10-Q 1 f10q063012.htm f10q063012.htm


 
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C.  20549
FORM 10-Q

[X] Quarterly Report Pursuant to Section 13 or 15(d)
of the Securities Exchange Act of 1934

For the quarterly period ended June 30,  2012

[   ] Transition Report Pursuant to Section 13 or 15(d)
of the Securities Exchange Act of 1934

For the transition period from ____________ to _____________

Commission File Number:  0-27622

HIGHLANDS BANKSHARES, INC.
(Exact name of registrant as specified in its charter)


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

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

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

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

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  [  ]   Accelerated Filer  [  ]    Non-Accelerated Filer [  ]  Smaller Reporting Company  [X]
 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes [  ] No [X ]

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.
 
5,011,152 shares of common stock, par value $0.625 per share, outstanding as of August 14, 2012
 
 



 
1

 
Highlands Bankshares, Inc.

FORM 10-Q
For the Quarter Ended June 30, 2012

INDEX
   
PART I. FINANCIAL INFORMATION                                                                                                                      
PAGE
   
Item 1.  Financial Statements
 
   
Consolidated Balance Sheets
  at June 30, 2012 (Unaudited) and December 31, 2011
 
3
 
 
Consolidated Statements of Income (Unaudited)
  for the Three Months and Six Months Ended June 30, 2012 and 2011
4
   
 
Consolidated Statements of Comprehensive Income (Unaudited)
  for the Three Months and Six Months Ended June 30, 2012 and 2011
5
Consolidated Statements of Cash Flows (Unaudited)
  for the  Six Months Ended June 30, 2012 and 2011
6
   
Consolidated Statements of Changes in
  Stockholders’ Equity (Unaudited) for the Three Months and Six Months
  Ended June 30, 2012 and 2011
7
   
Notes to Consolidated Financial Statements (Unaudited)
8-38
   
Item 2. Management’s Discussion and Analysis of
              Financial Condition and Results of Operations
39-46
   
Item 3. Quantitative and Qualitative Disclosures About Market Risk
46
   
Item 4.  Controls and Procedures
46
 
 
PART II.  OTHER INFORMATION
 
   
Item 1.  Legal Proceedings
47
   
Item 1A. Risk Factors
47
   
Item 2.  Unregistered Sales of Equity Securities and Use of Proceeds
47
   
Item 3.  Defaults Upon Senior Securities
47
   
Item 4.  Mine Safety Disclosures
47
   
Item 5.  Other Information
47
   
Item 6.  Exhibits
48
   
SIGNATURES AND CERTIFICATIONS
48


 
2

 

PART I.
FINANCIAL INFORMATION
ITEM 1.  Financial Statements

Consolidated Balance Sheets
(Amounts in thousands)
   
(Unaudited)
 June 30, 2012
   
(Note 1)
December 31, 2011
 
                                              ASSETS
           
Cash and due from banks
  $ 19,580     $ 15,734  
Federal funds sold
    53,345       70,341  
                 
   Total Cash and Cash Equivalents
    72,925       86,075  
                 
Investment securities available for sale  (amortized cost $63,689 at  June 30, 2012, $67,372 at December 31, 2011)
    61,307       64,252  
Other investments, at cost
    5,015       5,308  
Loans, net of allowance for loan losses of $8,050 at June 30, 2012, $9,024 at December 31, 2011
    392,707       398,780  
Premises and equipment, net
    21,509       21,883  
Deferred tax assets
    8,364       8,615  
Interest receivable
    2,291       2,369  
Bank owned life Insurance
    13,458       13,230  
Other real estate owned, net
    17,688       16,724  
Other assets
    4,211       3,747  
                 
    Total Assets
  $ 599,475     $ 620,983  
                 
LIABILITIES AND STOCKHOLDERS’ EQUITY
               
                 
LIABILITIES
               
                 
Deposits:
               
  Non-interest bearing
  $ 102,495     $ 98,950  
  Interest bearing
    390,058       416,411  
                 
    Total Deposits
    492,553       515,361  
                 
Interest, taxes and other liabilities
    2,401       2,570  
Other short-term borrowings
    57,679       57,676  
Long-term debt
    13,875       13,964  
Capital securities
    3,150       3,150  
                 
    Total Other Liabilities
    77,105       77,360  
                 
    Total Liabilities
    569,658       592,721  
                 
STOCKHOLDERS’ EQUITY
               
                 
Common stock (5,011 shares issued and outstanding)
    3,132       3,132  
Additional paid-in capital
    7,783       7,783  
Retained earnings
    20,474       19,406  
Accumulated other comprehensive income (loss)
    (1,572 )     (2,059 )
                 
  Total Stockholders’ Equity
    29,817       28,262  
                 
    Total Liabilities and Stockholders’ Equity
  $ 599,475     $ 620,983  
                 
See accompanying Notes to Consolidated Financial Statements

 
3

 

Consolidated Statements of Income
(Amounts in thousands, except per share data)
(Unaudited)
   
Six Months Ended June 30, 2012
   
Six Months Ended June 30, 2011
   
Three Months
Ended June 30, 2012
   
Three Months
Ended June 30, 2011
 
INTEREST INCOME
                       
Loans receivable and fees on loans
  $ 11,984     $ 12,728     $ 6,054     $ 6,301  
Securities available for sale:
                               
  Taxable
    469       410       235       126  
  Exempt from taxable income
    377       656       177       431  
Other investment income
    44       35       23       18  
Federal funds sold
    76       73       34       37  
                                 
    Total Interest Income
    12,950       13,902       6,523       6,913  
                                 
INTEREST EXPENSE
                               
Deposits
    2,393       3,438       1,096       1,640  
Other borrowed funds
    1,705       1,765       860       858  
                                 
    Total Interest Expense
    4,098       5,203       1,956       2,498  
                                 
    Net Interest Income
    8,852       8,699       4,567       4,415  
                                 
Provision for Loan Losses
    621       3,789       116       186  
                                 
    Net Interest Income after Provision for Loan Losses
    8,231       4,910       4,451       4,229  
                                 
NON-INTEREST INCOME
                               
Securities gains, losses, net
    205       143       202       114  
Service charges on deposit accounts
    1,000       1,031       509       537  
Other service charges, commissions and fees
    975       895       471       499  
Other operating income
    410       345       182       179  
Other than temporary impairment
    (167 )     (269 )     --       (155 )
    Total Non-Interest Income
    2,423       2,145       1,364       1,174  
                                 
NON-INTEREST EXPENSE
                               
Salaries and employee benefits
    4,667       5,062       2,400       2,534  
Occupancy expense of bank premises
    596       520       319       260  
Furniture and equipment expense
    644       699       311       361  
Other operating expense
    2,803       2,863       1,540       1,526  
Foreclosed Assets – Loss on Sale / Write-down
    208       717       169       464  
Foreclosed Assets – Operating Expenses
    421       695       231       383  
    Total Non-Interest Expense
    9,339       10,556       4,970       5,528  
                                 
    Income (Loss) Before Income Taxes
    1,315       (3,501 )     845       (125 )
                                 
Income Tax Expense (Benefit)
    247       (1,400 )     191       (147 )
                                 
    Net Income (Loss)
  $ 1,068     $ (2,101 )   $ 654     $ 22  
                                 
Basic Earnings Per Common Share – Weighted Average
  $ 0.21     $ (0.42 )   $ 0.13     $ -  
                                 
Earnings Per Common Share – Assuming Dilution
  $ 0.21     $ (0.42 )   $ 0.13     $ -  

See accompanying Notes to Consolidated Financial Statements



 
4

 




Consolidated Statements of Comprehensive Income
(Amounts in thousands)
(Unaudited)

   
Six Months Ended  
June 30, 2012
   
Six Months Ended June 30, 2011
 
             
             
Net Income (Loss)
  $ 1,068     $ (2,101 )
                 
     Other Comprehensive Income
               
          Unrealized gains on securities during the period
    943       1,457  
  Less: reclassification adjustment for gains included in net income
    (205 )     (143 )
          Other Comprehensive Income, before tax
    738       1,314  
           Income tax expense related to other
           comprehensive income
    251       446  
    Other Comprehensive Income
    487       868  
Comprehensive Income (Loss)
  $ 1,555     $ (1,233 )
                 




   
Three Months Ended  
June 30, 2012
   
Three Months Ended June 30, 2011
 
             
             
Net Income (Loss)
  $ 654     $ 22  
                 
     Other Comprehensive Income
               
          Unrealized gains on securities during the period
    365       1,041  
  Less: reclassification adjustment for gains included in net income
    (202 )     (114 )
          Other Comprehensive Income, before tax
    163       927  
           Income tax expense related to other
           comprehensive income
    56       315  
    Other Comprehensive Income
    107       612  
Comprehensive Income (Loss)
  $ 761     $ 634  
                 

See accompanying Notes to Consolidated Financial Statements



 
5

 


Consolidated Statements of Cash Flows
(Amounts in thousands)
(Unaudited)
   
Six Months Ended
   
Six Months Ended
 
   
June 30, 2012
   
June 30, 2011
 
CASH FLOWS FROM OPERATING  ACTIVITIES:
           
Net income (loss)
  $ 1,068     $ (2,101 )
Adjustments to reconcile net income  (loss) to net cash provided by                 
operating activities
               
Provision for loan losses
    621       3,789  
Depreciation and amortization
    503       576  
Net realized (gains) losses on available for sale securities
    (205 )     (143 )
Net amortization on securities
    342       242  
             Other than temporary impairment charge
    167       269  
Amortization of Capital issue costs
    3       3  
            (Increase) decrease in interest receivable
    78       (151 )
Valuation adjustment of other real estate owned
    106       601  
Increase in other assets
    (695 )     (955 )
Decrease in interest, taxes and other liabilities
    (169 )     (400 )
                 
Net cash provided by operating activities
     1,819       1,730  
                 
CASH FLOWS FROM INVESTING ACTIVITIES:
               
Securities available for sale:
               
       Proceeds from sale of securities
    2,379       6,776  
Proceeds from maturities of debt and equity securities
    10,573       2,914  
Purchase of debt and equity securities
    (9,573 )     (19,175 )
Redemption of other investments
    293       352  
Net decrease in loans
    332       14,057  
Proceeds from sales of other real estate owned
    4,130       1,466  
Premises and equipment expenditures
    (209 )     -  
                 
Net cash provided by investing activities
    7,925       6,390  
                 
CASH FLOWS FROM FINANCING ACTIVITIES:
               
Net decrease in time deposits
    (35,467 )     (21,773 )
Net increase in demand, savings and other deposits
    12,659       11,901  
Increase (decrease) in short-term borrowings
    3       (8,282 )
Decrease in long-term debt
    (89 )     (910 )
                 
Net cash  used in financing activities
    (22,894 )     (19,064 )
                 
Net increase (decrease) in cash and cash equivalents
    (13,150 )     (10,944 )
CASH AND CASH EQUIVALENTS AT BEGINNING OF YEAR
    86,075       82,152  
                 
CASH AND CASH EQUIVALENTS AT END OF PERIOD
  $ 72,925     $ 71,208  
                 
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION
               
Cash paid during the year for:
               
Interest
  $ 3,921     $ 5,305  
                 
     SUPPLEMENTAL DISCLOSURE OF NONCASH TRANSACTIONS
               
Transfer of loans to other real estate owned
  $ 5,200     $ 3,670  

See accompanying Notes to Consolidated Financial Statements



 
6

 


Consolidated Statements of Changes in Stockholders’ Equity
(Amounts in thousands)
(Unaudited)
                           
Accumulated
       
               
Additional
         
Other
   
Total
 
   
Common Stock
   
Paid-in
   
Retained
   
Comprehensive
   
Stockholders’
 
   
Shares
   
Par Value
   
Capital
   
Earnings
   
Income
   
Equity
 
                                     
Balance, March 31, 2011
    5,011     $ 3,132     $ 7,783     $ 23,800     $ (3,702 )   $ 31,013  
                                                 
Net income / (loss)
    -       -       -       22       -       22  
                                                 
Other comprehensive income
    -       -       -       -       612       612  
                                                 
Balance, June 30, 2011
    5,011     $ 3,132     $ 7,783     $ 23,822     $ (3,090 )   $ 31,647  
                                                 
Balance, March 31, 2012
    5,011     $ 3,132     $ 7,783     $ 19,820     $ (1,679 )   $ 29,056  
                                                 
Net income / (loss)
    -       -       -       654       -       654  
                                                 
Other comprehensive income
    -       -       -       -       107       107  
                                                 
                                                 
Balance, June 30, 2012
    5,011     $ 3,132     $ 7,783     $ 20,474     $ (1,572 )   $ 29,817  
                                                 
                                                 


                           
Accumulated
       
               
Additional
         
Other
   
Total
 
   
Common Stock
   
Paid-in
   
Retained
   
Comprehensive
   
Stockholders’
 
   
Shares
   
Par Value
   
Capital
   
Earnings
   
Income
   
Equity
 
                                     
Balance, December 31, 2010
    5,011     $ 3,132     $ 7,783     $ 25,923     $ (3,958 )   $ 32,880  
                                                 
Net income / (loss)
    -       -       -       (2,101 )     -       (2,101 )
                                                 
Other comprehensive income
    -       -       -       -       868       868  
                                                 
Balance, June 30, 2011
    5,011     $ 3,132     $ 7,783     $ 23,822     $ (3,090 )   $ 31,647  
                                                 
Balance, December 31, 2011
    5,011     $ 3,132     $ 7,783     $ 19,406     $ (2,059 )   $ 28,262  
                                                 
Net income / (loss)
    -       -       -       1,068       -       1,068  
                                                 
Other comprehensive income
    -       -       -       -       487       487  
                                                 
                                                 
Balance, June 30, 2012
    5,011     $ 3,132     $ 7,783     $ 20,474     $ (,1572 )   $ 29,817  
                                                 
                                                 

See accompanying Notes to Consolidated Financial Statements

 
7

 


Notes to Consolidated Financial Statements
(Unaudited)
(in thousands, except share, per share and percentage data)

Note 1  -  General

The consolidated financial statements of Highlands Bankshares, Inc. (the “Company”) conform to United States generally accepted accounting principles and to banking industry practices. The accompanying consolidated interim financial statements are unaudited. In the opinion of management, all adjustments necessary for a fair presentation of the consolidated financial statements have been included. All such adjustments are of a normal and recurring nature. The consolidated balance sheet as of December 31, 2011 has been extracted from the audited financial statements included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2011 (the “2011 Form 10-K”). The notes included herein should be read in conjunction with the notes to consolidated financial statements included in the 2011 Form 10-K. The results of operations for the three-month and six-month periods ended June 30, 2012 are not necessarily indicative of the results to be expected for the full year.

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

Note 2  -  Loans and Allowance for Loan Losses  (amounts in thousands)
 The composition of net loans is as follows:

   
June 30,
2012
   
December 31,
2011
 
Real Estate Secured:
           
Residential 1-4 family
  $ 170,287     $ 169,027  
Multifamily
    16,675       15,375  
Construction and Land Loans
    19,968       23,295  
Commercial, Owner Occupied
    66,695       71,367  
Commercial, Non-owner occupied
    36,875       36,489  
Second mortgages
    10,533       12,247  
Equity lines of credit
    8,498       9,126  
Farmland
    11,763       12,207  
      341,294       349,133  
                 
Secured (other) and unsecured
               
Personal
    22,933       23,824  
Commercial
    33,308       32,407  
Agricultural
    3,587       2,784  
      59,828       59,015  
                 
Overdrafts
    179       207  
                 
      401,301       408,355  
Less:
               
  Allowance for loan losses
    8,050       9,024  
  Net deferred fees
    544       551  
      8,594       9,575  
                 
Loans, net
  $ 392,707     $ 398,780  


 
8

 


Notes to Consolidated Financial Statements
(Unaudited)
(in thousands, except share, per share and percentage data)

The following table is an analysis of past due loans as of June 30, 2012:

   
30-59 Days Past Due
   
60-89 Days Past Due
   
Greater Than 90 Days
   
Total Past Due
   
Current
   
Total Financing Receivables
   
Recorded Investment > 90 Days and Accruing
 
                                           
Real Estate Secured
                                         
Residential 1-4 family
  $ 2,561     $ 906     $ 3,953     $ 7,420     $ 162,867     $ 170,287     $ -  
Equity lines of credit
    23       88       193       304       8,194       8,498       193  
Multifamily
    -       -       -       -       16,675       16,675       -  
Farmland
    -       131       -       131       11,632       11,763       -  
Construction, Land Development, Other Land Loans
    466       112       379       957       19,011       19,968       -  
Commercial Real Estate- Owner Occupied
    1,516       291       2,591       4,398       62,297       66,695       -  
Commercial Real Estate- Non Owner Occupied
    14       -       290       304       36,571       36,875       -  
Second Mortgages
    114       74       66       254       10,279       10,533       -  
Non Real Estate Secured
                                                       
Personal
    231       66       46       343       22,769       23,112       1  
Business
    291       117       782       1,190       32,118       33,308       -  
Agricultural
    5       -       4       9       3,578       3,587       -  
                                                         
          Total
  $ 5,221     $ 1,785     $ 8,304     $ 15,310     $ 385,991     $ 401,301     $ 194  
                                                         

The following table is an analysis of past due loans as of  December 31, 2011:

   
30-59 Days Past Due
   
60-89 Days Past Due
   
Greater Than 90 Days
   
Total Past Due
   
Current
   
Total Financing Receivables
   
Recorded Investment > 90 Days and Accruing
 
                                           
Real Estate Secured
                                         
Residential 1-4 family
  $ 3,471     $ 1,071     $ 4,236     $ 8,778     $ 160,249     $ 169,027     $ 171  
Equity lines of credit
    -       205       -       205       8,921       9,126       -  
Multifamily
    97       -       646       743       14,632       15,375       -  
Farmland
    -       134       -       134       12,073       12,207       -  
Construction,  Land Development, Other Land Loans
    271       59       1,846       2,176       21,119       23,295       -  
Commercial Real Estate- Owner Occupied
    1,199       476       6,989       8,664       62,703       71,367       920  
Commercial Real Estate- Non Owner Occupied
    -       1,446       863       2,309       34,180       36,489       292  
Second Mortgages
    243       10       518       771       11,476       12,247       26  
Non Real Estate Secured
                                                       
Personal
    244       113       134       491       23,540       24,031       41  
Commercial
    224       25       630       879       31,528       32,407       -  
Agricultural
    17       7       2       26       2,758       2,784       -  
                                                         
          Total
  $ 5,766     $ 3,546     $ 15,864     $ 25,176     $ 383,179     $ 408,355     $ 1,450  
                                                         


 
9

 


Notes to Consolidated Financial Statements
(Unaudited)
(in thousands, except share, per share and percentage data)

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

The following is a summary of non-accrual loans at June 30, 2012 and December 31, 2011:


   
June 30,
2012
   
December 31, 2011
 
Real Estate Secured
           
Residential 1-4 Family
  $ 3,953     $ 4,065  
Multifamily
    -       646  
Construction and Land Loans
    379       1,846  
Commercial-Owner Occupied
    2,591       6,069  
Commercial- Non Owner Occupied
    290       4,871  
Second Mortgages
    66       492  
Equity Lines of Credit
    -       -  
Farmland
    -       630  
Secured (other) and Unsecured
               
Personal
    45       94  
Commercial
    782       630  
Agricultural
    4       2  
                 
Total
  $ 8,110     $ 19,345  


The December 31, 2011 total includes approximately $4.9 million of loans that were current and paying under the terms of their existing loan agreement but included in non-accrual per regulatory guidance.

 
10

 



Notes to Consolidated Financial Statements
(Unaudited)
(in thousands, except share, per share and percentage data)

The following tables represent a summary of credit quality indicators of the Company’s loan portfolio at June 30, 2012 and December 31, 2011. The grades are assigned and / or modified by the Company’s credit review and credit analysis departments based on the creditworthiness of the borrower and the overall strength of the loan.

Credit Risk Profile by Internally Assigned Grade as of June 30, 2012

Grade (1)
 
Residential 1-4 Family
   
Multifamily
   
Farmland
   
Construction, Land Loans
   
Commercial Real Estate- Owner Occupied
   
Commercial Real Estate Non-Owner Occupied
 
                                     
Quality
    35,705       1,588       1,052       4,029       5,646       1,272  
Satisfactory
    81.228       11,050       3,631       6,107       25,616       14,962  
Acceptable
    33,907       2,722       6,557       6,188       20,426       8,676  
Special Mention
    3,843       -       11       3,326       3,293       1,710  
Substandard
    15,604       1,315       512       318       11,714       10,255  
Doubtful
    -       -       -       -       -       -  
                                                 
     Total
  $ 170,287     $ 16,675     $ 11,763     $ 19,968     $ 66,695     $ 36,875  

Credit Risk Profile by Internally Assigned Grade as of December 31, 2011
Grade (1)
 
Residential 1-4 Family
   
Multifamily
   
Farmland
   
Construction, Land Loans
   
Commercial Real Estate- Owner Occupied
   
Commercial Real Estate Non-Owner Occupied
 
                                     
Quality
    37,509       1,220       1,104       4,108       6,119       1,604  
Satisfactory
    79,225       9,790       3,419       6,026       23,168       14,756  
Acceptable
    33,427       1,481       3,944       5,940       25,652       9,270  
Special Mention
    3,739       1,318       1,767       2,195       4,073       1,518  
Substandard
    15,127       1,566       1,973       5,026       12,355       9,341  
Doubtful
    -       -       -       -       -       -  
                                                 
     Total
  $ 169,027     $ 15,375     $ 12,207     $ 23,295     $ 71,367     $ 36,489  

 
(1)  Quality--This grade is reserved for the Bank’s top quality loans. These loans have excellent sources of repayment, with no significant identifiable risk of collection.  Generally, loans assigned this rating will demonstrate the following characteristics:
 
 
·  
Conformity in all respects with Bank policy, guidelines, underwriting standards, and Federal and State regulations (no exceptions of any kind).
 
 
·  
Documented historical cash flow that meets or exceeds required minimum Bank guidelines, or that can be supplemented with verifiable cash flow from other sources.
 
 
·  
Adequate secondary sources to liquidate the debt, including combinations of liquidity, liquidation of collateral, or liquidation value to the net worth of the borrower or guarantor.
 
 
For existing loans, all of the requirements above apply plus all payments have been made as agreed, current financial information on all borrowers and guarantors has been obtained and analyzed, and overall business operating trends are either stable or improving.
 
 
Satisfactory-This grade is given to performing loans. These loans have adequate sources of repayment, with little identifiable risk of collection. Loans assigned this rating will demonstrate the following characteristics:
 
 
·  
General conformity to the Bank's policy requirements, product guidelines and underwriting standards.  Any exceptions that are identified during the underwriting and approval process have been adequately mitigated by other factors.
 
 
 
11

 

 
Notes to Consolidated Financial Statements
(Unaudited)
(in thousands, except share, per share and percentage data)
 
 
·  
Documented historical cash flow that meets or exceeds required minimum Bank guidelines, or that can be supplemented with verifiable cash flow from other sources.  
 
 
·  
Adequate secondary sources to liquidate the debt, including combinations of liquidity, liquidation of collateral, or liquidation value to the net worth of the borrower or guarantor
 
 
For existing loans, all of the requirements outlined above will apply, plus all payments have been made as agreed, current financial information on all borrowers and guarantors has been obtained and analyzed, and overall business operating trends are stable with any declines considered minor and temporary.
 
 
Acceptable-This grade is given to loans that show signs of weakness in either adequate sources of repayment or collateral, but have demonstrated mitigating factors that minimize the risk of delinquency or loss.  Loans assigned this rating may demonstrate some or all of the following characteristics:
 
 
·  
Additional exceptions to the Bank's policy requirements, product guidelines or underwriting standards that present a higher degree of risk to the Bank.  Although the combination and/or severity of identified exceptions is greater, all exceptions have been properly mitigated by other factors.
 
 
·  
Unproved, insufficient or marginal primary sources of repayment that appear sufficient to service the debt at this time.  Repayment weaknesses may be due to minor operational issues, financial trends, or reliance on projected (not historical) performance.
 
 
·  
Marginal or unproven secondary sources to liquidate the debt, including combinations of liquidation of collateral and liquidation value to the net worth of the borrower or guarantor.
 
 
For existing loans, payments have generally been made as agreed with only minor and isolated delinquencies.
 
 
Special Mention -This grade is given to Watch List loans that include the following characteristics:
 
 
·  
Loans with underwriting guideline tolerances and/or exceptions with no identifiable mitigating factors.
 
 
·  
Extending loans that are currently performing satisfactorily but with potential weaknesses that may, if not corrected, weaken the asset or inadequately protect the Bank's position at some future date. Potential weaknesses are the result of deviations from prudent lending practices.
 
 
·  
Loans where adverse economic conditions that develop subsequent to the loan origination do not jeopardize liquidation of the debt, but do substantially increase the level of risk may also warrant this rating.
 
 
  Substandard-Loans in this category are characterized by deterioration in quality exhibited by any number of well-defined weaknesses requiring corrective action. A substandard loan is inadequately protected by the current sound net worth and paying capacity of the obligor or of the collateral pledged, if any. Loans classified as substandard must have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt; they are characterized by the distinct possibility that the institution will sustain some loss if the deficiencies are not corrected.
 
 
The weaknesses may include, but are not limited to:
 
 
·  
High debt to worth ratios and or declining or negative earnings trends
 
 
·  
Declining or inadequate liquidity
 
 
·  
Improper loan structure  or questionable repayment sources
 
 
·  
Lack of well-defined secondary repayment source, and
 
 
·  
Unfavorable competitive comparisons.
 
 
 
12

 

Notes to Consolidated Financial Statements
(Unaudited)
(in thousands, except share, per share and percentage data)
 
Such loans are no longer considered to be adequately protected due to the borrower's declining net worth, lack of earnings capacity, declining collateral margins and/or unperfected collateral positions. A possibility of loss of a portion of the loan balance cannot be ruled out. The repayment ability of the borrower is marginal or weak and the loan may have exhibited excessive overdue status or extensions and/or renewals.
 
Doubtful -Loans classified Doubtful have all the weaknesses inherent in loans classified Substandard, plus the added characteristic that the weaknesses make collection or liquidation in full on the basis of currently existing facts, conditions, and values highly questionable and improbable. The ability of the borrower to service the debt is extremely weak, overdue status is constant, the debt has been placed on non-accrual status, and no definite repayment schedule exists.
 
However, these loans are not yet rated as loss because certain events may occur which would salvage the debt. Among these events are:
 
 
·  
Injection of capital
 
 
·  
Alternative financing
 
 
·  
Liquidation of assets or the pledging of additional collateral.
 
Credit Risk Profile based on payment activity as of June 30, 2012:
   
Consumer - Non Real Estate
   
Equity Line of Credit / Second Mortgages
   
Commercial - Non Real Estate
   
Agricultural - Non Real Estate
 
                         
Performing
  $ 23,066     $ 18,772     $ 32,526     $ 3,583  
Nonperforming (>90 days past due)
    46       259       782       4  
                                 
     Total
  $ 23,112     $ 19,031     $ 33,308     $ 3,587  
                                 

Credit Risk Profile based on payment activity as of December 31, 2011:
   
Consumer - Non Real Estate
   
Equity Line of Credit /Jr. liens
   
Commercial - Non Real Estate
   
Agricultural - Non Real Estate
 
                         
Performing
  $ 23,897     $ 20,855     $ 31,777     $ 2,782  
Nonperforming (>90 days past due)
    134       518       630       2  
                                 
     Total
  $ 24,031     $ 21,373     $ 32,407     $ 2,784  
                                 


 
13

 



Notes to Consolidated Financial Statements
(Unaudited)
(in thousands, except share, per share and percentage data)

The following tables reflect the Bank’s impaired loans at June 30, 2012:
   
Recorded
Investment
   
Unpaid
Principal
Balance
   
Related
Allowance
   
Average
Recorded
Investment
   
Interest
 Income
Recognized
 
With No Related Allowance
                             
Real Estate Secured
                             
Residential 1-4 family
  $ 9,368     $ 9,689     $ -     $ 9,201     $ 190  
Equity lines of credit
    -       -       -       -       -  
Multifamily
    905       905       -       913       31  
Farmland
    275       275       -       279       9  
Construction, Land Development, Other Land Loans
    138       138       -       1,313       1  
Commercial Real Estate- Owner Occupied
    7,448       7,448       -       8,302       58  
Commercial Real Estate- Non Owner Occupied
    8,668       8,749       -       6,674       192  
Second Mortgages
    222       222       -       407       6  
Non Real Estate Secured
                                       
Personal /Consumer
    62       62       -       46       2  
Business Commercial
    586       586       -       1,516       12  
Agricultural
    20       20       -       10       -  
                                         
          Total
  $ 27,692     $ 28,094     $ -     $ 28,661     $ 501  




 
14

 


Notes to Consolidated Financial Statements
(Unaudited)
(in thousands, except share, per share and percentage data)

   
Recorded
Investment
   
Unpaid
Principal
Balance
   
Related
Allowance
   
Average
Recorded
Investment
   
Interest
Income
Recognized
 
With an Allowance Recorded
                             
Real Estate Secured
                             
Residential 1-4 family
  $ 4,141     $ 4,158     $ 350     $ 3,974     $ 69  
Equity lines of credit
    -       -       -       -       -  
Multifamily
    409       409       9       528       6  
Farmland
    205       205       4       256       7  
Construction, Land Development, Other Land Loans
    110       110       29       1,324       -  
Commercial Real Estate- Owner Occupied
    3,329       3,329       231       2,658       46  
Commercial Real Estate- Non Owner Occupied
    1,586       1,586       180       3,034       19  
Second Mortgages
    107       107       4       108       3  
Non Real Estate Secured
                                       
Personal /Consumer
    39       57       5       57       -  
Business Commercial
    963       963       883       910       6  
Agricultural
    716       1,385       110       358       47  
                                         
          Total
  $ 11,605     $ 12,309     $ 1,805     $ 13,207     $ 203  

The following tables reflect the Bank’s impaired loans at December 31, 2011:

   
Recorded Investment
   
Unpaid
Principal
Balance
   
Related
Allowance
   
Average
Recorded
Investment
   
Interest
Income
Recognized
 
   With No Related
   Allowance
                             
Real Estate Secured
                             
Residential 1-4 family
  $ 9,034     $ 9,342     $ -     $ 8,243     $ 285  
Equity lines of credit
    -       -       -       -       -  
Multifamily
    920       920       -       480       63  
Farmland
    283       283       -       529       16  
Construction, Land Development, Other Land Loans
    2,487       2,487       -       3,170       108  
Commercial Real Estate- Owner Occupied
    9,155       9,155       -       7,327       187  
Commercial Real Estate- Non Owner Occupied
    4,859       4,859       -       4,183       143  
Second Mortgages
    591       591       -       646       6  
Non Real Estate Secured
                                       
Personal
    30       30       -       26       3  
Commercial
    2,446       3,115       -       1,856       64  
Agricultural
    -       -       -       -       -  
                                         
          Total
  $ 29,805     $ 30,782     $ -     $ 26,460     $ 875  


 
15

 

Notes to Consolidated Financial Statements
(Unaudited)
(in thousands, except share, per share and percentage data)


   
Recorded
Investment
   
Unpaid
Principal
Balance
   
Related
Allowance
   
Average
Recorded
Investment
   
Interest
Income
Recognized
 
With an Allowance Recorded
                             
Real Estate Secured
                             
Residential 1-4 family
  $ 3,806     $ 3,840     $ 571     $ 4,161     $ 132  
Equity lines of credit
    -       -       -       -       -  
Multifamily
    646       866       201       1,139       11  
Farmland
    307       307       38       309       11  
Construction, Land Development, Other Land Loans
    2,538       2,538       606       4,787       80  
Commercial Real Estate- Owner Occupied
    1,986       2,086       323       3,132       11  
Commercial Real Estate- Non Owner Occupied
    4,482       4,482       343       4,758       54  
Second Mortgages
    108       108       10       138       4  
Non Real Estate Secured
                                       
Personal
    74       74       41       62       4  
Commercial
    856       856       675       1,494       22  
Agricultural
    -       -       -       14       -  
                                         
          Total
  $ 14,803     $ 15,157     $ 2,808     $ 19,994     $ 329  



 
16

 

Notes to Consolidated Financial Statements
(Unaudited)
(in thousands, except share, per share and percentage data)


The following tables present the balance in the allowance for loan losses and the recorded investment in loans by loan category and is segregated by impairment evaluation method as of June 30, 2012 and June 30. 2011.
Six  months ended June 30, 2012
 
Residential
1-4 Family
   
Multifamily
   
Construction and Land Loans
   
Commercial Owner Occupied
   
Commercial Non-Owner Occupied
   
Second Mortgages
   
Equity Line of Credit
   
Farmland
   
Personal and Overdrafts
   
Commercial and Agricultural
   
Unallocated
   
Total
 
Allowance for Credit Losses:
                                                                       
Beginning Balance December 31,  2011
  $ 1,618     $ 477     $ 1,746     $ 1,209     $ 400     $ 371     $ 69     $ 336     $ 764     $ 1,620     $ 414       9,024  
Provision for Credit Losses
    (316 )     131       (577 )     (152 )     811       (57 )     8       (145 )     1       (5 )     922       621  
Charge-offs
    261       246       446       183       656       63       23       4       248       79       -       2,209  
Recoveries
    125       -       307       -       -       2       -       1       49       130       -       614  
Net Charge-offs
    136       246       139       183       656       61       23       3       199       (51 )     -       1,595  
Ending Balance
 June 30, 2012
    1,166       362       1,030       874       555       253       54       188       566       1,666       1336       8,050  
Ending Balance: Individually evaluated for impairment
    350       9       29       231       180       4       -       4       5       993       -       1,805  
Ending Balance:  Collectively Evaluated for Impairment
    816       353       1,001       643       375       249       54       184       561       673       1,336       6,245  
Loans:
                                                                                               
Ending Balance: Individually Evaluated for Impairment
    13,509       1,314       248       10,777       10,254       329       -       480       101       2,285       -       39,297  
Ending Balance: Collectively Evaluated for Impairment
    156,778       15,361       19,720       55,918       26,621       10,204       8,498       11,283       23,011       34,610       -       362,004  
Ending Balance: June 30, 2012
  $ 170,287     $ 16,675     $ 19,968     $ 66,695     $ 36,875     $ 10,533     $ 8,498     $ 11,763     $ 23,112     $ 36,895       -     $ 401,301  

 
 
 
 
 
 
 
 

 


 
17

 


Notes to Consolidated Financial Statements
(Unaudited)
(in thousands, except share, per share and percentage data)

   
Residential
1-4 Family
   
Multifamily
   
Construction and
Land
Loans
   
Commercial Owner Occupied
   
Commercial Non-Owner Occupied
   
Second Mortgages
   
Equity Line of Credit
   
Farmland
   
Personal
and 
Overdrafts
   
Commercial and Agricultural
   
Unallocated
   
Total
 
Allowance for Credit Losses:
                                                                       
Beginning Balance December 31,  2010
  $ 1,521     $ 229     $ 2,155     $ 504     $ 1,353     $ 323     $ 83     $ 229     $ 516     $ 2,185     $ 1,222       10,320  
Provision for Credit Losses
    697       372       882       823       144       510       43       179       588       643       (1,092 )     3,789  
Charge-offs
    291       40       1,242       135       89       271       10       143       321       530       -       3,072  
Recoveries
    5       -       50       -       -       10       -       20       25       10       -       120  
Net Charge-offs
    286       40       1,192       135       89       261       10       123       296       520       -       2,952  
Ending Balance
 June 30, 2011
    1,932       561       1,845       1,192       1,408       572       116       285       808       2,308       130       11,157  
Ending Balance: Individually evaluated for impairment
    922       278       697       965       845       92       -       40       35       1,112       -       4,986  
Ending Balance:  Collectively Evaluated for Impairment
    1,010       283       1,148       227       563       480       116       245       773       1,196       130       6,171  
Loans:
                                                                                               
Ending Balance: Individually Evaluated for Impairment
    13,869       2,565       6,467       12,761       7,844       932       -       310       128       4,905       -       49,781  
Ending Balance: Collectively Evaluated for Impairment
    158,824       12,514       20,581       66,214       29,118       12,028       10,055       11,910       24,888       34,568       -       380,700  
Ending Balance: June 30, 2011
  $ 172,693     $ 15,079     $ 27,048     $ 78,975     $ 36,962     $ 12,960     $ 10,055     $ 12,220     $ 25,016     $ 39,473       -     $ 430,481  

 
 
 
 
 

 

 
18

 



Notes to Consolidated Financial Statements
(Unaudited)
(in thousands, except share, per share and percentage data)

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

·  
A loan is 60 days or more delinquent on scheduled principal or interest;
·
A loan is presently in an unapproved over advanced position;
·
A loan is newly modified; or
·
A loan is expected to be modified.

The Company’s credit administration personnel and senior financial officers are responsible for tracking, coding, and monitoring loans that become Troubled Debt Restructurings. Concessions are made to existing borrowers in the form of modified interest rates and / or payment terms. The loans are segregated for regulatory and external reporting. Each specific TDR is reviewed to determine if the accrual of interest should be discontinued and also reviewed for impairment. The Company’s senior credit administration officer performs this analysis on a quarterly basis in addition to determining any other loans that are impaired within the loan portfolio. The Company had a total of $18.19 million and $16.03 million of loans categorized as troubled debt restructurings as of June 30, 2012 and December 31, 2011, respectively. Interest is accrued on TDRs if the loan is otherwise not impaired and the full collection of principal and interest under the modified terms is still deemed likely.

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

 
 
 
 
 
 
 
 
 

 
 
19

 


Notes to Consolidated Financial Statements
(Unaudited)
(dollars in thousands, except share, per share and percentage data)
 
The following is a summary of troubled debt restructurings occurring during the six months ended June 30, 2012

Troubled Debt Restructurings
Interest only
 
Number of Contracts
   
Pre- Modification 
Outstanding
Recorded Investment
   
Recorded Investment
at period end
 
    Real Estate Secured
                 
Residential 1-4 family
    1     $ 729     $ 729  
Equity lines of credit
                       
Multifamily
                       
Farmland
    1       138       138  
Construction, Land Development,
Other Land Loans
                       
Commercial Real Estate-  Owner Occupied
                       
Commercial Real Estate-  Non Owner Occupied
                       
Second Mortgages
    1       84       84  
    Non Real Estate Secured
                       
Personal / Consumer
                       
Business Commercial
                       
Agricultural
                       
                         
Total
    3     $ 951     $ 951  

 
 
Troubled Debt Restructurings
Below Market Rate
 
Number of Contracts
   
Pre- Modification 
Outstanding
Recorded Investment
   
Recorded Investment
at period end
 
    Real Estate Secured
    1     $ 885     $ 881  
Residential 1-4 family
                       
Equity lines of credit
                       
Multifamily
                       
Farmland
                       
Construction, Land Development,
Other Land Loans
                       
Commercial Real Estate-  Owner Occupied
    2       2,657       2,645  
Commercial Real Estate-  Non Owner Occupied
    2       5,955       5,927  
Second Mortgages
                       
    Non Real Estate Secured
                       
Personal / Consumer
                       
Business Commercial
                       
Agricultural
                       
                         
Total
    5     $ 9,497     $ 9,453  

 
20

 
Notes to Consolidated Financial Statements
(Unaudited)
(dollars in thousands, except share, per share and percentage data)

Troubled Debt Restructurings
Loan term extension
 
Number of
Contracts
   
Pre- Modification 
Outstanding
Recorded Investment
   
Recorded
Investment
at period end
 
    Real Estate Secured
                 
Residential 1-4 family
    2     $ 522     $ 520  
Equity lines of credit
                       
Multifamily
                       
Farmland
                       
Construction, Land Development,
Other Land Loans
                       
Commercial Real Estate-  Owner Occupied
    2       1,017       1,008  
Commercial Real Estate-  Non Owner Occupied
                       
Second Mortgages
                       
    Non Real Estate Secured
                       
Personal / Consumer
                       
Business Commercial
                       
Agricultural
                       
                         
Total
    4     $ 1,539     $ 1,528  
 
Troubled Debt Restructurings
All
 
Number of
Contracts
   
Pre- Modification 
Outstanding
Recorded Investment
   
Recorded
Investment
 at period end
 
Total Restructurings
    12     $ 11,987     $ 11,932  


Troubled Debt Restructurings
That subsequently defaulted
 
Number of
Contracts
   
Pre- Modification 
Outstanding
Recorded Investment
   
Recorded
Investment
at period end
 
    Real Estate Secured
                 
Residential 1-4 family
                       
Equity lines of credit
                       
Multifamily
                       
Farmland
                       
Construction, Land Development,
Other Land Loans
                       
Commercial Real Estate-  Owner Occupied
                       
Commercial Real Estate-  Non Owner Occupied
                       
Second Mortgages
                       
    Non Real Estate Secured
                       
Personal / Consumer
                       
Business Commercial
                       
Agricultural
                       
                         
Total
    -       -       -  
 



 
21

 


Notes to Consolidated Financial Statements
(Unaudited)
(dollars in thousands, except share, per share and percentage data)

The following is a summary of troubled debt restructurings occurring during the six months ended June 30, 2011
 

Troubled Debt Restructurings
Interest only
 
Number of
Contracts
   
Pre- Modification 
Outstanding Recorded Investment
   
Recorded Investment
at period end
 
    Real Estate Secured
                 
Residential 1-4 family
                 
Equity lines of credit
                 
Multifamily
                 
Farmland
    1     $ 152     $ 152  
Construction, Land Development,
Other Land Loans
    1       1,364       834  
Commercial Real Estate-  Owner Occupied
    3       811       811  
Commercial Real Estate-  Non Owner Occupied
                       
Second Mortgages
                       
    Non Real Estate Secured
                       
Personal / Consumer
                       
Business Commercial
                       
Agricultural
    1       129       129  
                         
Total
    6     $ 2,456     $ 1,926  



Troubled Debt Restructurings
Below Market Rate
 
Number of
Contracts
   
Pre- Modification 
Outstanding Recorded Investment
   
Recorded Investment
at period end
 
    Real Estate Secured
    -       -       -  
Residential 1-4 family
    -       -       -  
Equity lines of credit
    -       -       -  
Multifamily
    -       -       -  
Farmland
    -       -       -  
Construction, Land Development,
Other Land Loans
    -       -       -  
Commercial Real Estate-  Owner Occupied
    -       -       -  
Commercial Real Estate-  Non Owner Occupied
    1     $ 399     $ 397  
Second Mortgages
    -       -       -  
    Non Real Estate Secured
    -       -       -  
Personal / Consumer
    -       -       -  
Business Commercial
    -       -       -  
Agricultural
    -       -       -  
      -       -       -  
Total
    1     $ 399     $ 397  
                         
 
22

 


Notes to Consolidated Financial Statements
(Unaudited)
(dollars in thousands, except share, per share and percentage data)


Troubled Debt Restructurings
Loan term extension
 
Number of
Contracts
   
Pre- Modification 
Outstanding Recorded Investment
   
Recorded Investment
at period end
 
    Real Estate Secured
                 
Residential 1-4 family
    2     $ 912     $ 909  
Equity lines of credit
                       
Multifamily
                       
Farmland
                       
Construction, Land Development,
Other Land Loans
                       
Commercial Real Estate-  Owner Occupied
                       
Commercial Real Estate-  Non Owner Occupied
                       
Second Mortgages
    1       426       426  
    Non Real Estate Secured
                       
Personal / Consumer
                       
Business Commercial
                       
Agricultural
    2       670       670  
                         
Total
    5     $ 2,008     $ 2,005  
                   
Troubled Debt Restructurings
 
All
 
Number of Contracts
   
Pre- Modification Outstanding Recorded Investment
   
Recorded Investment
 at period end
 
Total Restructurings
    12     $ 4,863     $ 4,328  

Troubled Debt Restructurings
That subsequently defaulted
 
Number of
Contracts
   
Pre- Modification 
Outstanding Recorded Investment
   
Recorded Investment
at period end
 
                   
    Real Estate Secured
                 
Residential 1-4 family  (Loan Term Extension)
                 
Equity lines of credit
                 
Multifamily
                 
Farmland
                 
Construction, Land Development, Other Land Loans  (Interest Only)
    1     $ 1,364     $ 834  
Commercial Real Estate-  Owner Occupied (Interest Only)
    2       742       742  
Commercial Real Estate-  Non Owner Occupied (Loan Term Extension)
                       
Second Mortgages  (Loan Term Extension)
    1       426       426  
    Non Real Estate Secured
                       
Personal / Consumer
                       
Business Commercial
                       
Agricultural
                       
                         
Total
    4     $ 2,532     $ 2,002  
 

 
 
23

 

Notes to Consolidated Financial Statements
(Unaudited)
(in thousands, except share, per share and percentage data)

Overview of Loan Review and ALLL Processes

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

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

On a quarterly basis, the ALLL methodology begins with the identification of loans subject to individual impairment.  All loans that are rated “7” (Doubtful) are assessed as impaired based on the expectation that the full collection of principal and interest is in doubt. All loans that are rated “6” (Substandard) or are expected to be downgraded to “6”, require additional analysis to determine whether they may be individually impaired.  All loans that are rated “5” (Special Mention) are presumed not to be impaired. However, “5” rated loans, together with any Troubled Debt Restructured (TDR) loan, may warrant further analysis before completing an assessment of impairment.  For ASC 310 loans that are individually evaluated and found to be impaired (primarily those designated as Substandard and Doubtful), the associated ALLL will be based upon one of the three impairment measurement methods specified within ASC 310:


(1)  
Present value of expected future cash flows discounted at the loan’s effective interest rate;
(2)  
Loan’s observable market price; or
(3)  
Fair value of the collateral.


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



 
24

 



Notes to Consolidated Financial Statements
(Unaudited)
(in thousands, except share, per share and percentage data)

 
 
For all other loans, including individual loans determined not to be impaired under ASC 310, the associated ALLL is calculated in accordance with ASC 450 that provides for estimated credit losses likely to be realized on groups of loans with similar risk characteristics. The Bank uses standard call report categories to segregate loans into groups with similar risk characteristics.

Estimated credit losses reflect significant factors that affect the collectability of the portfolio as of the evaluation date. Key factors that influence risk within the Bank’s loan portfolio are divided into three major categories:

(1)  
Historical Loss Factor: To calculate the anticipated loan loss in each call report category for ASC 450 loans, the bank begins with the net loss in each category for each of the last twelve quarters.  The Bank uses a rolling twelve quarter weighted historical loss average where the most recent quarters are weighted heavier than the earlier quarters.  The total of weighted factors for each call report category is applied to the current outstanding loan balance in this category to calculate expected loss based on historical data for a group of loans with similar risk characteristics.

(2)  
External economic factors:  Economic conditions have a significant impact on the Bank’s loan portfolio because deteriorating conditions can adversely impact both collateral values and the customer’s ability to service debt.  Management has selected the following external factors as indicators of economic conditions:

a.  
National GDP Growth Rate
b.  
Local Unemployment Rates
c.  
The Prime Rate

(3)  
Internal process factors:  Internal factors that influence loss rates as a result of risk management and control practices include the following:

a.  
Past-Due Loans.
b.  
Non-Accrual Loans
c.  
CRE Concentrations
d.  
Loan Volume Level
e.  
Level and Trend of Classified Loans

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

Once the quarterly ALLL is computed, the calculations are reviewed by the Company’s credit administration committee which is comprised of the CEO, CFO, and Senior Lending Officers, including Credit Review personnel.  The Company’s controller also performs a detailed review of the computations, estimates, etc. included in the ALLL calculation. The ALLL is then reviewed and approved by the Board of Directors.














 
25

 



Notes to Consolidated Financial Statements
(Unaudited)
(in thousands, except share, per share and percentage data)

Note 3  -  Income Taxes

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

   
2012
   
2011
 
             
Tax expense (benefit) at statutory rate
  $ 448     $ (1,191 )
Reduction in taxes from:
               
Tax-exempt interest
    (128 )     (159 )
Other, net
    (73 )     (50 )
                 
Income tax expense (benefit)
  $ 247     $ (1,400 )

Note 4 - Capital Requirements

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

June 30, 2012
 
Entity
 
Tier 1
   
Total Risk Based
   
Leverage
 
                   
Highlands Bankshares, Inc.
    7.52 %     8.77 %     4.92 %
                         
Highlands Union Bank
    8.38 %     9.64 %     5.49 %

December 31, 2011
 
Entity
 
Tier 1
   
Total Risk Based
   
Leverage
 
                   
Highlands Bankshares, Inc.
    7.03 %     8.29 %     4.57 %
                         
Highlands Union Bank
    7.81 %     9.08 %     5.07 %

During the first quarter of 2011, the Bank’s total risk based capital ratio fell below the required minimum to be “well - capitalized.” The Bank’s Tier 1 Capital to Risk Weighted assets ratio and Tier 1 capital to Adjusted Total Assets remained above the “well-capitalized” thresholds. Because the Bank’s total risk-based capital ratio was below 10% as of December 31, 2011 and June 30 2012, the Bank is considered to be “adequately-capitalized” under the regulatory framework for prompt corrective action.  As a result of its status as “adequately-capitalized” for regulatory capital purposes, the Bank cannot renew or accept brokered deposits without prior regulatory approval and may not offer interest rates on deposit accounts that are significantly higher than the average rates in its market area. The Bank has increased its total risk

 
26

 
Notes to Consolidated Financial Statements
(Unaudited)
(dollars in thousands, except share, per share and percentage data)

based capital ratio from 8.77% at March 31, 2011 to 9.64% at June 30, 2012. The Bank’s total risk based capital ratio was 9.08% at December 31, 2011.

Note 5 - Capital Securities

The Company completed a $7.5 million capital issue of $2.3125 Preferred Securities (the “Trust Preferred Securities”) on January 23, 1998.  These Trust Preferred Securities were issued by Highlands Capital Trust I, a wholly owned subsidiary of the Company.

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

Note 6 – Per Share Amounts

The following table contains information regarding the Company’s computation of basic earnings (loss) per share and diluted earnings (loss) per share for the six and three months ended June 30, 2012 and 2011.


   
Six Months Ended June 30,
   
Three Months Ended June 30,
 
   
2012
   
2011
   
2012
   
2011
 
                         
Basic Earnings  (loss) per Share
  $ 0.21     $ (0.42 )   $ 0.13     $ 0.00  
                                 
Basic Number of Shares
    5,011,152       5,011,152       5,011,152       5,011,152  
                                 
Diluted Earnings (loss) per Share
  $ 0.21     $ (0.42 )   $ 0.13     $ 0.00  
                                 
Diluted Number of Shares
    5,011,152       5,011,152       5,011,152       5,011,152  
                                 


Note 7 – Commitments and Contingencies

The Bank is a party to various financial instruments with off-balance sheet risk arising in the normal course of business to meet the financing needs of its customers. Those financial instruments include commitments to extend credit and standby letters of credit. At June 30, 2012, these commitments included: standby letters of credit of $745 thousand; equity lines of credit of $9.64 million; credit card lines of credit of $5.69 million; commercial real estate, construction and land development commitments of $2.70 million; and other unused commitments to fund interest earning assets of $21.53 million.





 
27

 

 
Notes to Consolidated Financial Statements
(Unaudited)
(in thousands, except share, per share and percentage data)

Note  8 – Fair Value

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

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

 
Level 1 
 
Valuation is based upon quoted prices for identical instruments traded in active markets.
       
 
Level 2 
 
Valuation is based upon quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active, and model-based valuation techniques for which all significant assumptions are observable in the market.
       
 
Level 3 
 
Valuation is generated from model-based techniques that use at least one significant assumption not observable in the market. These unobservable assumptions reflect estimates of assumptions that market participants would use in pricing the asset or liability. Valuation techniques include use of option pricing models, discounted cash flow models and similar techniques.
        
In general, fair value is based upon quoted market prices, where available. If such quoted market prices are not available, fair value is based upon third party models that primarily use, as inputs, observable market-based parameters. Valuation adjustments may be made to ensure that financial instruments are recorded at fair value. These adjustments may include amounts to reflect counterparty credit quality, the Company’s creditworthiness, among other things, as well as unobservable parameters. Any such valuation adjustments are applied consistently over time. The Company’s valuation methodologies may produce a fair value calculation that may not be indicative of net realizable value or reflective of future fair values. While management believes the Company’s valuation methodologies are appropriate and consistent with other market participants, the use of different methodologies or assumptions to determine the fair value of certain financial instruments could result in a different estimate of fair value at the reporting date.











 
28

 


Notes to Consolidated Financial Statements
(Unaudited)
(in thousands, except share, per share and percentage data)

Recurring - Investment Securities Available for Sale

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

As of June 30, 2012, we own approximately $3.89 million (amortized cost) in collateralized debt obligation securities (TRUP CDOs) that are backed by trust preferred securities issued by banks, thrifts, and insurance companies.  The market for these and similar securities at June 30, 2012 is not active.  The TRUP CDOs have been classified within Level 3 of the fair value hierarchy because we determined that significant adjustments are required for fair value assessment at the measurement date.

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

The following tables summarize the Company’s available for sale securities portfolio measured at fair value on a recurring basis as of June 30, 2012 and December 31, 2011, segregated by the level of the valuation inputs within the fair value hierarchy.

June 30, 2012
 
   
Level 1
   
Level 2
   
Level 3
   
Total Fair Value
 
Available for Sale Securities
                       
US Treasuries
  $ -     $ 3,000     $ -     $ 3,000  
State and Political Subdivisions
  $ -     $ 14,201     $ -     $ 14,201  
Mortgage Backed Securities
  $ -     $ 33,725     $ -     $ 33,725  
TRUP CDO’s
  $ -     $ -     $ 282     $ 282  
Single Issue Trust Preferred
  $ -     $ 1,852     $ -     $ 1,852  
SBA Pools
  $ -     $ 7,755     $ -     $ 7,755  
SLMA
  $ -     $ 492     $ -     $ 492  
Total AFS Securities
  $ -     $ 61,025     $ 282     $ 61,307  



December 31, 2011
 
   
Level 1
   
Level 2
   
Level 3
   
Total Fair Value
 
Available for Sale Securities
                       
US Treasuries
  $ -     $ 6,032     $ -     $ 6,032  
State and Political Subdivisions
  $ -     $ 18,168     $ -     $ 18,168  
Mortgage Backed Securities
  $ -     $ 30,629     $ -     $ 30,629  
TRUP CDO’s
  $ -     $ -     $ 150     $ 150  
Single Issue Trust Preferred
  $ -     $ 1,815     $ -     $ 1,815  
SBA Pools
  $ -     $ 6,996     $ -     $ 6,996  
SLMA
  $ -     $ 462     $ -     $ 462  
Total AFS Securities
  $ -     $ 64,102     $ 150     $ 64,252  


 
29

 

Notes to Consolidated Financial Statements
(Unaudited)
(in thousands, except share, per share and percentage data)

Pursuant to ASC Topic 820, the following table shows a reconciliation of the beginning and ending balance at June 30, 2012 for Level 3 assets measured on a recurring basis using significant unobservable inputs. Level 3 assets represent the Company’s TRUP CDOs.
 
Investment Securities Available for Sale

Beginning balance, December 31, 2011
  $ 150  
Total losses included in net income
    (167 )
Included in other comprehensive income
    299  
Transfers in or out of Level 3
    --  
Ending balance, June 30, 2012
  $ 282  

The losses included in net income represent the other than temporary impairment charges taken during the six months ended June 30, 2012 for the securities classified as Level 3.

Loans

The Company does not record loans at fair value on a recurring basis. However, from time to time, a loan is considered impaired and an allowance for loan losses is established. Loans for which it is probable that payment of interest and principal will not be made in accordance with the contractual terms of the loan agreement are considered impaired. Once a loan is identified as individually impaired, management measures impairment using one of several methods, including collateral value, recent appraisal value and /or tax assessed value, liquidation value and discounted cash flows. At June 30, 2012 all of the total impaired loans were evaluated based on the fair value of the collateral. Fair value is based upon independent market prices or appraised values of the collateral which the Company considers as nonrecurring Level 2. The following tables summarize the Company’s impaired loans by loan category at fair value on a non - recurring basis as of June 30, 2012 and December 31, 2011, segregated by the level of the valuation inputs within the fair value hierarchy for which a specific allowance has been allocated.
 
June 30, 2012
                                                                                               
   Level 1    Level 2    Level 3    Total Fair Value  
           Real Estate Secured
   
 
   
 
 
  Residential 1-4 family
    $ 4,141     $ 4,141  
  Farmland
      205       205  
 Multifamilty
      409       409  
 Construction, Land Development,    Other  Land Loans
      110       110  
 Commercial Real Estate – Owner Occupied
      3,329       3,329  
Commercial Real Estate – Non Owner Occupied
      1,586       1,586  
Second Mortgages
      107       107  
        Non Real Estate Secured
                 
Personal
      39       39  
Business / Commercial
      963       963  
Agricultural
      716       716  
Total
    $ 11,605     $ 11,605  





 
30

 


Notes to Consolidated Financial Statements
(Unaudited)
(in thousands, except share, per share and percentage data)

December 31, 2011
                                                                                                                                       
    Level 1    Level 2    Level 3    Total Fair Value  
           Real Estate Secured
   
 
     
 
 
  Residential 1-4 family
    $ 3,806       $ 3,806  
  Multifamily
      646         646  
  Farmland
      307         307  
 Construction, Land Development,    Other  Land Loans
      2,538         2,538  
 Commercial Real Estate – Owner Occupied
      1,986         1,986  
Commercial Real Estate – Non Owner Occupied
      4,482         4,482  
Second Mortgages
      108         108  
        Non Real Estate Secured
                   
Personal
      74         74  
Business / Commercial
      856         856  
Total
    $ 14,803       $ 14,803  


Foreclosed Assets / Repossessions

Foreclosed assets and repossessions are adjusted to fair value upon transfer of the loans to foreclosed assets and repossessions. Subsequently, foreclosed assets and repossessions are carried at the lower of carrying value or fair value. Fair value is based upon independent market prices or appraised values of the collateral which the Company considers as nonrecurring Level 2. If additional specific write-downs have occurred, then the foreclosed asset balances are reclassified as non-recurring Level 3. The following tables summarize the Company’s foreclosed and repossessed assets at fair value on a non-recurring basis as of June 30, 2012 and December 31, 2011
 
June 30, 2012
                                                                         
   Level 1  Level 2  Level 3  Total Fair Value
Repossessions/OREO, net
       --
 $   17,707
               --
        $    17,707

December 31, 2011
 
                                                                                                            
       Level 1      Level 2   Level 3  Total Fair Value
Repossessions/OREO, net
       --
 $    16,852
               --
        $    16,852



 
 
 
 

 
 
31

 


Notes to Consolidated Financial Statements
(Unaudited)
(in thousands, except share, per share and percentage data)

General

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

Fair Value of Financial Instruments

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

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

Securities Available for Sale

Fair values are determined in the manner as described above.

Other Investments

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

Loans

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

Deposits

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

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

 
32

 


Notes to Consolidated Financial Statements
(Unaudited)
(in thousands, except share, per share and percentage data)


Long-term Debt and Capital Securities

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

Off-Balance Sheet Instruments

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

The carrying amounts and fair values of the Company's financial instruments at June 30, 2012 and December 31, 2011 were as follows:
 

   
June 30, 2012
   
December 31, 2011
 
   
Carrying Amount
   
Fair Value
   
Carrying Amount
   
Fair Value
 
 
                         
Cash and cash equivalents
  $ 72,925     $ 72,925     $ 86,075     $ 86,075  
Securities available for
 sale
    61,307       61,307       64,252       64,252  
Other investments
    5,015       5,015       5,308       5,308  
Loans, net
    392,707       392,327       398,780       398,221  
Deposits
    (492,553 )     (486,319 )     (515,361 )     (508,599 )
Other short-term
  borrowings
    (57,679 )     (65,682 )     (57,676 )     (65,844 )
Long-term debt
    (13,875 )     (14,792 )     (13,964 )     (14,951 )
Capital Securities
    (3,150 )     (3,014 )     (3,150 )     (3,014 )


 
33

 

Notes to Consolidated Financial Statements
(Unaudited)
(in thousands, except share, per share and percentage data)
 

 
Note  9.  - Investment Securities Available For Sale
 
The amortized cost and market value of securities available for sale are as follows:
 
   
June 30, 2012
 
   
Amortized Cost
   
Gross Unrealized Gains
   
Gross Unrealized Losses
   
Fair Value
 
 
                         
US Treasuries
  $ 3,000       -       -     $ 3,000  
State and political subdivisions
    13,958       255       12       14,201  
Mortgage backed securities
    32,905       820       -       33,725  
TRUP CDOs
    3,893       -       3,611       282  
Single Issue Trust Preferred
    1,921       -       69       1,852  
SBA Pools
    7,512       293       50       7,755  
SLMA
    500       -       8       492  
    $ 63,689     $ 1,368     $ 3,750     $ 61,307  

 
   
December 31, 2011
 
   
Amortized Cost
   
Gross Unrealized Gains
   
Gross Unrealized Losses
   
Fair Value
 
 
                         
U.S  Treasuries
  $ 6,029     $ 3     $ -     $ 6,032  
State and political subdivisions
    18,030       275       137       18,168  
Mortgage backed securities
    30,002       632       5       30,629  
TRUP CDOs
    4,067       -       3,917       150  
Single Issue Trust Preferred
    1,923       -       108       1,815  
SBA Pools
    6,821       219       44       6,996  
SLMA
    500       -       38       462  
    $ 67,372     $ 1,129     $ 4,249     $ 64,252  
 
 
Investment securities available for sale with a carrying value of $45,610 and $45,258 at June 30, 2012 and December 31, 2011, respectively, and a market value of $46,867 and $46,011 at June 30, 2012 and December 31, 2011, respectively, were pledged as collateral on public deposits, FHLB advances and for other purposes as required or permitted by law.
 
 

 
 
34

 


Notes to Consolidated Financial Statements
(Unaudited)
(in thousands, except share, per share and percentage data)

The following table presents the age of gross unrealized losses and fair value by investment category:
 
   
June 30, 2012
 
   
Less Than 12 months
   
12 Months or More
   
Total
 
   
Fair Value
   
Unrealized Losses
   
Fair Value
   
Unrealized Losses
   
Fair Value
   
Unrealized Losses
 
                                     
States and political subdivisions
  $ 2,159     $ 12       -       -     $ 2,159     $ 12  
Mortgage-backed securities
    -       -       -       -       -       -  
Pooled Trust Preferred Securities
    -       -       282       3,611       282       3,611  
Single Issue Trust Preferred
    -       -       840       69       840       69  
SBA Pools
    1,085       30       1,898       20       2,983       50  
SLMA
    -       -       492       8       492       8  
                                                 
  Total
  $ 3,244     $ 42     $ 3,512     $ 3,708     $ 6,756     $ 3,750  

 
   
December 31, 2011
 
   
Less Than 12 months
   
12 Months or More
   
Total
 
   
Fair Value
   
Unrealized Losses
   
Fair Value
   
Unrealized Losses
   
Fair Value
   
Unrealized Losses
 
                                     
State and political subdivisions
  $ 705     $ 45     $ 4,367     $ 92     $ 5,072     $ 137  
Mortgage-backed securities
    4,554       5       -       -       4,554       5  
Pooled Trust Preferred Securities
    -       -       150       3,917       150       3,917  
Single Issue Trust Preferred
    505       7       809       101       1,314       108  
SBA Pools
    -       -       2,007       44       2,007       44  
SLMA
    -       -       462       38       462       38  
                                                 
  Total
  $ 5,764     $ 57     $ 7,795     $ 4,192     $ 13,559     $ 4,249  

 
 
 
 
 
 
 
 

 
 
35

 


Notes to Consolidated Financial Statements
(Unaudited)
(in thousands, except share, per share and percentage data)


The segment of our portfolio that contains the largest unrealized loss is our pooled trust preferred securities (“TRUP CDOs”) which represent trust preferred securities issued primarily by banks and a limited number of insurance companies and real estate investment trusts. As of June 30, 2012, our TRUP CDOs book value totaled $3.89 million.

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

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

At June 30, 2012, the following assumptions were used in the cash flow projections:
·   Deferral / default ranges for 2012 – 1.00% to 2.00%.
·   Deferral / default rate for 2013 – 1.00%.
·   Deferral / default ranges for years thereafter – 0.25% to 0.36%.
·   Prepayments - 1% annually, 100% at maturity
·   The discount rate is calculated using the original discount margin as of the purchase date based on the purchase price added to the appropriate forward 3-month LIBOR rate.
·   15% recovery with 2 year lag extended to 5 years if has been in deferral for 2 years
·   0% recovery on existing defaults
·   Cash flows are discounted at the effective interest rate.


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

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

 
36

 


Notes to Consolidated Financial Statements
(Unaudited)
(in thousands, except share, per share and percentage data)

During the first three months of 2012, the Company incurred credit-related OTTI charges on our TRUP CDOs of $167 thousand. No OTTI charges were incurred in the second quarter of 2012. For the six months ended June 30, 2011, the Company incurred a total of $269 thousand of OTTI charges.

The Company also assesses other securities for OTTI quarterly by reviewing credit ratings, financial and regulatory reports as well as other pertinent published financial data. As of June 30, 2012 and December 31, 2011, the Company's assessment revealed no impairment other than that deemed temporary on those securities.

The amortized cost and estimated fair value of securities available for sale at June 30, 2012 by contractual maturity are shown below. Expected maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.

 
     
Amortized Cost
     
Approximate
Market Value
 
Due in one year or less
  $ 3,000     $ 3,000  
Due after one year through five years
    500       492  
Due after five years through ten years
    5,190       5,164  
Due after ten years
    22,094       18,926  
      30,784       27,582  
                 
Mortgage-backed securities
    32,905       33,725  
    $ 63,689     $ 61,307  

Note 10 – Formal Written Agreement

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

·  
strengthen board oversight of the management and operations of the Bank;
·  
strengthen credit risk management and administration;
·  
provide for the effective grading of the Bank’s loan portfolio;
·  
summarize the findings of its review of the adequacy of the staffing of its loan review function;
·  
improve the Bank’s position with respect to loans, relationships, or other assets in excess of $500,000 that currently are or in the future become past due more than 90 days, on the Bank’s problem loan list, or adversely classified in any report of examination of the Bank;
·  
review and revise the Bank’s methodology for determining the allowance for loan and lease losses (“ALLL”) and maintain an adequate ALLL;
·  
maintain sufficient capital at the Company and the Bank;
·  
establish a revised written contingency funding plan;
·  
establish a revised written strategic and capital plan
·  
establish a revised investment policy;
·  
improve the Bank’s earnings and overall condition;
·  
revise the Bank’s information technology program;
·  
establish a disaster recovery and business continuity program.and
·  
establish a committee to monitor compliance with all aspects of the written agreement.

 
37

 

Notes to Consolidated Financial Statements
(Unaudited)
(in thousands, except share, per share and percentage data)

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

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

In April 2011, the criteria used to determine effective control of transferred assets in the Transfers and Servicing topic of the ASC was amended by ASU 2011-03.  The requirement for the transferor to have the ability to repurchase or redeem the financial assets on substantially the agreed terms and the collateral maintenance implementation guidance related to that criterion were removed from the assessment of effective control.  The other criteria to assess effective control were not changed.  The amendments were effective for the Company on January 1, 2012 and had no effect on the financial statements.

ASU 2011-04 was issued in May 2011 to amend the Fair Value Measurement topic of the ASC by clarifying the application of existing fair value measurement and disclosure requirements and by changing particular principles or requirements for measuring fair value or for disclosing information about fair value measurements.  The amendments were effective for the Company beginning January 1, 2012 and had no effect on the financial statements.

The Comprehensive Income topic of the ASC was amended in June 2011.  The amendment eliminates the option to present other comprehensive income as a part of the statement of changes in stockholders’ equity and requires consecutive presentation of the statement of net income and other comprehensive income.

The amendments were applicable to the Company on January 1, 2012 and have been applied retrospectively.  In December 2011, the topic was further amended to defer the effective date of presenting reclassification adjustments from other comprehensive income to net income on the face of the financial statements.  Companies should continue to report reclassifications out of accumulated other comprehensive income consistent with the presentation requirements in effect prior to the amendments while FASB redeliberates future requirements.

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

 
 

 

 
38

 


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

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

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

Critical Accounting Policy

The financial condition and results of operations presented in the Consolidated Financial Statements, accompanying Notes to Consolidated Financial Statements and management’s discussion and analysis are, to a large degree, dependent upon the accounting policies of the Company.  The selection and application of these accounting policies involve judgments, estimates, and uncertainties that are susceptible to change.  For a discussion of the Company’s critical accounting policies related to its allowance for loan losses and other than temporary impairment, see the Company’s Annual Report on Form 10-K for the year ended December 31, 2011.

Regulatory Economic Environment
 
On July 21, 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”) was signed into law.  The Dodd-Frank Act contains significant modifications to the current bank regulatory structure and requires various federal agencies to adopt a broad range of new rules and regulations throughout 2011 and beyond.  While not determinable at this time, the impact of the Dodd-Frank Act and the rules and regulations that will be promulgated thereunder could significantly affect our operations, increase our operating costs and divert management resources and attention from the primary business of the Bank.
 
On April 5, 2012, President Obama signed into law the Jumpstart our Business Startups Act, (the “JOBS Act”).  The JOBS Act significantly amends federal securities laws to relax the general solicitation and general advertising prohibitions in private placements, create a new public offering exemption for offerings up to $50 million and increase the threshold number of shareholders of record over which companies are required to register with the SEC and begin filing periodic public reports.  The JOBS Act also increased the threshold number of shareholders of record for bank holding companies to deregister with the SEC and cease filing periodic public reports. The Company’s shareholder base currently exceeds this amended threshold, but in the event that the Company’s number of shareholders of record decreases in the future, the Company may consider deregistering to save the significant expense associated with SEC reporting.
 
Formal Written Agreement
 
As discussed in Footnote 13, on October 13, 2010, the Company and Bank entered into a written agreement (“Written Agreement”) with the Federal Reserve Bank of Richmond (the “Reserve Bank”).  Under the terms of the Written Agreement, the Bank has agreed to develop and submit to the Reserve Bank for approval within the time periods specified therein written plans or programs to:

 
39

 
·  
strengthen board oversight of the management and operations of the Bank;
·  
strengthen credit risk management and administration;
·  
provide for the effective grading of the Bank’s loan portfolio;
·  
summarize the findings of its review of the adequacy of the staffing of its loan review function;
·  
improve the Bank’s position with respect to loans, relationships, or other assets in excess of $500,000 that currently are or in the future become past due more than 90 days, on the Bank’s problem loan list, or adversely classified in any report of examination of the Bank;
·  
review and revise the Bank’s methodology for determining the allowance for loan and lease losses (“ALLL”) and maintain an adequate ALLL;
·  
maintain sufficient capital at the Company and the Bank;
·  
establish a revised written contingency funding plan;
·  
establish a revised investment policy;
·  
establish a revised written strategic and capital plan;
·  
improve the Bank’s earnings and overall condition;
·  
revise the Bank’s information technology program; and
·  
establish a disaster recovery and business continuity program.
·  
establish a committee to monitor compliance with all aspects of the written agreement.

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

The following summarizes the Company’s progress to comply with the items in the Written Agreement as of June 2012.

·  
A new board oversight policy has been approved and implemented
·  
Completed revising the Bank’s loan grading system and ALLLR methodology
·  
Implemented Problem Loan Action reports and Problem Asset reports for all assets over $500,000 which are reviewed with the Board and forwarded to the Federal Reserve Bank on a quarterly basis
·  
Completed revising the written contingency funding plan
·  
Completed revising the investment policy;
·  
Completed revising the strategic and capital plan;
·  
Implementing a capital plan targeted to improve the Company’s and Bank’s capital levels to include strategically reducing the risk weighted assets of the Company, improvement in earnings as well as exploring options to raise additional capital
·  
Completed a Business Continuity Plan and Disaster Recovery Plan
·  
Formed a Directors Compliance Committee to monitor the progress of each item in the written agreement that meets at least quarterly and files a report with the Federal Reserve Bank

Results of Operations

Results of operations for the three-month and six- month periods ended June 30, 2012 reflected earnings of $654 thousand and $1.07 million, respectively. For the first six months of 2012, provisions for loan loss reserves decreased $3.17 million from the corresponding period in 2011 as the Company’s non-performing loans decreased significantly over the prior 12 months. The Company reported a net loss of $2.10 million for the six months ended June 30, 2011 and earnings of $22 thousand for the three month period ended June 30, 2011.

 
40

 
Net interest income for the three-month period ended June 30, 2012 increased $152 thousand or 3.44% compared to the three months ended June 30, 2011. For the six-month period ended June 30, 2012 net interest income increased $153 thousand or 1.76% as compared to the six-month period ended June 30, 2011.  Average interest-earning assets decreased $36.37 million from the six-month period ended June 30, 2011 to the current six-month period, while average interest-bearing liabilities decreased $50.16 million over the same period. The tax-equivalent yield on average interest-earning assets was 4.92% for the six-month period ended June 30, 2012 representing a decrease of 7 basis points from the same period in 2011.  The average balance of federal funds sold during the quarter was $62.70 million during the period. The average yield on federal funds sold was .24% during the period. The rate on average interest-bearing liabilities decreased 26 basis points to 1.74% for the six-month period ended June 30, 2012 as compared to 2.00% for the same period in 2011.

Total interest income for the three and six months ended June 30, 2012 was $390 thousand and $952 thousand less than the comparable 2011 periods due primarily to a reduction in loan and securities balances, new loan and investment securities volume being booked at lower rates, and existing adjustable rate loans and investment securities re-pricing at lower rates. Yields on typical investment securities during the current economic cycle have decreased significantly; therefore, management has intentionally decreased its security portfolio and maintained a significant amount of cash and cash equivalents during 2012 and 2011. The majority of pay-downs during the last year have been callable agency securities, US treasuries, and agency mortgage backed securities. The Company has also reduced its municipal bond holdings by approximately $18.71 million over the last 24 months in an effort to reduce its exposure to municipal debt and related potential credit risk. This has negatively affected the Company’s net interest income as these proceeds were placed back into overnight federal funds sold balances.

The Company’s total interest expense decreased by $542 thousand for the three months and $1.11 million for the six months from the same periods in 2011, due primarily to the overall reduction in time deposit balances. Additionally, new interest-bearing deposits are continuing to be recorded at lower rates and existing interest-bearing deposits and other liabilities are re-pricing lower as they renew. The Company continues to face considerable competition in all of its market areas as it pertains to rates on deposits.

During the first six months of 2012, the Company’s non-interest income increased by $278 thousand over the corresponding period for 2011. OTTI write-downs for the first six months of 2012 were $167 compared to $269 for the first six months of 2011. Total non-interest income for the three months ended June 30, 2012 increased $190 thousand over the three month period ended June 30, 2011 due primarily to a reduction in OTTI charges and an increase in security gains of $88 thousand.

Total non-interest expense for the six month period ended June 30, 2012 decreased $1.22 million as compared to the six month period ended June 30, 2011. FDIC insurance premiums totaled $670 thousand and decreased $119 thousand for the six months ended June 30, 2012 compared to the six months ended June 30, 2011. OREO expenses, write-downs and losses on the sale of OREO and repossessions in the amount of $629  thousand decreased $783 thousand for the six month period ended June 30, 2012 as compared to the prior period. Salaries and employee benefits decreased $395 thousand for the six months ended June 30, 2012 as compared to the prior year period as the Company has reduced its number of employees and additionally has seen a reduction in medical insurance costs. Total non-interest expense for the three month period ended June 30, 2012 decreased $558 thousand compared to the three month period ended June 30, 2011. This decrease was largely a result of decreased expenses and write-downs related to foreclosed properties and a decrease in salaries and employee benefits.

In addition to FDIC insurance premiums, for the six months ended June 30, 2012, other operating expenses that exceeded 1% of total interest income and other operating income were charges for other contracted services totaling $456 thousand, software licensing and maintenance costs totaling $386 thousand, legal expenses totaling $221 thousand and postage and freight expenses totaling $158 thousand.

For the six months ended June 30, 2011, other operating expenses that exceeded 1% of total interest income and other operating income were charges for FDIC insurance totaling $789 thousand, other contracted services totaling $310 thousand, software licensing and maintenance totaling $298 thousand and legal expenses totaling $240 thousand.

 
41

 
For the three month period ended June 30, 2012, other operating expenses that exceeded 1% of total interest income and other operating income were charges for FDIC insurance totaling $330 thousand, legal expenses totaling $192 thousand, other contracted services totaling $205 thousand, software licensing and maintenance totaling $202 thousand and postage and freight expenses totaling $89 thousand.

For the three month period ended June 30, 2011, other operating expenses that exceeded 1% of total interest income and other operating income were charges for FDIC insurance totaling $360 thousand, other contracted services totaling $180 thousand, software licensing and maintenance totaling $152 thousand and legal expenses totaling $151 thousand.

Operating results of the Company when measured as a percentage of average equity reveals an increase in return on average equity to 7.36% for the six-month period ended June 30, 2012 from (13.19%) for the corresponding period in 2011. Return on average assets for the six months ended June 30, 2012 was 0.35% compared to (0.65%) for the six months ended June 30, 2011.
 
The provision for loan losses for the three-month and six month periods ended June 30, 2012 totaled $116 thousand and $621 thousand, respectively, a $70 thousand decrease and $3.17 million decrease as compared to the corresponding periods in 2011. This decreased provision during the first half of 2012 was primarily due to the Company’s improved asset quality, primarily non-accrual loans, a reduction in charge-offs, and a significant increase in recoveries. The Company continually monitors the loan portfolio for signs of credit weaknesses or developing collection problems. Loan loss provisions for each period are determined after evaluating the loan portfolio and determining the level necessary to absorb current charge-offs and maintain the reserve at adequate levels.  Net charge-offs (inclusive of recoveries) for the first half of 2012 were $1.59 million compared with $2.95 million for the first six months of 2011. Year–to–date net charge-offs were 0.40% and 0.69% of total loans for the periods ended June 30, 2012 and June 30, 2011, respectively. Loan loss reserves decreased 27.85% to $8.05 million at June 30, 2012 from $11.16 million at June 30, 2011.  The Company’s allowance for loan loss reserves at June 30, 2012 decreased to 2.01% of total loans versus 2.60% at June 30, 2011.  At December 31, 2011, the allowance for loan loss reserve as a percentage of total loans was 2.21%.
 
Financial Position
 
Total loans decreased from $429.91 million at June 30, 2011 to $400.76 million at June 30, 2012.  Total loans at December 31, 2011 were $407.81 million. Over the last 3 years, the Company has significantly decreased its construction portfolio as a result of the economic downturn. Since June 30, 2009 the Company has reduced its construction loan and other land loan balances approximately $29.62 million. The Company has also been reducing its overall commercial real estate loan portfolio in an effort to increase its risk based capital ratios. Overall loan demand has slowed significantly over the last 3 years due to the recessionary environment. The Company’s current focus is to moderately increase its 1-4 family residential loan portfolio. The loan to deposit ratio slightly decreased from 81.59% at June 30, 2011 to 81.36% at June 30, 2012. Both loans and deposits have decreased significantly over the past year. The loan to deposit ratio at December 31, 2011 was 79.13%.  Deposits at June 30, 2012 have decreased $34.35 million since June 30, 2011 and have decreased $22.81 million since December 31, 2011. During the last 36 months, the Company has continued to lower the interest rates paid on time deposits in a continuing effort to reduce its cost of funds. As a result being “adequately-capitalized” for regulatory capital purposes, the Bank cannot renew or accept brokered deposits without prior regulatory approval and cannot offer interest rates on deposit accounts that are significantly higher than the average rates in our market area.

The Company also owns approximately $3.89 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 June 30, 2012 is not active and markets for similar securities are also not active.  These securities are currently in non-accrual status.  As of June 30, 2012, the unrealized loss in these securities totaled $3.61 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 additional OTTI charges on these securities. During the first quarter of 2012 the Company recorded OTTI credit related impairment charges on its TRUP CDOs in the amount of $167 thousand.  No OTTI charges were incurred during the three months ended June 30, 2012.

 
42

 
Below is a table of the Company’s remaining pooled trust preferred balances as of June 30, 2012.
(in thousands)

Description
Type
Class
 
Original Amount
$
   
Book Value
6/30/12
$
   
Fair Value
6/30/12
$
   
Unrealized Gain/(Loss)
$
 
Lowest Credit Rating
                               
Pretsel  4-B
Pooled
Mezz B
    700       85       58       (27 )
Ca
Prestel 11-B
Pooled
Mezz B
    500       398       59       ( 339 )
Ca
Prestel 12-B
Pooled
Mezz B
    750       387       85       ( 302 )
Ca
Prestel 13-B
Pooled
Mezz B
    500       326       19       ( 307 )
Ca
Prestel 15-B
Pooled
Mezz B
    500       263       7       ( 256 )
Ca
Prestel 18-C
Pooled
Mezz C
    500       209       1       (208 )
Ca
Prestel 19-C
Pooled
Mezz C
    500       255       1       ( 254 )
Ca
Prestel 20-C
Pooled
Mezz C
    500       11       1       ( 10 )
Ca
Prestel 21-C
Pooled
Mezz C
    500       294       8       (286 )
Ca
Prestel 22-C
Pooled
Mezz C
    500       283       4       (279 )
Ca
Prestel 22-C
Pooled
Mezz C
    500       317       4       ( 313 )
Ca
Prestel 22-C
Pooled
Mezz C
    500       316       4       (312 )
Ca
Prestel 23-C
Pooled
Mezz C
    500       442       17       (425 )
C
Tropc CDO III
Pooled
 
Subordinate
    1,000       307       14       (293 )
C


The Company currently has approximately $67.93 million in outstanding FHLB advances. No new advances were originated during the last 24 months. The Company secures all of its existing and future advances from the FHLB with a selected group of in-house residential and commercial real estate secured loans and a selected group of securities that are held in safekeeping by the FHLB.

Non-performing assets are comprised of loans on non-accrual status, loans contractually past due 90 days or more and still accruing interest, other real estate owned and repossessions. In addition, the market value of any securities available for sale placed in non accrual status is included. Non-performing assets were $26.29 million or 4.39% of total assets at June 30, 2012, compared with $37.80 million or 6.09% of total assets at December 31, 2011 and $41.22 million or 6.49% of total assets at June 30, 2011. The Company continues to focus its efforts on reducing its NPAs, primarily by reducing non accrual loans and selling OREO property.

The adequacy of the allowance for loan losses is based on management's judgment and analysis of current and historical loss experience, risk characteristics of the loan portfolio, concentrations of credit and asset quality, as well as other internal and external factors, such as general economic conditions.  At June 30, 2012 and December 31, 2011, the internal credit review department as well as management determined that the Company's allowance for loan losses is sufficient and is appropriate based on the requirements of US Generally Accepted Accounting Principles.





 
43

 


At June 30, 2012, net OREO balances were $17.69 million and consisted of 54 relationships.    The following chart details each category type, number, and balance.

OREO Property at 6/30/12
   
     
OREO Description
Number
    Balance at 6/30/12
   
           (in thousands)
Land Development  - Vacant Land
            20
$              4,627
1-4 Family
            18
                5,700
Multifamily
              1
                2,635
Commercial Real Estate
            15
                4,726
     
Total
            54
$            17,688
     

At December 31, 2011, net OREO balances were $16.72 million and consisted of 50 relationships.    The following chart details each category type, number, and balance.

OREO Property at 12/31/2011
   
     
OREO Description
Number
Balance at 12/31/11
   
           (in thousands)
Land Development  - Vacant Land
            17
$              4,175
1-4 Family
            23
                6,198
Multifamily
              1
                2,635
Commercial Real Estate
              9
                3,716
     
Total
            50
$            16,724
     


The one multifamily property totaling $2.6 million contains twenty – eight residential units outside the Sevierville, Tennessee area. There has been greater deterioration in the Tennessee commercial real estate market compared to the Bank’s other markets. The Bank is actively marketing all of its property through its website, listing agents, and other marketing methods. The Company formed a special assets committee to focus directly on selling OREO properties and reducing other non-performing assets. The committee is comprised of lending officers from all of the Bank’s three market areas. The ability to sell OREO has been negatively affected by the current economic climate and the reduction of  non-performing assets, will to a large degree, depend on how quickly specific market areas rebound from the recession.

Investment securities and other investments totaled $66.32 million (market value) at June 30, 2012 which reflects a decrease of $3.24 million or 4.65% from the December 31, 2011 total of $69.56 million. Investment securities available for sale and other investments at June 30, 2012 were comprised of mortgage backed securities (49.24% of the total securities portfolio), municipal issues (21.41%), corporate bonds (3.96%), CMOs (1.62%),  SBAs pools (11.69%), and US Treasuries (4.52%).  The Company’s entire securities portfolio was classified as available for sale at both June 30, 2012 and December 31, 2011.
Other investments include the Bank’s holdings of Federal Reserve, Federal Home Loan Bank, Pacific Coast Bankers Bank, Community Bankers Bank stock. These investments (carrying value of $5.01 million and 7.56% of the total) are considered to be restricted as the Company is required to hold these investments and the only market for these investments is the issuing agency. Also included in Other Investments is a certificate of deposit purchased from another FDIC insured institution.  The balance of this CD was $250,000 at both June 30, 2012 and December 31, 2011 .


 
44

 
Liquidity and Capital Resources
 
Total stockholders’ equity of the Company was $29.82 million at June 30, 2012, representing a decrease of $1.83 million or 5.78% from June 30, 2011. Total stockholders’ equity at December 31, 2011 was $28.26 million. The decrease in stockholders’ equity from June 30, 2011 to June 30 , 2012 is primarily due to the net losses incurred during 2011.

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

Liquidity is the ability to provide sufficient cash levels to meet financial commitments and to fund loan demand and deposit withdrawals. The Company and subsidiary Bank maintain a significant level of liquidity in the form of cash and cash equivalents ($72.93 million as of June 30, 2012) and unrestricted investment securities available for sale ($10.65 million market value).  Cash and cash equivalents are immediately available for satisfaction of deposit withdrawals, customer credit needs, and operations of the Bank.  The Bank also maintains a significant amount of available credit with both the Federal Home Loan Bank and a correspondent financial institution. The Bank also has the ability to attract certificates of deposit outside its market area by posting rates on the internet. The primary investors utilizing this network are credit unions. Unencumbered investment securities available for sale represent a secondary level of liquidity available for conversion to liquid funds in the event of extraordinary needs. The Company believes that it maintains sufficient liquidity to meet its current and projected requirements and needs.
 
On April 27, 2009, the Company announced that it entered into a $7,500,000 Loan Commitment Agreement with Community Bankers Bank (“CBB”), pursuant to which CBB agreed to extend to the Company an aggregate of $7,500,000 under a Revolving Line of Credit of up to $3,000,000 (“Loan A”) and a Closed-End Term Loan of up to $4,500,000 (“Loan B”) (collectively, the “Loans”). The Company pledged the stock of the Bank as collateral for the Loans. The Loan proceeds can be down-streamed to the Bank and qualify as Tier 1 capital at the Bank level. As of March 31, 2010, the Company had borrowed $4,104,000 of Loan B and $1,000,000 of Loan A.  Proceeds of the loans of $3,200,000 were down-streamed into the Bank as additional Tier 1 capital with the remaining proceeds of $2,300,000 held in cash by the Company. Subsequently, during the second quarter of 2011, the Company requested and CBB agreed to modify the closed-end loan to extend the amortization period of the loan for a new 20-year period. The Company simultaneously paid off the Revolving Line of Credit. The Closed – End Term Loan has a balloon maturity in April 2014 and the Company deposited the 35 monthly payments up to the balloon date into a reserve account held at CBB. The Closed – End Term Loan had a balance of $3,596,707 at June 30, 2012. One of the covenants included in the loan documents requires that the Bank and Company remain well-capitalized. The Company did receive a covenant waiver from CBB during the second quarter of 2011 after falling below “well-capitalized” to “adequately-capitalized ”. Also at year end 2011, the Company was granted a debt service coverage covenant waiver. The covenant requires a two to one ratio as it pertains to net operating income versus annual debt service payments. This waiver was granted in part due to having already prepaid the monthly payments up to the April 2014 balloon date.

 
45

 


 
Caution About Forward-Looking Statements
 

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

Such forward-looking statements involve known and unknown risks including, but not limited to, the following factors:
 
·  
The ability to attract and maintain capital levels adequate to support the Company’s asset  levels;
·  
Our inability to comply with the Written Agreement dated October 13, 2010;
·  
Our inability to comply with certain covenants of the Company’s Loans with Community Bankers Bank;
·  
Continued problems related to the sluggish economic recovery;
·  
Unemployment continuing to rise;
·  
Difficult market conditions in our industry;
·  
Unprecedented levels of market volatility;
·  
Effects of the soundness of other financial institutions;
·  
Potential impact on us of recently enacted legislation;
·  
Further deterioration in the housing market and collateral values;
·  
The ability to successfully manage the Company’s strategic plan.
·  
The ability to continue to attract low cost core deposits
·  
Reliance on the Company’s management team, including its ability to attract and retain key personnel;
·  
The successful management of interest rate risk;
·  
Further adverse changes in general economic and business conditions in the Company’s market area;
·  
Changes in interest rates and interest rate policies;
·  
Risks inherent in making loans such as repayment risks and fluctuating collateral values;
·  
Competition with other banks and financial institutions, and companies outside of the banking industry, including those companies that have substantially greater access to capital and other resources;
·  
Demand, development and acceptance of new products and services;
·  
Problems with technology utilized by the Company;
·  
Changing trends in customer profiles and behavior; and
·  
Changes in banking and other laws and regulations applicable to the Company.



ITEM 3. Quantitative and Qualitative Disclosures About Market Risk
 
Not Applicable

ITEM 4. Controls and Procedures
 
We have carried out an evaluation, under the supervision and the participation of our management, including our Chief Executive Officer, Chief Financial Officer and Vice President of Accounting, of the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rule 13a-15(e) under the Exchange Act) as of the end of the period covered by this report. Based upon that evaluation, our Chief Executive Officer,  Chief Financial Officer and Vice President of Accounting

 
46

 

concluded that our disclosure controls and procedures are effective in providing reasonable assurance that (a) the information required to be disclosed by us in the reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and (b) such information is accumulated and communicated to our management, including our Chief Executive Officer, Chief Financial Officer and Vice President of Accounting, as appropriate to allow timely decisions regarding required disclosure.

There have not been any changes in the Company’s internal controls over financial reporting during the second quarter of 2012 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.


PART II. OTHER INFORMATION

Item 1.  Legal Proceedings

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

Item 1A. Risk Factors
 
Not applicable

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

None

Item 3.  Defaults Upon Senior Securities

None
 
Item 4.  Mine Safety Disclosures

Not Applicable

Item 5.  Other Information

None


 
47

 


Item 6.  Exhibits

 
31.1
Rule 13a-14(a) Certification of Executive Vice President and Chief Executive Officer
 
31.2
Rule 13a-14(a) Certification of Chief Financial Officer
 
31.3
Rule 13a-14(a) Certification of Vice President of Accounting
 
32.1
Certification Statement of Executive Vice President and Chief Executive Officer pursuant to 18 U.S.C. Section 1350.
 
32.2
Certification Statement of Chief Financial Officer pursuant to 18 U.S.C. Section 1350.
 
32.3
Certification Statement of Vice President of Accounting pursuant to 18 U.S.C. Section 1350.
  101 The following materials from the Registrant’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2012, formatted in Extensible Business Reporting Language (XBRL), include: (i) the Consolidated Balance Sheets, (ii) the Consolidated Statements of Income, (iii) the Consolidated Statements of Comprehensive Income, (iv) Consolidated Statements of Cash Flows; (v) Consolidated Statements of Changes in Stockholders' Equity and (vi) related notes (furnished herewith).
 


 
 

 

 
 
 
 
 

 
SIGNATURES
 

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

  HIGHLANDS BANKSHARES, INC.  
     (Registrant)  
       
       
Date:  August 14, 2012
By:
/s/Samuel L. Neese  
    Samuel L. Neese  
    Executive Vice President and  
    Chief Executive Officer  
       
     
       
Date:  August 14, 2012
By:
/s/Robert M. Little, Jr.  
    Robert M. Little, Jr.  
    Chief Financial Officer   
       
     
       
Date:  August 14, 2012
By:
/s/James R. Edmondson  
    James R. Edmondson  
    Vice President of Accounting  
       



 
48

 

 
Exhibits Index

 
31.1
Rule 13a-14(a) Certification of Executive Vice President and Chief Executive Officer
 
31.2
Rule 13a-14(a) Certification of Chief Financial Officer
 
31.3
Rule 13a-14(a) Certification of Vice President of Accounting
 
32.1
Certification Statement of Executive Vice President and Chief Executive Officer pursuant to 18 U.S.C. Section 1350.
 
32.2
Certification Statement of Chief Financial Officer pursuant to 18 U.S.C. Section 1350.
 
32.3
Certification Statement of Vice President of Accounting pursuant to 18 U.S.C. Section 1350.
  101 The following materials from the Registrant’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2012, formatted in Extensible Business Reporting Language (XBRL), include: (i) the Consolidated Balance Sheets, (ii) the Consolidated Statements of Income, (iii) the Consolidated Statements of Comprehensive Income, (iv) Consolidated Statements of Cash Flows; (v) Consolidated Statements of Changes in Stockholders' Equity and (vi) related notes (furnished herewith).
 

 
 
 
 
 
 
 
 
 

 
 
49