deposits in banks
                    
                    
                    524
                    
                    
                    
                    502Federal
      funds sold
                    
                    
                    8,984
                    
                    
                    
                    160Investment
      securities available for sale
                    
                    
                    20,801
                    
                    
                    
                    21,692Restricted
      investments
                    
                    
                    2,185
                    
                    
                    
                    2,177Loans
                    
                    
                    332,520
                    
                    
                    
                    325,754Allowance
      for loan losses
                    
                    
                    (3,579
                    )
                    
                    
                    (3,667
                    )Bank
      premises and equipment, net of depreciation
                    
                    
                    9,035
                    
                    
                    
                    8,031Interest
      receivable
                    
                    
                    2,023
                    
                    
                    
                    2,164Investment
      in life insurance contracts
                    
                    
                    6,560
                    
                    
                    
                    6,499Goodwill
                    
                    
                    1,534
                    
                    
                    
                    1,534Other
      intangible assets
                    
                    
                    1,166
                    
                    
                    
                    1,215Other
      assets
                    
                    
                    4,651
                    
                    
                    
                    4,645Total
      Assets
                    
                    $
                    393,442
                    
                    
                    $
                    378,295LIABILITIESDepositsNon-interest
      bearing deposits
                    
                    $
                    49,856
                    
                    
                    $
                    49,604Interest
      bearing transaction and savings accounts
                    
                    
                    72,769
                    
                    
                    
                    68,610Time
      deposits over $100,000
                    
                    
                    67,547
                    
                    
                    
                    64,779All
      other time deposits
                    
                    
                    140,045
                    
                    
                    
                    133,294Total
      Deposits
                    
                    
                    330,217
                    
                    
                    
                    316,287Overnight
      and other short term debt instruments
                    
                    
                    5,000
                    
                    
                    
                    4,800Long
      term debt instruments
                    
                    
                    11,207
                    
                    
                    
                    11,317Accrued
      expenses and other liabilities
                    
                    
                    6,976
                    
                    
                    
                    6,492Total
      Liabilities
                    
                    
                    353,400
                    
                    
                    
                    338,896STOCKHOLDERS’
      EQUITYCommon
      Stock, $5 par value, 3,000,000 shares authorized, 1,436,874
      shares  issued
                    
                    
                    7,184
                    
                    
                    
                    7,184Surplus
                    
                    
                    1,662
                    
                    
                    
                    1,662Treasury
      stock (100,001 shares, at cost at December 31, 2008)
                    
                    
                    (3,372
                    )
                    
                    
                    (3,372
                    )Retained
      earnings
                    
                    
                    35,732
                    
                    
                    
                    35,157Other
      accumulated comprehensive loss
                    
                    
                    (1,164
                    )
                    
                    
                    (1,232
                    )Total
      Stockholders’ Equity
                    
                    
                    40,042
                    
                    
                    
                    39,399Total
      Liabilities and Stockholders’ Equity
                    
                    $
                    393,442
                    
                    
                    $
                    378,295The
      accompanying notes are an integral part of these
statements
 
  Index
  
 Page
      Three
 
 
 
 HIGHLANDS
      BANKSHARES, INC.CONSOLIDATED
      STATEMENTSOF CHANGES IN STOCKHOLDERS’
    EQUITY(In
      Thousands of Dollars)Common
                            Stock
                          
                          
                          Surplus
                          
                          
                          Treasury
      Stock
                          
                          
                          Retained
      Earnings
                          
                          
                          Other
                            Comprehensive
                            Income
                          
                          
                          TotalBalances
      at December 31, 2007
                          
                          $
                          7,184
                          
                          
                          $
                          1,662
                          
                          
                          $
                          0
                          
                          
                          $
                          32,032
                          
                          
                          $
                          (285
                          )
                          
                          $
                          40,593Cumulative
      effect adjustment to retained earnings for change in accounting
      principle
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          (348
                          )
                          
                          
                          
                          
                          
                          
                          (348
                          )Other
      Comprehensive Income:Net
      Income
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          1,238
                          
                          
                          
                          
                          
                          
                          
                          1,238Change
      in other comprehensive income
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          99
                          
                          
                          
                          99Total
      Comprehensive Income
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          1,337Dividends
      Paid
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          (388
                          )
                          
                          
                          
                          
                          
                          
                          (388
                          )Balances
      March 31, 2008
                          
                          $
                          7,184
                          
                          
                          $
                          1,662
                          
                          
                          $
                          0
                          
                          
                          $
                          32,535
                          
                          
                          $
                          (186
                          )
                          
                          $
                          41,195Common
                            Stock
                          
                          
                          Surplus
                          
                          
                          Treasury
                            Stock
                          
                          
                          Retained
                            Earnings
                          
                          
                          Other
                            Comprehensive
                            Income
                          
                          
                          TotalBalances
      at December 31, 2008
                          
                          $
                          7,184
                          
                          
                          $
                          1,662
                          
                          
                          $
                          (3,372
                          )
                          
                          $
                          35,157
                          
                          
                          $
                          (1,232
                          )
                          
                          $
                          39,399Other
      Comprehensive Income:Net
      Income
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          963
                          
                          
                          
                          
                          
                          
                          
                          963Change
      in other comprehensive income
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          68
                          
                          
                          
                          68Total
      Comprehensive Income
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          1,031Dividends
      Paid
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          (388
                          )
                          
                          
                          
                          
                          
                          
                          (388
                          )Balances
      March 31, 2009
                          
                          $
                          7,184
                          
                          
                          $
                          1,662
                          
                          
                          $
                          (3,372
                          )
                          
                          $
                          35,732
                          
                          
                          $
                          (1,164
                          )
                          
                          $
                          40,042The
      accompanying notes are an integral part of these
statements
 
  Index
  
 Page
      Four
 
 HIGHLANDS
      BANKSHARES, INC.CONSOLIDATED
      STATEMENTS OF CASH FLOWS(In
      Thousands of Dollars)Three
      Months Ended March 31,2009
                    
                    
                    2008(unaudited)
                    
                    
                    (unaudited)Cash
      Flows From Operating ActivitiesNet
      Income
                    
                    $
                    963
                    
                    
                    $
                    1,238Adjustments
      to reconcile net income to netcash
      provided by operating activitiesLoss
      (gain) on investment securities
                    
                    
                    13
                    
                    
                    
                    (87
                    )Depreciation
                    
                    
                    155
                    
                    
                    
                    170Income
      from insurance contracts
                    
                    
                    (61
                    )
                    
                    
                    (60
                    )Net
      amortization of securities
                    
                    
                    24
                    
                    
                    
                    (116
                    )Provision
      for loan losses
                    
                    
                    284
                    
                    
                    
                    179Amortization
      of intangibles
                    
                    
                    49
                    
                    
                    
                    49Decrease
      in interest receivable
                    
                    
                    141
                    
                    
                    
                    121Decrease
      (increase) in other assets
                    
                    
                    (47
                    )
                    
                    
                    77Increase
      in accrued expenses and other liabilities
                    
                    
                    484
                    
                    
                    
                    544Net
      Cash Provided by Operating Activities
                    
                    
                    2,005
                    
                    
                    
                    2,115Cash
      Flows From Investing ActivitiesIncrease
      in federal funds sold
                    
                    
                    (8,824
                    )
                    
                    
                    (7,468
                    )Proceeds
      from maturities of securities available for sale
                    
                    
                    1,963
                    
                    
                    
                    10,117Purchase
      of securities available for sale
                    
                    
                    (1,000
                    )
                    
                    
                    (3,350
                    )Decrease
      (increase) in restricted investments
                    
                    
                    (8
                    )
                    
                    
                    (21
                    )(Increase)
      in interest bearing deposits in other banks
                    
                    
                    (22
                    )
                    
                    
                    (816
                    )Purchase
      of property and equipment
                    
                    
                    (1,159
                    )
                    
                    
                    (241
                    )Net
      Increase in Loans
                    
                    
                    (7,138
                    )
                    
                    
                    (1,270
                    )Net
      Cash Used in Investing Activities
                    
                    
                    (16,188
                    )
                    
                    
                    (3,049
                    )Cash
      Flows From Financing ActivitiesNet
      increase in deposits
                    
                    
                    13,930
                    
                    
                    
                    2,178Net
      change in short term borrowings
                    
                    
                    200Repayment
      of long term borrowings
                    
                    
                    (110
                    )
                    
                    
                    (154
                    )Dividends
      paid in cash
                    
                    
                    (388
                    )
                    
                    
                    (388
                    )Net
      Cash Provided by Financing Activities
                    
                    
                    13,632
                    
                    
                    
                    1,636Net
      Increase (decrease)  in Cash and Cash
Equivalents
                    
                    
                    (551
                    )
                    
                    
                    702Cash
      and Cash Equivalents, Beginning of Period
                    
                    
                    7,589
                    
                    
                    
                    7,935Cash
      and Cash Equivalents, End of Period
                    
                    $
                    7,038
                    
                    
                    $
                    8,637Supplemental
      DisclosuresCash
      paid for income taxes
                    
                    $
                    0
                    
                    
                    $
                    0Cash
      paid for interest
                    
                    $
                    2,044
                    
                    
                    $
                    2,685The
      accompanying notes are an integral part of these
    statements.
 
  Index
  
 Page
      Five
 
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 
 NOTE
      ONE
              ACCOUNTING
      PRINCIPLES
 
 The
consolidated financial statements conform to U. S. generally accepted accounting
principles and to general industry practices.  In the opinion of
management, the accompanying unaudited consolidated financial statements contain
all adjustments, consisting solely of normal recurring adjustments, necessary to
present fairly the financial position as of March 31, 2009 and the results of
operations for the three month periods ended March 31, 2009 and
2008.
 
 The
results of operations for the three month periods ended March 31, 2009 and 2008
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 2008 annual report on Form
10-K.
 
 Certain
reclassifications have been made to prior period balances to conform with the
current years’ presentation format.
 
 
 NOTE
      TWO
              LOANS
 
 A summary
of loans outstanding as of March 31, 2009 and December 31, 2008 is shown in the
table below (in thousands of dollars):
 
 March
      31,
                    
                    
                    December
      31,2009
                    
                    
                    2008Loan
      TypeCommercial
                    
                    $
                    99,780
                    
                    
                    $
                    97,709Real
      Estate construction
                    
                    
                    29,476
                    
                    
                    
                    27,210Real
      Estate mortgage
                    
                    
                    160,229
                    
                    
                    
                    156,877Consumer
      installment
                    
                    
                    43,035
                    
                    
                    
                    43,958Total
      Loans
                    
                    $
                    332,520
                    
                    
                    $
                    325,754
 
 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 March 31, 2009, the total balance of loans in the
portfolio secured by real estate was $269,678,000.
 
 
 NOTE
      THREE
              ALLOWANCE
      FOR LOAN LOSSES
 
 A summary
of the transactions in the allowance for loan losses for the three month periods
ended March 31, 2009 and 2008 is shown below (in thousands of
dollars):
 
 2009
                    
                    
                    2008Balance,
      beginning of period
                    
                    $
                    3,667
                    
                    
                    $
                    3,577Provisions
      charged to operations
                    
                    
                    284
                    
                    
                    
                    179Loan
      recoveries
                    
                    
                    65
                    
                    
                    
                    39Loan
      charge-offs
                    
                    
                    (437
                    )
                    
                    
                    (221
                    )Balance,
      end of period
                    
                    $
                    3,579
                    
                    
                    $
                    3,574
 
  Index
  
 Page
      Six
 
 
 NOTE
      FOUR
              INVESTMENT
      IN INSURANCE CONTRACTS
 
 Investment
in insurance contracts consist of single premium insurance contracts which have
the dual purposes of providing a rate of return to the Company which
approximately equals the Company’s average cost of funds and of providing life
insurance and retirement benefits to certain executives.
 
 
 NOTE
      FIVE
              SECURITIES
      AND RESTRICTED INVESTMENTS
 
 The
Company’s securities portfolio serves several purposes. Portions of the
portfolio secure certain public and trust deposits while the remaining portions
are held as investments or used to assist the Company in liquidity and
asset/liability management.
 
 The
amortized cost and market value of securities as of March 31, 2009 and December
31, 2008 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.
 
 March
      31, 2009
                    
                    
                    December
      31, 2008Amortized
                    
                    
                    Market
                    
                    
                    Amortized
                    
                    
                    MarketCost
                    
                    
                    Value
                    
                    
                    Cost
                    
                    
                    ValueAvailable For Sale
    SecuritiesU.S.
      Treasuries and Agencies
                    
                    $
                    7,411
                    
                    
                    $
                    7,596
                    
                    
                    $
                    7,504
                    
                    
                    $
                    7,726Mortgage
      backed securities
                    
                    
                    9,324
                    
                    
                    
                    9,520
                    
                    
                    
                    10,211
                    
                    
                    
                    10,342Obligations
      of states and municipalities
                    
                    
                    3,589
                    
                    
                    
                    3,669
                    
                    
                    
                    3,596
                    
                    
                    
                    3,609Marketable
      equities
                    
                    
                    15
                    
                    
                    
                    16
                    
                    
                    
                    28
                    
                    
                    
                    15Total
      Available For Sale Securities
                    
                    $
                    20,339
                    
                    
                    $
                    20,801
                    
                    
                    $
                    21,339
                    
                    
                    $
                    21,692
 
 Information
pertaining to securities with gross unrealized losses at December 31, 2008 and
March 31, 2009, 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
                        LossesMarch 31, 2009Investment
      CategoryMortgage
      backed securities
                      
                      
                      263
                      
                      
                      
                      (2
                      )
                      
                      
                      0
                      
                      
                      
                      0
                      
                      
                      
                      263
                      
                      
                      
                      (2
                      )U.S.
      Treasuries and Agencies
                      
                      
                      1,000
                      
                      
                      
                      (3
                      )
                      
                      
                      1,000
                      
                      
                      
                      (3
                      )
                      
                      
                      0
                      
                      
                      
                      (0
                      )Total
                      
                      $
                      1,263
                      
                      
                      $
                      (5
                      )
                      
                      $
                      1,000
                      
                      
                      $
                      (3
                      )
                      
                      $
                      263
                      
                      
                      $
                      (2
                      )December 31, 2008Investment
      CategoryMortgage
      backed securities
                      
                      
                      1,225
                      
                      
                      
                      (17
                      )
                      
                      
                      1,156
                      
                      
                      
                      (16
                      )
                      
                      
                      69
                      
                      
                      
                      (1
                      )State
      and municipals
                      
                      
                      1,908
                      
                      
                      
                      (16
                      )
                      
                      
                      1,708
                      
                      
                      
                      (15
                      )
                      
                      
                      200
                      
                      
                      
                      (1
                      )Other
      equity securities
                      
                      
                      15
                      
                      
                      
                      (13
                      )
                      
                      
                      0
                      
                      
                      
                      0
                      
                      
                      
                      15
                      
                      
                      
                      (13
                      )Total
                      
                      $
                      3,148
                      
                      
                      $
                      (46
                      )
                      
                      $
                      2,864
                      
                      
                      $
                      (31
                      )
                      
                      $
                      284
                      
                      
                      $
                      (15
                      )
 
 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
      Seven
 
 
 NOTE
      SIX
              EARNINGS
      PER SHARE
 
 During
the second and third quarters of 2008, the Company purchased, at varying
intervals, 100,001 shares of outstanding common stock. This purchase by the
Company of its outstanding shares reduced the number of weighted average shares
outstanding for the three month period ended March 31, 2009 as compared to the
three month period ended March 31, 2008.
 
 
 NOTE
      SEVEN
              DEPOSITS
 
 Interest
expense for time deposits over $100,000 and for all other time deposits for the
three month periods ended March 31, 2009 and 2008 is shown below (in thousands
of dollars):
 
 2009
                    
                    
                    2008Time
      deposits over $100,000
                    
                    $
                    607
                    
                    
                    $
                    780All
      other time deposits
                    
                    
                    1,163
                    
                    
                    
                    1,480Total
      interest paid on time deposits
                    
                    $
                    1,770
                    
                    
                    $
                    2,260
 
 
 NOTE
      EIGHT
              DEBT
      INSTRUMENTS
 
 The
Company has borrowed money from the Federal Home Loan Bank of Pittsburgh (FHLB).
This debt consists of both borrowings with terms of maturities of six month or
greater and also certain debts with maturities of thirty days or
less.
 
 The
borrowings with long term maturities may have either single payment maturities
or amortize. The interest rates on the various long term borrowings at March 31,
2009 range from 3.94% to 5.96%. The weighted average interest rate on the
borrowings at March 31, 2009 was 4.62%.
 
 In
addition to utilization of the FHLB for borrowings of long term debt, the
Company also can utilize the FHLB for overnight and other short term borrowings.
At March 31, 2009, the Company had balances of $5,000,000 in overnight and other
short term borrowings. At December 31, 2008, the Company had balances of
$4,800,000 in overnight and other short term borrowings. All of this short term
debt was through the FHLB.
 
 
 NOTE
      NINE
              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 December 31, 2008 and March
31, 2009 balances of retained earnings and is shown as an adjustment to retained
earnings in the Consolidated Statement of Changes in Stockholders’ Equity for
the period ended March 31, 2008.
  Index
  
 Page
      Eight
 
 
 NOTE
      TEN
              INTANGIBLE
      ASSETS
 
 The
Company’s balance sheet contains several components of intangible assets. At
March 31, 2009, 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.
 
 
 NOTE
      ELEVEN
              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 in 2006, 2007 and 2008 and expects to make contributions in
2009. The Bank has recognized liabilities of $1,893,000 at March 31, 2009. The
following table provides the components of the net periodic benefit cost for the
plan for the three month periods ended March 31, 2009 and 2008 (in thousands of
dollars):
 
 2009
                    
                    
                    2008Service
      cost
                    
                    $
                    51
                    
                    
                    $
                    31Interest
      cost
                    
                    
                    81
                    
                    
                    
                    50Expected
      return on plan assets
                    
                    
                    (98
                    )
                    
                    
                    (53
                    )Amortization
      of unrecognized prior service costs
                    
                    
                    1
                    
                    
                    
                    2Recognized
      net actuarial loss
                    
                    
                    16
                    
                    
                    
                    16Net
      periodic expense
                    
                    $
                    51
                    
                    
                    $
                    46
 
 
 NOTE
      TWELVE
              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:
  Index
  
 Page
      Nine
 
 The
Company, at March 31, 2009, had no liabilities subject to fair value reporting
requirements. The table below summarizes assets at March 31, 2009 measured at
fair value on a recurring basis (in thousands of dollars):
 
 Level 1
                
                
                Level 2
                
                
                Level 3
                
                
                Total
      Fair
                  Value
                  MeasurementsSecurities
      available for sale
                
                $
                0
                
                
                $
                20,801
                
                
                $
                0
                
                
                $
                20,801Total
                
                $
                0
                
                
                $
                20,801
                
                
                $
                0
                
                
                $
                20,801
 
 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.
 
 The table
below summarizes assets at March 31, 2009 measured at fair value on a non
recurring basis (in thousands of dollars):
 
 Level 1
                
                
                Level 2
                
                
                Level 3
                
                
                Total
      Fair
                  Value
                  MeasurementsOther
      real estate owned
                
                $
                0
                
                
                $
                0
                
                
                $
                1,661
                
                
                $
                1,661Impaired
      Loans
                
                
                0
                
                
                
                0
                
                
                
                4,636
                
                
                
                4,636Total
                
                $
                0
                
                
                $
                0
                
                
                $
                6,297
                
                
                $
                1,661
 
 Certain
assets such as other real estate owned (OREO) are measured at fair value less
cost to sell. Management believes that the fair value component in its valuation
follows the provisions of SFAS No. 157. Management estimates the fair value of
real estate acquired through foreclosure at an estimated fair value less costs
to sell. At or near the time of foreclosure, the subsidiary banks obtain real
estate appraisals on the properties acquired through foreclosure. The real
estate is then valued at the lesser of the appraised value or the loan balance,
including interest receivable, at the time of foreclosure less an estimate of
costs to sell the property. The estimate of costs to sell the property are based
on historical transactions at the subsidiary banks of similar
holdings.
 
 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. The impairment of loans is measured by the Company based on the
estimated value of underlying collateral of the loan. The value of the
collateral is typically based on either an appraisal of the collateral or
management’s best estimation of the realizable value of the collateral, less
estimated costs to sell.
 
  Index
  
 Page
      Ten
 
 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,
2008.  Current performance does not guarantee, and may not be
indicative of, similar performance in the future.
 
 Forward Looking
Statements
 
 Certain
statements in this report may constitute “forward-looking statements” within the
meaning of the Private Securities Litigation Reform Act of
1995.  Forward-looking statements are statements that include
projections, predictions, expectations or beliefs about future events or results
or otherwise are not statements of historical fact.  Such statements
are often characterized by the use of qualified words (and their derivatives)
such as “expect,” “believe,” “estimate,” “plan,” “project,” “anticipate” or
other similar words.  Although the Company believes that its
expectations with respect to certain forward-looking statements are based upon
reasonable assumptions within the bounds of its existing knowledge of its
business and operations, there can be no assurance that actual results,
performance or achievements of the Company will not differ materially from any
future results, performance or achievements expressed or implied by such
forward-looking statements.  Actual future results and trends may
differ materially from historical results or those anticipated depending on a
variety of factors, including, but not limited to, the effects of and changes
in:  general economic conditions, the interest rate environment,
legislative and regulatory requirements, competitive pressures, new products and
delivery systems, inflation, changes in the stock and bond markets, technology,
downturns in the trucking 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.
 
 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, 2008. 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.
  Index
  
 Page
      Eleven
 
 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 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 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.
 
 Intangible
Assets
 
 The
Company carries intangible assets related to the purchase of two banks. Amounts
paid to purchase these banks were allocated as intangible assets. Generally
accepted accounting principles were applied to allocate the intangible
components of the purchases. The excess was allocated between identifiable
intangibles (core deposit intangibles) and unidentified intangibles (goodwill).
Goodwill is required to be evaluated for impairment on an annual basis, and the
value of the goodwill adjusted accordingly, should impairment be
found.  As of December 31, 2008, the Company did not identify an
impairment of this intangible. In addition to the intangible assets associated
with the purchases of banks, the company also carries intangible assets relating
to the purchase of naming rights to certain features of a performing arts center
in Petersburg, WV. Intangible assets other than goodwill, which are determined
to have finite lives, are amortized based upon the estimated economic benefits
received.
 
 Post Retirement Benefits and
Life Insurance Investments
 
 The
Company has invested in and owns life insurance policies on key officers. The
policies are designed so that the company recovers the interest expenses
associated with carrying the policies and the officer will, at the time of
retirement, receive any earnings in excess of the amounts earned by the Company.
The Company recognizes as an asset the net amount that could be realized under
the insurance contract as of the balance sheet date. This amount represents the
cash surrender value of the policies less applicable surrender charges. The
portion of the benefits, which will be received by the executives at the time of
their retirement, is considered, when taken collectively, to constitute a
retirement plan. Therefore the Company accounts for these policies using
guidance found in Statement of Financial Accounting Standards No. 106,
"Employers' Accounting for Post Retirement Benefits Other Than Pensions.” SFAS
No. 106 requires that an employer’s obligation under a deferred compensation
agreement be accrued over the expected service life of the employee through
their normal retirement date. Assumptions are used in estimating the present
value of amounts due officers after their normal retirement
date.  These assumptions include the estimated income to be derived
from the investments and an estimate of the Company’s cost of funds in these
future periods.  In addition, the discount rate used in the present
value calculation will change in future years based on market
conditions.
  Index
  
 Page
      Twelve
 
 Recent Accounting
Pronouncements
 
 In
September 2006, the Financial Accounting Standards Board (FASB) reached a
consensus on Emerging Issues Task Force (“EITF”) Issue 06-4, “Accounting for
Deferred Compensation and Postretirement Benefit Aspects of Endorsement
Split-Dollar Life Insurance Arrangements,” (“EITF Issue 06-4”). In March 2007,
the FASB reached a consensus on EITF Issue 06-10, “Accounting for Collateral
Assignment Split-Dollar Life Insurance Arrangements,” (“EITF Issue 06-10”). Both
of these standards require a company to recognize an obligation over an
employee’s service period based upon the substantive agreement with the employee
such as the promise to maintain a life insurance policy or provide a death
benefit postretirement. 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
retained earnings and as such recorded a liability and corresponding reduction
of retained earnings of $348,000. There is no corresponding deferred tax
consequence relating to this liability.
 
 In April
2008, the FASB issued FASB Staff Position (FSP) No. 142-3, “Determination of the
Useful Life of Intangible Assets” (“FSP No. 142-3”). FSP No. 142-3 amends the
factors an entity should consider in developing renewal or extension assumptions
used in determining the useful life of recognized intangible assets under FASB
SFAS No. 142, “Goodwill and Other Intangible Assets” (“SFAS No. 142”). The
intent of FSP No. 142-3 is to improve the consistency between the useful life of
a recognized intangible asset under SFAS No. 142 and the period of expected cash
flows used to measure the fair value of the assets under SFAS No. 141(R). FSP
No. 142-3 is effective for the Company on January 1, 2009, and applies
prospectively to intangible assets that are acquired individually or with a
group of other assets in business combinations and asset acquisitions.The adoption of FSP No.
142-3 did not have a material impact on the Company’s consolidated financial
statements.
 
 In
October 2008, the FASB issued FSP FAS 157-3, “Determining the Fair Value of a
Financial Asset When the Market for That Asset Is Not Active,” (“FSP 157-3”).
FSP 157-3 clarifies the application of SFAS No. 157 in determining the fair
value of a financial asset during periods of inactive markets. FSP 157-3 was
effective as of September 30, 2008 and did not have material impact on the
Company’s consolidated financial statements.
 
 In April
2009, the FASB issued FSP FAS 157-4, “Determining Fair Value When the Volume and
Level of Activity for the Asset or Liability Have Significantly Decreased and
Identifying Transactions That Are Not Orderly.”  FSP FAS 157-4
provides additional guidance for estimating fair value in accordance with SFAS
157 when the volume and level of activity for the asset or liability have
significantly decreased.  The FSP also includes guidance on
identifying circumstances that indicate a transaction is not
orderly.  FSP FAS 157-4 is effective for interim and annual periods
ending after June 15, 2009, and shall be applied
prospectively.  Earlier adoption is permitted for periods ending after
March 15, 2009.  The Company does not expect the adoption of FSP FAS
157-4 to have a material impact on its consolidated financial
statements.
 
 In April
2009, the FASB issued FSP FAS 107-1 and APB 28-1, “Interim Disclosures about
Fair Value of Financial Instruments.”  FSP FAS 107-1 and APB 28-1
amends SFAS No. 107, “Disclosures about Fair Value of Financial Instruments,” to
require disclosures about fair value of financial instruments for interim
reporting periods of publicly traded companies as well as in annual financial
statements.  In addition, the FSP amends APB Opinion No. 28, “Interim
Financial Reporting,” to require those disclosures in summarized financial
information at interim reporting periods.  The FSP is effective for
interim periods ending after June 15, 2009, with earlier adoption permitted for
periods ending after March 15, 2009.  The Company does not expect the
adoption of FSP FAS 107-1 and APB 28-1 to have a material impact on its
consolidated financial statements.
 
 In April
2009, the Securities and Exchange Commission issued Staff Accounting Bulletin
No. 111 (SAB 111).  SAB 111 amends and replaces SAB Topic 5.M. in the
SAB Series entitled “Other Than Temporary Impairment of Certain Investments in
Debt and Equity Securities.”  SAB 111 maintains the SEC Staff’s
previous views related to equity securities and amends Topic 5.M. to exclude
debt securities from its scope.  The Company/Bank does not expect the
implementation of SAB 111 to have a material impact on its consolidated
financial statements.
  Index
  
 Page
      Thirteen
 
 In April
2009, the FASB issued FSP FAS 115-1 and FAS 124-2, “Recognition and Presentation
of Other-Than-Temporary Impairments.”  FSP FAS 115-1 and FAS 124-2
amends other-than-temporary impairment guidance for debt securities to make
guidance more operational and to improve the presentation and disclosure of
other-than-temporary impairments on debt and equity securities.  The
FSP does not amend existing recognition and measurement guidance related to
other-than-temporary impairments of equity securities.  FSP FAS 115-1
and FAS 124-2 is effective for interim and annual periods ending after June 15,
2009, with earlier adoption permitted for periods ending after March 15,
2009.  The Company does not expect the adoption of FSP FAS 115-1 and
FAS 124-2 to have a material impact on its consolidated financial
statements.
 
 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.
 
 Overview of First Quarter
Results
 
 Net
income for the first three months of 2009, as compared to the same period in
2008, decreased by 22.21%.
 
 Total
assets increased 4.00% from December 31, 2008 to March 31, 2009 with loan
balances increasing 2.08% over the same time period. Although average balances
of earning assets for the first three months of 2009 were .48% higher than for
the same period in 2008, average balances of interest bearing liabilities
increased 1.23% for the same comparative time period, which contributed largely
to a 2.47% decrease in net interest income.
 
 In
response to increasing loan delinquencies and net charge-offs of loans, the
Company’s provision for loan losses was $105,000 more in the first quarter of
2009 as compared to the same quarter in 2008.
 
 Non
interest income was $115,000 less in the first quarter of 2009 as compared to
2008. During 2008, the company recorded $87,000 in gains related to securities
which were called prior to their scheduled maturities. Although the Company
experienced declines in its costs of occupancy and equipment, data processing
and legal and professional fees, increases in salary and benefits expense and
other miscellaneous operating expense resulted in a 4.20% increase in non
interest expense.
 
 Performance
Measures
 
 The
following table compares selected commonly used measures of bank performance for
the three month periods ended March 31, 2009 and 2008:
 
 
 Three
      months ended March 31,2009
                      
                      
                      2008Annualized
      return on average assets
                      
                      
                      1.00
                      %
                      
                      
                      1.30
                      %Annualized
      return on average equity
                      
                      
                      9.69
                      %
                      
                      
                      12.20
                      %Net
      interest margin (1)
                      
                      
                      4.66
                      %
                      
                      
                      4.79
                      %Efficiency
      Ratio (2)
                      
                      
                      61.87
                      
                      
                      
                      56.76Earnings
      per share (3)
                      
                      $
                      .72
                      
                      
                      $
                      .86(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 month period ended March 31,
      2009 reflect the impact of the share repurchase of 100,001 shares during
      the second and third quarters of 2008.
 
 
 
  Index
  
 Page
      Fourteen
 
 Impact of Non Recurring
Items
 
 Non
recurring items had an impact on the income for the first quarter of 2009 as
compared to the first quarter of 2008. During the first quarter of 2008, the
Company recorded significant non recurring gains of $94,000 and during the first
quarter of 2009 recorded significant non recurring losses totaling $13,000. A
summary of the impact to income of these non recurring items is found in the
table below (in thousands of dollars):
 
 2009
                    
                    
                    2008
                    
                    
                    ChangeNet
      gains on securities
                    
                    $
                    (13
                    )
                    
                    $
                    87
                    
                    
                    $
                    (100
                    )Net
      gains on other real estate owned and other foreclosed
    assets
                    
                    
                    0
                    
                    
                    
                    7
                    
                    
                    
                    (7
                    )Total
                    
                    
                    (13
                    )
                    
                    
                    94
                    
                    
                    $
                    (107
                    )Income
      tax effect of non recurring items
                    
                    
                    (4
                    )
                    
                    
                    35
                    
                    
                    
                    39Impact
      of non recurring items on net income
                    
                    $
                    (9
                    )
                    
                    $
                    59
                    
                    
                    $
                    (68
                    )
 
 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 5.84% of total assets
and 57.40% of total shareholders’ equity at March 31, 2009.
 
 The
securities portfolio typically will consist of three
components:  securities held to maturity, securities available for
sale and restricted securities.  Securities are classified as held to
maturity when management has the intent and the Company has the ability at the
time of purchase to hold the securities to maturity.  Held to maturity
securities are carried at cost, adjusted for amortization of premiums and
accretion of discounts. Securities to be held for indefinite periods of time are
classified as available for sale and accounted for at market
value.  Securities available for sale include securities that may be
sold in response to changes in market interest rates, changes in the security's
prepayment risk, increases in loan demand, general liquidity needs and other
similar factors.  Restricted securities are those investments
purchased as a requirement of membership in certain governmental lending
institutions and cannot be transferred without the issuer’s
permission.  The Company's purchases of securities have generally been
limited to securities of high credit quality with short to medium term
maturities.
 
 The
Company identifies at the time of acquisition those securities that are
available for sale. These securities are valued at their market value with any
difference in market value and amortized cost shown as an adjustment in
stockholders' equity.  Changes in market values of securities which
are considered temporary changes due to changes in the market rate of interest
are reflected as changes in other comprehensive income, net of the deferred tax
effect.  Any changes in market values of securities deemed by
management to be attributable to reasons other than changes in market rates of
interest would be recorded through results of operations  It is
management’s determination that all securities held at March 31, 2009 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 March 31, 2009 can be found in
Footnote Five to the financial statements. Management reviews all securities
with unrealized losses, and all securities in the portfolio on a regular basis
to determine whether the potential for other than temporary impairment
exists
  Index
  
 Page
      Fifteen
 
 Loan
Portfolio
 
 The
Company is an active residential mortgage and construction lender and generally
extends commercial loans to small and medium sized businesses within its primary
service area.  The Company's commercial lending activity extends
across its primary service areas of Grant, Hardy, Hampshire, Mineral, Randolph,
Tucker, and northern Pendleton counties in West Virginia, Frederick County,
Virginia and Garrett County, Maryland.  Consistent with its focus on
providing community-based financial services, the Company does not attempt to
diversify its loan portfolio geographically by making significant amounts of
loans to borrowers outside of its primary service area.
 
 Credit Quality and Allowance
for Loan Losses
 
 The
following table illustrates certain ratios related to quality of the Company’s
loan portfolio:
 
 March 31, 2009
                  
                  
                  December 31, 2008Allowance
      for loan losses as a percentage of gross loans
                  
                  
                  1.08
                  %
                  
                  
                  1.13
                  %Non
      performing loans as a percentage of gross loans
                  
                  
                  2.10
                  %
                  
                  
                  1.70
                  %Ratio
      of allowance for loan losses to non-performing loans
                  
                  
                  .51
                  
                  
                  
                  .66
 
 
 The
following table summarizes the Company’s non-performing loans at March 31, 2009
and December 31, 2008 (in thousands of dollars):
 
 March
      31,
                    
                    
                    December
      31,2009
                    
                    
                    2008Non-accrual
      loans
                    
                    $
                    2,805
                    
                    
                    $
                    1,346Loans
      past due 90 days and still accruing interest
                    
                    
                    1,507
                    
                    
                    
                    3,472Restructured
      loans
                    
                    
                    2,655
                    
                    
                    
                    705Total
      non-performing loans
                    
                    $
                    6,967
                    
                    
                    $
                    5,523
 
 The
following table summarizes the Company’s net charge-offs by loan type for the
three month periods ended March 31, 2009 and 2008 (in thousands of
dollars):
 
 2009
                        
                        
                        2008Charge-offsCommercial
                        
                        $
                        (98
                        )
                        
                        $
                        (14
                        )Mortgage
      and construction
                        
                        
                        (136
                        )
                        
                        
                        (78
                        )Consumer
                        
                        
                        (204
                        )
                        
                        
                        (129
                        )Total
      Charge-offs
                        
                        
                        (438
                        )
                        
                        
                        (221
                        )RecoveriesCommercial
                        
                        
                        3
                        
                        
                        
                        13Mortgage
                        
                        
                        0
                        
                        
                        
                        0Consumer
                        
                        
                        62
                        
                        
                        
                        26Total
      Recoveries
                        
                        
                        65
                        
                        
                        
                        39Total
      Net Charge-offs
                        
                        $
                        (373
                        )
                        
                        $
                        (182
                        )
 
 
 
  Index
  
 
 Page
      Sixteen
 
 
 The
following table shows the allocation for loans in the loan portfolio and the
corresponding amounts of the allowance allocated by loan type as of March 31,
2009 and December 31, 2008 (in thousands of dollars):
 
 March
      31, 2009
                      
                      
                      December
      31, 2008Percent
      of
                      
                      
                      
                      
                      
                      Percent
      ofAmount
                      
                      
                      Loans
                      
                      
                      Amount
                      
                      
                      LoansLoan TypeCommercial
                      
                      $
                      1,515
                      
                      
                      
                      30
                      %
                      
                      $
                      1,349
                      
                      
                      
                      30
                      %Mortgage
      and construction
                      
                      
                      830
                      
                      
                      
                      57
                      %
                      
                      
                      994
                      
                      
                      
                      57
                      %Consumer
                      
                      
                      1,135
                      
                      
                      
                      13
                      %
                      
                      
                      1,285
                      
                      
                      
                      13
                      %Unallocated
                      
                      
                      99
                      
                      
                      
                      
                      
                      
                      
                      39Totals
                      
                      $
                      3,579
                      
                      
                      
                      
                      
                      
                      $
                      3,667
 
 Because
of its large impact on the local economy, management continues to monitor the
economic health of the poultry industry. The Company has direct loans to poultry
growers and the industry is a large employer in the Company’s trade area. In
addition, multiple manufacturers of household cabinetry are large employers in
the Company’s primary trade area. Due to the downturn in the housing market
nationally, there have been indications that the demand for cabinetry has
decreased, impacting the performance of these manufacturers. Because of the
impact on the local economy, management has begun to monitor the performance of
this industry as it relates to local employment trends. In recent periods, the
Company’s loan portfolio has also begun to reflect a concentration in loans
collateralized by heavy equipment, particularly in the trucking, mining and
timber industries. Because of the impact of the slowing economic conditions on
the housing market, the timber sector has experienced a recent downturn. While
the Company has experienced some losses related to the downturn in this
industry, no material losses related to foreclosures of loans collateralized by
assets typical to the timber harvest industry have occurred.
 
 Net Interest
Income
 
 The
Company’s net interest income, on a fully taxable equivalent basis, decreased
2.34% from the first three months of 2008 as compared to the same period in 2009
as average balances of earning assets increased .48% as compared to a 1.23%
increase in the average balances of interest bearing liabilities.
 
 Decreases
during recent years in the target rate for federal funds sold has caused overall
rates on both interest bearing liabilities and earning assets to decrease.
Although these decreases didn’t occur in the first quarter of 2009, the effects
are still being seen in the Company’s net interest income as variable loans
reprice and older balances of other earning assets and interest bearing
liabilities mature and are replaced with new assets and liabilities at lower
rates. In addition, increased competition for loans has impacted loan earning
rates as the average rate earned on loans in the first quarter of 2009 fell 107
basis points as compared to the same quarter in 2008. Although rates paid on
interest bearing liabilities decreased also, the decrease was not as large as
experienced with loans.
 
 In
addition to increased competition for loan balances, the Company has been
required, in order to increase deposit balances to fund loan growth, to match or
better local competitive rates paid on deposits, which also contributes to the
decline in net interest margins. During previous years, the Company has chosen
to fund loan growth through reduction in balances of comparatively lower earning
assets such as securities and federal funds sold. In the recent quarters, the
Company has begun to fund this loan growth through either new borrowings,
typically short term or overnight borrowings, or through increases in balances
of time deposits.
 
 Also, the
Company has recently placed larger balances of loans into non-accrual status
than have been placed there historically. This, combined with increases in
balances of Other Real Estate Owned due to foreclosures, has had a negative
impact on interest income.
  Index
  
 Page
      Seventeen
 
 
 
 The table
below illustrates the effects on net interest income, on a fully taxable
equivalent basis, and for the first three months of each year, of changes in
average volumes of interest bearing liabilities and earning assets from 2008 to
2009 and changes in average rates on interest bearing liabilities and earning
assets from 2008 to 2009 (in thousands of dollars):
 
 EFFECT
      OF RATE-VOLUME CHANGES ON NET INTEREST INCOMEIncrease
      (Decrease) Three Months Ended March 31, 2009 Compared to
Three
                    Months
      Ended March 31, 2008Due
      to change in:Average Volume
                  
                  
                  Average Rate
                  
                  
                  Total ChangeInterest
      IncomeLoans
                  
                  $
                  332
                  
                  
                  $
                  (832
                  )
                  
                  $
                  (500
                  )Federal
      funds sold
                  
                  
                  (7
                  )
                  
                  
                  (136
                  )
                  
                  
                  (143
                  )Interest
      bearing deposits
                  
                  
                  (10
                  )
                  
                  
                  (4
                  )
                  
                  
                  (14
                  )Taxable
      investment securities
                  
                  
                  (39
                  )
                  
                  
                  (24
                  )
                  
                  
                  (63
                  )Nontaxable
      investment securities
                  
                  
                  4
                  
                  
                  
                  9
                  
                  
                  
                  13Total
      Interest Income
                  
                  
                  280
                  
                  
                  
                  (987
                  )
                  
                  
                  (707
                  )Interest
      ExpenseDemand
      deposits
                  
                  
                  (1
                  )
                  
                  
                  (21
                  )
                  
                  
                  (22
                  )Savings
      deposits
                  
                  
                  (2
                  )
                  
                  
                  (89
                  )
                  
                  
                  (91
                  )Time
      deposits
                  
                  
                  11
                  
                  
                  
                  (508
                  )
                  
                  
                  (497
                  )Short
      term borrowings
                  
                  
                  5
                  
                  
                  
                  0
                  
                  
                  
                  5Long
      term borrowings
                  
                  
                  8
                  
                  
                  
                  (10
                  )
                  
                  
                  (2
                  )Total
      Interest Expense
                  
                  
                  21
                  
                  
                  
                  (628
                  )
                  
                  
                  (607
                  )Net
      Interest Income
                  
                  $
                  259
                  
                  
                  $
                  (359
                  )
                  
                  $
                  (100
                  )
 
  Index
  
 Page
      Eighteen
 
 The table
below sets forth an analysis of net interest income for the three month periods
ended March 31, 2009 and 2008 (Average balances and interest/expense shown in
thousands of dollars):
 
 2009
                      
                      
                      2008Average
                      
                      
                      Income/
                      
                      
                      
                      
                      
                      Average
                      
                      
                      Income/Balance
                      
                      
                      Expense
                      
                      
                      Rate
                      
                      
                      Balance
                      
                      
                      Expense
                      
                      
                      RateInterest
      IncomeLoans1,2
                      
                      $
                      329,207
                      
                      
                      $
                      5,890
                      
                      
                      
                      7.16
                      %
                      
                      $
                      310,635
                      
                      
                      $
                      6,390
                      
                      
                      
                      8.23
                      %Federal
      funds sold
                      
                      
                      8,192
                      
                      
                      
                      5
                      
                      
                      
                      .24
                      %
                      
                      
                      20,110
                      
                      
                      
                      148
                      
                      
                      
                      2.94
                      %Interest
      bearing deposits
                      
                      
                      547
                      
                      
                      
                      3
                      
                      
                      
                      1.90
                      %
                      
                      
                      2,306
                      
                      
                      
                      17
                      
                      
                      
                      2.95
                      %Taxable
      investment securities
                      
                      
                      17,092
                      
                      
                      
                      192
                      
                      
                      
                      4.49
                      %
                      
                      
                      20,522
                      
                      
                      
                      255
                      
                      
                      
                      4.97
                      %Nontaxable
      investment securities3
                      
                      
                      3,255
                      
                      
                      
                      55
                      
                      
                      
                      6.76
                      %
                      
                      
                      3,009
                      
                      
                      
                      42
                      
                      
                      
                      5.58
                      %Total
      Earning Assets
                      
                      
                      358,293
                      
                      
                      
                      6,145
                      
                      
                      
                      6.86
                      %
                      
                      
                      356,582
                      
                      
                      
                      6,852
                      
                      
                      
                      7.69
                      %Cash
      and cash equivalents
                      
                      
                      6,740
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      7,510Allowance
      for loan losses
                      
                      
                      (3,686
                      )
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      (3,580
                      )Insurance
      contracts
                      
                      
                      6,522
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      6,323Non-earning
      assets
                      
                      
                      18,731
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      15,999Total
      Assets
                      
                      $
                      386,600
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      $
                      382,834Interest
      ExpenseInterest
      bearing demand deposits
                      
                      $
                      22,463
                      
                      
                      $
                      13
                      
                      
                      
                      .23
                      %
                      
                      $
                      23,939
                      
                      
                      $
                      35
                      
                      
                      
                      .58
                      %Savings
      and money markets
                      
                      
                      47,840
                      
                      
                      
                      55
                      
                      
                      
                      .46
                      %
                      
                      
                      49,876
                      
                      
                      
                      146
                      
                      
                      
                      1.17
                      %Time
      deposits
                      
                      
                      202,579
                      
                      
                      
                      1,770
                      
                      
                      
                      3.49
                      %
                      
                      
                      201,324
                      
                      
                      
                      2,267
                      
                      
                      
                      4.50
                      %Short
      term borrowings
                      
                      
                      5,038
                      
                      
                      
                      5
                      
                      
                      
                      .40
                      %Long
      term borrowings
                      
                      
                      12,486
                      
                      
                      
                      132
                      
                      
                      
                      4.23
                      %
                      
                      
                      11,751
                      
                      
                      
                      134
                      
                      
                      
                      4.56
                      %Total
      Interest Bearing Liabilities
                      
                      
                      290,406
                      
                      
                      
                      1,975
                      
                      
                      
                      2.72
                      %
                      
                      
                      286,890
                      
                      
                      
                      2,582
                      
                      
                      
                      3.60
                      %Demand
      deposits
                      
                      
                      49,070
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      50,003Other
      liabilities
                      
                      
                      7,385
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      5,124Stockholders’
      equity
                      
                      
                      39,739
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      40,817Total
      liabilities and stockholders’ equity
                      
                      $
                      386,600
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      $
                      382,834Net
      Interest Income
                      
                      
                      
                      
                      
                      $
                      4,170
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      $
                      4,270Net
      Yield on Earning Assets3
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      4.66
                      %
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      4.79
                      %1Balances
      of loans include loans in non accrual status2Interest
      income on loans includes fees3Yields
      are on a fully taxable equivalent basis
 
  Index
  
 Page
      Nineteen
 
 Non-interest
Income
 
 Non
interest income decreased $115,000, or 17.50% from the first quarter of 2008
compared to the same quarter in 2009. The year over year change in non-interest
income was significantly impacted by non-recurring items.  Further
discussion relating to non-recurring items can be found earlier on page
thirteen.
 
 Service
charges on deposit accounts decreased 3.17%. The largest portion of these
charges is non-sufficient funds fees on non interest bearing transaction
accounts. In prior periods, these charges had increased as the subsidiary banks
implemented programs commonly referred to as “courtesy overdraft” programs. In
the periods after implementation, both subsidiary banks experienced increases in
non-sufficient funds fees. Both subsidiaries have now had these courtesy
overdraft programs in place for in excess of twelve months and the volumes of
fees from these programs appear to have stabilized.
 
 During
the periods 2004 through the present, the Company’s volume of new installment
loans decreased. These loans are the primary market for credit life and accident
and health insurance. As a result, earnings on the sales of these insurance
policies decreased over this same period as old policies matured but were not
replaced by new policies at the same rate of maturity of the older credit
related policies. This has contributed to a decline in insurance
earnings.
 
 Non-interest
Expense
 
 Non-interest
expense increased 4.20% for the first quarter of 2009 as compared to
2008.
 
 Changes in salary and
benefits expense
 
 The
following table compares the components of salary and benefits expense for the
three month periods ended March 31, 2009 and 2008 (in thousands of
dollars):
 
 Salary
      and Benefits Expense2009
                    
                    
                    2008
                    
                    
                    Increase
                      (Decrease)Employee
      salaries
                    
                    $
                    1,103
                    
                    
                    $
                    1,040
                    
                    
                    $
                    63Employee
      benefit insurance
                    
                    
                    227
                    
                    
                    
                    203
                    
                    
                    
                    24Payroll
      taxes
                    
                    
                    103
                    
                    
                    
                    94
                    
                    
                    
                    9Post
      retirement plans
                    
                    
                    228
                    
                    
                    
                    223
                    
                    
                    
                    5Total
                    
                    $
                    1,661
                    
                    
                    $
                    1,560
                    
                    
                    $
                    101
 
 The table
below illustrates the change in salary expense for the first three months of
2009 as compared to the same period in 2008 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
                    
                    $
                    108Changes
      due to increase in the average full time equivalent employees for the
      periods
                    
                    
                    (45
                    )Total
      increase in salary expense
                    
                    $
                    63
 
 Changes in data processing
expense
 
 Data
processing expense decreased 18.75%. During the later parts of 2008 and early
into 2009, the Company completed a process for selection of a new service to
complete its largest data processing activities. The Company chose to remain
with its current vendor, but chose to utilize new services from this same
vendor. Conversion to a new service is expected to occur in the third and fourth
quarters of 2009. After this conversion, the costs associated with this system
are expected to be approximately equivalent to the recent costs of the current
system. However, during negotiations, the vendor of the new system provided
incentives related to credits for the Company’s current contractual
arrangements. This contributed significantly to the decline in data processing
costs. Although recurring costs post-conversion are expected to be approximately
equivalent to recent data processing costs, allowing for customer increases due
to operational growth, the Company may experience certain other additional costs
in the remaining quarters of 2009 relating to this
implementation.
  Index
  
 Page
      Twenty
 
 Changes in occupancy and
equipment expense
 
 The
following table illustrates the components of occupancy and equipment expense
for the three month periods ended March 31, 2009 and 2008 (in thousands of
dollars):
 
 2009
                  
                  
                  2008
                  
                  
                  Increase
                    (Decrease)Depreciation
      of buildings and equipment
                  
                  $
                  155
                  
                  
                  $
                  170
                  
                  
                  $
                  (15
                  )Maintenance
      expense on buildings and equipment
                  
                  
                  97
                  
                  
                  
                  110
                  
                  
                  
                  (13
                  )Utilities
      expense
                  
                  
                  36
                  
                  
                  
                  28
                  
                  
                  
                  8Real
      estate and personal property tax
                  
                  
                  20
                  
                  
                  
                  19
                  
                  
                  
                  1Other
      expense related to occupancy and equipment
                  
                  
                  21
                  
                  
                  
                  23
                  
                  
                  
                  (2
                  )Total
      occupancy and equipment expense
                  
                  $
                  329
                  
                  
                  $
                  350
                  
                  
                  $
                  (21
                  )
 
 Changes in miscellaneous non
interest expense
 
 Most
other components of other non interest expense remained comparatively flat for
2009 as compared to 2008. 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. As discussed in Part I, Item 1 in the
Company’s Annual Report on Form 10-K for the period ended December 31, 2008,
under the heading Regulation and Supervision, the Company’s FDIC assessments
increased for the first quarter of 2009 as compared to the same period in 2008.
Additional increases during the remainder of 2009 could further increase non
interest expenses.
 
 The table
below illustrates components of other non interest expense for the three month
periods ended March 31, 2009 and 2008 (in thousands of dollars). All significant
individual components of other non interest expense are itemized.
 
 2009
                  
                  
                  2008
                  
                  
                  Increase
                    (Decrease)Office
      supplies and postage & freight expense
                  
                  $
                  122
                  
                  
                  $
                  121
                  
                  
                  $
                  1FDIC
      Premiums
                  
                  
                  55
                  
                  
                  
                  9
                  
                  
                  
                  46ATM
      expense
                  
                  
                  53
                  
                  
                  
                  48
                  
                  
                  
                  5Amortization
      of intangible assets
                  
                  
                  49
                  
                  
                  
                  50
                  
                  
                  
                  (1
                  )Advertising
      and marketing expense
                  
                  
                  38
                  
                  
                  
                  35
                  
                  
                  
                  3Miscellaneous
      components of other non interest expense
                  
                  
                  188
                  
                  
                  
                  172
                  
                  
                  
                  16Total
                  
                  $
                  505
                  
                  
                  $
                  435
                  
                  
                  $
                  70
 
 Borrowed
Funds
 
 The
Company borrows funds from the Federal Home Loan Bank (“FHLB”) to reduce market
rate risks or to provide operating liquidity.  Management typically
will initiate these borrowings in response to a specific need for managing
market risks or for a specific liquidity need and will attempt to match features
of these borrowings to best suit the specific need. Therefore, the borrowings on
the Company’s balance sheet as of March 31, 2009 and throughout the three month
periods ended March 31, 2008 and 2009 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.
 
 
  Index
  
 Page
      Twenty One
 
 Liquidity
 
 Operating
liquidity is the ability to meet present and future financial obligations. Short
term liquidity is provided primarily through cash balances, deposits with other
financial institutions, federal funds sold, non-pledged securities and loans
maturing within one year. Additional sources of liquidity available to the
Company include, but are not limited to, loan repayments, the ability to obtain
deposits through the adjustment of interest rates and the purchasing of federal
funds.  To further meet its liquidity needs, the Company also
maintains lines of credit with correspondent financial institutions, the Federal
Reserve Bank of Richmond and the Federal Home Loan Bank of
Pittsburgh.
 
 Historically,
the Company’s primary need for additional levels of operational liquidity has
been to fund increases in loan balances. The Company has normally funded
increases in loans by increasing deposits and with decreases in liquid assets
such as balances of federal funds sold and balances of securities. The Company
also utilizes existing borrowing facilities for additional levels of operating
liquidity. In choosing which sources of operating liquidity to utilize,
management evaluates the implications of each liquidity source and its impact on
profitability, balance sheet stability and potential future liquidity
needs.
 
 The
parent Company’s operating funds, funds with which to pay shareholder dividends
and funds for the exploration of new business ventures have been supplied
primarily through dividends paid by the Company’s subsidiary banks Capon Valley
Bank (CVB) and The Grant County Bank (GCB).  The various regulatory
authorities impose restrictions on dividends paid by a state bank.  A
state bank cannot pay dividends without the consent of the relevant banking
authorities in excess of the total net profits of the current year and the
combined retained profits of the previous two years.  As of April 1,
2009, the subsidiary banks could pay dividends to Highlands Bankshares, Inc. of
approximately $3,726,000 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 March 31, 2009, the Company was above the regulatory
minimum levels of capital. The table below summarizes the capital ratios for the
Company and its subsidiary banks as of March 31, 2009 and December 31,
2008:
 
 March
      31, 2009
                          
                          
                          December
      31, 2008Actual
                          
                          
                          Regulatory
                          
                          
                          Actual
                          
                          
                          RegulatoryRatio
                          
                          
                          Minimum
                          
                          
                          Ratio
                          
                          
                          MinimumTotal Risk Based Capital
    RatioHighlands
      Bankshares
                          
                          
                          13.93
                          %
                          
                          
                          8.00
                          %
                          
                          
                          14.20
                          %
                          
                          
                          8.00
                          %Capon
      Valley Bank
                          
                          
                          12.85
                          %
                          
                          
                          8.00
                          %
                          
                          
                          12.77
                          %
                          
                          
                          8.00
                          %The
      Grant County Bank
                          
                          
                          13.50
                          %
                          
                          
                          8.00
                          %
                          
                          
                          13.99
                          %
                          
                          
                          8.00
                          %Tier 1 Leverage RatioHighlands
      Bankshares
                          
                          
                          10.03
                          %
                          
                          
                          4.00
                          %
                          
                          
                          10.18
                          %
                          
                          
                          4.00
                          %Capon
      Valley Bank
                          
                          
                          8.96
                          %
                          
                          
                          4.00
                          %
                          
                          
                          9.11
                          %
                          
                          
                          4.00
                          %The
      Grant County Bank
                          
                          
                          9.84
                          %
                          
                          
                          4.00
                          %
                          
                          
                          10.00
                          %
                          
                          
                          4.00
                          %Tier 1 Risk Based Capital
    RatioHighlands
      Bankshares
                          
                          
                          12.81
                          %
                          
                          
                          4.00
                          %
                          
                          
                          12.98
                          %
                          
                          
                          4.00
                          %Capon
      Valley Bank
                          
                          
                          11.59
                          %
                          
                          
                          4.00
                          %
                          
                          
                          11.52
                          %
                          
                          
                          4.00
                          %The
      Grant County Bank
                          
                          
                          12.42
                          %
                          
                          
                          4.00
                          %
                          
                          
                          12.79
                          %
                          
                          
                          4.00
                          %
 
  Index
  
 Page
      Twenty Two
 
 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, 2008.
 
 Item 4.Controls and
Procedures
 
 The
Company’s management, with the participation of the Company’s Chief Executive
Officer and Principal Financial Officer, has evaluated the effectiveness of the
Company’s disclosure controls and procedures as of March 31, 2009. Based on this
evaluation, the Company’s Chief Executive Officer and Principal Financial
Officer concluded that the Company’s disclosure controls and procedures are
effective as of March 31, 2009. 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, 2008.
 
 Item
2.     Unregistered Sales of Equity
Securities and Use of Proceeds.
 
 None
 
 Item
3.     Defaults Upon Senior
Securities
 
 None
  Index
  
 Page
      Twenty Three
 
 
 Item
4.     Submissionof 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 of2002
      Chapter 63, Title 18 USC Section 1350 (A) and (B).31.2
                    Certification
      of Principal Financial Officer  Pursuant to section 302 of the
      Sarbanes-Oxley Act of2002
      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 Principal 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 OfficerMay
      12, 2009