**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

Washington, D.C. 20549

 

**FORM 10-K**

 

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

**of the Securities Exchange Act of 1934**

 

For the fiscal year ended December 31, 2008

 

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. Yeso  No x

 

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

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes            xNo o

 

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

 

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

 

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. $64,917,492.

 

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 11, 2009, there were 5,001,136 shares of Common Stock outstanding. 

 

**DOCUMENTS INCORPORATED BY REFERENCE**

|   | Annual Financial Statements – Part II |
|--------|---------------------------------------------|

Proxy Statement for the 2009 Annual Meeting of Shareholders—Part III

 

 

 

----

 

|         | **Table of Contents**                                                                                              |            |
|--------------|--------------------------------------------------------------------------------------------------------------------|-----------------|
|         |                                                                                                               | **Page Number** |
| **Part I**   |                                                                                                               |            |
|         |                                                                                                               |            |
| Item 1.      | Business                                                                                                           | 2               |
| Item 1A.     | Risk Factors                                                                                                       | 16              |
| Item 1B.     | Unresolved Staff Comments                                                                                          | 19              |
| Item 2.      | Properties                                                                                                         | 19              |
| Item 3.      | Legal Proceedings                                                                                                  | 19              |
| Item 4.      | Submission of Matters to a Vote of Security Holders                                                                | 20              |
|         |                                                                                                               |            |
|         |                                                                                                               |            |
| **Part II**  |                                                                                                               |            |
|         |                                                                                                               |            |
| Item 5.      | Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities | 20              |
| Item 6.      | Selected Financial Data                                                                                            | 21              |
| Item 7.      | Management’s Discussion and Analysis of Financial Condition

and Results of Operations                       | 21              |
| Item 7A.     | Quantitative and Qualitative Disclosures About Market Risk                                                         | 41              |
| Item 8.      | Financial Statements and Supplementary Data                                                                        | 43              |
| Item 9       | Changes in and Disagreements with Accountants on

Accounting and Financial Disclosure                              | 43              |
| Item 9A(T).  | Controls and Procedures                                                                                            | 43              |
| Item 9B.     | Other Information                                                                                                  | 44              |
|         |                                                                                                               |            |
|         |                                                                                                               |            |
| **Part III** |                                                                                                               |            |
|         |                                                                                                               |            |
| Item 10.     | Directors, Executive Officers and Corporate Governance                                                             | 44              |
| Item 11.     | Executive Compensation                                                                                             | 44              |
| Item 12.     | Security Ownership of Certain Beneficial Owners and

Management and Related Stockholder Matters                    | 44              |
| Item 13.     | Certain Relationships and Related Transactions, and Director Independence                                          | 45              |
| Item 14.     | Principal Accounting Fees and Services                                                                             | 45              |
|         |                                                                                                               |            |
|         |                                                                                                               |            |
| **Part IV**  |                                                                                                               |            |
|         |                                                                                                               |            |
| Item 15.     | Exhibits, Financial Statement Schedules                                                                            | 46              |
|         |                                                                                                               |            |
|         |                                                                                                               |            |

 

 

 

 

 

----

 

**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, 2008: 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. 

*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, 2008, 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, 2008.

*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 offer third –party mutual funds and other financial services to its            customers in all market areas served. During 2004, changes to the NASD rules required financial services to be operated underneath the bank structure once again. The only activity in 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 

 

2

 

 

----

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. During 2007, Bankers Investments was acquired by Infinex, LLC, a full service provider of a wide array of investment sevices. Infinex, LLC is owned by member banks and banking associations. 

**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 recorded as 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 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. During the current economic crisis, the Company has seen a decline in the area of construction lending.

*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. 

 

3

 

 

----

*Participation 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, one industry 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 two fiscal years ended December 31, 2008 and 2007, 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, 2008 | Interest and Fees on Loans | 86.76%                       |
| December 31, 2007 | Interest and Fees on Loans | 73.03%                       |

 

**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                                          |
| **•** |    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. 

4

----

 

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 as of 2007. The educational ,            health and social services sector provides the most jobs and contributes 17.80% of the total city/county employment. The latest unemployment figures as of December 2008 reflect an unemployment rate of 8.3% and 6.9% for the Bristol, Virginia and Washington County, Virginia respectively.

 

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 6.8% reported as of December 2008. In Smyth County, manufacturing is the largest employment industry and makes up 33.3% of all jobs throughout the County,            totaling 4,958 individuals. The educational, health and social services sector accounts for 18.5% of the total jobs, totaling 2,756 individuals.

 

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 5.8% as of December 2008. 

 

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 7.6% as of December 2008. 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 53.9% percent of all jobs throughout the County.

 

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 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 8.5% as of December 2008. The total population has increased sharply, since its 2000 population of 71,709. 

 

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. The latest            unemployment figures reflect an unemployment rate of 5.7% as of December 2008. Knox County had a population that was estimated at 411,967 for the year 2007 and Knoxville had an estimated population of 187,337 for the year 2007. 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 42,700 as of December 2007. Watauga County’s three largest employment sectors are private industry, education services and retail trade. The latest unemployment figures reflect an unemployment rate of 5.7% as of            December 2008. 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 four years.

 

 

5

 

 

----

 

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 17,674 as of December 2007. In Avery County, education, health and social services, retail trade, and the accommodation and food services sectors are the largest industries, in terms of total number of jobs in 2007. The            latest unemployment figures reflect an unemployment rate of 7.6% as of December 2008.

 

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 25,499 as of December 2007. 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 10.1% as of December 2008.

 

**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 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 at            www.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.

 

6

 

 

----

*Highlands Bankshares, Inc.*

 

The Company is a bank holding company within the meaning of the Bank Holding Company Act of 1956 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 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.

 

7

 

 

----

 

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

 

*Troubled Asset Relief and Temporary Liquidity Guarantee Programs.*On October 3, 2008, President Bush signed into law the Emergency Economic Stabilization Act of 2008 (the “EESA”). The legislation was the result of a proposal by Treasury Secretary Henry Paulson to the U.S. Congress in response to the financial crises affecting the banking system            and financial markets and threats to investment banks and other financial institutions. Pursuant to the EESA, the U.S. Treasury will have the authority to among other things, purchase up to $700 billion of mortgages, mortgage-backed securities and certain other financial instruments from financial institutions for the purpose of stabilizing and providing liquidity to the U.S. financial markets. On October 14, 2008 the U.S. Department of Treasury announced a program under the EESA            pursuant to which it would make senior preferred stock investments in participating financial institutions (the “TARP Capital Purchase Program”). On October 14, 2008, the Federal Deposit Insurance Corporation announced the development of a guarantee program under the systemic risk exception to the Federal Deposit Act (“FDA”) pursuant to which the FDIC would offer a guarantee of certain financial institution indebtedness in exchange for an insurance premium to            be 

 

8

 

 

----

paid to the FDIC by issuing financial institutions (the “FDIC Temporary Liquidity Guarantee Program”).

 

Under the TARP Capital Purchase Program, the Treasury will make $250 billion of capital available to U.S. financial institutions in the form of preferred stock (from the $700 billion authorized by the EESA). In conjunction with the purchase of preferred stock, the Treasury will receive warrants to purchase common stock with an aggregate market price equal to 15% of the preferred            investment. Participating financial institutions will be required to adopt the Treasury’s standards for executive compensation and corporate governance for the period during which the Treasury holds equity issued under the Capital Purchase Program. Secretary Paulson also announced that nine large financial institutions agreed to participate in the Capital Purchase Program. The standards include a prohibition against incentives to take unnecessary and excessive risks, recovery            of bonuses paid to senior executives based on materially inaccurate earnings or other statements and a prohibition against agreements for the payment of golden parachutes. Institutions that sell more than $300 million in assets under TARP auctions or participate in the Capital Purchase Program will not be entitled to a tax deduction for compensation in excess of $500,000 paid to its chief executive or chief financial official or any of its other three most highly compensated            officers. In addition, any severance paid to such officers for involuntary termination or termination in connection with a bankruptcy or receivership will be subject to the golden parachute rules under the Internal Revenue Code. Additional standards with respect to executive compensation and corporate governance for institutions that have participated or will participate in the Capital Purchase Program were enacted as part of ARRA.

 

The ARRA was enacted on February 17, 2009. The ARRA includes a wide variety of programs intended to stimulate the economy and provide for extensive infrastructure, energy, health, and education needs. In addition, the ARRA imposes certain new executive compensation and corporate governance obligations on all current and future TARP Capital Purchase Program recipients, including the            Company, until the institution has redeemed the preferred stock, which TARP Capital Purchase Program recipients are now permitted to do under the ARRA without regard to the three year holding period and without the need to raise new capital, subject to approval of its primary federal regulator. The executive compensation restrictions under the ARRA (described below) are more stringent than those currently in effect under the TARP Capital Purchase Program, but it is yet unclear how            these executive compensation standards will relate to the similar standards recently announced by the Treasury, or whether the standards will be considered effective immediately or only after implementing regulations are issued by the Treasury. 

 

The ARRA amends Section 111 of the EESA to require the Secretary of the Treasury (the “Secretary”) to adopt additional standards with respect to executive compensation and corporate governance for TARP Capital Purchase Program recipients. The standards required to be established by the Secretary include, in part, (1) prohibitions on making golden parachute payments to            senior executive officers and the next five most highly-compensated employees during such time as any obligation arising from financial assistance provided under the TARP Capital Purchase Program remains outstanding (the “Restricted Period”), (2) prohibitions on paying or accruing bonuses or other incentive awards for certain senior executive officers and employees, except for awards of long-term restricted stock with a value equal to no greater than 1/3 of the subject            employee’s annual compensation that do not fully vest during the Restricted Period or unless such compensation is pursuant to a valid written employment contract prior to February 11, 2009, (3) requirements that TARP Capital Purchase Program participants provide for the recovery of any bonus or incentive compensation paid to senior executive officers and the next 20 most highly-compensated employees based on statements of earnings, revenues, gains or other criteria later found            to be materially inaccurate, and (4) a review by the Secretary of all 

 

9

 

----

bonuses and other compensation paid by TARP Capital Purchase Program participants to senior executive employees and the next 20 most highly-compensated employees before the date of enactment of the ARRA to determine whether such payments were inconsistent with the purposes of the Act with the Secretary having authority to negotiate for reimbursement. 

 

The ARRA also sets forth additional corporate governance obligations for TARP Capital Purchase Program recipients, including requirements for the Secretary to establish standards that provide for semi-annual meetings of compensation committees of the board of directors to discuss and evaluate employee compensation plans in light of an assessment of any risk posed from such            compensation plans. TARP Capital Purchase Program recipients are further required by the ARRA to have in place company-wide policies regarding excessive or luxury expenditures, permit non-binding shareholder “say-on-pay” proposals to be included in proxy materials, as well as require written certifications by the chief executive officer and chief financial officer with respect to compliance. The Secretary is required to promulgate regulations to implement the executive            compensation and certain corporate governance provisions detailed in the ARRA. 

 

There can be no assurance, however, as to the actual impact that the EESA, ARRA and their implementing regulations, the FDIC programs, or any other governmental program will have on the financial markets. The failure to the EESA, ARRA, the FDIC, or the U.S. government to stabilize the financial markets and a continuation or worsening of current financial market conditions could            materially and adversely affect our business, financial condition, results of operations, access to credit or the trading price of our common stock. Additionally, if EESA fails to bring stability to the financial markets, additional burdensome regulation may be enacted.

 

In December of 2008, the Company applied for and received preliminary approval to issue up to $14.4 million of preferred stock to the U. S. Treasury. During the first quarter of 2009, the Company began the process of requesting shareholder approval to amend its Articles of Incorporation to issued preferred shares. The Company’s Board of Directors and management are currently            reviewing the merits of the program.

 

The Company and Bank also elected to participate in the Temporary Liquidity Guarantee Program. As of December 31, 2008, neither entity however, had any senior unsecured debt. The second aspect of the program is related to all non-interest bearing transaction accounts and all deposit transaction accounts with a interest rate up to .50% are fully insured. Beginning in December of 2008,            the Bank began taking full advantage of this additional insurance.

 

*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 $250,000 per depositor, subject to aggregation rules through December 31, 2009). 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 paid on deposits, interest rates or fees            chargeed 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            

 

10

 

 

----

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 or 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 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 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) bolstered 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 

 

11

 

 

----

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, 2008 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 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. |
|--------|----|----------------------------------------------------------------------------------------------------------------------|

 

12

 

 

----

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.

 

*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. 

 

13

 

 

----

During 2008, the FDIC increased the “base” amount of FDIC insurance from $100,000 to $250,000. This additional coverage is extended until December 31, 2009. The FDIC has also issued revisions to its premium scale which will approximately double the amount of FDIC premium that the Bank is currently paying. The new FDIC rates are effective in 2009. Currrently the Bank is            categorized in the highest or most beneficial classification in terms of deposit insurance premiums. On February 27th, 2009, the FDIC also approved a special assessment to all banks payable on September 30th, 2009 to replenish the fund to an acceptable level during this time of economic crisis and numerous bank failures. It is estimated that this special assessment will be approximately $500 thousand dollars.

 

*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.

 

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 

 

14

 

 

----

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.

 

**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, 2008, the Company had no employees, except 

 

15

 

 

----

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, 2008, the Bank employed 249 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 at www.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**

 

*The current economic environment poses significant challenges for the Company and could adversely affect its financial condition and results of operations.*

 

The Company is operating in a challenging and uncertain economic environment, including generally uncertain national and local conditions. Financial institutions continue to be affected by sharp declines in the real estate market and constrained financial markets. Dramatic declines in the housing market over the past year, with falling home prices and increasing foreclosures and            unemployment, have resulted in significant write-downs of asset values by financial institutions. Continued declines in real estate values, home sales volumes, and financial stress on borrowers as a result of the uncertain economic environment could have an adverse effect on the Company’s borrowers or their customers, which could adversely affect the Company’s financial condition and results of operations. A worsening of these conditions would likely exacerbate the            adverse effects on the Company and others in the financial institutions industry. For example, further deterioration in local economic conditions in the Company’s markets could drive losses beyond that which is provided for in its allowance for loan losses. The Company may also face the following risks in connection with these events: 

 

 

| •  | Economic conditions that negatively affect housing prices and the job market have resulted, and may continue to result, in a deterioration in credit quality of the Company’s loan portfolios, and such deterioration in credit quality has had, and could continue to have, a negative impact on the Company’s business. |
|--------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|         |                                                                                                                                                                                                                                                                                                                                  |
| •  | Market developments may affect consumer confidence levels and may cause adverse changes in payment patterns, causing increases in delinquencies and default rates on loans and other credit facilities.                                                                                                                               |
|         |                                                                                                                                                                                                                                                                                                                                  |
| •  | The processes the Company uses to estimate allowance for loan losses and reserves may no longer be reliable because they rely on complex judgments, including forecasts of economic conditions, which may no longer be capable of accurate estimation.                                                                                |

 

 

16

 

 

----

 

|         |                                                                                                                                                                                                                           |
|--------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| •  | The Company’s ability to assess the creditworthiness of its customers may be impaired if the models and approaches it uses to select, manage, and underwrite its customers become less predictive of future charge-offs. |
|         |                                                                                                                                                                                                                           |
| •  | The Company expects to face increased regulation of its industry, and compliance with such regulation may increase our costs, limit our ability to pursue business opportunities, and increase compliance challenges.          |

 

As these conditions or similar ones continue to exist or worsen, the Company could experience continuing or increased adverse effects on its financial condition. 

 

*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 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

 

 

17

 

 

----

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.

 

*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.

 

*Uncertainty in the financial markets could adversely affect our investment portfolio values.*

 

The upheaval in the financial markets over the past year has adversely impacted investor demand for all classes of securities and has resulted in volatility in the fair values of our investment securities. Significant prolonged reduction in investor demand could result in lower fair values for these securities and may

 

18

 

----

result in recognition of an other-than-temporary impairment charge, which would have a direct adverse impact on results of operations.

 

**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; two 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 and leases office space in West Jefferson,            North Carolina for a loan production office.

 

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

 

19

 

 

----

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

 

None.

**Part II**

 

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

 

**Common Stock Information and Dividends**

 

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 2008 and 2007.

 

| Common Stock Performance – December 31, 2008 |
|----------------------------------------------------|
|                                               |   |   |   |   |
|                                               | High | Low | Quarterly Average | Dividends per Share |
|                                               |   |   |   |   |
| First Quarter                                      | $17.00 | $14.25 | $16.94 | $ - |
|                                               |   |   |   |   |
| Second Quarter                                     | $18.00 | $13.20 | $16.77 | $ 0.22 |
|                                               |   |   |   |   |
| Third Quarter                                      | $17.00 | $ 8.50 | $15.79 | $ - |
|                                               |   |   |   |   |
| Fourth Quarter                                     | $17.00 | $ 8.16 | $10.79 | $ - |
|                                               |   |   |   |   |
| 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 | $ - |

 

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. The Board will be further considering the current economic downturn and its effect on the earnings stream of the Company. 

 

20

 

 

----

 

As of March 11, 2009, the Company had approximately 1,472 shareholders of record.

 

**Issuer Repurchases of Equity Securities**

 

The Company had no repurchases of common stock during the three months ended December 31, 2008. The Company does not anticipate any significant repurchases during 2009 in an effort to retain regulatory capital during the economic downturn.

 

The Company currently has 5,001,136 shares of common stock outstanding.

 

**Item 6. Selected Financial Data**

 

|   | Not Applicable |
|--------|----------------|

 

 

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

 

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:

 

|   | **•** | Difficult market conditions in our industry; |
|--------|------------|----------------------------------------------|

|   | **•** | Unprecedented levels of market volatility; |
|--------|------------|--------------------------------------------|

|   | **•** | Effects of soundness of other financial institutions; |
|--------|------------|-------------------------------------------------------|

|   | **•** | Uncertain outcome of recently enacted legislation to stabilize the U.S. financial system; |
|--------|------------|-------------------------------------------------------------------------------------------|

|   | **•** | Potential impact on us of recently enacted legislation; |
|--------|------------|---------------------------------------------------------|

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

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

|   | **•** | Unemployment continuing to rise; |
|--------|------------|----------------------------------|

|   | **•** | 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; |
|--------|------------|---------------------------------------------------------------------------------|

|   | **•** | The ability to attract and maintain capital levels adequate to support the Company’s growth; |
|--------|------------|----------------------------------------------------------------------------------------------------|

 

21

 

 

----

|   | **•** | 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; |
|--------|------------|-----------------------------------------------------------------------------------------|

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

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

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

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

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

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

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

 

**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 Insurance Services, Inc. (HUIS), which was formed in 1999, and Highlands Union Financial Services, Inc. (HUFS),            which was formed in 2001. 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". 

 

At December 31, 2008, the Bank had total assets of $667.43 million. Total deposits at this date were $523.25 million. The Bank’s net income for 2008 was $620 thousand which produced a return on average assets of 0.09% and a return on average stockholders' equity of 1.44%. Refer to Note 21 of the Notes to Consolidated Financial Statements for the Bank’s risk-based            capital ratios.

 

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.

 

22

 

 

----

**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.

 

**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, 2008 and 2007:

 

 

|                     | 12/31/08                             | 12/31/07                                          |
|--------------------------|--------------------------------------|---------------------------------------------------|
|                     |                                 |                                              |
| Return on Average Assets |       0.02% |          0.76% |
| Return on Average Equity |       0.27% |        10.61%       |
| Basic Earnings Per Share | $ 0.02                               | $   0.95                                |

 

23

 

 

----

 

| Fully Diluted Earnings Per Share                                                                                                                                                    | $        0.02                                     | $    0.94                    |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------------------------------------------------------------------------------------|--------------------------------------------------|
| Dividend Payout Ratio                                                                                                                                                               |           960.00%                       |        21.06% |
| Average Equity to Average   

  Assets                                                                                                                               |               6.30% |        7.13%       |
| Net Interest Margin (1)                                                                                                                                                             |               3.41% |        3.43%       |
|                                                                                                                                                                                     |                                                                                      |                                                  |
| (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, 2008 and 2007:

 

(dollar amounts in thousands)

 

|       | 12/31/08 | 12/31/07 |
|------------|----------|----------|
|       |     |     |
| Securities | $106,647 | $131,132 |
| Loans, net | $485,254 | $446,661 |
| Deposits   | $522,736 | $512,747 |
| Assets     | $668,996 | $660,794 |

 

 

**Asset Quality**

 

The following table shows the Company’s key asset quality indicators for the years ended December 31, 2008 and 2007:

 

(dollar amounts in thousands)

 

|                        | 12/31/08                                             | 12/31/07                          |
|-----------------------------|------------------------------------------------------|-----------------------------------|
|                        |                                                 |                              |
| Non- accrual loans          | $    6,278                            | $ 7,849                           |
| Loans past due over 90 days |          656 |      268 |
| Other real estate owned     |      3,792                       |     617            |

 

 

24

 

 

----

 

| Allowance for loan losses to total loans | 1.05% | 1.03% |
|------------------------------------------|-------|-------|
| Net charge-off ratio                     | 0.21% | 0.14% |

 

 

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

 

**2008 Economic Environment**

 

                During 2008, macro-economic conditions negatively impacted liquidity and credit quality across the financial markets, especially in the consumer sector, as the U.S. economy experienced a recession. The National Bureau of Economic Research published a report in December indicating that the U.S. has been in a            recession since December 2007 as indicated most prominently, in their view, by the declining labor market since that time. Since December 2007, in addition to deterioration in the labor market, the recession has caused rising unemployment, volatile equity markets, and declining home values, all of which are weighing negatively on consumer sentiment as evidenced by weak spending throughout the year, especially during the fourth quarter. During the year, financial markets experienced            unprecedented events, and the market exhibited extreme volatility and evaporating liquidity as credit quality concerns, sharp fluctuations in commodity prices, volatility in rate indices such as Prime and LIBOR, and illiquidity persisted. Concerns regarding increased credit losses from the weakening economy negatively affected the capital and earnings levels of most financial institutions. In addition, certain financial institutions failed or merged with stronger institutions and            two government sponsored enterprises entered into conservatorship with the U.S. government. Liquidity in the debt markets was extremely low despite the Treasury and Federal Reserve efforts to inject capital and liquidity into financial institutions, and as a result, asset values continued to be under pressure. 

 

                  In October 2008, the United States government established the EESA in response to instability in the financial markets. The specific implications of the EESA include the authorization given to the Secretary of the Treasury to establish the Troubled Asset Relief Program to purchase troubled assets            from financial institutions. The definition of troubled assets is broad but includes residential and commercial mortgages, as well as mortgage-related securities originated on or before March 14, 2008, if the Secretary determines the purchase promotes financial market stability. To date, the Treasury has not purchased troubled assets under its authority to do so under the EESA. 

 

                Alternatively, the Treasury has focused on providing assistance through the associated TARP Capital Purchase Program, as described in “Certain Regulatory Considerations” in Item 1 to this report, and Targeted Investment Program by purchasing preferred equity interests in the country’s            largest financial institutions. As mentioned above, we are currently evaluating whether to participate in the TARP Capital Purchase Program.

 

The degree of government intervention through the purchase of direct investments in private and public companies is unprecedented. As a result, the complete effect and impact from these actions is uncertain. In addition, several federal, state, and local legislative proposals are pending that may affect our business. It is unclear whether these will be enacted, and if so, the            impact they will have on our industry. We remain active and vigilant in monitoring these 

 

25

 

 

----

developments and supporting the interests of our shareholders, while also supporting the broader economy.

 

**Results of Operations**

 

**Net Interest Income**

(dollar amounts in thousands)

 

2008 versus 2007

 

Net interest income for 2008 was $19,694 or an increase of $790 over 2007. During 2008 interest income decreased by $1,027. This was a result of both existing interest earning assets re-pricing at lower rates and new loans made and securities purchased at lower rates. Interest-bearing liabilities also re-priced downward, causing a decrease in interest expense of $1,818. During the            latter part of 2007, the Federal Reserve Board began lowering interest rates due to recessionary fears and the current weaknesses in the economy. The Fed continued to lower rates during 2008 with the Fed Funds target rate falling to historic lows due the credit crisis / recession. The net result of these changes was a slight decrease in the Company’s net interest margin to 3.41% in 2008 from 3.43% in 2007. 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 2008, the Company increased its net funding from the FHLB by $8,000. The Company’s new borrowings during 2008 had a weighted rate of 2.63%. The continued competition for deposits in the Company’s market areas has slowed deposit growth. The tax equivalent yield on earning assets for 2008 was 6.58%, decreasing 45 basis points during the year. During the same period, the yield on interest            bearing liabilities was 3.65%, which was a decrease of 51 basis points. During the year, the Company also joined a program to be able to bid on the State of Virginia’s general fund public deposits. During the year, the Company received $14.2 million of the State’s funds at a lower rate than local CD rates. During 2008, the Bank also became a member of the CDARS network, both to provide alternative funding and to provide its customers with full FDIC insurance by            “swapping” deposits with other FDIC insured banks”. See additional information on the CDARS network in the “Deposits” section below. The Bank continues 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.

 

26

 

 

----

|                                                                                                                                                                                                                                                             | Year Ended December 31,         |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|---------------------------------|
|                                                                                                                                                                                                                                                             | 2008                            | 2007 |
|                                                                                                                                                                                                                                                             | (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)                                                                                                                                                                                                                     |  

 

$  477,027 |  

 

$ 32,937 |  

 

6.90% |  

 

$   441,308 |  

 

$ 32,832 |  

 

7.44% |
| Securities (2)(3)                                                                                                                                                                                                                                                | 137,664                         | 6,296 |      5.60 | 148,500 | 7,175 |            5.89 |
| Federal funds sold                                                                                                                                                                                                                                               | 4,163                           | 85 |    2.04 | 6,521 | 338 |          5.18 |
|  

Total interest-earning

assets                                                                                                                                                                                                                           |  

 

$618,854        |  

 

$ 39,318 |  

 

6.58% |  

 

$  596,329 |  

 

$ 40,345 |  

 

7.03% |
|  

LIABILITIES                                                                                                                                                                                                                                              |                            |   |   |   |   |   |
| Interest bearing

liabilities:                                                                                                                                                                                                                                   |                            |   |   |   |   |   |
|  

Interest bearing deposits                                                                                                                                                                                                                                |  

$  430,347         |  

$ 14,823 |  

3.44% |  

$  426,116 |  

$ 16,886 |  

3.96% |
|  

Other interest bearing

liabilities                                                                                                                                                                                                                      |  

 

107,876         |  

 

4,800 |  

 

 4.45 |  

 

88,694 |  

 

4,555 |  

 

      5.14 |
|  

Total interest-bearing

liabilities                                                                                                                                                                                                                      |  

 

$  538,223 |  

 

$ 19,623 |  

 

3.65% |  

 

$  514,810 |  

 

$ 21,441 |  

 

4.16% |
|  

Net interest income                                                                                                                                                                                                                                      |  

                   |   |  |       $ 19,964 |  

  |  

  |  

$ 18,904 |  

  |
| Net margin on interest

earning assets on a

tax equivalent basis                                                                                                                                                                                                |  

                   |  

  |  

 

3.41% |  

  |  

  |  

 

3.43% |
|  

Average interest spread                                                                                                                                                                                                                                  |  

                   |  

  |  

2.93% |  

  |  

  |  

2.87% |
|                                                                                                                                                                                                                                                             |                            |   |   |   |   |   |
| (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. |

 

 

27

 

 

----

**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***

 

| Increase (Decrease) in                              | Increase (decrease) due to change in volume   | 2008 Compared to 2007

                    |  

 

Net increase 

(decrease)                 |
|-----------------------------------------------------|-----------------------------------------------|-------------------------------------------------|-----------------------------------------------------------|
| Increase (decrease) due to change in rate           |
|                                                | (Dollars in Thousands)                        |
|  

INTEREST INCOME

Securities                 |  

 

$    (607)     |  

 

$     (272) |  

 

$      (879)     |
| Federal funds sold                                  | (48)                                          | (205)                                           |   (253)                                         |
| Loans                                               | 2,466                                         | (2,361)                                         |   105                                                |
|  

Total Income Change                         |  

$   1,811                   |  

$  (2,838)                         |  

$  (1,027)                              |
|  

INTEREST EXPENSE

Savings and time deposits |  

 

$     146 |  

 

$   (2,209)           |  

 

$   (2,063)                     |
| Other interest-bearing

liabilities                 |  

 853                             |  

(608)                                   |  

 245                                         |
|  

Total Expense Change                        |  

$    999               |  

$  (2,817)                         |  

$   (1,818)                             |
|  

Increase (Decrease) in

Net Interest Income |  

 

$    812       |  

 

$     (21)  |  

 

$       791 |

 

**Non-interest Income**

(dollar amounts in thousands)

 

2008 versus 2007

 

Non-interest income for 2008 included an “other-than-temporary-impairment charge” in the amount of $5.99 million on our investment in preferred stock of the Federal Home Loan Mortgage Corporation (“Freddie Mac”) and the Federal National Mortgage Corporation (Fannie Mae”), both government sponsored enterprises (“GSE”). The decision to recognize the unrealized            mark-to-market loss on these securities as an “other-than-temporary impairment” (“OTTI”) is based on the significant decline in the market value of the securities caused by recent events. 

 

On September 7, 2008 the U.S. Treasury, the Federal Reserve and the Federal Housing Finance Agency (FHFA) announced that the FHFA was putting both Fannie Mae and Freddie Mac under conservatorship, eliminating dividend payments on Fannie Mae and Freddie Mac common and preferred stock for an unspecified amount of time and giving management control to their regulator, the FHFA. Due to these actions of            the United States government and the uncertainty surrounding the ongoing viability of these two Government Sponsored Enterprises, the Company determined that the OTTI charge was necessary under generally accepted accounting principles. This OTTI charge is a one time, non-cash impairment charge and was recorded during the third quarter of 2008. Prior to this charge, impairment was recorded as an unrealized mark-to-market 

 

28

 

 

----

loss on securities available-for-sale and reflected as a reduction to equity through other comprehensive income.

 

These agency preferred stocks were widely held by banks, both large and small, and by insurance companies. The company and the Bank have consistently reported their tier one leverage, tier one risk based, and total risk based regulatory capital ratios reflecting the market losses in these equity securities in compliance with regulatory standards. After considering the impact of this one time charge to            earnings, both the company and the bank remain “well capitalized” under regulatory guidelines. The non-cash impairment charge does not affect the Company’s cash flows.

 

Before the “OTTI” charge, the Company’s non-interest income increased by $20. Service charges on deposit accounts (primarily NSF fees) increased $45 as compared to 2007. The number of checks processed continues to decline as the number of electronic transactions increases. Debit card fee income increased by $114 over 2007 due to increases in visa check card interchange fees. The use            of debit cards continued to increase significantly over the prior period. The Company also introduced a rewards points program related to signature based debit card transactions during the latter part of 2008. This program is geared to increase the Company’s debit card fee income in future periods.

 

Financial Services income decreased by $107 during 2008 as the economy worsened and the stock market dramatically declined.

 

Earnings related to the Company’s holdings of Bank Owned Life Insurance totaled $499 in 2008 and $483 in 2007.

 

Net securities gains totaled $137 in 2008 compared to $80 in 2007.

 

**Non-interest Expense**

(dollar amounts in thousands)

 

2008 versus 2007

 

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 2008 was $18,177, an increase of $1,057 over 2007. The increase is primarily attributable to the continued growth of the Company that was achieved during 2008. Salaries and employee benefits increased            by 3.85% or $380 primarily due to the Company opening a new branch in Knoxville, TN during 2007 and opening a second branch in Servierville, TN in the fourth quarter of 2008. Expenditures related to these branch expansions also increased occupancy expense and furniture and fixtures expense over 2007. Recent technology enhancements, however, have allowed the bank to leverage its existing personnel base to help minimize overall increases in personnel costs.

 

29

 

 

----

**Income Taxes**

(dollar amounts in thousands)

 

2008 vs. 2007

 

Income tax expense for 2008 decreased $2,354 when compared to 2007 primarily due to the decrease in pretax income resulting from the Company’s other than temporary impairment charge occurring in the third quarter of 2008 relating to our investment in Fannie Mae and Freddie Mac preferred stock. The income tax “benefit” related to this OTTI charge was $2,036. As a            result of new legislation passed in 2008, losses on these securities can be counted as “ordinary” losses. Interest income from tax exempt municipal bonds and earnings related to the Company’s investment in BOLI are the primary elements of tax exempt income.

 

**Provision and Allowance for Loan Losses**

(dollar amounts in thousands)

 

2008 vs. 2007

 

The adequacy of the allowance for loan losses is based on management's judgment and analysis of current and historical loss experience, risk characteristics of the loan portfolio, concentrations of credit and asset quality, as well as other internal and external factors, such as general economic conditions. The internal credit review department performs pre-approval analyses of            large credits and also conducts credit review activities that provide management with an early warning of loan deterioration. The 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.

 

 

30

 

 

----

 

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

 

|                                                         | Years Ended December 31,

(Dollars in Thousands)

  |
|--------------------------------------------------------------|----------------------------------------------------------|
|                                                         | 2008                                                     | 2007 | 2006 | 2005 | 2004 |
| Allowance for loan losses at

beginning of year              |  

$   4,630                              |  

$  4,565 |  

$  4,359 |  

$     4,181 |  

$    4,274 |
|  

Loans charged off:                                   |                                                     |   |   |   |   |
| Commercial                                                   | 195                                                      | 47 | 206 | 131 | 219 |
| Real Estate – mortgage                                 | 283                                                      | 99 | 58 | 205 | 192 |
| Consumer                                                     | 607                                                      | 444 | 539 | 791 | 1,089 |
| Other                                                        | 231                                                      | 242 | 277 | 0 | 0 |
|  

Total                                                |  

$   1,316                              |  

$     832 |  

$  1,080 |  

$    1,127 |  

$   1,500 |
|  

Recoveries of loans previously

charged off:         |                                                     |   |   |   |   |
| Commercial                                                   | $       122                     | $       36 | $       14 | $        17 | $          2 |
| Real Estate – mortgage                                 | 1                                                        | 54 | 10 | 10 |  1 |
| Consumer                                                     | 144                                                      | 121 | 115 | 123 | 104 |
| Other                                                        | 0                                                        | 1 | 0 | 0 | 0 |
|  

Total                                                |  

$       267             |  

$      212 |  

$      139 |  

$      150 |  

$       107 |
|                                                         |                                                     |   |   |   |   |
| Net loans charged off                                        | $    1,049                                | $      620 | $      941 | $      977 | $    1,393 |
|                                                         |                                                     |   |   |   |   |
| Provision for loan losses                                    | 1,590                                                    | 685 | 1,147 | 1,155 | 1,300 |
|  

Allowance for loan losses end of year                |  

$    5,171                        |  

$    4,630 |  

$    4,565 |  

$    4,359 |  

$     4,181 |
|  

Average total loans (net of unearned income)         |  

$ 477,027                                        |  

$ 441,308 |  

$ 422,525 |  

$ 400,759 |  

$  385,434 |
|  

Total loans (net of unearned income) at year-end     |  

$ 490,425                                        |  

$ 451,291 |  

$ 437,599 |  

$ 411,633 |  

$  391,314 |
|  

Ratio of net charge-offs to average loans            |  

0.220%                                           |  

0.140% |  

0.223% |  

0.244% |  

0.361% |
|  

Ratio of provision for loan losses to average loans  |  

0.333%                                           |  

0.155% |  

0.271% |  

0.288% |  

0.337% |
|  

Ratio of provision for loan losses to net charge-off |  

151.573%                                         |  

110.484% |  

121.892% |  

118.219% |  

123.973% |
|  

Allowance for loan losses to year-end loans          |  

1.054%                                           |  

1.026% |  

1.043% |  

1.059% |  

1.068% |

 

**Non-performing loans**

(dollar amounts in thousands)

 

The loan portfolio of the Bank is reviewed regularly by senior officers to monitor loan performance. The frequency of the review is based on the 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 non-accrual. 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.

 

31

 

 

----

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.

 

 

|                                                                 | 2008                   | 2007    | 2006    | 2005    | 2004    |
|----------------------------------------------------------------------|------------------------|---------|---------|---------|---------|
|                                                                 | (Amounts in thousands) |
|                                                                 |                   |    |    |    |    |
| Non-performing loans                                                 | $ 6,934                | $ 8,117 | $ 3,400 | $ 4,201 | $ 4,653 |
|                                                                 |                   |    |    |    |    |
| Non-accrual loans                                                    | $ 6,278                | $ 7,849 | $ 2,696 | $ 2,920 | $ 3,902 |
|                                                                 |                   |    |    |    |    |
| Loans past-due 90 days 

  and more and still 

  accruing | $ 656                  | $ 268   | $ 704   | $ 1,281 | $ 661   |
|                                                                 |                   |    |    |    |    |
| Interest income lost on 

  non-accruing loans                  | $ 417                  | $ 333   | $ 234   | $ 227   | $ 237   |
|                                                                 |                   |    |    |    |    |
|                                                                 |                   |    |    |    |    |

 

 

The most significant single component of the Bank’s non-performing assets at December 31, 2008 and December 31, 2007 is related to one large commercial credit - approximately $4.2 million. The Company is currently acquiring the property through foreclosure and bankruptcy proceedings. Approximately $1.3 million of the balance was transferred to OREO in June of 2008. In the event the collateral            value is over-estimated or deteriorates management believes a sufficient amount of loan loss reserve has been allocated to the remainder of the loan to cover any potential future losses.

 

 

32

 

 

----

**Allocation of the allowance for loan losses**

 

|   | The following table provides an allocation of the allowance for loan losses at December 31, 2008, 2007, 2006, 2005 and 2004. |
|--------|------------------------------------------------------------------------------------------------------------------------------|

 

 

|                | December 31,

Percent of Loans on each Category

 

(Dollars in Thousands) |
|---------------------|---------------------------------------------------------------------------------|
|                | 2008                                                                            | 2007 | 2006 |
|                | 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  |  

$    262                                                 |  

               5.07% |  

       9.83% |  

$   1,005 |  

  21.71% |  

  9.46% |  

$   1,691 |  

   37.04% |  

        9.76% |
| Real Estate         | 3,401                                                                           |           65.78 |    82.79 |      2,187 | 47.22 |       81.94 |        593 | 12.99 |     80.77 |
| Consumer            | 455                                                                             |                8.79 | 6.35 |        589 | 12.72 | 7.42 |             768 | 16.82 |       8.14 |
| Other / Unallocated | 1,053                                                                           |              20.36 | 1.03 |    849 | 18.35 |    1.18 |  1,513 | 33.15 |   1.33 |
|  

Total       |  

$  5,171                                                           |  

         100.00% |  

    100.00% |  

$   4,630 |  

100.00% |  

100.00% |  

$   4,565 |  

 100.00% |  

100.00% |

 

 

|                |  

 

 

2005                   | 2004                           |
|---------------------|------------------------------------------------|--------------------------------|
|                | 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  |  

$  710                            |  

   16.29%    |  

    9.38% |  

     $      705 |  

     16.86% |  

       9.13% |
| Real Estate         |  1,255                                    | 28.79                          | 79.42 |           1,302 |    31.16 |    76.40 |
| Consumer            |     858                         | 19.68                          | 10.07 |              953 |    22.79 |    13.25 |
| Other / Unallocated | 1536                                           |      35.24 |     1.13 |  1,221 | 29.19 | 1.22 |
|  

Total       |  

      $ 4,359 |  

100.00%                |  

100.00% |  

$    4,181 |  

          100.00% |  

     100.00% |

 

 

33

 

 

----

**Financial Condition**

 

**Balance Sheet**

(dollar amounts in thousands)

 

Total assets for the Company increased by $8,202 or 1.24% in 2008. Average interest earning assets grew by $22,524 or 3.78% for the year. Average interest bearing liabilities increased by $23,413 or 4.55% in 2008. Asset growth was primarily attributable to increased market share in both North Carolina and Tennessee.

 

**Loans**

(dollar amounts in thousands)

 

Loans net of unearned income and deferred fees increased by $39,134 or 8.67% in 2008. 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 increased approximately $36,322, whereas loans secured by collateral other than real estate and unsecured loans increased approximately            $3,492. 

 

The Company’s portfolio of commercial, construction and land development loans has also experienced significant growth over the past few years. During 2008, this segment of loans grew $19,544 or 12.23%. 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.

 

During the year however, management made a concerted effort to curtail its lending on development lending and construction lending due to the current economic environment. As the sales of real estate has slowed significantly in the latter part of the year a diligent effort was made to concentrate on permanent financing for residential mortgages and owner occupied commercial real            estate loans. The Company has also implemented a separate credit analysis department to review the larger loan requests, typically loan requests in excess of $250,000. This department operates separately from the loan origination arm of the Company and completes independent and unbiased reviews of each new loan request. The senior officer of this committee meets monthly with the Loan Committee of the Board of Directors.

 

34

 

 

----

**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)

  |
|------------------------------------------------|----------------------------------------------|
|                                           | 2008                                         | 2007 | 2006 | 2005 | 2004 |
|                                           | Amount                                       | Percentage | Amount | Percentage | Amount | Percentage | Amount | Percentage | Amount | Percentage |
| Real Estate Secured:                           |                                         |   |   |   |   |   |   |   |   |   |
| Residential 1-4 family                         | $ 176,239                                    |    35.89% | $163,918 |      36.28% | $ 156,753 |   35.77% | $151,815 | 36.88% | $ 146,970 |     37.54% |
| Multi-family                                   | 13,114                                       | 2.67 | 9,420 |    2.08 | 10,520 |          2.40 | 4,148 | 1.01 | 3,379 |    0.86 |
| Commercial, Construction

and Land Development |  

179,339                              |         36.52 |  

159,795 |   35.35 |  

152,491 |        34.80 |  

140,178 |   34.05 |  

122,997 |    31.42 |
| Second Mortgages                               | 18,499                                       |          3.77 | 17,964 |     3.97 | 15,305 |          3.49 | 10,962 |    2.66 | 7,419 |     1.89 |
| Equity Line of Credit                          | 9,984                                        |          2.03 | 9,782 |     2.16 | 9,493 |          2.17 | 9,800 |     2.38 | 8,981 |     2.29 |
| Farmland                                       | 9,501                                        |     1.93 | 9,475 | 2.10 | 9,343 |     2.13 | 10,015 | 2.43 | 9,347 | 2.39 |
|                                           | $ 406,676                                    | 82.81% | $ 370,354 |    81.94% | $ 353,905 | 80.77% | $ 326,918 |     79.41% | $ 299,093 |    76.39% |
|  

Secured, Other:                        |                                         |   |   |   |   |   |   |   |   |   |
| Personal                                       | $ 21,854                                     |    4.45% | $ 24,741 |     5.47% | $ 27,384 |   6.25% | $ 33,395 |       8.11% | $ 44,222 |     11.30% |
| Commercial                                     | 32,725                                       | 6.66 | 26,433 |  5.85 | 26,943 | 6.15 | 25,628 |    6.23 | 24,992 |    6.38 |
| Agricultural                                   | 4,319                                        | 0.88 | 4,232 |  0.94 | 5,093 | 1.16 | 3,653 | .89 | 4,024 | 1.03 |
|                                           | $ 58,898                                     | 11.99% | $ 55,406 | 12.26% | $ 59,420 | 13.56% | $ 62,676 |    15.23% | $ 73,238 |     18.71% |
|                                           |                                         |   |   |   |   |   |   |   |   |   |
| Unsecured:                                     | $ 25,497                                     | 5.20% | $ 26,192 | 5.80% | $ 24,845 | 5.67% | $ 22,048 |    5.36% | $ 19,176 |    4.90% |
|                                           |                                         |   |   |   |   |   |   |   |   |   |
| Loans, gross                                   | $ 491,071                                    | 100.00% | $ 451,952 | 100.00% | $ 438,170 | 100.00% | $ 411,642 |     100.00% | $ 391,507 |     100.00% |
|                                           |                                         |   |   |   |   |   |   |   |   |   |

 

 

 

 

 

 

35

 

 

----

The following table shows the maturity of loans outstanding, inclusive of contractual amortization, at December 31, 2008:

 

|                                             | December 31, 2008

(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                           |  

$  11,090                    |  

$  5,204 |  

$  41,576 |  

$  6,960 |  

$  56,899 |  

$  54,510 | $  176,239 |
| Multi-family                                     | 6,464                                     | 49 | 2,854 | 235 | 1,889 | 1,623 | 13,114 |
| Commercial, Construction

& Land Development | 44,945                                    | 23,817 | 79,124 | 6,851 | 18,169 | 6,433 | 179,339 |
| Second Mortgages                                 | 2,405                                     | 1,049 | 5,688 | 119 | 8,507 | 731 | 18,499 |
| Equity Line of Credit                            | 0                                         | 799 | 0 | 3,604 | 0 | 5,581 | 9,984 |
| Farmland                                         | 1,464                                     | 2,146 | 5,264 | 34 | 434 | 159 | 9,501 |
| Secured, Other:                                  |                                      |   |   |   |   |   |   |
| Personal                                         | 9,387                                     | 4 | 12,000 | 4 | 415 | 44 | 21,854 |
| Commercial                                       | 10,289                                    | 6,723 | 14,978 | 80 | 655 | 0 | 32,725 |
| Agricultural                                     | 1,148                                     | 1,950 | 773 | 59 | 389 | 0 | 4,319 |
| Unsecured                                        | 9,252                                     | 9,572 | 1,995 | 1,442 | 3,236 | 0 | 25,497 |
|                                             |                                      |   |   |   |   |   |   |
| Loans, Gross                                     | $  96,444                            | $  51,313 | $  164,252 | $  19,388 | $  90,593 | $  69,081 | $  491,071 |
|                                             |                                      |   |   |   |   |   |   |

 

 

 

36

 

 

----

**Securities**

(dollar amounts in thousands)

 

2008 vs. 2007

 

Investment securities available for sale decreased $24,485 (market value) from December 31, 2007 to December 31, 2008 as a result of maturities and prepayments. The Company made fewer purchases during 2008 primarily due to the Company being able to lend out its excess funds during the year. The Company also made a concerted effort to keep its excess funds in overnight investment            due to the worsening credit crisis and the need for liquidity. Purchases during the year consisted primarily in fixed rate agency notes and fixed rate mortgage backed securities. 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.

 

During the third quarter of 2008 the Company made the decision to record a $5.99 million “other than temporary impairment” charge on its holdings of preferred stock of the Federal Home Loan Mortgage Corporation (“Freddie Mac”) and the Federal National Mortgage Corporation (Fannie Mae”), both government sponsored enterprises (“GSE”). The decision to recognize            the unrealized mark-to-market loss on these securities as an “other-than-temporary impairment (“OTTI”) was based on the significant decline in the market value of the securities caused by recent events.

 

Since the time we purchased these instruments (which occurred during 2001-2003), we have continued to monitor the market value of our ownership in these instruments. Even as late as July 2008, these instruments were rated as an investment grade security by the various credit rating agencies. On September 7, 2008 the U.S. Treasury, the Federal Reserve and the Federal Housing Finance Agency (FHFA)            announced that the FHFA was putting both Fannie Mae and Freddie Mac under conservatorship, eliminating dividend payments on Fannie Mae and Freddie Mac common and preferred stock for an unspecified amount of time and giving management control to their regulator, the FHFA. Due to the actions of the United States government and the uncertainty surrounding the ongoing viability of these two Government Sponsored Enterprises, the Company determined that the OTTI charge was necessary under            generally accepted accounting principles. This OTTI charge is a one time, non-cash impairment charge. Prior to this charge, impairment was recorded as an unrealized mark-to-market loss on securities available-for-sale and reflected as a reduction to equity through other comprehensive income.

 

These agency preferred stocks were widely held by banks, both large and small, and by insurance companies. The company and the bank have consistently reported their tier one leverage, tier one risk based, and total risk based regulatory capital ratios reflecting the market losses in these equity securities in compliance with regulatory standards. After considering the impact of this one time charge to            earnings, both the company and the bank remained “well capitalized” under regulatory guidelines. Being a one time, non-cash impairment charge, it does not affect the Company’s cash flows.

 

The Company also owns approximately $11.82 million (book value) in collateralized debt obligation securities that are backed by trust preferred securities issued by banks, thrifts, and insurance companies (TRUP CDOs). The market for these securities at December 31, 2008 is not active and markets for similar securities are also not active. The inactivity was evidenced first by a significant widening of            the bid-ask spread in the brokered markets in which TRUP CDOs trade and then by a significant decrease in the volume of trades relative to historical levels. The new issue market is also inactive as no new TRUP CDOs have been issued since 2007. There are currently very few market participants who are willing and or able to transact for these securities.

 

37

 

 

----

 

The market values for these securities (and any securities other than those issued or guaranteed by the US Treasury) are very depressed relative to historical levels. For example, the yield spreads for the broad market of investment grade and high yield corporate bonds reached all time wide levels versus Treasuries at the end of November and remain near those levels today. Thus in today’s            market, a low market price for a particular bond may only provide evidence of stress in the credit markets in general versus being an indicator of credit problems with a particular issuer. As of December 31, 2008, the unrealized loss in these securities totaled $8.538 million. Management feels that these losses are temporary and primarily a result of the current inactive market.The market discounts reflect the current illiquidity and the negative credit events            within the banking sector. Continuing deterioration of profits of banks nationally and the possibility of increased bank failures could result in changes in the Company’s outlook for these securities and cause the Company to consider recording an OTTI charge on these securities.

 

**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, 2008.

 

 

|   | (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           | $         - | $ 3,050 |      $   1,746 | $ 14,295 | 5.32% | $ 19,091 | $ 18,810 |
|   | Mtg.-backed Sec – variable rate            | - | - | 198 | 19,422 | 4.62 | 19,620 | 19,912 |
|   | State & Municipal’s – tax exempt | - | - | 872 | 48,415 | 6.05 | 49,289 | 50,820 |
|   | State & Municipal’s – taxable    | 706 | 318 | 204 | 475 | 4.84 | 1,703 | 1,716 |
|   | U.S. Agencies – fixed rate                 |   | - | - | 11,439 | 6.12 | 11,439 | 11,377 |
|   | Agency Preferred – variable rate           | - | - | - | 51 | 0.00 | 51 | 262 |
|   | Corporate bonds – fixed rate               | - | - | - | 1,121 | 6.87 | 1,121 | 1,434 |
|   | Corporate bonds – variable rate            | - | - | 266 | 3,825 | 4.41 | 4,091 | 12,318 |
|   | SBA bonds – variable rate                  | - | - | - | 53 | 2.47 | 53 | 54 |
|   | CMO’s – fixed rate                   | - | - | - | 177 | 4.93 | 177 | 176 |
|   | CMO’s – variable rate                | - | - | - | 12 | 3.93 | 12 | 12 |
|   |  

TOTAL                                    | 706 | $  3,368 | $   3,286 | $ 99,285 |   | $ 106,647 | $116,891 |
|   | Total fixed rate securities                      | $     706 | $  3,368 | $   2,822 | $ 75,922 |   | $  82,818 | $ 84,333 |
|   |  

Total variable rate securities           | $         - | $         - | $      464 | $ 23,363 |   | $  23,829 | $ 32,558 |
|        |                                                  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

 

**Deposits**

(dollar amounts in thousands)

 

2008 vs. 2007

 

Total deposits grew by $9,989 or 1.95% in 2008. Non-interest bearing demand deposits decreased by $3,817. Interest bearing demand deposits increased by $4,739. Total time deposits increased by $6,193. Savings accounts increased by $2.874 during the year. The increase in time deposits is primarily a result of customers placing their funds in FDIC accounts with the volatile stock            market and the deepening recession. The majority of the increase in time deposits was growth in shorter term CD’s due to the current interest rate environment. The Company and banks nationwide are continuing to face the 

 

38

 

 

----

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 2008, the Company increased its net borrowings from the FHLB by $8,000. The total amount of FHLB borrowings as of December 31, 2008 was $99,097. 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. During 2008, the Company also joined the “CDARS” network. This deposit placement service allows banks to swap funds with each other while still allowing their customers only one institution to deal with.            All of the funds placed in the CDARS network are fully insured by the FDIC. The Company also participates in the FDIC’s Temporary Liquidity Guarantee program that was implemented in the fourth quarter of 2008. Under this program, non-interest bearing transaction accounts and transaction accounts earning a rate of up to 0.50% are fully insured above and beyond the existing FDIC insurance coverage amount. 

 

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

 

|                                 | December 31,              |
|--------------------------------------|---------------------------|
|                                 | (Amounts in Thousands)    |
|                                 | 2008                      | 2007 |
|                                 |                      |   |
| Non-interest bearing demand deposits | $   80,169 | $   83,986 |
| Interest bearing demand deposits     | 66,023                    | 61,284 |
| Savings deposits                     | 49,805                    | 46,931 |
| Time deposits                        | 326,739                   | 320,546 |
|  

Total Deposits               |  

$ 522,736         |  

$ 512,747 |

 

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) |
|-----------------------------------------------|-------------------------------------------------|
|                                          | 2008                                            | 2007 |
|                                          |  

Amount                                  |   |  

Rate |  

Amount |   |  

Rate |
|  

Non-interest bearing

demand deposits |  

 

$  85,719                  |   |  

 

       0.00% |  

 

$  81,746 |   |  

 

    0.00% |
| Interest-bearing demand

deposits             |  

62,300                                  |   |  

   1.53 |  

59,468 |   |  

1.92 |
| Savings deposits                              | 50,389                                          |   |    0.98 | 50,497 |   | 1.25 |
| Time deposits                                 | 317,656                                         |   |    4.21 | 316,151 |   | 4.78 |
|  

Total                                 |  

$ 516,064                               |   |   |  

$ 507,862 |   |   |

 

 

 

 

 

 

39

 

 

----

The remaining maturities of time deposits greater than or equal to $100,000 at December 31, 2008 are as follows (Amount in thousands):

 

| **Maturity**                    | **Amount**                                                                                                                                                                                                                                                               |
|---------------------------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                                 |                                                                                                                                                                                                                                                                          |  |
| 3 months or less                |                                                                                                                                                                                                                                                                          | $     33,255 |
| Over 3 months through 6 months  |                                                                                                                                                                                                                                                                          |     22,352 |
| Over 6 months through 12 months |                                                                                                                                                                                                                                                                          |    27,864 |
| Over 12 months                  |                                              |           36,152 |
| Total                           |                                                                                                                                                                                                                                                                     |    $   119,623 |

 

 

**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. The Company has also implemented a contingency funding plan due to the current economic crisis as an additional measure of liquidity management. 

 

**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.

 

40

 

 

----

**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 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, 2008, 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.

 

41

 

 

----

|                                                                                                                                                       | December 31, 2008

(Dollars in Thousands)

Maturing / Re-pricing |
|------------------------------------------------------------------------------------------------------------------------------------------------------------|------------------------------------------------------------------|
|                                                                                                                                                       |  

Within One

Year                                         |  

After One But

Within Five Years |  

After Five

Years |  

 

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

Investment Securities                                                                                                                    |  

$ 39,808                                                 |  

$ 10,636 |  

$ 62,679 |  

$ 113,123 |
| Fed Funds Sold                                                                                                                                             | 3,736                                                            | - | - | 3,736 |
| Loans                                                                                                                                                      | 231,853                                                          | 216,443 | 42,130 | 490,426 |
| Non-interest bearing

Other Assets                                                                                                                         |  

-                                                        |  

- |  

61,711 |  

61,711 |
|                                                                                                                                                       |                                                             |   |   |   |
| Total Assets                                                                                                                                               | $ 275,397                                                        | $ 227,079 | $ 166,520 | $ 668,996 |
|                                                                                                                                                       |                                                             |   |   |   |
| LIABILITIES AND SHARE-

HOLDERS’ EQUITY                                                                                                              |                                                             |   |   |   |
| Interest-bearing                                                                                                                                           |                                                             |   |   |   |
| (1) All Interest- bearing Deposits                                                                                                                         | $ 338,517                                                        | $ 103,367 | $ 308 | $ 442,192 |
| Other Interest- bearing Liabilities                                                                                                                        | 75,545                                                           | 24,103 | 3,771 | 103,419 |
| Non-interest-bearing                                                                                                                                       |                                                             |   |   |   |
| Demand Deposits                                                                                                                                            | -                                                                | - | 80,543 | 80,543 |
| Other Liabilities                                                                                                                                          | -                                                                | - | 3,795 | 3,795 |
| Shareholders’ Equity                                                                                                                                 | -                                                                | - | 39,047 | 39,047 |
| Total Liabilities and Shareholders’ 

Equity                                                                                                         |  

$ 414,062                                                |  

$ 127,470 |  

$ 127,464 |  

$ 668,996 |
|                                                                                                                                                       |                                                             |   |   |   |
| Interest Rate Sensitivity GAP                                                                                                                              | $(138,665)                                                       | $ 99,609 | $ 39,056 | $ - |
|                                                                                                                                                       |                                                             |   |   |   |
| (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 (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.

 

42

 

 

----

The following table shows the estimated cumulative impact on net interest income (NII) for the next 12 months as of December 31, 2008, 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   | -2.79%          | -708,000        |
| Up 200 basis points   | -5.08%          | -1,287,000      |
| Down 100 basis points | 1.52%           | 385,000         |
| Down 200 basis points | 0.44%           | 113,000         |

 

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. The above changes are within the acceptable parameters established by management and approved by the            Board of Directors.

 

**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, 2008:

 

Report of Independent Registered Public Accounting Firm on the Financial Statements;

Consolidated Balance Sheets as of December 31, 2008 and 2007;

Consolidated Statements of Income for each of the years in the two year period ended December 31, 2008;

Consolidated Statements of Stockholders’ Equity for each of the years in the two year period ended December 31, 2008;

Consolidated Statements of Cash Flows for each of the years in the two year period ended December 31, 2008; and

Notes to Consolidated Financial Statements for December 31, 2008

 

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

 

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

 

**Item 9A(T). 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 

 

43

 

 

----

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, CFO and VP Accounting, as appropriate to allow timely decisions regarding required disclosure.

 

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.

 

**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 2009 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 2009 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 2009 Annual Meeting of Shareholders is incorporated herein by reference.

 

The following table sets forth information as of December 31, 2008, with respect to compensation plans under which shares of Common Stock are authorized for issuance.

 

44

 

 

----

**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         |  

 

                       280,585 |  

 

$ 13.28                                                                                                                                                                     |  

 

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

 

                     _______             |  

 

                  $        -    |  

 

200,000                                                                             |
|                                                       |                                                                                                                                                         |                                                                                                                                                                                        |                                                                                                |
| Total                                                      |                                                                                                                                                         |  280,585                                                                                                                                                                               |                                                                                                     |   | $13.28 |  |   | 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 2009 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 2009 Annual Meeting of Shareholders is incorporated herein by reference.

 

45

 

 

----

**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 2008 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 13 of the Notes to Consolidated Financial Statements in the 2008 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 Financial Officer of the Corporation |
|--------|------|-------------------------------------------------------------------------|

 

|   | 31.3 | Section 302 Certification of Vice President of Accounting |
|--------|------|-----------------------------------------------------------|

 

|   | 32.1 | Statement of Chief Executive Officer Pursuant to 18 U.S.C. § 1350. |
|--------|------|-------------------------------------------------------------------------|

 

|   | 32.2 | Statement of Chief Financial Officer of the Corporation Pursuant to 18 U.S.C. § 1350. |
|--------|------|--------------------------------------------------------------------------------------------|

 

|   | 32.3 | Statement of Vice President of Accounting Pursuant to 18 U.S.C. § 1350. |
|--------|------|------------------------------------------------------------------------------|

 

46

 

 

----

|   | (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.

 

 

47

 

 

----

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: March 27, 2009 |   | BY:    | /s/ Samuel L. Neese          |
|                 |   |   | Samuel L. Neese              |
|                 |   |   | Executive Vice President and |
|                 |   |   | Chief Executive Officer      |

 

| BY:    | /s/Robert M. Little, Jr.    | BY:    | /s/James R. Edmondson        |
|--------|-----------------------------|--------|------------------------------|
|   | Robert M. Little, Jr.       |   | James R. Edmondson           |
|   | Chief Financial Officer     |   | Vice President of Accounting |
|   | Principal Financial Officer |   | Principal Accounting 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 March 27, 2009.

 

 

| Signature

 

 

                           | Title                                                                                                       |               Date |
|------------------------------------------------------------|-------------------------------------------------------------------------------------------------------------|-------------------------------------------------------------------------------------|
| /s/ James D. Morefield 

James D. Morefield           | Chairman of the Board, and Director

 

 

                                                  | March 27, 2009                                                                      |
| /s/ Dr. James D. Moore, Jr. 

Dr. James D. Moore, Jr. | President

 

 

                                                                            | March 27, 2009                                                                      |
| /s/ J. Carter Lambert 

J. Carter Lambert

      | Vice Chairman

 

 

                                                                        | March 27, 2009                                                                      |
| /s/ Samuel L. Neese 

Samuel L. Neese

 

  | Executive Vice President, and Chief Executive Officer (principal executive officer)

 

 

  | March 27, 2009                                                                      |

 

 

48

 

 

----

 

| /s/ William E. Chaffin 

William E. Chaffin

 

              | Director

 

 

       | March 27, 2009 |
|------------------------------------------------------------------------------|---------------------------------------|----------------|
| /s/ E. Craig Kendrick 

E. Craig Kendrick

                        | Director 

                      | March 27, 2009 |
| _______________ 

Clydes B. Kiser

 

                        | Direc­tor

 

 

  |           |
| /s/ Charles P. Olinger 

Charles P. Olinger

 

              | Direc­tor

 

 

  | March 27, 2009 |
| /s/ William J. Singleton 

William J. Singleton

 

          | Direc­tor

 

 

  | March 27, 2009 |
| /s/ Dr. H. Ramsey White, Jr. 

Dr. H. Ramsey White, Jr.

 

  | Direc­tor

 

 

  | March 27, 2009 |
|                                                                         |                                  |           |

 

 

49

----

 

**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 2008 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 Financial Officer of the Corporation |
|--------|------|-------------------------------------------------------------------------|

 

|   | 31.3 | Section 302 Certification of Vice President of Accounting of the Bank. |
|--------|------|------------------------------------------------------------------------|

 

|   | 32.1 | Statement of Chief Executive Officer Pursuant to 18 U.S.C. § 1350. |
|--------|------|-------------------------------------------------------------------------|

 

|   | 32.2 | Statement of Chief Financial Officer of the Corporation Pursuant to 18 U.S.C. § 1350. |
|--------|------|--------------------------------------------------------------------------------------------|

 

|   | 32.3 | Statement of Vice President of Accounting Pursuant to 18 U.S.C. § 1350. |
|--------|------|------------------------------------------------------------------------------|

 

50