**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

Washington, D.C. 20549

 

**FORM 10-K/A**

 

**Annual Report Pursuant to Section 13 or 15(d)**

**of            the Securities Exchange Act of 1934**

 

For            the fiscal year ended December 31, 2007

 

Commission File Number 000-27622

 

**HIGHLANDS BANKSHARES, INC.**

(Exact name of registrant as specified in its charter)

 

| **Virginia**

(State or other jurisdiction

of incorporation or organization)

                              | **54-1796693**

(I.R.S. Employer

Identification No.) |
|-------------------------------------------------------------------------------------------------------------------|-------------------------------------------------------|
| **340 West Main Street**

**Abingdon, Virginia**

(Address of principal executive offices)                        |  

**24210-1128**

(Zip Code)                    |

 

Registrant’s telephone number, including area            code:**(276) 628-9181**

 

Securities registered pursuant to Section 12(g) of the Act:

**Common Stock, $0.625 par value**

(Title of class)

 

Indicate by check mark if the registrant is a well-known seasoned            issuer, as defined in Rule 405 of the Securities Act. YesoNox

             

Indicate by check mark if the registrant is not required to file reports            pursuant to Section 13 or Section 15d of the Act. YesoNox

 

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. YesxNoo

 

Indicate by check mark if disclosure of delinquent filers pursuant to            Item 405 of Regulation S-K is not contained herein, and will not be contained, to the            best of registrant’s knowledge, in definitive proxy or information statements            incorporated by reference in Part III of this Form 10-K or any amendment to this Form            10-K.x

             

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

| Large accelerated filer                       | o      | Accelerated filer         | o |
|-----------------------------------------------|--------|---------------------------|---|
| Non-accelerated filer                         | o      | Smaller reporting company | x |
| (Do not check if a smaller reporting company) |   |

             

Indicate by check mark whether the registrant is a shell company (as            defined in Rule 12b-2 of the Act) YesoNox

             

State the aggregate market value of the voting and non-voting common            equity held by non-affiliates computed by reference to the price at which the common            equity was last sold, or the average bid and asked price of such common equity, as of            the last business day of the registrant’s most recently completed second fiscal            quarter. $65,309,389.

 

Indicate the number of shares outstanding of each of the            registrant’s classes of common stock as of the latest practicable date. As of            March 12, 2008, there were 5,053,482 shares of Common Stock.

 

**DOCUMENTS INCORPORATED BY REFERENCE**

Annual Financial Statements – Part II

Proxy            Statement for the 2008 Annual Meeting of Shareholders—Part III

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**EXPLANATORY NOTE**

             

This Amendment No. 1 on Form 10-K/A            (this “Amendment”) amends Highlands Bankshares, Inc.’s (the            “Company”) Annual Report on Form 10-K for the year ended December 31,            2007, originally filed with the Securities and Exchange Commission (the            “SEC”) on March 31, 2008 (the “Original Filing”). It is being            filed to attach as Exhibit 13.1 the Company’s Financial Statements.Except as discussed above, we have not modified or            updated the disclosures presented in the Original Filing.

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|         | **Table of Contents**                                                                                                                                                     |                                       |
|--------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------------------------------------------|
|         |                                                                                                                                                                      | **Page                            Number** |
| **Part I**   |                                                                                                                                                                      |                                       |
|         |                                                                                                                                                                      |                                       |
| Item 1.      | Business                                                                                                                                                                  | 3                                          |
| Item 1A.     | Risk Factors                                                                                                                                                              | 15                                         |
| Item 1B.     | Unresolved Staff Comments                                                                                                                                                 | 17                                         |
| Item 2.      | Properties                                                                                                                                                                | 17                                         |
| Item 3.      | Legal Proceedings                                                                                                                                                         | 17                                         |
| Item 4.      | Submission of Matters to a Vote of Security                            Holders                                                                                            | 17                                         |
|         |                                                                                                                                                                      |                                       |
|         |                                                                                                                                                                      |                                       |
| **Part II**  |                                                                                                                                                                      |                                       |
|         |                                                                                                                                                                      |                                       |
| Item 5.      | Market for Registrant’s Common Equity, Related                            Stockholder

Matters and Issuer Purchases of Equity                            Securities | 18                                         |
| Item 6.      | Selected Financial Data                                                                                                                                                   | 19                                         |
| Item 7.      | Management’s Discussion and Analysis of Financial                            Condition

and Results of Operation                                                    | 20                                         |
| Item 7A.     | Quantitative and Qualitative Disclosures About Market                            Risk                                                                                     | 33                                         |
| Item 8.      | Financial Statements and Supplementary Data                                                                                                                               | 36                                         |
| Item 9.      | Changes in and Disagreements with Accountants                            on

Accounting and Financial Disclosure                                                          | 36                                         |
| Item 9A.     | Controls and Procedures                                                                                                                                                   | 36                                         |
| Item 9B.     | Other Information                                                                                                                                                         | 37                                         |
|         |                                                                                                                                                                      |                                       |
|         |                                                                                                                                                                      |                                       |
| **Part III** |                                                                                                                                                                      |                                       |
|         |                                                                                                                                                                      |                                       |
| Item 10.     | Directors, Executive Officers and Corporate                            Governance                                                                                         | 37                                         |
| Item 11.     | Executive Compensation                                                                                                                                                    | 37                                         |
| Item 12.     | Security Ownership of Certain Beneficial Owners                            and

Management and Related Stockholder Matters                                                | 37                                         |
| Item 13.     | Certain Relationships and Related Transactions, and                            Director Independence                                                                      | 38                                         |
| Item 14.     | Principal Accounting Fees and Services                                                                                                                                    | 38                                         |
|         |                                                                                                                                                                      |                                       |
|         |                                                                                                                                                                      |                                       |
| **Part IV**  |                                                                                                                                                                      |                                       |
|         |                                                                                                                                                                      |                                       |
| Item 15.     | Exhibits, Financial Statement Schedules                                                                                                                                   | 39                                         |
|         |                                                                                                                                                                      |                                       |
|         |                                                                                                                                                                      |                                       |

 

 

 

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**Part I.**

 

**Item I. Business**

 

**History and Business**

Highlands Bankshares, Inc. (the “Company”) is a one-bank            holding company organized under the laws of Virginia in 1995 and registered under the            Bank Holding Company Act (BHCA). The Company conducts the majority of its business            operations through its wholly-owned bank subsidiary, Highlands Union Bank (the            “Bank”). The Company has two direct subsidiaries as of December 31, 2007:            the Bank, which was formed in 1985, and Highlands Capital Trust I (HCTI), a statutory            business trust (the “Trust”) which was formed in 1998.

**Highlands Union Bank**

The Bank is a Virginia state chartered bank that was incorporated in            1985. The Bank operates a full-service banking business from its headquarters in            Abingdon, Virginia, and its twelve area full service branch offices. The Bank offers            general retail and commercial banking services to individuals, businesses and local            government unit customers. These products and services include accepting deposits in            the form of checking accounts, money market deposit accounts, interest-bearing demand            deposit accounts, savings accounts and time deposits; making real estate, commercial,            revolving, consumer, credit card and agricultural loans; offering letters of credit;            providing other consumer financial services, such as automatic funds transfer,            collections, night depository, safe deposit, travelers checks and savings bond sales;            and providing other miscellaneous services normally offered by commercial banks. The            Bank makes loans in all major loan categories, including commercial, commercial and            residential real estate, construction and consumer loans. The Bank has two wholly owned            subsidiaries, Highlands Union Insurance Services, Inc. (HUIS), which was formed in            1999, and Highlands Union Financial Services, Inc. (HUFS), which was formed in 2001. At            December 31, 2007, the Bank had total assets of $657.79 million. Total deposits at this            date were $517.59 million. The Bank’s net income for 2007 was $5.38 million which            produced a return on average assets of 0.83% and a return on average stockholders'            equity of 11.35%. Refer to Note 21 of the Notes to Consolidated Financial Statements            for the Bank’s risk-based capital ratios.

*Highlands Union Insurance Services, Inc.*

Highlands Union Insurance Services, Inc., a wholly owned subsidiary of            the Bank, was formed in 1999. The Bank, through HUIS, joined a consortium of            approximately forty-seven other financial institutions to form Bankers’            Insurance, LLC. Bankers’ Insurance, LLC, as of December 31, 2007, had purchased            eight full service insurance agencies across the state of Virginia. HUIS is used to            sell insurance services through Bankers’ Insurance, LLC. The number of owner            banks involved with Bankers’ Insurance, LLC was forty-two as of December 31,            2007.

*Highlands Union Financial Services, Inc.*

The Bank operated a financial services department for the purpose of            brokering various investment vehicles until January 2, 2001. At that time, Highlands            Union Financial Services, Inc., a wholly-owned subsidiary of the Bank, was created to            convert that department into a separate legal entity in order to transact financial            services in all of the Bank’s market areas. HUFS was formed in order for the Bank            to continue to offer third-party mutual funds, annuities and other financial services            to its customers

 

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in            all market areas served. During 2004, changes to the NASD rules required financial            services to be operated underneath the bank structure once again. This change occurred            August 1, 2004. The only activity running through Highlands Union Financial Services            now relates to commissions from the sale of life insurance

In February 2005, the Bank became an equity owner in Bankers’            Investments, LLC, headquartered in Richmond, Virginia. The Bank’s equity            investment was $250,000 for two units of ownership. Bankers’ Investments, LLC was            formed for the purpose of providing owner banks the ability to offer a full line of            financial services to their customers. As of December 31, 2007, Bankers’            Investments, LLC was in partnership with 35 owner banks.

**Lending Activities**

*Commercial Loans*

The Bank makes both secured and unsecured loans to businesses and to            individuals for business purposes. Loan requests are granted based upon several factors            including credit history, past and present relationships with the Bank, marketability            of collateral and the cash flow of the borrowers. Unsecured commercial loans must be            supported by a satisfactory balance sheet and income statement. Collateralized business            loans may be secured by a security interest in marketable investments, accounts            receivable, business equipment and/or general intangibles of the business. In addition,            or as an alternative, the loan may be secured by a deed of trust lien on business real            estate. The risks associated with commercial loans are related to the strength of the            individual business, the value of loan collateral and the general health of the            economy.

*Residential Real Estate Loans*

Loans secured by residential real estate are originated and held by the            Bank. Residential real estate loans carry risks associated with the continued            credit–worthiness of the borrower and changes in the value of collateral. The            Bank also offers secondary market fixed rate mortgages through multiple sources. These            loans and servicing rights are generally sold immediately into the secondary market and            fees received are booked into income. These loans must meet certain criteria generally            set by the secondary market.

*Construction Loans*

The Bank makes loans for the purpose of financing the construction of            business and residential structures to financially responsible business entities and            individuals. These loans are subject to the same credit criteria as commercial and            residential real estate loans. In addition to the risks associated with all real estate            loans, construction loans bear the risks that the project will not be finished            according to schedule, the project will not be finished according to budget or the            value of the collateral may at any point in time may be less than the principal amount            of the loan. Construction loans also bear the risk that the general contractor, who may            or may not be the Bank's loan customer, is unable to finish the construction project as            planned because of financial pressures unrelated to the project. Loans to customers            that are made as permanent financing of construction loans may likewise under certain            circumstances be affected by external financial pressures.

 

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*Consumer Loans*

The Bank routinely makes consumer loans, both secured and unsecured. The            credit history, cash flow and character of individual borrowers is evaluated as a part            of the credit decision. Loans used to purchase vehicles or other specific personal            property and loans associated with real estate are usually secured with a lien on the            subject vehicle or property. Negative changes in a customer's financial circumstances            due to a large number of factors, such as illness or loss of employment, can place the            repayment of a consumer loan at risk. In addition, deterioration in collateral value            adds risk to consumer loans.

*Sales and Purchases of Loans*

The Bank will occasionally buy or sell all or a portion of a loan. The            Bank will consider selling a loan or a participation in a loan, if: (i) the full amount            of the loan to a single borrower will exceed the Bank's legal lending limit,which is 15 percent of the unimpaired capital and unimpaired surplus of            the bank; (ii) the full amount of the loan, when combined with a borrower's previously            outstanding loans, will exceed the Bank's legal lending limit to a single borrower;            (iii) the Board of Directors or an internal Loan Committee believes that a particular            borrower has a sufficient level of debt with the Bank; (iv) the borrower requests the            sale; (v) the loan to deposit ratio is at or above the optimal level as determined by            Bank management; and/or (vi) the loan may create too great a concentration of loans in            one particular location or in one particular type of loan. The Bank will consider            purchasing a participation in a loan from another financial institution if the loan            meets all applicable credit quality standards and (i) the Bank's loan to deposit ratio            is at a level where additional loans would be desirable; and/or (ii) a common customer            requests the purchase.

The following table sets forth, for the three fiscal years ended            December 31, 2007, 2006 and 2005, the percentage of total operating revenue contributed            by each class of similar services which contributed 15% or more of total operating            revenues of the Company during such periods.

| Period            | Class of Service           | Percentage of Total Revenues |
|-------------------|----------------------------|------------------------------|
|              |                       |                         |
| December 31, 2007 | Interest and Fees on Loans | 73.03%                       |
| December 31, 2006 | Interest and Fees on Loans | 72.46%                       |

**Market Area**

*Highlands Union Bank Market Area*

The Bank’s primary market area consists of:

|   | **•** | all of Washington County, Virginia |
|--------|------------|------------------------------------|

|   | **•** | portions of Smyth County, Virginia |
|--------|------------|------------------------------------|

|   | **•** | the City of Bristol, Virginia |
|--------|------------|-------------------------------|

|   | **•** | the City of Bristol, Tennessee and adjacent portions of                            Sullivan County, Tennessee |
|--------|------------|---------------------------------------------------------------------------------------------------------------|

 

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|   | **•** | the Town of Rogersville, Tennessee and adjacent portions                            of Hawkins County, Tennessee |
|--------|------------|------------------------------------------------------------------------------------------------------------------|

|   | **•** | the City of Sevierville, Tennessee and adjacent portions                            of Sevier County, Tennessee, |
|--------|------------|------------------------------------------------------------------------------------------------------------------|

|   | **•** | the City of Knoxville, Tennessee and adjacent portions                            of Knox County, Tennessee |
|--------|------------|-------------------------------------------------------------------------------------------------------------|

|   | **•** | the Town of Banner Elk and adjacent portions of Avery                            County, North Carolina |
|--------|------------|---------------------------------------------------------------------------------------------------------|

|   | **•** | the Town of Boone and adjacent portions of Watauga                            County, North Carolina |
|--------|------------|------------------------------------------------------------------------------------------------------|

|   | **•** | the Town of West Jefferson, North Carolina and adjacent                            portions of Ashe County, North Carolina |
|--------|------------|----------------------------------------------------------------------------------------------------------------------------|

The local economy is diverse and is oriented toward retail and service,            light manufacturing, higher education and agriculture.

The independent city of Bristol, Virginia is located in far southwestern            Virginia and lies directly on the Virginia-Tennessee state line. Washington County            surrounds Bristol to the west, north and east. In the Bristol/Washington County            community, manufacturing, trade, and services sectors are the largest industries, in            terms of total number of jobs in 2006. The services sector provides the most jobs and            contributes 34.9 percent of the total city/county employment. This totals 11,591            employees. The manufacturing and trade industries total 19.3% and 19.1% of all            employment.The latest unemployment figures as of September 2007            reflect an unemployment rate of 4.25% for the Bristol/Washington County, Virginia area.            Per capita income reported in 2005 was $27,127.

             

The Bank has a branch office located in Marion which is the county seat            of Smyth County, Virginia. Marion is approximately 30 miles northeast of Abingdon,            Virginia. The latest unemployment figures reflect an unemployment rate of 4.24%            reported as of September 30, 2007. In Smyth County, manufacturing, services, and            government are the largest employment industries. Manufacturing is the largest            employment industry and makes up 34.2% of all jobs throughout the county, totaling            4,737 individuals. The services and government sectors account for 24.7% and 20.9% of            the total jobs, respectively.In Smyth County, Virginia, the entire number of jobs in            all industries overall has decreased by 65 total jobs from January            2006.

 

Bristol, Tennessee is located in Sullivan County, Tennessee and is            Bristol, Virginia’s twin city. Bristol, Tennessee’s three largest            employment sectors are services, manufacturing and retail trade. The latest            unemployment figures reflect an unemployment rate of 3.9% for November 2007.

 

Rogersville, Tennessee is located in Hawkins County approximately 45            miles southwest of Bristol, Tennessee. Rogersville is the county seat for Hawkins            County. Rogersville’s three largest employment sectors are services,            manufacturing and retail trade. The latest unemployment figures reflect an unemployment            rate of 4.2% for November 2007. In Hawkins County, manufacturing, and retail trade are            the largest sectors, in terms of total employment. Manufacturing is the major employer            in the county making up 65.5% percent of all jobs throughout the county, totaling 4,203            employees.

 

Sevierville, Tennessee is located in Sevier County, Tennessee.            Sevierville, Tennessee is located approximately 20 miles east of Knoxville, Tennessee.            Sevierville serves as the county seat and is the largest city located in Sevier County.            Major employers for the county include tourism, retail, and service

 

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related industries. There is some industrial base that mitigates some of            the seasonal employment fluctuation from the tourism and related businesses. The latest            unemployment figures reflect an unemployment rate of 4.3% for November 2007. Sevier            County, Tennessee had a population that was estimated at 81,382 for the year 2006. The            total population has increased sharply, since its 2000 population of 71,709. This            growth represents an increase of 14.3%.The city of Sevierville            is currently involved in a $182 million dollar development project that will include            both private and public capital improvements.The primary improvement will be a 200,000            square foot Events Center.

 

Knoxville, Tennessee is located in Knox County, Tennessee. Knoxville,            Tennessee is located approximately 20 miles west of Sevierville, Tennessee. Knoxville            serves as the county seat and is the third largest city in the state of Tennessee.            Major employers for the county include manufacturing, retail, entertainment industries,            and warehousing and distribution industries. Knox County had a population that was            estimated at 404,972 for the year 2006 and Knoxville had an estimated population of            173,890 for the year 2006. Knoxville’s central location to two major interstate            highways which link the eastern half of the United States continues to provide many            opportunities for economic growth in the future.

 

Boone, North Carolina is located in Watauga County in the northwestern            mountains of North Carolina. Watauga County, North Carolina has an estimated population            of 43,406 as of July 2006. Watauga County’s three largest employment sectors are            private industry, education services and retail trade. The latest unemployment figures            reflect an unemployment rate of 4.0% as of June 2007. Watauga County, North            Carolina’s largest employer is Appalachian State University. Appalachian State is            the sixth largest university in the University of North Carolina system. Employment at            Appalachian State University has remained relatively stable over the past three years.            Per capita income personal income as of 2005 was $28,323.

 

Banner Elk, North Carolina is located in Avery County in the            northwestern mountains of North Carolina. Avery County, North Carolina had an estimated            population of 18,174 as of July 2006. In Avery County, health care and social            assistance, retail trade, and the accommodation and food services sectors are the            largest industries, in terms of total number of jobs in 2006. The latest unemployment            figures reflect an unemployment rate of 5.1% as of June 2007. Per capita income            personal income as of 2005 was $25,115.

 

West Jefferson, North Carolina is located in Ashe County in the            northwestern mountains of North Carolina. Ashe County, North Carolina had a population            that was estimated at 25,778 as of July            2006.In Ashe            County, manufacturing, education and health services, and public administration are the            largest employment industries. The latest unemployment figures reflect an unemployment            rate of 5.4% as of June 2007. Per capita income personal income as of 2005 was            $25,899.

 

**Competition**

 

The banking and financial service business in Virginia, generally, and            in the Bank’s market areas specifically, is highly competitive. The increasingly            competitive environment is a result of changes in regulation, changes in technology and            product delivery systems and new competition from non-traditional financial services.            The Bank competes for loans and deposits with other commercial banks, savings and loan            associations, securities and brokerage companies, mortgage companies, money market            funds, credit unions and other non-bank financial service providers. Many of these            competitors are much larger in total assets and capitalization, have greater access to            capital markets and offer a broader array of financial services than the Bank. In order            to compete, the Bank relies upon service-based business philosophies, personal            relationships with customers, specialized services tailored to meet customers' needs            and the convenience of office locations and extended hours of operation. In addition,            the Bank is generally

 

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competitive with other financial institutions in its market areas with            respect to interest rates paid on deposit accounts, interest rates charged on loans and            other service charges on loans and deposit accounts. Deposit market share for each of            the Bank’s market areas can be found on the FDIC’s website atwww.fdic.govunder the Industry Analysis/Summary of Deposits section.

             

**Certain Regulatory Considerations**

 

The Company and the Bank are subject to various state and federal            banking laws and regulations which impose specific requirements or restrictions on and            provide for general regulatory oversight with respect to virtually all aspects of            operations. As a result of the substantial regulatory burdens on banking, financial            institutions, including the Company and the Bank, are disadvantaged relative to other            competitors who are not as highly regulated, and their costs of doing business are much            higher.

             

The following is a summary of the material provisions of certain            statutes, rules and regulations which affect the Company and the Bank. This summary is            qualified in its entirety by reference to the particular statutory and regulatory            provisions referred to below, and is not intended to be an exhaustive description of            the statutes or regulations which are applicable to the businesses of the Company and            the Bank. Any change in applicable laws or regulations may have a material adverse            effect on the business and prospects of the Company and the Bank.

 

*Highlands Bankshares, Inc.*

 

The Company is a bank holding company within the meaning of the BHCA and            Chapter 13 of the Virginia Banking Act, as amended (the Virginia Banking Act). The            activities of the Company also are governed by the Gramm-Leach-Bliley Act of            1999.

             

*The Bank Holding Company Act***.**The BHCA is administered by the Federal Reserve Board, and the Company            is required to file with the Federal Reserve Board an annual report and any additional            information the Federal Reserve Board may require under the BHCA. The Federal Reserve            Board also is authorized to examine the Company and its subsidiaries. The BHCA requires            every bank holding company to obtain the approval of the Federal Reserve Board before            (i) it or any of its subsidiaries (other than a bank) acquires substantially all the            assets of any bank; (ii) it acquires ownership or control of any voting shares of any            bank if after the acquisition it would own or control, directly or indirectly, more            than 5% of the voting shares of the bank; or (iii) it merges or consolidates with any            other bank holding company.

             

The BHCA and the Change in Bank Control Act, together with regulations            promulgated by the Federal Reserve Board, require that, depending on the particular            circumstances, either Federal Reserve Board approval must be obtained or notice must be            furnished to the Federal Reserve Board and not disapproved prior to any person or            company acquiring "control" of a bank holding company, such as the Company, subject to            certain exemptions. Control is conclusively presumed to exist if an individual or            company acquires 25% or more of any class of voting securities of the Company. Control            is rebuttably presumed to exist if a person acquires 10% or more, but less than 25%, of            any class of voting securities of the Company. The regulations provide a procedure for            challenging the rebuttable control presumption.

             

Under the BHCA, a bank holding company is generally prohibited from            engaging in, or acquiring direct or indirect control of more than 5% of the voting            shares of any company engaged in non-banking activities, unless the Federal Reserve            Board, by order or regulation, has found those activities to be so closely related to            banking or managing or controlling banks as to be incident to banking. The Federal            Reserve Board imposes certain capital requirements on the Company under the BHCA,            including a minimum leverage ratio and a minimum ratio of "qualifying" capital to            risk-weighted assets. Subject to its

 

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capital requirements and certain other restrictions, the Company can            borrow money to make a capital contribution to the Bank, and these loans may be repaid            from dividends paid from the Bank to the Company (although the ability of the Bank to            pay dividends are subject to regulatory restrictions). The Company can raise capital            for contribution to the Bank by issuing securities without having to receive regulatory            approval, subject to compliance with federal and state securities laws.

             

*The Gramm-Leach-Bliley Act.*The            Gramm-Leach-Bliley Act (the GLBA) permits significant combinations among different            sectors of the financial services industry; allows for significant expansion of            financial service activities by Bank holding companies and provides for a regulatory            framework by various governmental authorities responsible for different financial            activities; and offers certain financial privacy protections to consumers. The GLBA            repealed affiliation and management interlock prohibitions of the Depression-era            Glass-Steagall Act and, by amending the Bank Holding Company Act, the GLBA added new            substantive provisions to the non-banking activities permitted under the BHCA with the            creation of the financial holding company. The GLBA preempts most state laws that            prohibit financial holding companies from engaging in insurance activities. The GLBA            permits affiliations between banks and securities firms within the same holding company            structure, and the GLBA permits financial holding companies to directly engage in a            broad range of securities and merchant banking activities. The Company has not elected            to become a financial holding company.

             

The Gramm-Leach-Bliley Act has led to important changes in the manner in            which financial services are delivered in the United States. Bank holding companies and            their subsidiary banks are able to offer a much broader array of financial services;            however, there is greater competition in all sectors of the financial services            market.

             

*The Virginia Banking Act*. All Virginia bank            holding companies must register with the Virginia State Corporation Commission (the            “Commission”) under the Virginia Banking Act. A registered bank holding            company must provide the Commission with information with respect to the financial            condition, operations, management and inter-company relationships of the holding            company and its subsidiaries. The Commission also may require such other information as            is necessary to keep itself informed about whether the provisions of Virginia law and            the regulations and orders issued under Virginia law by the Commission have been            complied with, and may make examinations of any bank holding company and its            subsidiaries. The Virginia Banking Act allows bank holding companies located in any            state to acquire a Virginia bank or bank holding company if the Virginia bank or bank            holding company could acquire a bank holding company in their state and the Virginia            bank or bank holding company to be acquired has been in existence and continuously            operated for more than two years. The Virginia Banking Act permits bank holding            companies from throughout the United States to enter the Virginia market, subject to            federal and state approval.

             

*Sarbanes-Oxley Act of 2002*. The            Sarbanes-Oxley Act of 2002 (the “SOX Act”) implements legislative reforms            intended to address corporate and accounting fraud. In addition to the establishment of            a new accounting oversight board that enforces auditing, quality control and            independence standards and is funded by fees from all publicly traded companies, the            law restricts provision of both auditing and consulting services by accounting firms.            To ensure auditor independence, any non-audit services being provided to an audit            client requires pre-approval by the issuer’s audit committee members and the SOX            Act also restricts certain services that the audit firm may perform. In addition, the            audit partners must be rotated. The SOX Act requires chief executive officers and chief            financial officers, or their equivalent, to certify to the accuracy of periodic reports            filed with the SEC, subject to civil and criminal penalties if they knowingly or            willfully violate this certification requirement. In addition, under the SOX Act, legal            counsel is required to report evidence of a material violation of the securities laws            or a breach of fiduciary duty by a company to its chief executive officer or its chief            financial officer, and, if such officer does not

 

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appropriately respond, to report such evidence to the audit committee or            other similar committee of the board of directors or the board itself.

 

*Highlands Union Bank*

 

*General.*The Bank, as a state chartered            member of the Federal Reserve, is subject to regulation and examination by the Virginia            State Corporation Commission and the Federal Reserve Board. In addition, the Bank is            subject to the rules and regulations of the Federal Deposit Insurance Corporation.            Deposits in the Bank are insured by the FDIC up to a maximum amount (generally $100,000            per depositor, subject to aggregation rules). The Federal Reserve Board and the            Virginia Bureau of Financial Institutions regulate or monitor all areas of the            Bank’s operations, including security devices and procedures, adequacy of            capitalization and loss reserves, loans, investments, borrowings, deposits, mergers,            issuances of securities, payment of dividends, interest rates payable on deposits,            interest rates or fees chargeable on loans, establishment of branches, corporate            reorganizations and maintenance of books and records. The Federal Reserve Board            requires the Bank to maintain certain capital ratios. The Bank is required by the            Federal Reserve Board to prepare quarterly reports on the Bank’s financial            condition and to conduct an annual audit of its financial affairs in compliance with            minimum standards and procedures prescribed by the Federal Reserve Board. The Bank also            is required by the Federal Reserve Board to adopt internal control structures and            procedures in order to safeguard assets and monitor and reduce risk exposure. While            appropriate for safety and soundness of banks, these requirements impact banking            overhead costs.

             

The Bank is organized as a Virginia-chartered banking corporation and is            regulated and supervised by the Bureau of Financial Institutions (BFI) of the Virginia            State Corporation Commission. In addition, as a federally insured bank, the Bank is            regulated and supervised by the Federal Reserve Board, which serves as its primary            federal regulator, and is subject to certain regulations promulgated by the FDIC. Under            the provisions of federal law, federally insured banks are subject, with certain            exceptions, to certain restrictions on extensions of credit to their affiliates, on            investments in the stock or other securities of affiliates and on the taking of such            stock or securities as collateral from any borrower. In addition, these banks are            prohibited from engaging in certain tie-in arrangements in connection with any            extension of credit or the providing of any property of service.

             

The Virginia State Corporation Commission and the Federal Reserve Board            conduct regular examinations of the Bank reviewing the adequacy of the loan loss            reserves, quality of the loans and investments, propriety of management practices,            compliance with laws and regulations and other aspects of the bank's operations. In            addition to these regular examinations, Virginia chartered banks must furnish to the            Federal Reserve Board quarterly reports containing detailed financial statements and            schedules.

             

*Community Reinvestment Act.*The Bank is            subject to the provisions of the Community Reinvestment Act of 1977 (the            “CRA”), which requires the appropriate federal bank regulatory agency, in            connection with its regular examination of a bank, to assess the bank's record in            meeting the credit needs of the community served by the bank, including low and            moderate-income neighborhoods. The focus of the regulations is on the volume and            distribution of a bank's loans, with particular emphasis on lending activity in low and            moderate-income areas and to low and moderate-income persons. The regulations place            substantial importance on a bank's product delivery system, particularly branch            locations. The regulations require banks, including the Bank to comply with significant            data collection requirements. The regulatory agency's assessment of the bank's record            is made available to the public. Further, this assessment is required for any bank            which has applied to, among other things, establish a new branch office that will            accept deposits, relocate an existing office, or merge, consolidate with or acquire the            assets or assume the liabilities of a federally regulated financial institution.            Management expects that the Bank’s compliance with the CRA, as well as other fair            lending laws, will face ongoing government

 

10

 

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scrutiny and that costs associated with compliance will continue to            increase. The Bank received "Satisfactory" CRA ratings in the last examination by bank            regulators.

             

*Federal Deposit Insurance Corporation Improvement Act of            1991*. The difficulties encountered nationwide by financial            institutions from the 1980s through 1991 prompted federal legislation designed to            reform the banking industry and to promote the viability of the industry and of the            deposit insurance system. The Federal Deposit Insurance Corporation Improvement Act of            1991 (FDICIA) bolsters the deposit insurance fund, tightened bank and thrift regulation            and trimmed the scope of federal deposit insurance as summarized below.

             

FDICIA requires each federal banking regulatory agency to prescribe, by            regulation, standards for all insured depository institutions and depository            institution holding companies relating to (i) internal controls, information systems            and audit systems; (ii) loan documentation; (iii) credit underwriting; (iv) interest            rate exposure; (v) asset growth; (vi) compensation, fees and benefits; and (vii) such            other operational and managerial standards as the agency determines to be appropriate.            The compensation standards would prohibit employment contracts, compensation or benefit            arrangements, stock option plans, fee arrangements or other compensatory arrangements            that provide excessive compensation, fees or benefits or could lead to material            financial loss. In addition, each federal banking regulatory agency must prescribe by            regulation standards specifying (i) a maximum ratio of classified assets to capital;            (ii) minimum earnings sufficient to absorb losses without impairing capital; (iii) to            the extent feasible, a minimum ratio of market value to book value for publicly traded            shares of depository institutions and depository institution holding companies; and            (iv) such other standards relating to asset quality, earnings and valuation as the            agency determines to be appropriate. If an insured institution fails to meet any of the            standards promulgated by regulation, then such institution will be required to submit a            plan to its federal regulatory agency specifying the steps it will take to correct the            deficiency.

 

Prompt corrective action measures adopted in FDICIA impose significant            restrictions and requirements on depository institutions that fail to meet their            minimum capital requirements. Under Section 38 of the Federal Deposit Insurance Act            (the FDI Act), the federal banking regulatory agencies have developed a classification            system pursuant to which all depository institutions are placed into one of five            categories based on their capital levels and other supervisory criteria: well            capitalized, adequately capitalized; undercapitalized; significantly undercapitalized;            and critically undercapitalized.

             

The Bank met the requirements at December 31, 2007 to be classified as            “well capitalized.” This classification is determined solely for the            purposes of applying the prompt corrective action regulations and may not constitute an            accurate representation of the Bank’s overall financial condition.

 

If its principal federal regulator determines that an adequately            capitalized institution is in an unsafe or unsound condition or is engaging in an            unsafe or unsound practice, it may require the institution to submit a corrective            action plan, restrict its asset growth and prohibit branching, new acquisitions and new            lines of business. An institution’s principal federal regulator may deem it to be            engaging in unsafe or unsound practices if it receives a less than satisfactory rating            for asset quality, management, earnings or liquidity in its most recent            examination.

 

Section 36 of FDICIA significantly affects financial institutions with            more than $500 million in total assets. The Bank came under the provisions beginning in            January 2004. Effective December 28, 2005, the FDIC lessened the requirements of Part            363 by raising the asset size threshold from $500 million to $1 billion for internal            control assessments by management and external auditors. For institutions under $1            billion, management is no longer required to assess and report on the effectiveness of            internal control over financial reporting, the external auditors are no longer required            to examine and attest to management’s internal control assertions, and only a            majority of the outside directors on the audit

 

11

 

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committee must be independent of management. Section 36 of FDICIA            requires insured depository institutions with at least $500 million but less than $1            billion in total assets to file annual reports that must include the            following:

             

|   | 1. | Audited comparative annual financial                            statements. |
|--------|----|-----------------------------------------------------------------------------|

|   | 2. | The independent public accountant’s report on the                            audited financial statements. |
|--------|----|------------------------------------------------------------------------------------------------------------------|

|   | 3. | A management report that contains a statement of                            management’s responsibilities for preparing the financial                            statement, establishing and maintaining an adequate internal control                            structure over financial reporting and complying with the laws and                            regulations designed by the FDIC and appropriate banking                            regulators. |
|--------|----|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

|   | 4. | An assessment by management of the institutions                            compliance with the designated laws and regulations during the                            year. |
|--------|----|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

 

These amendments provide relief for covered institutions of less than $1            billion in assets only for purposes of this section of Part 363. These covered            institutions must continue to fully comply with the remaining provisions of Part 363            including the annual financial statement audit requirement. These amendments do not            relieve public companies of their obligations to comply with the SOX Act and the            SEC’s rules on internal control reporting and audit committee            independence.

 

*The Riegle-Neal Interstate Banking and Branching Efficiency Act of            1994*(the Interstate Act) allows bank holding companies to            acquire banks in any state, without regard to state law, except that if the state has a            minimum requirement for the amount of time a bank must be in existence, that law must            be preserved. Under the Virginia Banking Act, a Virginia bank or all of the            subsidiaries of Virginia holding companies sought to be acquired must have been in            continuous operation for more than two years before the date of such proposed            acquisition. The Interstate Act also permits banks to acquire out-of-state branches            through interstate mergers, if the state has not opted out of interstate branching. De            novo branching, where an out-of-state bank holding company sets up a new branch in            another state, requires a state's specific approval. An acquisition or merger is not            permitted under the Interstate Act if the bank, including its insured depository            affiliates, will control more than 10% of the total amount of deposits of insured            depository institutions in the United States, or will control 30% or more of the total            amount of deposits of insured depository institutions in any state.

             

Virginia has, by statute, elected to opt-in fully to interstate            branching under the Interstate Act. Under the Virginia statute, Virginia state banks            may, with the approval of the Virginia State Corporation Commission, establish and            maintain a de novo branch or acquire one or more branches in a state other than            Virginia, either separately or as part of a merger. Procedures also are established to            allow out-of-state domiciled banks to establish or acquire branches in Virginia,            provided the "home" state of the bank permits Virginia banks to establish or acquire            branches within its borders. The activities of these branches are subject to the same            laws as Virginia domiciled banks, unless such activities are prohibited by the law of            the state where the bank is organized. The Virginia State Corporation Commission has            the authority to examine and supervise out-of-state state banks to ensure that the            branch is operating in a safe and sound manner and in compliance with the laws of            Virginia. The Virginia statute authorizes the Bureau of Financial Institutions to enter            into cooperative agreements with other state and federal regulators for the examination            and supervision of out-of-state banks with Virginia operations, or Virginia domiciled            banks with operations in other states. Likewise, national banks, with the approval of            the OCC, may branch into and out of the state of Virginia. Any Virginia branch of an            out-of-state state chartered bank is subject to Virginia law (enforced by the Virginia            Bureau of Financial Institutions) with respect to intrastate branching, consumer            protection, fair lending and community reinvestment as if it were a branch of a            Virginia bank, unless preempted by federal law.

             

12

 

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*Deposit Insurance.*The Bank’s            deposits are insured up to applicable limits by the Deposit Insurance Fund (DIF) of the            FDIC. The DIF was created by the merger of the Bank Insurance Fund (BIF) and Savings            Association Insurance Fund (SAIF) provided for in the Federal Deposit Insurance Reform            Act of 2005 (FDIRA), as enacted in February 2006. This legislation also increased            coverage for retirement accounts to $250,000 and indexed the insurance levels for            inflation, among other changes. In addition, as a result of the FDIRA, the FDIC has            adopted a revised, risk-based assessment system to determine assessment rates to be            paid by member institutions, such as the Bank. Under this revised assessment system,            risk is defined and measured using an institution’s supervisory ratings, combined            with certain other risk measures, including certain financial ratios and long-term debt            issuer ratings. The annual risk based assessment rates for 2007 range from $0.05 to            $0.43 per $100 of insured deposits. The FDIRA also provided for a one-time assessment            credit, to be allocated among member institutions. The FDIC one-time assessment credit            may be used to offset future deposit insurance assessments beginning in            2007.

             

*Gramm-Leach-Bliley Act*. The            Gramm-Leach-Bliley Act of 1999 (the GLBA) allows banks, with primary regulator            approval, to acquire financial subsidiaries to engage in any activity that is financial            in nature or incidental to a financial activity, as defined in the Bank Holding Act,            except (i) insurance underwriting, (ii) merchant or insurance portfolio investments,            and (iii) real estate development or investment. Well-capitalized banks are also given            the authority to engage in municipal bond underwriting.

             

To establish or acquire a financial subsidiary, a bank must be            well-managed, and the consolidated assets of its financial subsidiary must not exceed            the lesser of 45% of the consolidated total assets of the bank or $50 billion. The            relationship between a bank and a financial subsidiary are subject to a variety of            supervisory enhancements from regulators.

             

*USA Patriot Act*. The USA Patriot Act            facilitates the sharing of information among government entities and financial            institutions to combat terrorism and money laundering. The USA Patriot Act creates an            obligation on banks to report customer activities that may involve terrorist activities            or money laundering.

             

*Government Policies*. The operations of the            Bank are affected not only by general economic conditions, but also by the policies of            various regulatory authorities. In particular, the Federal Reserve Board regulates            money and credit and interest rates in order to influence general economic conditions.            These policies have a significant influence on overall growth and distribution of            loans, investments and deposits and affect interest rates charged on loans or paid for            time and savings deposits. Federal Reserve Board monetary policies have had a            significant effect on the operating results of commercial banks in the past and are            expected to continue to do so in the future.

             

*Limits on Dividends and Other Payments*. As            a state member bank subject to the regulations of the Federal Reserve Board, the Bank            must obtain the approval of the Federal Reserve Board for any dividend if the total of            all dividends declared in any calendar year would exceed the total of its net profits,            as defined by the Federal Reserve Board, for that year, combined with its retained net            profits for the preceding two years. In addition, a state member bank may not pay a            dividend in an amount greater than its undivided profits then on hand after deducting            its losses and bad debts. For this purpose, bad debts are generally defined to include            the principal amount of loans which are in arrears with respect to interest by six            months or more, unless such loans are fully secured and in the process of collection.            Moreover, for purposes of this limitation, a state member bank is not permitted to add            the balance in its allowance for loan losses account to its undivided profits then on            hand; however, it may net the sum of its bad debts as so defined against the balance in            its allowance for loan losses account and deduct from undivided profits only bad debts            as so defined in excess of that account.

             

13

 

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In addition, the Federal Reserve Board is authorized to determine, under            certain circumstances relating to the financial condition of a state member bank, that            the payment of dividends would be an unsafe or unsound practice and to prohibit payment            thereof. The payment of dividends that depletes a bank's capital base could be deemed            to constitute such an unsafe or unsound practice. The Federal Reserve Board has            indicated that banking organizations should generally pay dividends only out of current            operating earnings.

             

Virginia law also imposes restrictions on the ability of the Bank to pay            dividends. A Virginia state bank is permitted to declare a dividend out of its "net            undivided profits", after providing for all expenses, losses, interest and taxes            accrued or due by the bank. In addition, a deficit in capital originally paid in must            be restored to its initial level, and no dividend can be paid which could impair the            Bank's paid in capital. The Bureau of Financial Institutions further has authority to            limit the payment of dividends by a Virginia bank if it determines the limitation is in            the public interest and is necessary to ensure the bank's financial            soundness.

             

The Federal Deposit Insurance Corporation Improvement Act of 1991            (FDICIA) provides that no insured depository institution may make any capital            distribution (which would include a cash dividend) if, after making the distribution,            the institution would not satisfy one or more of its minimum capital            requirements.

             

*Capital Requirements*. The Federal Reserve            Board has adopted risk-based capital guidelines which are applicable to the Company and            the Bank. The Federal Reserve Board guidelines redefine the components of capital,            categorize assets into different risk classes and include certain off-balance sheet            items in the calculation of risk-weighted assets. The minimum ratio of qualified total            capital to risk-weighted assets (including certain off-balance sheet items, such as            standby letters of credit) is 8.0%. At least half of the total capital must be            comprised of Tier 1 capital for a minimum ratio of Tier 1 Capital to risk-weighted            assets of 4.0%. The remainder may consist of a limited amount of subordinated debt,            other preferred stock, certain other instruments and a limited amount of loan and lease            loss reserves.

             

In addition, the Federal Reserve Board has established minimum leverage            ratio (Tier 1 capital to total average assets less intangibles) guidelines that are            applicable to the Company and the Bank. These guidelines provide for a minimum ratio of            4.0% for banks that meet certain specified criteria, including that they have the            highest regulatory CAMELS rating and are not anticipating or experiencing significant            growth and have well-diversified risk. All other banks will be required to maintain an            additional cushion of at least 100 to 200 basis points, based upon their particular            circumstances and risk profiles. The guidelines also provide that banks experiencing            internal growth or making acquisitions will be expected to maintain strong capital            positions substantially above the minimum supervisory levels, without significant            reliance on intangible assets.

             

**Other Legislative and Regulatory Concerns**

             

Other legislative and regulatory proposals regarding changes in banking            and the regulation of banks, thrifts and other financial institutions are periodically            considered by the executive branch of the federal government, Congress and various            state governments, including Virginia. New proposals could significantly change the            regulation of banks and the financial services industry. It cannot be predicted what            might be proposed or adopted or how these proposals would affect the            Company.

             

**Other Business Concerns**

             

The banking industry is particularly sensitive to interest rate            fluctuations, as the spread between the rates which must be paid on deposits and those            which may be charged on loans is an important

 

14

 

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component of profit. In addition, the interest which can be earned on a            bank's invested funds has a significant effect on profits. Rising interest rates            typically reduce the demand for new loans, particularly the real estate loans which            represent a significant portion of the Bank’s loan demand.

             

**Registrant's Organization and Employment**

 

The Company, the Bank, HCTI, HUFS and HUIS are organized in a holding            company/subsidiary structure. As of December 31, 2007, the Company had no employees,            except for officers, and it conducted substantially all of its operations through its            subsidiaries. All cash compensation paid to the Company’s officers was paid by            the subsidiary bank, including fees paid to its directors. In previous years, stock            based compensation, through the form of stock options, is paid/granted through the            Company. During 2007, compensation paid to HUFS officers and employees was paid through            the Bank. At December 31, 2007, the Bank employed 239 full time equivalent employees at            its main office, operations center and branch offices. The Company, HCTI, HUFS and HUIS            had no employees at this time.

             

The Company’s relationship with its employees is considered to be            good. Employment has remained very stable over the last several years with very little            turnover. There are no employment contracts in existence for any employee or            officer.

 

**Company Website**

             

The Bank maintains a website atwww.hubank.com.            The Company makes available through its website its annual report on Form 10-K,            quarterly reports on Form 10-Q, current reports on Form 8-K, and all amendments to            those reports, free of charge, as soon as reasonably practicable after the material is            electronically filed with the Securities and Exchange Commission.

             

**Item 1A. Risk Factors**

 

*Changes in interest rates could have an adverse effect on our            income.*

 

If market interest rates rise, our net interest income can be negatively            affected in the short term. The direction and speed of interest rate changes affect our            net interest margin and net interest income. In the short term, rising interest rates            can negatively affect our net interest income, because our interest-bearing liabilities            (generally deposits) reprice sooner than our interest-earning assets (generally            loans).

             

*Our failure to maintain adequate capital could have adverse effects            on our financial condition.*

 

Highlands Bankshares, Inc. and its bank subsidiary are subject to            regulatory capital adequacy guidelines. If the Bank fails to meet capital adequacy            guidelines, it could have a material effect on our financial condition and could            subject us to a variety of enforcement actions, as well as impose, restrictions on our            business. In addition, it could lead to a decline in the confidence that our customers            have in us and a reduction in the demand for our products and services. If we are not            in compliance with governmental regulation, we can be subject to fines, penalties or            restrictions of our business.

 

*Our            profitability and the value of your investment may suffer because of rapid and            unpredictable changes in the highly regulated environment in which we            operate.*

 

Our businesses are subject to stringent regulation by federal and state            governmental and regulatory agencies and self-regulatory organizations. In addition,            our customers have a number of

 

15

 

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complex confidentiality and fiduciary requirements. We have established            policies, procedures and systems that are designed to comply with these regulatory and            operational risk requirements. However, as a financial services institution, we face            complexity and costs related to our compliance efforts. We also face the potential for            loss resulting from failed or inadequate internal processes and from external events,            which could have a material impact on our results of operations. Adverse publicity and            damage to our reputation from the failure or perceived failure to comply with legal,            regulatory or capital requirements could affect our ability to attract or maintain            customers or maintain access to capital markets, or could result in enforcement            actions, fines, penalties and lawsuits. If there is a significant economic downturn in            our region, our credit risk could be adversely affected and result in loss.

 

*Our            business is subject to various lending and other economic risks that could adversely            impact our results of operations and financial condition.*

 

We do business in a small geographic area, and a large percentage of our            loans are made in our market area. If the region suffers a significant or prolonged            period of economic downturn, there is a greater likelihood that more of our customers            could become delinquent on their loans or other obligations which could adversely            affect our performance. If more competitors come into our market area, our business            could suffer.

 

*Our            future success is dependent on our ability to compete effectively in the highly            competitive banking industry*

 

Financial services in our market area are highly competitive, with a            number of commercial banks, credit unions, insurance companies and stockbrokers seeking            to do business with our customers.

             

*Inadequate disaster recovery plans could significantly impact our            operations.*

 

If the disaster recovery plans that we have in place are not adequate to            continue our operations in the event of a disaster, the business disruption can            adversely impact our operations. Natural or man-made disasters, such as fires, storms,            terrorist or military actions could cause damage to our physical facilities, or could            cause delays or disruptions to operational functions, including information processing            or check settlements. In addition, our vendors could suffer from such events. Should            these events affect us or the vendors with whom we do business, our results of            operations could be negatively impacted.

 

*An interruption or breach of our information systems may result in a            loss of customers.*

 

We rely heavily on communications and information systems to conduct our            business. In addition, we rely on third parties to provide key components of our            infrastructure, including internet connections and network access. Any disruption in            service of these key components could adversely affect our ability to deliver products            and services to our customers and otherwise to conduct our operations. Furthermore, any            security breach of our information systems or data, whether managed by us or by third            parties, could harm our reputation or cause a decrease in the number of customers that            choose to do business with us.

             

*Our liquidity is dependent on dividends from the Bank.*

 

The Bank’s ability to pay dividends to the Company is limited by            various statutes and regulations. In the event the Bank was unable to pay dividends to            the Company, dividends on our common stock which we pay to shareholders could be            adversely affected. Failure to pay dividends or a reduction in the dividend rate could            have a material adverse effect on the market price of our common stock.

 

16

 

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*Our performance depends on attracting and retaining key employees and            skilled personnel to operate our business effectively.*

 

There are a limited number of qualified personnel in the markets we            serve, so our success depends in part on the continued services of many of our current            management and other key employees. Failure to maintain our key officers and employees            and maintain adequate staffing of qualified personnel could adversely impact our            operations and ability to compete.

 

17

 

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**Item 1B. Unresolved Staff Comments**

 

Not Applicable

             

**Item 2. Properties**

 

The Company’s and the Bank’s headquarters are located at 340            W. Main Street, Abingdon, Virginia. In addition to the Bank's Main Office location, the            Bank owns twelve branch offices: one in the Town of Abingdon, Virginia; one in            Washington County, Virginia; two in the City of Bristol, Virginia; one in the Town of            Glade Spring, Virginia; one in the Town of Marion, Virginia; one in the City of            Bristol, Tennessee; one in the Town of Rogersville, Tennessee; one in the Town of            Boone, North Carolina; one in the Town of Banner Elk, North Carolina; one in the City            of Sevierville, Tennessee; and one in the City of Knoxville, Tennessee. The Bank owns            the land and buildings of all of these branch offices as well as the main office for            the Company and Bank.

             

The Bank also owns the land and building used for its Collections, Human            Resources, Customer Call Center and IRA Operations in Abingdon, Virginia. The Bank owns            a vacant piece of land in Bristol, Tennessee that is being held for a potential future            branch site. The Bank leases office space in Abingdon, Virginia for operational            purposes, leases office space in West Jefferson, North Carolina for a loan production            office and leases office space in Sevierville, Tennessee that was previously used as a            loan production office. The Bank now subleases this space.

             

The Company owns the land and buildings used as the Bank’s            Operations Center and Technology House in Abingdon, Virginia. The Company owns the land            and vacant building on property adjacent to the Company’s Operations Center in            Abingdon, Virginia. The Company owns vacant land adjacent to its Main Branch Office in            Abingdon, Virginia. The Company owns approximately 14 acres of vacant land in Abingdon,            Virginia for future possible development of a corporate headquarters. The Company also            owns an additional lot in Sevierville, Tennessee and an additional lot in Boone, North            Carolina (both approximately 1 acre) to for future branching.

             

All of the existing properties are in good operating condition and are            adequate for the Company’s present and anticipated future needs.

             

The Bank owns all its computer and data processing hardware and is a            licensee of the software it utilizes.

 

**Item 3. Legal Proceedings**

 

The Company is not currently involved in any pending legal proceedings,            other than routine litigation incidental to the Bank’s banking business. These            proceedings are not material to the Company or the Bank.

 

**Item 4. Submission of Matters to a Vote of Security            Holders**

             

None.

 

 

18

 

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**Part II**

 

**Item 5. Market for Registrant's Common Equity, Related Stockholder            Matters and Issuer Purchases of Equity Securities**

 

**Common Stock Information and Dividend**

 

Trades in the Company’s common stock are reported on the            Over-The-Counter Bulletin Board (OTCBB) and in the Pinksheets by at least five broker            dealers under the symbol HBKA.OB. In addition, the Company maintains a list of            individuals who are interested in purchasing its common stock and connects these people            with shareholders who are interested in selling their stock. These parties negotiate            the per share price independent of the Company. The stock transfer agent of the Company            attempts to keep a record of stock sales by asking the parties about the trade price            per share. Please refer to the table below entitled Common Stock Performance for a            summary of sales prices known to the Company for each of the four quarters of 2007 and            2006.

 

| Common Stock Performance – December 31,                            2007 |
|-------------------------------------------------------------------------------|
|                                                                          |   |   |   |   |
|                                                                          | High | Low | Quarterly Average | Dividends per Share |
|                                                                          |   |   |   |   |
| First Quarter                                                                 | $16.50 | $15.35 | $16.41 | $ - |
|                                                                          |   |   |   |   |
| Second Quarter                                                                | $16.50 | $15.10 | $16.29 | $ 0.20 |
|                                                                          |   |   |   |   |
| Third Quarter                                                                 | $17.00 | $14.50 | $16.32 | $ - |
|                                                                          |   |   |   |   |
| Fourth Quarter                                                                | $17.00 | $13.10 | $16.74 | $ - |
|                                                                          |   |   |   |   |

 

| Common Stock Performance – December 31,                            2006 |
|-------------------------------------------------------------------------------|
|                                                                          |   |   |   |   |
|                                                                          | High | Low | Quarterly Average | Dividends per Share |
|                                                                          |   |   |   |   |
| First Quarter                                                                 | $16.84 | $15.85 | $15.99 | $ - |
|                                                                          |   |   |   |   |
| Second Quarter                                                                | $16.50 | $15.85 | $16.38 | $ 0.15 |
|                                                                          |   |   |   |   |
| Third Quarter                                                                 | $16.75 | $14.75 | $16.36 | $ - |
|                                                                          |   |   |   |   |
| Fourth Quarter                                                                | $20.00 | $15.75 | $16.51 | $ - |

 

 

The Company historically has paid cash dividends on an annual basis. The            final determination of the timing, amount and payment of dividends on the Common Stock            is at the discretion of the Company’s Board of Directors and will depend upon the            earnings of the Company and its subsidiaries, principally the Bank, the financial            condition of the Company and other factors, including general economic conditions and            applicable governmental regulations and policies as discussed in Item 1.,            “Business – Certain Regulatory Considerations,” above.

 

As of March 12, 2008, the Company had approximately 1,457 shareholders            of record.

 

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**Issuer Repurchases of Equity Securities**

 

The following table sets forth information with respect to repurchases            of common stock that the Company made during the three months ended December 31,            2007:

 

|  

                             

                             

Period | Total Number of Shares Purchased |  

Average Price Paid per Share |  

Total Number of Shares Purchased as Part of Publicly                                Announced Programs (1) | Maximum Number of Shares that May Yet Be Purchased                                Under the Program

(in thousands) |
|----------------------------------------------------------------------------------------|----------------------------------|--------------------------------------|--------------------------------------------------------------------------------------------------------------------|---------------------------------------------------------------------------------------------------------------------|
|                                                                                   |                             |                                 |                                                                                                               |                                                                                                                |
| Oct. 1, 2007 – Oct. 31, 2007                                                     | 20,999                           | $16.75                               | 20,999                                                                                                             | 59,856                                                                                                              |
| Nov. 1, 2007 – Nov 30, 2007                                                      | 9,918                            | $17.00                               | 9,918                                                                                                              | 49,938                                                                                                              |
| Dec. 1, 2007 – Dec. 31, 2007                                                     | 16,784                           | $17.00                               | 16,784                                                                                                             | 33,154                                                                                                              |
|                                                                                   |                             |                                 |                                                                                                               |                                                                                                                |
| Total                                                                                  | 47,701                           | $16.89                               | 47,701                                                                                                             | 33,154                                                                                                              |

 

(1)                      On December 13, 2006, the            Company’s board of directors approved a stock repurchase program to purchase over            the next 12 months up to 151,515 shares of its outstanding common stock (the Program).            The Company has allocated $2.5 million to the Program and anticipates funding for the            Program to come from available corporate funds.

 

**Item 6. Selected Financial Data**

 

The Company and Subsidiaries Selected Consolidated Financial Data:            (Refer to the Annual Report of Shareholders for the complete set of the Company’s            financial statements)

             

**(Amounts in thousands, except per share data)**

|                                       |                       | Years Ended December 31, |
|--------------------------------------------|----------------------------|--------------------------|
|                                       |                       | 2007                     | 2006 | 2005 | 2004 | 2003 |
|                                       |                       |                     |   |   |   |   |
|                                       | Interest income            | $ 40,345                 | $ 37,012 | $ 32,189 | $ 29,460 | $ 29,463 |
|                                       | Interest expense           | 21,441                   | 18,491 | 14,490 | 12,162 | 12,877 |
|                                       | Net interest income        | 18,904                   | 18,521 | 17,699 | 17,298 | 16,586 |
| Selected Income

Statement Data            | Provision for loan

losses | 685                      | 1,147 | 1,155 | 1,300 | 2,053 |
|                                       | Non-interest income        | 4,613                    | 4,828 | 4,850 | 4,572 | 4,652 |
|                                       | Non-interest expense       | 17,120                   | 15,886 | 14,998 | 14,871 | 13,470 |
|                                       | Income taxes               | 811                      | 1,108 | 1,363 | 1,042 | 1,195 |
|                                       | Net income                 | 4,901                    | 5,208 | 5,033 | 4,657 | 4,520 |
|                                       |                       |                     |   |   |   |   |
|                                       | Basic net income           | $ 0.95                   | $ 1.00 | $ 0.95 | $ 0.88 | $ 0.85 |
|                                       | Diluted net income         | 0.94                     | 0.98 | 0.94 | 0.87 | 0.85 |
| *Per share data                            | Cash dividends

declared   | .20                      | .15 | 0.075 | 0.06 | 0.05 |
|                                       | Book value per share       | 9.14                     | 8.81 | 7.98 | 7.37 | 6.67 |
|                                       |                       |                     |   |   |   |   |
| Selected Balance Sheet Data at End of Year | Loans, net                 | $446,661                 | $433,034 | $407,274 | $387,133 | $373,534 |
| Total securities                           | 136,867                    | 142,953                  | 140,284 | 133,203 | 124,964 |
| Total assets                               | 660,794                    | 632,649                  | 599,341 | 567,060 | 543,416 |
| Total deposits                             | 512,747                    | 500,109                  | 486,908 | 468,657 | 450,009 |
|                                       | Stockholders’ equity | 46,711                   | 45,707 | 42,132 | 39,299 | 35,434 |

 

 

20

 

----

 

|                                  |                             |     |     |     |     |     |
|---------------------------------------|----------------------------------|----------|----------|----------|----------|----------|
| Selected Balance Sheet Daily Averages | Loans, net                       | $436,758 | $418,100 | $396,530 | $381,178 | $355,593 |
| Total securities                      | 143,989                          | 143,034  | 130,367  | 129,611  | 115,313  |
| Total assets                          | 647,936                          | 615,354  | 584,500  | 556,995  | 517,497  |
| Total deposits                        | 507,862                          | 490,288  | 479,808  | 459,749  | 439,330  |
|                                  | Stockholders’ equity       | 46,213   | 43,358   | 40,290   | 38,895   | 36,886   |
|                                  |                             |     |     |     |     |     |
|                                  | Return on average assets         | 0.76%    | 0.85%    | 0.86%    | 0.83%    | 0.87%    |
| Selected Ratios                       | Return on average equity         | 10.61%   | 12.01%   | 12.43%   | 12.55%   | 13.27%   |
|                                  | Dividend payout ratio            | 21.06%   | 15.11%   | 7.94%    | 6.87%    | 5.86%    |
|                                  | Average equity to average assets | 7.13%    | 7.05%    | 6.89%    | 6.64%    | 6.59%    |
|                                  |                             |     |     |     |     |     |

 

*            Data adjusted for 2:1 split effective September 9, 2005.

 

**Item 7. Management’s Discussion and Analysis of Financial            Condition and Results of Operation**

 

The purpose of this discussion is to provide information about the            financial condition and results of operations of the Company and its wholly-owned            subsidiaries and other information included in this report. This discussion should be            read in conjunction with the Company’s Consolidated Financial Statements and            Notes to Consolidated Financial Statements.

 

**Caution About Forward-Looking Statements**

 

This Annual Report on Form 10-K contains forward-looking statements            within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the            Securities Exchange Act of 1934. The Company's actual results could differ materially            form those set forth in the forward-looking statements.

             

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

 

|   | **•** | The ability to successfully manage the Company’s                            growth or implement its growth strategies if it is unable to identify                            attractive markets, locations or opportunities to expand in the                            future; |
|--------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

|   | **•** | The ability to continue to attract low cost core                            deposits to fund asset growth; |
|--------|------------|------------------------------------------------------------------------------------------------------------|

|   | **•** | Maintaining capital levels adequate to support the                            Company’s growth; |
|--------|------------|-------------------------------------------------------------------------------------------------------|

|   | **•** | Maintaining cost controls and asset qualities as the                            Company opens or acquires new branches; |
|--------|------------|-------------------------------------------------------------------------------------------------------------------------|

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

|   | **•** | The successful management of interest rate                            risk; |
|--------|------------|-----------------------------------------------------------------------------|

|   | **•** | Changes in general economic and business conditions in                            the Company’s market area; |
|--------|------------|--------------------------------------------------------------------------------------------------------------------|

|   | **•** | Further deterioration in the housing market; |
|--------|------------|----------------------------------------------|

|   | **•** | Continued problems related to the national credit                            crisis; |
|--------|------------|--------------------------------------------------------------------------------------|

|   | **•** | Changes in interest rates and interest rate                            policies; |
|--------|------------|----------------------------------------------------------------------------------|

 

21

 

----

|   | **•** | Risks inherent in making loans such as repayment risks                            and fluctuating collateral values; |
|--------|------------|----------------------------------------------------------------------------------------------------------------------|

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

|   | **•** | Demand, development and acceptance of new products and                            services; |
|--------|------------|---------------------------------------------------------------------------------------------|

|   | **•** | Problems with technology utilized by the                            Company; |
|--------|------------|------------------------------------------------------------------------------|

|   | **•** | Changing trends in customer profiles and behavior;                            and |
|--------|------------|-----------------------------------------------------------------------------------|

|   | **•** | Changes in banking and other laws and regulations                            applicable to the Company. |
|--------|------------|---------------------------------------------------------------------------------------------------------|

             

**Overview**

 

The Company is a bank holding company located in southwest Virginia. It            conducts commercial banking operations primarily through its full service banking            subsidiary, Highlands Union Bank (the “Bank”). The Bank has two            wholly-owned subsidiaries, Highlands Union Financial Services, Inc. and Highlands Union            Insurance Services, Inc. These two subsidiaries offer investment and insurance            products. Revenues and net income derived from these two sources are not significant at            this time. Management characterizes the Bank as a "community bank".

             

The Bank offers general retail and commercial banking services to            individuals, businesses and local government units. These products and services include            accepting deposits in the form of checking accounts, money market deposit accounts,            interest-bearing demand deposit accounts, savings accounts and time deposits; making            real estate, commercial, revolving, consumer, credit card and agricultural loans;            offering letters of credit; providing other consumer financial services, such as            automatic funds transfer, collections, night depository, safe deposit, travelers checks            and savings bond sales; and providing other miscellaneous services normally offered by            commercial banks. The Bank makes loans in all major loan categories, including            commercial, commercial and residential real estate, construction and consumer            loans.

 

The Company makes money primarily by earning an interest rate spread            between the interest rates it earns on loans and securities and interest rates it pays            on deposits and other borrowed money. The Company also earns money through fees,            service charges and other non-interest income.

 

**Critical Accounting Policies**

 

**General**

 

The financial condition and results of operations presented in the            Consolidated Financial Statements, accompanying Notes to Consolidated Financial            Statements and management’s discussion and analysis are, to a large degree,            dependent upon the accounting policies of the Company. The selection and application of            these accounting policies involve judgments, estimates, and uncertainties that are            susceptible to change.

             

Presented below is a discussion of the Accounting Policy that management            believes is important to the understanding of the Company’s financial condition            and results of operations. This critical accounting policy requires management’s            most difficult, subjective and complex judgments about matters that are inherently            uncertain. In the event that different assumptions or conditions were to prevail, and            depending upon the severity of such changes, the possibility of materially different            financial condition or results of operations is a reasonable likelihood. See also Note            1 of the Notes to Consolidated Financial Statements.

 

22

 

----

 

**Allowance for Loan Losses**

 

The Company monitors and maintains an allowance for loan losses to            absorb the estimate of probable losses inherent in the loan portfolio. The allowance            for loan losses is based on management’s judgment and analysis of current and            historical loss experience, risk characteristics of the loan portfolio, concentrations            of credit and asset quality, as well as other internal and external factors, such as            general economic conditions. The Company recognizes the inherent imprecision in            estimates of losses due to various uncertainties, and variability related to the            factors used. If different assumptions or conditions were to prevail and it is            determined that the allowance is not adequate to absorb the new estimate of probable            losses, an additional provision for loan losses would be made, which amount may be            material to the Consolidated Financial Statements.

 

**Performance Summary**

 

The following table shows the Company’s key performance ratios for            the years ended December 31, 2007 and 2006:

 

|                                                                                                                                                                                                                     | 12/31/07 |   | 12/31/06 |   |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|----------|--------|----------|--------|
|                                                                                                                                                                                                                     |     |   |     |   |
| Return on Average Assets                                                                                                                                                                                                 | 0.76%    |   | 0.85%    |   |
| Return on Average Equity                                                                                                                                                                                                 | 10.61%   |   | 12.01%   |   |
| Basic Earnings Per Share                                                                                                                                                                                                 | $0.95    |   | $1.00    |   |
| Fully Diluted Earnings Per Share                                                                                                                                                                                         | $0.94    |   | $0.98    |   |
| Net Interest Margin (1)                                                                                                                                                                                                  | 3.43%    |   | 3.50%    |   |
|                                                                                                                                                                                                                     |     |   |     |   |
| (1) Net Interest Margin - Year-to-date tax                            equivalent net interest income divided by year-to-date average earning                            assets.

                              |

 

**Growth**

 

The following table shows the Company’s key growth indicators for            the years ended December 31, 2007 and 2006:

             

(dollar amounts in thousands)

                

|       | 12/31/07 |   | 12/31/06 |
|------------|----------|--------|----------|
|       |     |   |     |
| Securities | $131,132 |   | $137,984 |
| Loans, net | $446,661 |   | $433,034 |
| Deposits   | $512,747 |   | $500,109 |
| Assets     | $660,794 |   | $632,649 |

 

 

23

 

----

**Asset Quality**

 

The following table shows the Company’s key asset quality            indicators for the years ended December 31, 2007 and 2006:

 

| (dollar amounts in thousands)            |     |   |     |
|------------------------------------------|----------|--------|----------|
|                                     | 12/31/07 |   | 12/31/06 |
|                                     |     |   |     |
| Non- accrual loans                       | $7,849   |   | $2,696   |
| Loans past due over 90 days              | 268      |   | 704      |
| Other real estate owned                  | 617      |   | 1,924    |
| Allowance for loan losses to total loans | 1.03%    |   | 1.04%    |
| Net charge-off ratio                     | 0.14%    |   | 0.22%    |

 

For further information see the discussion under "Provision and            Allowances for Loan Losses".

 

**Results of Operations**

 

**Net Interest Income**

(dollar amounts in thousands)

 

2007            versus 2006

 

Net interest income for 2007 was $18,904 or an increase of $383 over            2006. During 2007 interest income increased $3,333. This was a result of both existing            interest earning assets re-pricing at higher rates and new loans made and securities            purchased at higher rates. Interest-bearing liabilities also re-priced upward, causing            an increase in interest expense of $2,950. During the latter part of 2007, the Federal            Reserve Board began lowering interest rates due to recessionary fears and the current            economic weaknesses. The net result of these events was a slight decrease in the            Company’s net interest margin to 3.43% in 2007 from 3.50% in 2006. The Company            has also made a concerted effort to lock in longer term funding by increasing its long            term funding from the Federal Home Loan Bank. During 2007, the Company increased its            net funding from the FHLB by $15,000. The continued competition for deposits in the            Company’s market areas has not only slowed deposit growth but has also            significantly increased the weighted yields paid for such deposits. The current trend            is the result of short-term interest rates rising after an unusually long period of low            interest rates. The flat and/or slightly inverted yield curve during the majority of            2007 has also impacted the Company’s ability to attract longer term deposits. The            tax equivalent yield on earning assets for 2007 was 7.03%, increasing 30 basis points            during the year. During the same period, the yield on interest bearing liabilities was            4.16%, which was an increase of increase of 37 basis points. The Company will continue            to look for alternative funding sources in an effort to reduce its cost of            funds.

             

**Analysis of Net Interest Earnings**

 

The following table shows the major categories of interest-earning            assets and interest-bearing liabilities, the interest earned or paid, the average yield            or rate on the average balance outstanding, net interest income and net yield on            average interest-earning assets and average interest spread for the years            indicated.

 

24

 

----

|                                                                                                                                                                                                                                                                                                                            | Year Ended December 31,  |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------------------------|
|                                                                                                                                                                                                                                                                                                                            | 2007                     | 2006 |
|                                                                                                                                                                                                                                                                                                                            | (Dollars in Thousands)   |
|                                                                                                                                                                                                                                                                                                                            |  

Average

Balance | Interest Income/ Expense |  

Yield/

Rate |  

Average

Balance | Interest Income/ Expense |  

Yield/

Rate |
| ASSETS                                                                                                                                                                                                                                                                                                                          |                     |   |   |   |   |   |
| Interest earning assets (taxable-equivalent                            basis):                                                                                                                                                                                                                                                  |                     |   |   |   |   |
| Loans (net of unearned discount )(1)                                                                                                                                                                                                                                                                                            | $441,308                 | $ 32,832 | 7.44% | $422,505 | $ 30,319 | 7.18% |
| Securities (2)(3)                                                                                                                                                                                                                                                                                                               | 148,500                  | 7,175 | 5.89 | 146,390 | 6,540 | 5.48 |
| Federal funds sold                                                                                                                                                                                                                                                                                                              | 6,521                    | 338 | 5.18 | 3,049 | 153 | 5.02 |
| Total interest-earning assets                                                                                                                                                                                                                                                                                                   | $596,329                 | $ 40,345 | 7.03% | $571,945 | $ 37,012 | 6.73% |
| LIABILITIES                                                                                                                                                                                                                                                                                                                     |                     |   |   |   |   |   |
| Interest bearing liabilities:                                                                                                                                                                                                                                                                                                   |                     |   |   |   |   |   |
| Interest bearing deposits                                                                                                                                                                                                                                                                                                       | $426,116                 | $ 16,886 | 3.96% | $410,749 | $ 14,429 | 3.51% |
| Other interest bearing liabilities                                                                                                                                                                                                                                                                                              | 88,694                   | 4,555 | 5.14 | 77,771 | 4,062 | 5.22 |
| Total interest-bearing liabilities                                                                                                                                                                                                                                                                                              | $514,810                 | $ 21,441 | 4.16% | $488,520 | $ 18,491 | 3.79% |
| Net interest income                                                                                                                                                                                                                                                                                                             |                     | $ 18,904 |   |   | $ 18,521 |   |
| Net margin on interest earning assets on a

tax equivalent basis                                                                                                                                                                                                                                                                |                     |   | 3.43% |   |   |  

3.50% |
| Average interest spread                                                                                                                                                                                                                                                                                                         |                     |   | 2.87% |   |   | 2.94% |
|                                                                                                                                                                                                                                                                                                                            |                     |   |   |   |   |   |
| (1) For the purposes of these computations, non-accruing                            loans are included in the daily average loan amounts                            outstanding.                                                                                                                                                |
| (2) Tax equivalent adjustments (using 34% federal tax                            rates) have been made in calculating yields on tax-free investments.                            Virginia banks are exempt from state income tax.                                                                                               |
| (3) The yield on securities classified as available for                            sale is computed based on the average balance of the historical                            amortized cost balance without the effects of the fair value adjustment                            required by Financial Accounting Standard 115. |

 

 

**Analysis of Changes in Interest Income and Interest            Expense**

 

The Company's primary source of revenue is net interest income, which is            the difference between the interest and fees earned on loans and investments and the            interest paid on deposits and other funds. The Company's net interest income is            affected by changes in the amount and mix of interest-earning assets and            interest-bearing liabilities and by changes in yields earned on interest-earning assets            and rates paid on interest-bearing liabilities. The following table sets forth, for the            years indicated, a summary of the changes in interest income and interest expense            resulting from changes in average asset and liability balances (volume) and changes in            average interest rates (rate).

***Increase/(Decrease) Due to Volume and Rate***

 

|                                                                                                   | 2007 Compared to 2006                       |
|--------------------------------------------------------------------------------------------------------|---------------------------------------------|
|  

                             

                             

Increase (Decrease) in | Increase (decrease) due to change in volume | Increase (decrease) due to change in rate |  

                             

Net increase

(decrease) |
|                                                                                                   | (Dollars in Thousands)                      |
| INTEREST INCOME

Securities                                                                            |  

$ 125                               |  

$ 510 |  

$ 635 |
| Federal funds sold                                                                                     | 179                                         | 6 | 185 |
| Loans                                                                                                  | 1,399                                       | 1,114 | 2,513 |
| Total Income Change                                                                                    | $ 1,703                                     | $ 1,630 | $ 3,333 |
| INTEREST EXPENSE

Savings and time deposits                                                            |  

$ 609                               |  

$ 1,848 |  

$ 2,457 |
| Other interest-bearing liabilities                                                                     | 561                                         | (68) | 493 |
| Total Expense Change                                                                                   | $ 1,170                                     | $ 1,780 | $ 2,950 |
| Increase (Decrease) in Net Interest Income                                                             | $ 533                                       | $ (151) | $ 383 |

 

 

25

 

----

**Non-interest Income**

(dollar amounts in thousands)

 

2007            versus 2006

 

Non-interest income for 2007 was $4,613. Service charges on deposit            accounts (primarily NSF fees) decreased $436 as compared to 2006. The number of checks            processed continues to decline as the number of electronic transactions increases.            Merchant and debit card fee income increased by $139 over 2006 due to increases in            merchant fees and visa check card interchange fees. The use of debit cards continued to            increase significantly over the prior period.

             

Income received during 2007 from the Company’s investment in            Virginia Title Company, LLC totaled $162. During 2007, the Bank purchased an additional            $2.5 million in Bank Owned Life Insurance covering selected officers. Earnings related            to its investment in Bank Owned Life Insurance totaled $483 or an increase of $112 as            compared to 2006.

 

Net securities gains totaled $80 compared to $99 in 2006.

             

**Non-interest Expense**

(dollar amounts in thousands)

 

2007            versus 2006

 

Non-interest expense is comprised of salaries and employee benefit            costs, occupancy expenses, furniture and equipment expenses and other operating            expenses. Non-interest expense for 2007 was $17,120, an increase of $1,234 over 2006.            The increase is primarily attributable to the continued growth of the Company that was            achieved during 2007. Salaries and employee benefits increased by 8.94% or $811            primarily due to the Company opening a new branch in Knoxville, TN during 2007 as well            as a full year of personnel cost for its new branch opened in Sevierville, TN in August            of 2006. Recent technology enhancements however have allowed the bank to leverage its            existing personnel base to help minimize overall increases in personnel            costs.

 

**Income Taxes**

(dollar amounts in thousands)

 

2007            vs. 2006

 

Income tax expense for 2007 decreased $297 when compared to 2006            primarily due to the decrease in pretax income and the increase in tax exempt income.            Interest income from tax exempt municipal bonds and earnings related to the            Company’s investment in BOLI are the primary assets with tax exempt            income.

 

 

26

 

----

**Provision and Allowance for Loan Losses**

(dollar amounts in thousands)

 

2007            vs. 2006

 

The adequacy of the allowance for loan losses is based on management's            judgment and analysis of current and historical loss experience, risk characteristics            of the loan portfolio, concentrations of credit and asset quality, as well as other            internal and external factors, such as general economic conditions. The internal credit            review department performs pre-credit analyses of large credits and also conducts            credit review activities that provide management with an early warning of asset quality            deterioration. The internal credit review department also prepares regular analyses of            the adequacy of the allowance for loans losses. These analyses include calculations            based upon a mathematical formula that considers identified potential losses on            specific loans and makes pool allocations for historical losses for various loan types.            The Company uses a rolling three year history by loan category in determining pool            allocation factors. In addition, an amount is allocated based upon such factors as            changing trends in the loan mix, the effects of changes in business conditions and            market area, unemployment trends, the effects of any changes in loan policies, and the            effects of competition and regulatory factors on the loan portfolio.

             

The internal credit review department as well as management has            determined that the Company's allowance for loan losses is sufficient. Loans past due            ninety days or more and still accruing were $268 at December 31, 2007, compared to $704            at December 31, 2006. Net charge-offs to total loans decreased from 0.22% in 2006 to            0.14% in 2007. This was in large part due to the changes implemented in 2004 related to            credit scoring, underwriting, analysis and review.

             

The following table presents the Company’s loan loss experience            for the past five years:

             

|                                                                            | Years Ended December 31,

(Dollars in Thousands) |
|---------------------------------------------------------------------------------|--------------------------------------------------|
|                                                                            | 2007                                             | 2006 | 2005 | 2004 | 2003 |
| Allowance for loan losses at beginning of                            year       | $ 4,565                                          | $ 4,359 | $ 4,181 | $ 4,274 | $ 3,877 |
| Loans charged off:                                                              |                                             |   |   |   |   |
| Commercial                                                                      | 47                                               | 206 | 131 | 219 | 299 |
| Real Estate – mortgage                                                    | 99                                               | 58 | 205 | 192 | 270 |
| Consumer                                                                        | 444                                              | 539 | 791 | 1,089 | 1,211 |
| Other                                                                           | 242                                              | 277 | 0 | 0 | 0 |
| Total                                                                           | $ 832                                            | $ 1,080 | $ 1,127 | $ 1,500 | $ 1,780 |
| Recoveries of loans previously charged off:                                     |                                             |   |   |   |   |
| Commercial                                                                      | $ 36                                             | $ 14 | $ 17 | $ 2 | $ 8 |
| Real Estate – mortgage                                                    | 54                                               | 10 | 10 | 1 | 0 |
| Consumer                                                                        | 121                                              | 115 | 123 | 104 | 116 |
| Other                                                                           | 1                                                | 0 | 0 | 0 | 0 |
| Total                                                                           | $ 212                                            | $ 139 | $ 150 | $ 107 | $ 124 |
|                                                                            |                                             |   |   |   |   |
| Net loans charged off                                                           | $ 620                                            | $ 941 | $ 977 | $ 1,393 | $ 1,656 |
|                                                                            |                                             |   |   |   |   |
| Provision for loan losses                                                       | 685                                              | 1,147 | 1,155 | 1,300 | 2,053 |
| Allowance for loan losses end of year                                           | $ 4,630                                          | $ 4,565 | $ 4,359 | $ 4,181 | $ 4,274 |
| Average total loans (net of unearned income)                                    | $ 441,308                                        | $ 422,525 | $ 400,759 | $ 385,434 | $ 359,187 |
| Total loans (net of unearned income) at                            year-end     | $ 451,291                                        | $ 437,599 | $ 411,633 | $ 391,314 | $ 377,808 |
| Ratio of net charge-offs to average loans                                       | 0.140%                                           | 0.223% | 0.244% | 0.361% | 0.461% |
| Ratio of provision for loan losses to average                            loan   | 0.155%                                           | 0.271% | 0.288% | 0.337% | 0.572% |
| Ratio of provision for loan losses to net                            charge-off | 110.484%                                         | 121.892% | 118.219% | 123.973% | 123.973% |
| Allowance for loan losses to year-end loans                                     | 1.026%                                           | 1.043% | 1.059% | 1.068% | 1.131% |

 

 

27

 

----

**Non-performing loans**

(dollar amounts in thousands)

 

The loan portfolio of the Bank is reviewed regularly by senior officers            to evaluate loan performance. The frequency of the review is based on a rating of            credit worthiness of the borrower utilizing various factors such as net worth, credit            history and customer relationship. The evaluations emphasize different factors            depending upon the type of loan involved. Commercial and real estate loans are reviewed            on the basis of projections of cash flow and estimated net realizable value through an            evaluation of collateral and the financial strength of the borrower. Installment loans            are evaluated largely on the basis of delinquency data because of the large number of            such loans and relatively small size of each individual loan.

 

Management’s review of commercial and other loans may result in a            determination that a loan should be placed on a non-accrual of interest basis. It is            the policy of the Bank to discontinue the accrual of interest on any loan on which full            repayment of principal and / or interest is doubtful. Subsequent collection of interest            is recognized as income on a cash basis upon receipt. Placing a loan on non-accrual            status for the purpose of income recognition is not in itself a reliable indication of            potential loss of principal. Other factors, such as the value of the collateral            securing the loan and the financial condition of the borrower, serve as more reliable            indications of potential loss of principal.

The policy of the Bank is that non-performing loans consist of loans            accounted for on a non-accrual basis and loans which are contractually past due 90 days            or more in regards to interest and/or principal payments. The following table presents            non-performing assets at December 31.

 

|                                                                          | 2007                   | 2006    | 2005    | 2004    | 2003    |
|-------------------------------------------------------------------------------|------------------------|---------|---------|---------|---------|
|                                                                          | (Amounts in thousands) |
|                                                                          |                   |    |    |    |    |
| Non-performing loans                                                          | $ 8,117                | $ 3,400 | $ 4,201 | $ 4,653 | $ 4,521 |
|                                                                          |                   |    |    |    |    |
| Non-accrual loans                                                             | $ 7,849                | $ 2,696 | $ 2,920 | $ 3,902 | $ 3,723 |
|                                                                          |                   |    |    |    |    |
| Loans past-due 90 days and more and still                            accruing | $ 268                  | $ 704   | $ 1,281 | $ 661   | $ 802   |
|                                                                          |                   |    |    |    |    |
| Interest income lost on non-accruing loans                                    | $ 333                  | $ 234   | $ 227   | $ 237   | $ 235   |

 

The majority of the increase in non-performing assets during 2007 from            the prior year was related to a $4.07 million commercial real estate loan that was            placed in non-accrual status during the third quarter of 2007. This customer is            currently being processed for collections on real estate and other collateral.            Management believes that the underlying value of the collateral is sufficient to cover            the balance of this loan. However, in the event the collateral value is underestimated            or deteriorates a sufficient amount of loan loss reserve has been allocated to this            loan to cover any potential future losses.

 

 

28

 

----

**Allocation of the allowance for loan losses**

 

The following table provides an allocation of the allowance for loan            losses at December 31, 2007, 2006, 2005, 2004 and 2003.

 

|                | December 31,

Percent of Loans on each Category

                             

(Dollars in Thousands)

                              |
|---------------------|-------------------------------------------------------------------------------------------------------------------------------------------------|
|                | 2007(1)                                                                                                                                         | 2006(1) | 2005(1) |
|                | Allowance for

Loan Loss                                                                                                                        | Percentage of Total Allowance | Percentage of

Total Loans | Allowance for

Loan Loss | Percentage of Total Allowance | Percentage of

Total Loans | Allowance for

Loan Loss | Percentage of Total Allowance | Percentage of

Total Loans |
|  

Commercial  |  

$ 1,005                                                                                                                                 |  

21.71% |  

9.46% |  

$ 1,691 |  

37.04% |  

9.76% |  

$ 710 |  

16.29% |  

9.38% |
| Real Estate         | 2,187                                                                                                                                           | 47.22 | 81.94 | 593 | 12.99 | 80.77 | 1,255 | 28.79 | 79.42 |
| Consumer            | 589                                                                                                                                             | 12.72 | 7.42 | 768 | 16.82 | 8.14 | 858 | 19.68 | 10.07 |
| Other / Unallocated | 849                                                                                                                                             | 18.35 | 1.18 | 1,513 | 33.15 | 1.33 | 1536 | 35.24 | 1.13 |
|  

Total       |  

$ 4,630                                                                                                                                 |  

100.00% |  

100.00% |  

$ 4,565 |  

100.00% |  

100.00% |  

$ 4,359 |  

100.00% |  

100.00% |

 

 

|                | 2004(1)                  | 2003                          |
|---------------------|--------------------------|-------------------------------|
|                | Allowance for

Loan Loss | Percentage of Total Allowance | Percentage of

Total Loans | Allowance for

Loan Loss | Percentage of Total Allowance | Percentage of

Total Loans |
|  

Commercial  |  

$ 705            |  

16.86%                |  

9.13% |  

$ 830 |  

19.42% |  

10.37% |
| Real Estate         | 1,302                    | 31.16                         | 76.40 | 224 | 5.24 | 73.25 |
| Consumer            | 953                      | 22.79                         | 13.25 | 3,220 | 75.34 | 15.08 |
| Other / Unallocated | 1,221                    | 29.19                         | 1.22 | 0 | 0.00 | 1.30 |
|  

Total       |  

$ 4,181          |  

100.00%               |  

100.00% |  

$ 4,274 |  

100.00% |  

100.00% |

             

|   | 1) | Percentages for 2007, 2006, 2005, and 2004 are                            categorized differently from 2003 due to the Company’s change in                            its methodology of the calculation of the Allowance for Loan Loss                            reserve. More enhanced pooling allocation factors are now being used,                            in addition to more detailed historical data being utilized. The                            allowance for loan loss reserve is computed quarterly by the                            Company’s internal credit review department and is reviewed by                            the Senior Financial Officers of the Company. Management believes its                            method, implemented in 2004, pertaining to the allocation of loan loss                            reserve is both adequate and more properly allocates the reserve among                            the various categories. The additional reserves allocated for Real                            Estate loans in 2007 is primarily due to the Company’s increase                            in commercial real estate lending . |
|--------|----|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

 

**Financial Condition**

 

**Balance Sheet**

(dollar amounts in thousands)

 

2007            vs. 2006

 

Total assets for the Company increased by $28,145 or 4.45% in 2007.            Average interest earning assets grew by $24,385 or 4.26% for the year. Average interest            bearing liabilities increased by $26,294 or 5.38% in 2007. Asset growth was primarily            attributable to the continued increased market share in both North Carolina and            Tennessee.

 

29

 

----

**Loans**

(dollar amounts in thousands)

 

2007            vs. 2006

 

Loans net of unearned income and deferred fees increased by $13,692 or            3.13% in 2007. The majority of the increase was related to the Company’s            continued growth in market share in North Carolina and Tennessee. Loans secured by real            estate showed an increase of approximately $16,449, offset by a decline in loans            secured by collateral other than real estate of approximately $2,757. The decline in            loans secured by collateral other than real estate was primarily due to the            Company’s decision to discontinue its dealer finance division in the first            quarter of 2005. This decision was made due to the competitive nature of this program            and the risks associated with these indirect loans. The Company also implemented a more            stringent credit analysis and scoring system in 2004 which also contributed to a            decline in the number of approved loans. Management also believes the decline in loans            secured by collateral other than real estate was also due to the following:

 

|   | **•** | General economic conditions and the lack of employment                            opportunity in portions of the Company's market area. |
|--------|------------|-----------------------------------------------------------------------------------------------------------------------------------------|

|   | **•** | A decline in consumer requests for new car financing                            because of special financing incentives offered by automobile                            companies. |
|--------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

|   | **•** | Consumers taking advantage of low mortgage rates to                            refinance home mortgages to obtain funds that might otherwise have been                            borrowed through a consumer loan. |
|--------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

 

Reversal of this trend may occur to some extent as economic conditions            change and higher interest rates make mortgage refinancing less appealing. Likewise in            the current mortgage environment, loans secured by residential real estate could be            harder to obtain. Also, management believes that automotive related financing offers            and competition from the credit card sector will remain. Since loans to individuals are            generally higher yielding, this trend will not have a favorable effect on net interest            income in the future but should have a favorable impact on future net charge-offs as            the percentage of real estate secured loans to total loans increases.

 

The Company’s portfolio of commercial, construction and land            development loans has also experienced significant growth over the past few years.            During 2007, this segment of loans grew $7,303 or 4.79%. This is primarily attributable            to the North Carolina and Tennessee markets the Company has entered and the amount of            growth occurring in these particular areas. The Company continues to see more loan            growth in commercial real estate as opposed to residential activity.

 

30

 

----

**Loan Portfolio**

 

The table below classifies gross loans by major category and percentage            distribution at December 31, for each of the past five years:

 

 

|                                                                      | December 31,

(Dollars in thousands)

                              |
|---------------------------------------------------------------------------|--------------------------------------------------------------------------|
|                                                                      | 2007                                                                     | 2006 | 2005 | 2004 | 2003 |
|                                                                      | **Amount**                                                               | **Percentage** | **Amount** | **Percentage** | **Amount** | **Percentage** | **Amount** | **Percentage** | **Amount** | **Percentage** |
| Real Estate Secured:                                                      |                                                                     |   |   |   |   |   |   |   |   |   |
| Residential 1-4                                family | $ 163,918                                                                | 36.28% | $156,753 | 35.77% | $151,815 | 36.88% | $ 146,970 | 37.54% | $141,693 | 37.49% |
| Multi-family                                                              | 9,420                                                                    | 2.08 | 10,520 | 2.40 | 4,148 | 1.01 | 3,379 | 0.86 | 2,651 | 0.70 |
| Commercial, Construction

and Land Development                            |  

159,795                                                          | 35.35 |  

152,491 | 34.80 |  

140,178 | 34.05 |  

122,997 | 31.42 |  

113,146 | 29.93 |
| Second Mortgages                                                          | 17,964                                                                   | 3.97 | 15,305 | 3.49 | 10,962 | 2.66 | 7,419 | 1.89 | 6,976 | 1.85 |
| Equity Line of Credit                                                     | 9,782                                                                    | 2.16 | 9,493 | 2.17 | 9,800 | 2.38 | 8,981 | 2.29 | 7,430 | 1.96 |
| Farmland                                                                  | 9,475                                                                    | 2.10 | 9,343 | 2.13 | 10,015 | 2.43 | 9,347 | 2.39 | 4,843 | 1.28 |
|                                                                      | $ 370,354                                                                | 81.94% | $353,905 | 80.77% | $326,918 | 79.41% | $ 299,093 | 76.39% | $276,739 | 73.21% |
| Secured, Other:                                                           |                                                                     |   |   |   |   |   |   |   |   |   |
| Personal                                                                  | $ 24,741                                                                 | 5.47% | $ 27,384 | 6.25% | $ 33,395 | 8.11% | $ 44,222 | 11.30% | $ 48,637 | 12.87% |
| Commercial                                                                | 26,433                                                                   | 5.85 | 26,943 | 6.15 | 25,628 | 6.23 | 24,992 | 6.38 | 27,247 | 7. 21 |
| Agricultural                                                              | 4,232                                                                    | 0.94 | 5,093 | 1.16 | 3,653 | .89 | 4,024 | 1.03 | 4,506 | 1.19 |
|                                                                      | $ 55,406                                                                 | 12.26% | $ 59,420 | 13.56% | $ 62,676 | 15.23% | $ 73,238 | 18.71% | $ 80,390 | 21.27% |
|                                                                      |                                                                     |   |   |   |   |   |   |   |   |   |
| Unsecured:                                                                | $ 26,192                                                                 | 5.80% | $ 24,845 | 5.67% | $ 22,048 | 5.36% | $ 19,176 | 4.90% | $ 20,868 | 5.52% |
|                                                                      |                                                                     |   |   |   |   |   |   |   |   |   |
| Loans, gross                                                              | $ 451,952                                                                | 100.00% | $438,170 | 100.00% | $411,642 | 100.00% | $ 391,507 | 100.00% | $ 377,997 | 100.00% |
|                                                                      |                                                                     |   |   |   |   |   |   |   |   |   |

 

 

The            following table shows the maturity of loans outstanding, inclusive of contractual            amortization, at December 31,            2007:      

 

|                                             | December 31, 2007

(Amounts in Thousands) |
|--------------------------------------------------|-------------------------------------------|
|                                             | Within One Year                           | After One Year But

Within Five Years | After Five Years |   |
|                                             | Fixed                                     | Floating | Fixed | Floating | Fixed | Floating | Total |
|                                             |                                      |   |   |   |   |   |   |
| Real Estate Secured:                             |                                      |   |   |   |   |   |   |
| Residential 1-4 Family                           | $13,867                                   | $3,542 | $36,462 | $6,965 | $43,123 | $59,959 | $163,918 |
| Multi-family                                     | 1,151                                     | 0 | 6,336 | 0 | 1,933 | 0 | 9,420 |
| Commercial, Construction

& Land Development | 47,862                                    | 19,406 | 63,923 | 4,085 | 15,111 | 9,408 | 159,795 |
| Second Mortgages                                 | 1,674                                     | 925 | 5,633 | 85 | 8,405 | 772 | 17,964 |
| Equity Line of Credit                            | 0                                         | 978 | 0 | 3,913 | 0 | 4,891 | 9,782 |
| Farmland                                         | 1,674                                     | 1,494 | 5,490 | 30 | 616 | 171 | 9,475 |
| Secured, Other:                                  |                                      |   |   |   |   |   |   |
| Personal                                         | 9,099                                     | 5 | 15,089 | 3 | 499 | 46 | 24,741 |
| Commercial                                       | 7,920                                     | 6,995 | 10,669 | 102 | 747 | 0 | 26,433 |
| Agricultural                                     | 1,005                                     | 2,469 | 580 | 178 | 0 | 0 | 4,232 |
| Unsecured                                        | 14,469                                    | 5,593 | 3,014 | 1,113 | 1,967 | 36 | 26,192 |
|                                             |                                      |   |   |   |   |   |   |
| Loans, Gross                                     | $ 99,191                                  | $ 41,407 | $147,196 | $ 16,474 | $ 72,401 | $ 75,283 | $451,952 |
|                                             |                                      |   |   |   |   |   |   |

 

 

31

 

----

**Securities**

(dollar amounts in thousands)

 

2007            vs. 2006

 

Investment securities available for sale decreased $6,852 (market value)            from December 31, 2006 to December 31, 2007 as a result of maturities and prepayments.            The Company made fewer purchases during 2007 primarily due to the flat yield curve. The            Company maintained a large percentage of its excess funds in overnight funds during the            year due to the higher yields obtained in fed funds versus longer term bond yields.            Purchases during the year consisted primarily of fixed rate agency notes and fixed rate            municipal bonds. During the year, management has continued its investment strategy to            purchase securities that will not only blend in with the Company’s overall asset            liability strategy but also maximize yield. The majority of the pay downs were            contractual amortization and prepayments on variable rate securities as a result of            prepayments occurring on the underlying mortgages

 

At December 31, 2007, net unrealized losses in the Company’s            securities portfolio classified available for sale totaled $2,134. The majority of            these unrealized losses were related to the Company’s holdings ($6,250 in book            value) of Federal Home Loan Mortgage Corporation and Federal National Mortgage            Association agency preferred stock. As discussed in Footnote 2 in the Company’s            Consolidated Financial Statements, management of the Company does not consider any of            these losses to be other than temporary. It is management’s opinion that the            unrealized losses are primarily related to interest rate changes. Management also feels            that the market values of these particular instruments have also been negatively            affected by the accounting related irregularities at both Fannie Mae and Freddie Mac.            The Company has both the ability and intent to hold these instruments for a time            necessary to recover its cost These instruments are stocks and do not have a stated            maturity date. The Company continues to hold a “laddered” structure of            these investments (a single 1- year floater, two 2- year floaters and a single 5- year            floater). 70% of the quarterly dividends paid on these instruments are tax exempt.            Therefore, as the coupon rates on these stocks increase, the “tax exempt            benefit” increases as well which also supports management’s position that            the values of these stocks are related to the interest rate cycle.

 

**Investment Portfolio**

 

The following table presents the maturity distribution, market value,            amortized cost and approximate tax equivalent yield (assuming a 34% federal income tax            rate) of the investment portfolio at December 31, 2007.

             

|                                                                        | (Dollars in Thousands)   |
|-----------------------------------------------------------------------------|--------------------------|
|                                                                        |  

Within One

Year | One Year

Through

Five Years | Five Years

Through

Ten Years |  

After Ten

Years |  

                             

Yield |  

Market

Value |  

Amortized

Cost |
| Mortgage-backed Sec – fixed rate                                      | $ 3                      | $ 2,758 | $ 1,680 | $ 3,254 | 4.32% | $ 7,695 | $ 7,744 |
| Mtg.-backed Sec – variable rate                                       | -                        | - | 30 | 26,935 | 5.06 | 26,965 | 27,100 |
| State & Municipal’s – tax                            exempt | -                        | - | 684 | 60,978 | 6.03 | 61,662 | 62,043 |
| State & Municipal’s – taxable                               | -                        | 1,005 | - | 694 | 4.84 | 1,699 | 1,718 |
| U.S. Agencies – fixed rate                                            | 750                      | - | 3,318 | 11,300 | 5,89 | 15,368 | 15,272 |
| Agency Preferred – variable rate                                      | -                        | - | - | 4,136 | 5.68 | 4,136 | 6,250 |
| Corporate bonds – fixed rate                                          | -                        | - | - | 1,445 | 6.66 | 1,445 | 1,438 |
| Corporate bonds – variable rate                                       | -                        | - | 394 | 11,370 | 6.50 | 11,764 | 12,405 |
| SBA bonds – variable rate                                             | -                        | - | - | 83 | 5.12 | 83 | 83 |
| CMO’s – fixed rate                                              | -                        | - | - | 298 | 5.31 | 298 | 297 |
| CMO’s – variable rate                                           | -                        | - | - | 14 | 3.91 | 14 | 14 |
| TOTAL                                                                       | 753                      | $ 3,762 | $ 6,106 | $120,507 |   | $131,132 | $134,365 |
| Total fixed rate securities                                                 | $ 753                    | $ 3,762 | $ 5,682 | $ 77,969 |   | $ 88,168 | $ 88,513 |
| Total variable rate securities                                              | $ -                      | $ - | $ 424 | $ 42,538 |   | $ 42,964 | $ 45,852 |

 

32

 

----

**Deposits**

(dollar amounts in thousands)

 

2007            vs. 2006

 

Total deposits grew by $12,638 or 2.53% in 2007. Non-interest bearing            demand deposits increased by $4,305. Total time deposits increased by $11,633. Savings            accounts declined $4,735 during the year as customers began placing more funds back            into the equity markets or moving their funds to time deposits. The increase in time            deposits is primarily a result of growth in the Company’s newer markets. The            majority of the increase in time deposits was growth in shorter term CD’s due to            the current interest rate environment and the current yield curve. The Company and            banks nationwide are continuing to face the challenge of gathering deposits, especially            non-interest bearing deposits. The Company has continued to use its alternative funding            sources (primarily FHLB advances) to help facilitate growth. During 2007, the Company            increased its borrowings from the FHLB by $15,000. The total amount of FHLB borrowings            as of December 31, 2007 was $91,100. See Footnotes 9 and 10 in the Company’s            Consolidated Financial Statements for a description of the Bank’s outstanding            FHLB advances. The Company secures the FHLB advances with a selected group of            residential mortgage loans and commercial real estate loans as well as a specific group            of securities available for sale.

 

The following table provides a breakdown of deposits at December 31 as            indicated:

 

|                                 | December 31,           |
|--------------------------------------|------------------------|
|                                 | (Amounts in Thousands) |
|                                 | 2007                   | 2006 |
|                                 |                   |   |
| Non-interest bearing demand deposits | $ 83,986               | $ 79,681 |
| Interest bearing demand deposits     | 61,284                 | 59,849 |
| Savings deposits                     | 46,931                 | 51,666 |
| Time deposits                        | 320,546                | 308,913 |
| Total Deposits                       | $ 512,747              | $ 500,109 |

 

The average daily amount of deposits and rates paid on such deposits is            summarized for the periods indicated in the following table:

             

|                                         | Year Ended December 31,

(Dollars in Thousands) |
|----------------------------------------------|-------------------------------------------------|
|                                         | 2007                                            | 2006 |
|                                         | Amount                                          |   | Rate | Amount |   | Rate |
|  

Non-interest bearing demand deposits |  

$ 81,746                                |   |  

0.00% |  

$ 79,667 |   |  

0.00% |
| Interest-bearing demand deposits             | 59,468                                          |   | 1.92 | 57,689 |   | 1.89 |
| Savings deposits                             | 50,497                                          |   | 1.25 | 60,685 |   | 1.26 |
| Time deposits                                | 316,151                                         |   | 4.78 | 292,247 |   | 4.30 |
| Total                                        | $507,862                                        |   |   | $490,288 |   |   |

 

The remaining maturities of time deposits greater than or equal to            $100,000 at December 31, 2007 are as follows (Amount in thousands):

             

| **Maturity**                    | **Amount** |
|---------------------------------|------------|
| 3 months or less                | $ 21,448   |
| Over 3 months through 6 months  | 29,583     |
| Over 6 months through 12 months | 26,732     |
| Over 12 months                  | 34,387     |
| Total                           | $ 112,150  |

 

 

33

 

----

**Effects of Inflation**

 

The Company's consolidated statements of income generally reflect the            effects of inflation. Since interest rates, loan demand, and deposit levels are related            to inflation, the resulting changes are included in net income. The most significant            item which does not reflect the effects of inflation is depreciation expense.            Historical dollar values used to determine depreciation expense do not reflect the            effects of inflation on the market value of depreciable assets after their            acquisition.

 

**Liquidity and Capital Resources**

(dollar amounts in thousands)

 

Liquidity is the measure of the Bank’s ability to generate            sufficient funds in order to meet customers’ demands for withdrawal of deposit            balances and for the funding of loan requests. The Bank maintains cash reserves, in            accordance with Federal Reserve Bank guidelines, and has sufficient flow of funds from            investment security payments as well as loan payments to meet current liquidity            needs.

 

Management of the Bank continuously monitors and plans the Bank’s            liquidity position for the future. Liquidity is provided from cash and due from banks,            federal funds sold, loan and investment security payments, core deposits, the national            certificate of deposit market, lines of credit with correspondent banks and lines of            credit with the Federal Home Loan Bank, Management believes that these sources of funds            provide sufficient and timely liquidity for the foreseeable future.

 

**Recent Accounting Pronouncements**

 

See Note 1 of Notes to Consolidated Financial Statements for information            relating to recent accounting pronouncements.

 

**Off-Balance Sheet Arrangements**

 

See Note 16 of Notes to Consolidated Financial Statements for            information relating to Off-Balance Sheet Arrangements.

 

**Item 7A. Quantitative and Qualitative Disclosures About Market            Risk**

 

**Interest Rate Sensitivity Analysis**

 

Interest rate risk refers to the exposure of the Company’s            earnings and market value of equity (“MVE”) to changes in interest rates.            The amount of change in net interest income and MVE resulting from shifts in interest            rates is determined by contractual maturity of fixed rate instruments, the re-pricing            date for variable rate instruments, competition and customer reactions.

 

The Company runs simulation models through a range of positive and            negative interest rate movements to determine the effect these shifts in interest rates            would have on the market value of the Company’s equity. The market value is            determined by applying a discount rate to the Company’s interest-earning assets            and interest-bearing liabilities that are not carried at market value, based on current            rate levels at the time the model is run and calculating the present value of future            cash flows.

 

There are several common components of interest rate risk that must be            effectively managed to maintain minimal impact on the Company’s earnings and            capital. Re-pricing risk comes largely from

 

34

 

----

timing differences in the pricing of interest-earning assets and            interest-bearing liabilities. Reinvestment risk refers to the reinvestment of cash            flows from interest and principal payments and maturing assets at lower or higher            rates. Basis risk arises when different yield curves or pricing indices do not change            at precisely the same moment in time or magnitude so that earning assets and            interest-bearing liabilities with the same maturity are not affected equally. Yield            curve risk refers to unequal movements in short-term and long-term interest            rates.

 

The Company is not a party to derivative financial instruments with            off-balance sheet risks such as futures, forwards, swaps, and options. The Company,            however, is a party to financial instruments with off-balance sheet risks such as            commitments to extend credit and standby letters of credit and recourse obligations in            the normal course of business to meet the financing needs of its customers. See Note 16            of Notes to Consolidated Financial Statements for additional information relating to            financial instruments with off-balance sheet risk. Management does not plan any future            involvement in high risk derivative products.

             

The following table provides the maturities or re-pricing of investment            securities, loans, and deposits as of December 31, 2007, and measures the interest rate            sensitivity gap for each range of maturity indicated. The table presents the carrying            amount of assets and liabilities in the periods they are expected to re-price or            mature. The amounts below also reflect various prepayment assumptions.

             

|                                                                                                                                                                              | December 31, 2007

(Dollars in Thousands)

Maturing / Re-pricing |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------------------------------------------------------------|
|                                                                                                                                                                              | Within One

Year                                                 | After One

But Within

Five Years | After Five

Years | Total |
| ASSETS                                                                                                                                                                            |                                                             |   |   |   |
| Interest-bearing

Investment Securities                                                                                                                                           |  

$ 36,712                                                 |  

$ 14,765 |  

$ 85,389 |  

$ 136,866 |
| Fed Funds Sold                                                                                                                                                                    | 8,129                                                            | - | - | 8,129 |
| Loans                                                                                                                                                                             | 223,757                                                          | 193,706 | 33,828 | 451,291 |
| Non-interest bearing

Other Assets                                                                                                                                                |  

-                                                        |  

- |  

64,508 |  

64,508 |
|                                                                                                                                                                              |                                                             |   |   |   |
| Total Assets                                                                                                                                                                      | $ 268,598                                                        | $ 208,471 | $ 183,725 | $ 660,794 |
|                                                                                                                                                                              |                                                             |   |   |   |
| LIABILITIES AND SHAREHOLDERS’ EQUITY                                                                                                                                        |                                                             |   |   |
| Interest-bearing                                                                                                                                                                  |                                                             |   |   |   |
| (1) All Interest- bearing Deposits                                                                                                                                                | $ 332,110                                                        | $ 94,900 | $ 1,754 | $ 428,764 |
| Other Interest- bearing Liabilities                                                                                                                                               | 12,404                                                           | 17,368 | 67,902 | 97,674 |
| Non-interest-bearing                                                                                                                                                              |                                                             |   |   |   |
| Demand Deposits                                                                                                                                                                   | -                                                                | - | 83,983 | 83,983 |
| Other Liabilities                                                                                                                                                                 | -                                                                | - | 3,662 | 3,662 |
| Shareholders’ Equity                                                                                                                                                        | -                                                                | - | 46,711 | 46,711 |
| Total Liabilities and Shareholders’                            Equity                                                                                                       | $ 344,514                                                        | $ 112,268 | $ 204,012 | $ 660,794 |
|                                                                                                                                                                              |                                                             |   |   |   |
| Interest Rate Sensitivity GAP                                                                                                                                                     | $(75,916)                                                        | $ 96,203 | $ (20,287) | $ - |
|                                                                                                                                                                              |                                                             |   |   |   |
| (1) For purposes of this schedule, the Company includes                            100% of its statement savings, NOW and MMDA in the one year                            column. |

**Asset Liability Management**

 

The Company’s primary objectives for asset and liability            management are to establish internal controls and procedures that will result in            managing interest rate risk, liquidity management, capital planning, asset mix and            volume control, and loan and deposit pricing. The Asset and Liability            Committee

 

35

 

----

(ALCO) is headed by the CEO and includes management personnel from the            different areas of the Bank. The ALCO meets on a monthly basis.

             

In determining the appropriate level of interest rate risk, the ALCO            reviews the changes in projected net interest income subject to various changes in            interest rates. To help effectively measure interest rate risk, the ALCO utilizes rate            sensitivity and simulation analysis to determine the impact on net interest income as            well as the changes in the Economic Value of Equity. Simulation analysis is used to            subject or “shock” the current re-pricing and maturing amounts to rising            and falling interest rates. Rate change increments of 1% and 2% up and down are used in            the monthly simulation analysis. Loan and investment security prepayments are estimated            using current market information.

             

While this planning process is designed to protect the Company over the            long-term, it does not provide near-term protection from interest rate shocks, as            interest rate sensitive assets and liabilities do not, by their nature, move up or down            in tandem in response to changes in the overall rate environment. The Company's            profitability in the near term may be temporarily affected either positively by a            falling interest rate scenario or negatively by a period of rising rates.

 

The following table shows the estimated cumulative impact on net            interest income (NII) for the next 12 months as of December 31, 2007, subject to the            specified interest rate changes. For purposes of this schedule the Company used a            parallel rate shock on its interest earning assets and interest bearing liabilities. A            parallel rate shock means that a 100 basis point increase in the rate index (prime            rate) would result in an immediate 100 basis point increase on interest earning assets            and interest bearing liabilities subject to the interest rate reset date. The Company            uses a 50 basis point slope for its computation. The slope is the number of basis            points per month that an index can increase or decrease until it reaches the target            rate.

 

| Rate change increment | % change in NII | $ change in NII |
|-----------------------|-----------------|-----------------|
|                  |            |            |
| Up 100 basis points   | -4.03%          | -877,000        |
| Up 200 basis points   | -7.31%          | -1,593,000      |
| Down 100 basis points | 3.83%           | 835,000         |
| Down 200 basis points | 4.98%           | 1,086,000       |

 

 

The above schedule assumes that 100% of the Company’s interest            bearing checking accounts and 100% of its statement savings accounts would re-price            according to the above increments. The above schedule also assumes an approximate            growth in assets of 5% over the next 12 months.

             

36

 

----

**Item 8. Financial Statements and Supplementary            Data**

 

The following financial statements are incorporated by reference from            the Annual Report to Shareholders for the fiscal year ended December 31,            2007:

 

| **•** | Report of Independent Registered Public Accounting Firm                            on the Financial Statements per the annual report |
|------------|--------------------------------------------------------------------------------------------------------------------------------------|

| **•** | Consolidated Balance Sheets as of December 31, 2007 and                            2006; |
|------------|------------------------------------------------------------------------------------------|

| **•** | Consolidated Statements of Income for each of the years                            in the two year period ended December 31, 2007; |
|------------|------------------------------------------------------------------------------------------------------------------------------------|

| **•** | Consolidated Statements of Stockholders’ Equity                            for each of the years in the two year period ended December 31,                            2007; |
|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

| **•** | Consolidated Statements of Cash Flows for each of the                            years in the two year period ended December 31, 2007; and |
|------------|--------------------------------------------------------------------------------------------------------------------------------------------|

| **•** | Notes to Consolidated Financial Statements for December                            31, 2007 |
|------------|---------------------------------------------------------------------------------------------|

 

**Item 9. Changes in and Disagreements with Accountants on            Accounting and Financial Disclosure**

 

|   | None. |
|--------|-------|

 

 

**Item 9A. Controls and Procedures**

             

On an on-going basis, senior management monitors and reviews the            internal controls established for the various operating activities of the Bank.            Additionally, the Company has created a Disclosure Review Committee to review not only            internal controls but the information used by Company’s financial officers to            prepare the Company’s periodic SEC filings and corresponding financial            statements. The Committee is comprised of the Senior Management Team of the Bank and            meets at least quarterly. Internal audits conducted by the Company’s internal            audit department are also reviewed by senior officers to assist them in assessing the            adequacy of the Company’s internal control structure. These audits are also            discussed in detail with the Company’s Audit Committee.

             

We have carried out an evaluation, under the supervision and the            participation of our management, including our Executive Vice President and Chief            Executive Officer, our Executive Vice President and Chief Operations Officer, our Chief            Financial Officer and our Vice President of Accounting, of the effectiveness of the            design and operation of our disclosure controls and procedures (as defined in Rule            13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the            “Act”), as of the end of the fiscal year covered by this report. Based upon            that evaluation, our CEO, COO, CFO and VP Accounting concluded that our disclosure            controls and procedures are effective in providing reasonable assurance that (a) the            information required to be disclosed by us in the reports that we file or submit under            the Act is recorded, processed, summarized and reported within the time periods            specified in the Securities and Exchange Commission’s rules and forms, and (b)            such information is accumulated and communicated to our management, including our CEO,            COO, CFO and VP Accounting, as appropriate to allow timely decisions regarding required            disclosure.

             

Because of the inherent limitations in all control systems, no            evaluation of controls can provide absolute assurance that our disclosure controls and            procedures will detect or uncover every situation involving the failure of persons            within Highlands Bankshares, Inc. to disclose material information otherwise required            to be set forth in our periodic reports.

             

37

 

----

There were not any changes in the Company’s internal controls over            financial reporting during the fourth fiscal quarter of the fiscal year covered by this            report that have materially affected, or are reasonably likely to materially affect,            our internal control over financial reporting.

 

This annual report does not include an attestation report of the            Company’s registered public accounting firm regarding internal control over            financial reporting. Management’s report was not subject to attestation by the            company’s registered public accounting firm pursuant to temporary rules of the            Securities and Exchange Commission that permit the company to provide only            management’s report in this annual report. 

 

**Item 9B. Other Information**

 

|   | None |
|--------|------|

 

 

**Part III.**

 

**Item 10. Directors, Executive Officers and Corporate            Governance**

 

Pursuant to General Instruction G(3) of Form 10-K, the information            contained under the headings “The Nominees,” “Executive Officers Who            Are Not Directors,” “Section 16(a) Beneficial Ownership Reporting            Compliance,” “The Board of Directors and its Committees” and            “Code of Ethics” in the Company’s Proxy Statement for the 2008 Annual            Meeting of Shareholders is incorporated herein by reference.

 

**Item 11. Executive Compensation**

 

Pursuant to General Instruction G(3) of Form 10-K, the information            contained under the headings “Executive Compensation in the Company’s Proxy            Statement for the 2008 Annual Meeting of Shareholders is incorporated herein by            reference.

 

**Item 12. Security Ownership of Certain Beneficial Owners and            Management and Related Stockholder Matters**

 

Pursuant to General Instruction G(3) of Form 10-K, the information            contained under the heading “Security Ownership of Management and Certain            Beneficial Owners” in the Company’s Proxy Statement for the 2008 Annual            Meeting of Shareholders is incorporated herein by reference.

 

The following table sets forth information as of December 31, 2007, with            respect to compensation plans under which shares of Common Stock are authorized for            issuance.

 

38

 

----

**Equity Compensation Plan Information**

 

|  

                             

                             

**Plan Category** |  

Number of Securities to Be Issued upon Exercise of                            Outstanding Options, Warrants and Rights |  

Weighted Average

Exercise Price of Outstanding Options, Warrants and                            Rights | Number of Securities Remaining Available

for Future Issuance

Under Equity

Compensation Plans (a) |
|---------------------------------------------------------------------------------------------------|--------------------------------------------------------------------------------------------------------------------------------|-----------------------------------------------------------------------------------------------------------------|-----------------------------------------------------------------------------------------------------|
|                                                                                              |                                                                                                                           |                                                                                                            |                                                                                                |
| Equity Compensation Plans Approved by                            Shareholders                     |  

314,321                                                                                                                |  

$ 12.86                                                                                                 |  

--                                                                                          |
|                                                                                              |                                                                                                                           |                                                                                                            |                                                                                                |
| Equity Compensation Plans Not Approved by Shareholders                            (b)             |  

                                                                                                                  |  

$ -                                                                                                     |  

200,000                                                                                     |
|                                                                                              |                                                                                                                           |                                                                                                            |                                                                                                |
| Total                                                                                             | 314,321                                                                                                                        | $ 12.86                                                                                                         | 200,000                                                                                             |

              

| (a) | Amounts exclude any securities to be issued upon                            exercise of outstanding options, warrants and rights. |
|-----|-----------------------------------------------------------------------------------------------------------------------------------|

| (b) | On September 13, 2006, the Board of Directors of the                            Company approved the Highlands Bankshares, Inc. 2006 Equity                            Compensation Plan (the Plan). The Plan authorizes the Personnel and                            Compensation Committee (the Committee) of the Board of Directors to                            grant options, stock appreciation rights, stock awards and stock units                            to directors, officers, key employees, consultants and advisors to the                            Company and its subsidiaries who are designated by the Committee. The                            Company is authorized to issue under the Plan up to 200,000 shares of                            its Common Stock. Generally, if an award is forfeited, expires or                            terminates, the shares allocated to that award under the Plan may be                            reallocated to new awards under the Plan. Shares surrendered pursuant                            to the exercise of a stock option or other award or in satisfaction of                            tax withholding requirements under the Plan may also be reallocated to                            other awards. |
|-----|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

 

**Item 13. Certain Relationships and Related Transactions, and            Director Independence**

 

Pursuant to General Instruction G(3) of Form 10-K, the information            contained under the heading “Transactions with Related Parties” and            “The Board of Directors and its Committees” in the Company’s Proxy            Statement for the 2008 Annual Meeting of Shareholders is incorporated herein by            reference.

 

**Item 14. Principal Accounting Fees and Services**

             

Pursuant to General Instruction G(3) of Form 10-K, the information            contained under the headings “Services and Fees” and “Pre-Approved            Policies and Procedures” in the Company’s Proxy Statement for the 2008            Annual Meeting of Shareholders is incorporated herein by reference.

 

 

39

 

----

**Part IV.**

 

**Item 15. Exhibits, Financial Statement            Schedules**

 

|   | (a) (1) | The response to this portion of Item 15 is submitted as                            a separate section of this report. |
|--------|---------|-----------------------------------------------------------------------------------------------------------------------|

 

|   | (2) | All applicable financial statement schedules required by                            Regulation S-X are included in the Notes to the 2007 Consolidated                            Financial Statements. |
|--------|-----|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

             

|   | (3) | Exhibits: |
|--------|-----|-----------|

             

| 3.1    | Articles of Incorporation of Highlands Bankshares, Inc.                            (as restated in electronic format only as of July 27, 2005), filed as                            Exhibit 3.1 to the Current Report on Form 8-K, File No. 000-27622,                            filed with the Commission on August 2, 2005, incorporated herein by                            reference. |
|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |                                                                                                                                                                                                                                                                                                                                                                                        |
| 3.2    | Bylaws of Highlands Bankshares, Inc. attached as Exhibit                            3.2 to the Registration Statement on Form 8-A, File No. 000-27622,                            filed with the Commission on January 24, 1996, incorporated herein by                            reference.                                                                                               |
|   |                                                                                                                                                                                                                                                                                                                                                                                        |
| 10.1   | Highlands Union Bank 1995 Stock Option Plan, attached as                            Exhibit 10.1 to the Annual Report on Form 10-K for the fiscal year                            ended December 31, 2002, File No. 000-27622, incorporated herein by                            reference.                                                                                                 |
|   |                                                                                                                                                                                                                                                                                                                                                                                        |
| 10.2   | Highlands Bankshares, Inc. 2006 Equity Compensation                            Plan, filed as Exhibit 3.1 to the Current Report on Form 8-K, File No.                            000-27622, filed with the Commission on September 20, 2006,                            incorporated herein by reference.                                                                                   |
|   |                                                                                                                                                                                                                                                                                                                                                                                        |
| 11     | Statement regarding computation of per share earnings                            (included as Note 1 of the Notes to Consolidated Financial Statements                            in the 2007 Annual Report to Shareholders and incorporated herein by                            reference).                                                                                               |
|   |                                                                                                                                                                                                                                                                                                                                                                                        |
| 13.1   | Annual Report to Shareholders – Financial                            Statements                                                                                                                                                                                                                                                                                                       |
|   |                                                                                                                                                                                                                                                                                                                                                                                        |
| 21     | Subsidiaries of the Corporation.                                                                                                                                                                                                                                                                                                                                                            |
|   |                                                                                                                                                                                                                                                                                                                                                                                        |
| 23.1   | Consent of Brown, Edwards & Company,                            L.L.P.                                                                                                                                                                                                                                                                                                                  |
|   |                                                                                                                                                                                                                                                                                                                                                                                        |
| 31.1   | Section 302 Certification of Chief Executive                            Officer.                                                                                                                                                                                                                                                                                                            |
|   |                                                                                                                                                                                                                                                                                                                                                                                        |
| 31.2   | Section 302 Certification of Chief Operations                            Officer.                                                                                                                                                                                                                                                                                                           |
|   |                                                                                                                                                                                                                                                                                                                                                                                        |
| 31.3   | Section 302 Certification of Chief Financial Officer of                            the Corporation.                                                                                                                                                                                                                                                                                         |
|   |                                                                                                                                                                                                                                                                                                                                                                                        |
| 31.4   | Section 302 Certification of Chief Financial Officer of                            the Bank.                                                                                                                                                                                                                                                                                                |
|   |                                                                                                                                                                                                                                                                                                                                                                                        |
| 32.1   | Statement of Chief Executive Officer Pursuant to 18                            U.S.C. § 1350.                                                                                                                                                                                                                                                                                          |
|   |                                                                                                                                                                                                                                                                                                                                                                                        |
| 32.2   | Statement of Chief Operations Officer Pursuant to 18                            U.S.C. § 1350.                                                                                                                                                                                                                                                                                         |
|   |                                                                                                                                                                                                                                                                                                                                                                                        |

 

 

40

 

----

 

| 32.3   | Statement of Chief Financial Officer of the Corporation                            Pursuant to 18 U.S.C. § 1350. |
|--------|-----------------------------------------------------------------------------------------------------------------------|
|   |                                                                                                                  |
| 32.4   | Statement of Chief Financial Officer of the Bank                            Pursuant to 18 U.S.C. § 1350.        |

             

|   | (b) | Exhibits. |
|--------|-----|-----------|

 

The response to this portion of Item 15 as listed in Item 15(a)(3) above            is submitted as a separate section of this report.

 

|   | (c) | Financial Statement Schedules. |
|--------|-----|--------------------------------|

 

The response to this portion of Item 15 is submitted as a separate            section of this report.

             

41

 

----

SIGNATURES

 

Pursuant to the requirements of Section 13 or 15(d) 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.

 

| Date: April 1, 2008 | BY:/s/ Samuel L.                            Neese |
|---------------------|---------------------------------------------------|

Samuel L. Neese

Executive Vice President and

Chief Executive Officer

 

Pursuant to the requirements of the Securities Exchange Act of 1934,            this report has been signed below by the following persons on behalf of the registrant            and in the capacities and on the dates indicated on April 1, 2008.

 

 

| Signature

                             

                                                                          | Title                                                                                                               | Date          |
|-------------------------------------------------------------------------------------------------------------------------------|---------------------------------------------------------------------------------------------------------------------|---------------|
| /s/ James D. Morefield                                                                                                        | Chairman of the Board, and Director                                                                                 | April 1, 2008 |
| James D. Morefield                                                                                                            |  

                             

                                                                   |          |
| /s/ Dr. James D. Moore, Jr.                                                                                                   | President                                                                                                           | April 1, 2008 |
| Dr. James D. Moore, Jr.

                                                                                                |                                                                                                                |          |
| /s/ J. Carter Lambert                                                                                                         | Vice Chairman                                                                                                       | April 1, 2008 |
| J. Carter Lambert

                                                                                                      |                                                                                                                |          |
| /s/ Samuel L. Neese                                                                                                           | Executive Vice President, and Chief                                                                                 | April 1, 2008 |
| Samuel L. Neese

                                                                                                        | Executive Officer (principal executive                            officer)

                                   |          |
| /s/ James T. Riffe                                                                                                            | Executive Vice President and                                                                                        | April 1, 2008 |
| James T. Riffe                                                                                                                | Cashier (principal financial and accounting                            officer)

                              |          |
| /s/ William E. Chaffin                                                                                                        | Director                                                                                                            | April 1, 2008 |
| William E. Chaffin

                             

                                                                 |  

                                                                                                       |          |
| /s/ E. Craig Kendrick                                                                                                         | Director                                                                                                            | April 1, 2008 |
| E. Craig Kendrick

                             

                             

                              |                                                                                                                |          |

 

 

42

 

----

 

| /s/ Clydes B. Kiser                                                                              | Director                                                                       | April 1, 2008 |
|--------------------------------------------------------------------------------------------------|--------------------------------------------------------------------------------|---------------|
| Clydes B. Kiser

                             

                                       |  

                             

                              |          |
| /s/ Charles P. Olinger                                                                           | Director                                                                       | April 1, 2008 |
| Charles P. Olinger

                             

                                    |  

                             

                              |          |
| /s/ William J. Singleton                                                                         | Director                                                                       | April 1, 2008 |
| William J. Singleton

                             

                                  |  

                             

                              |          |
| /s/ Dr. H. Ramsey White, Jr.                                                                     | Director                                                                       | April 1, 2008 |
| Dr. H. Ramsey White, Jr.

                             

                              |  

                             

                              |          |

 

43

----

**EXHIBIT INDEX**

 

| Exhibit No | Description |
|------------|-------------|
|       |        |   |
| 3.1        |        | Articles of Incorporation of Highlands Bankshares, Inc.                            (as restated in electronic format only as of July 27, 2005), filed as                            Exhibit 3.1 to the Current Report on Form 8-K, File No. 000-27622,                            filed with the Commission on August 2, 2005, incorporated herein by                            reference. |
|       |        |   |
| 3.2        |        | Bylaws of Highlands Bankshares, Inc. attached as Exhibit                            3.2 to the Registration Statement on Form 8-A, File No. 000-27622,                            filed with the Commission on January 24, 1996, incorporated herein by                            reference. |
|       |        |   |
| 10.1       |        | Highlands Union Bank 1995 Stock Option Plan, attached as                            Exhibit 10.1 to the Annual Report on Form 10-K for the fiscal year                            ended December 31, 2002, File No. 000-27622, incorporated herein by                            reference. |
|       |        |   |
| 10.2       |        | Highlands Bankshares, Inc. 2006 Equity Compensation                            Plan, filed as Exhibit 3.1 to the Current Report on Form 8-K, File No.                            000-27622, filed with the Commission on September 20, 2006,                            incorporated herein by reference. |
|       |        |   |
| 11         |        | Statement regarding computation of per share earnings                            (included as Note 1 of the Notes to Consolidated Financial Statements                            in the 2007 Annual Report to Shareholders and incorporated herein by                            reference). |
|       |        |   |
| 13.1       |        | Annual Report to Shareholders – Financial                            Statements |
|       |        |   |
| 21         |        | Subsidiaries of the Corporation. |
|       |        |   |
| 23.1       |        | Consent of Brown, Edwards & Company,                            L.L.P. |
|       |        |   |
| 31.1       |        | Section 302 Certification of Chief Executive                            Officer. |
|       |        |   |
| 31.2       |        | Section 302 Certification of Chief Operations                            Officer. |
|       |        |   |
| 31.3       |        | Section 302 Certification of Chief Financial Officer of                            the Corporation. |
|       |        |   |
| 31.4       |        | Section 302 Certification of Chief Financial Officer of                            the Bank. |
|       |        |   |
| 32.1       |        | Statement of Chief Executive Officer Pursuant to 18                            U.S.C. § 1350. |
|       |        |   |
| 32.2       |        | Statement of Chief Operations Officer Pursuant to 18                            U.S.C. § 1350. |
|       |        |   |
| 32.3       |        | Statement of Chief Financial Officer of the Corporation                            Pursuant to 18 U.S.C. § 1350. |
|       |        |   |
| 32.4       |        | Statement of Chief Financial Officer of the Bank                            Pursuant to 18 U.S.C. § 1350. |

 

 

3