10-Q 1 hbi10q11142016.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 September 30, 2016

[   ] 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.
 
8,199,229 shares of common stock, par value $0.625 per share,outstanding as of November 14, 2016
 


 
 
 
Highlands Bankshares, Inc.

FORM 10-Q
For the Quarter Ended September 30, 2016

INDEX
     
PART I. FINANCIAL INFORMATION       
PAGE
 
     
Item 1.  Financial Statements
   
     
Consolidated Balance Sheets
  at September 30, 2016 (Unaudited) and December 31, 2015
   
3
 
     
Consolidated Statements of Income (Unaudited)
  for the Three Months and Nine Months Ended September 30, 2016 and 2015
4
 
     
 
Consolidated Statements of   Comprehensive Income (Unaudited)
for the Three Months and Nine Months Ended September 30, 2016 and 2015
5
 
Consolidated Statements of Cash Flows (Unaudited)
 for the Nine Months Ended September 30, 2016 and 2015
6
 
     
Consolidated Statements of Changes in
 Stockholders' Equity (Unaudited) for the Three Months and Nine Months
 Ended September 30, 2016 and 2015
7-9
 
     
Notes to Consolidated Financial Statements (Unaudited)
10-40
 
     
Item 2. Management's Discussion and Analysis of
              Financial Condition and Results of Operations
41-47
 
     
Item 3. Quantitative and Qualitative Disclosures About Market Risk
47
 
     
Item 4.  Controls and Procedures
47
 
     
PART II.  OTHER INFORMATION
   
     
Item 1.  Legal Proceedings
48
 
     
Item 1A. Risk Factors
48
 
     
Item 2.  Unregistered Sales of Equity Securities and Use of Proceeds
48
 
     
Item 3.  Defaults Upon Senior Securities
48
 
     
Item 4.  Mine Safety Disclosures
48
 
     
Item 5.  Other Information
48
 
     
Item 6.  Exhibits
48
 
     
SIGNATURES AND CERTIFICATIONS
49
 


2

  FINANCIAL INFORMATION  
 ITEM 1.  Financial Statements
Consolidated Balance Sheets
(Amounts in thousands)
   
(Unaudited)
September 30, 2016
   
(Note 1)
December 31, 2015
 
                                              ASSETS
           
Cash and due from banks
 
$
24,824
   
$
26,713
 
Federal funds sold
   
22,379
     
20,178
 
                 
   Total Cash and Cash Equivalents
   
47,203
     
46,891
 
                 
Investment securities available for sale (amortized cost $95,914 at Sept. 30, 2016, $80,239 at December 31, 2015)
   
96,860
     
79,860
 
Other investments, at cost
   
6,636
     
6,592
 
Loans held for sale
   
2,760
     
-
 
Loans, net of allowance for loan losses of  $5,004 at September 30, 2016, $5,654 at December 31, 2015
   
405,089
     
426,429
 
Premises and equipment, net
   
19,972
     
20,612
 
Deferred tax assets
   
12,006
     
12,126
 
Interest receivable
   
1,945
     
1,761
 
Bank owned life Insurance
   
14,217
     
14,585
 
Other real estate owned
   
3,288
     
5,694
 
Other assets
   
2,294
     
2,432
 
                 
    Total Assets
 
$
612,270
   
$
616,982
 
                 

3



LIABILITIES AND STOCKHOLDERS' EQUITY
           
             
LIABILITIES
           
             
Deposits:
           
  Non-interest bearing
 
$
132,005
   
$
129,634
 
  Interest bearing
   
356,058
     
365,278
 
                 
    Total Deposits
   
488,064
     
494,912
 
                 
Interest, taxes and other liabilities
   
1,099
     
761
 
Other short-term borrowings
   
27,551
     
20,052
 
Long-term debt
   
40,160
     
47,698
 
    Total Other Liabilities
   
68,810
     
68,511
 
                 
    Total Liabilities
   
556,874
     
563,422
 
                 
STOCKHOLDERS' EQUITY
               
                 
Common stock (8,199 and 7,851) shares issued and outstanding at September 30, 2016 and December 31, 2015, respectively)
   
5,124
     
4,907
 
Preferred Stock (2,092 shares issued and outstanding)
   
4,184
     
4,184
 
Additional paid-in capital
   
18,837
     
17,944
 
Retained earnings
   
26,627
     
26,773
 
Accumulated other comprehensive income
   
624
     
(248
)
                 
  Total Stockholders' Equity
   
55,396
     
53,560
 
                 
    Total Liabilities and Stockholders' Equity
 
$
612,270
   
$
616,982
 

See accompanying Notes to Consolidated Financial Statements
4



Consolidated Statements of Income
(Amounts in thousands, except per share data)
(Unaudited)
 
   
Nine Months Ended September 30, 2016
   
Nine Months Ended September 30, 2015
   
Three Months
Ended
September 30, 2016
   
Three Months
Ended
September 30, 2015
 
INTEREST INCOME
                       
Loans receivable and fees on loans
 
$
15,978
   
$
15,921
   
$
5,224
   
$
5,347
 
Securities available for sale:
                               
  Taxable
   
1,034
     
873
     
390
     
281
 
  Exempt from taxable income
   
245
     
281
     
87
     
84
 
Other investment income
   
173
     
161
     
61
     
48
 
Federal funds sold
   
69
     
66
     
20
     
20
 
                                 
    Total Interest Income
   
17,499
     
17,302
     
5,782
     
5,780
 
                                 
INTEREST EXPENSE
                               
Deposits
   
1,344
     
1,662
     
445
     
545
 
Other borrowed funds
   
1,779
     
1,774
     
596
     
598
 
                                 
    Total Interest Expense
   
3,123
     
3,436
     
1,041
     
1,143
 
                                 
    Net Interest Income
   
14,376
     
13,866
     
4,741
     
4,637
 
                                 
Provision for Loan Losses
   
1,486
     
697
     
173
     
215
 
                                 
    Net Interest Income after Provision for Loan Losses
   
12,890
     
13,169
     
4,568
     
4,422
 
                                 
NON-INTEREST INCOME
                               
Securities gains, net
   
47
     
16
     
-
     
-
 
Mortgage Banking Income
   
361
     
-
     
361
     
-
 
Service charges on deposit accounts
   
1,330
     
1,260
     
464
     
439
 
Other service charges, commissions and fees
   
1,177
     
1,220
     
381
     
391
 
Other operating income
   
602
     
433
     
142
     
152
 
    Total Non-Interest Income
   
3,517
     
2,929
     
1,348
     
982
 
                                 
NON-INTEREST EXPENSE
                               
Salaries and employee benefits
   
8.850
     
7,598
     
2,895
     
2,585
 
Occupancy expense of bank premises
   
1,008
     
865
     
358
     
271
 
Furniture and equipment expense
   
1,148
     
1,026
     
412
     
350
 
Other operating expense
   
4,344
     
4,528
     
1,639
     
1,794
 
Foreclosed Assets – Write-down and operating expenses
   
1,530
     
684
     
684
     
(139)
 
    Total Non-Interest Expense
   
16,880
     
14,701
     
5,988
     
4,861
 
                                 
    Income Before Income Taxes
   
(473
)
   
1,397
     
(72
)
   
543
 
                                 
 
Income Tax Expense (Benefit)
   
(330
)
   
(746
)
   
(73
)
   
114
 
                                 
    Net Income
 
$
(143
)
 
$
2,143
   
$
1
   
$
429
 
                                 
Basic Earnings Per Common Share – Weighted Average
 
$
(0.02
)
 
$
0.27
   
$
0.00
   
$
0.05
 
                                 
Earnings Per Common Share – Assuming Dilution
 
$
(0.02
)
 
$
0.22
   
$
0.00
   
$
0.04
 

See accompanying Notes to Consolidated Financial Statements




5



Consolidated Statements of Comprehensive Income
(Amounts in thousands)
(Unaudited)
   
Nine Months Ended September 30, 2016
   
Nine Months Ended September 30, 2015
 
             
             
Net Income (loss)
 
$
(143)
 
 
$
2,143
 
                 
     Other Comprehensive Income
               
  Unrealized gains on securities during  the period
   
1,369
     
68
 
  Less: reclassification adjustment for gains included in net income
   
(47)
 
   
(16)
 
          Other Comprehensive Income, before tax
   
1,322
     
52
 
           Income tax expense related to other
           comprehensive income
   
(450)
 
   
(18))
 
    Other Comprehensive Income
   
872
     
34
 
Comprehensive Income
 
$
729
   
$
2,177
 
                 


   
Three Months Ended September 30, 2016
   
Three Months Ended September 30, 2015
 
             
             
Net Income
 
$
1
   
$
429
 
                 
Other Comprehensive Income
               
  Unrealized gains  (losses) on securities during  the period
   
(275)
 
   
326
 
  Less: reclassification adjustment for losses  included in net income
   
-
     
-
 
 Other Comprehensive Income (Loss), before tax
   
(275)
 
   
326
 
           Income tax (expense) benefit related to other
           comprehensive income
   
94
     
(111)
 
Other Comprehensive Income (loss)
   
(181)
 
   
215
 
Comprehensive Income (loss)
 
$
(180)
 
 
$
644
 
                 



See accompanying Notes to Consolidated Financial Statements
6



Consolidated Statements of Cash Flows
(Amounts in thousands)
(Unaudited)
   
Nine Months Ended
   
Nine Months Ended
 
   
September 30, 2016
   
September 30, 2015
 
CASH FLOWS FROM OPERATING  ACTIVITIES:
           
Net income (loss)
 
$
(143)
 
 
$
2,143
 
Adjustments to reconcile net income to net cash provided by                 operating activities
               
Provision for loan losses
   
1,486
     
697
 
Depreciation and amortization
   
721
     
749
 
Net realized (gains) losses on available for sale securities
   
(47)
 
   
(16)
 
Net amortization on securities
   
683
     
798
 
            (Increase) decrease in interest receivable
   
(184)
 
   
(75)
 
Valuation adjustment of other real estate owned
   
719
     
(155)
 
Valuation adjustment of deferred tax assets
   
-
     
(1,000)
 
Origination of loans held for sale
   
(9,094)
 
   
-
 
Proceeds from loans held for sale
   
6,334
     
-
 
Decrease (increase) in other assets
   
911
     
188
 
Increase (decrease) in interest, taxes and other liabilities
   $
338
     $
552
 
                 
Net cash provided by operating activities
   $
1,724
     $
3,881
 
                 
CASH FLOWS FROM INVESTING ACTIVITIES:
               
Securities available for sale:
               
       Proceeds from sale of securities
   $
21,284
     $
1,025
 
Proceeds from maturities of debt and equity securities
   
13,842
     
13,992
 
Purchase of securities
   
(51,437)
 
   
(15,875)
 
(Purchases) sales of other investments
   
(44)
 
   
168
 
Net (increase) decrease in loans
   
18,336
     
(19,635)
 
Proceeds from sales of other real estate owned
   
2,666
     
2,705
 
Premises and equipment expenditures
   $
(282)
 
   $
(1,092)
 
                 
Net cash provided by (used in) investing activities
   $
4,365
     $
(18,712)
 
                 
CASH FLOWS FROM FINANCING ACTIVITIES:
               
      Issuance of Common Stock
   $
1,110
     $
-
 
      Issuance of Preferred Stock
   
-
     
-
 
 
Net decrease in time deposits
   
(10,056)
 
   
(9,645)
 
Net increase (decrease) in demand, savings and other deposits
   
3,208
     
17,517
 
Increase in short-term borrowings
   
7,499
     
-
 
Decrease in long-term debt
   
(7,538)
 
   
(38)
 
Net cash  provided by  (used in) financing activities
   $
(5,777)
 
   $
7,834
 
                 
Net  increase (decrease) in cash and cash equivalents
   
312
     
(6,997)
 
CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD
   $
46,891
     $
55,810
 
                 
CASH AND CASH EQUIVALENTS AT END OF PERIOD
 
$
47,203
   
$
48,813
 
                 
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION
               
Cash paid during the period for:
               
Interest
 
$
3,128
   
$
3,458
 
                 
     SUPPLEMENTAL DISCLOSURE OF NONCASH TRANSACTIONS
               
Transfer of loans to other real estate owned
 
$
1,519
   
$
3,645
 
Loans originated from sales of other real estate owned
 
$
105
   
$
130
 
See accompanying Notes to Consolidated Financial Statements


7


Consolidated Statements of Changes in Stockholders' Equity
(Amounts in thousands)
(Unaudited)

Three Months Ended September 30
                                     
Accumulated
       
                           
Additional
         
Other
   
Total
 
   
Common Stock
         
Preferred Stock
   
Paid In
   
Retained
   
Comprehensive
   
Stockholders'
 
   
Shares
   
Par Value
   
Shares
   
Par Value
   
Capital
   
Earnings
   
Income (Loss)
   
Equity
 
                                                 
 
Balance, June 30, 2015
   
7,851
   
$
4,907
     
2,092
   
$
4,184
   
$
17,947
   
$
27,150
   
$
(86)
 
 
$
54,102
 
                                                                 
 
Net income
   
-
     
-
                     
-
     
429
     
-
     
429
 
                                                                 
Other comprehensive income
   
-
     
-
                     
-
     
-
     
215
     
215
 
                                                                 
 
Balance September 30, 2015
   
7,851
   
$
4,907
     
2,092
   
$
4,184
   
$
17,947
   
$
27,579
   
$
129
   
$
54,746
 
                                                                 
 
 
Balance, June 30, 2016
   
8,113
   
$
5,070
     
2,092
   
$
4,184
   
$
18,891
   
$
26,626
   
$
805
   
$
55,576
 
                                                                 
Net income
   
-
     
-
                     
-
     
1
     
-
     
1
 
                                                                 
Grant of Restricted Stock
   
86
     
54
                     
(54)
 
                   
-
 
                                                                 
Other comprehensive income (loss)
   
-
     
-
                     
-
     
-
     
(181)
 
   
(181)
 
                                                                 
 
Balance, September 30, 2016
   
8,199
   
$
5,124
     
2,092
   
$
4,184
   
$
18,837
   
$
26,627
   
$
624
   
$
54,396
 
                                                                 
                                                                 



8



Consolidated Statements of Changes in Stockholders' Equity
(Amounts in thousands)
(Unaudited)





Nine Months Ended September 30
                                     
Accumulated
       
                           
Additional
         
Other
   
Total
 
   
Common Stock
         
Preferred Stock
   
Paid-in
   
Retained
   
Comprehensive
   
Stockholders'
 
   
Shares
   
Par Value
   
Shares
   
Par Value
   
Capital
   
Earnings
   
Income (Loss)
   
Equity
 
                                                 
 
Balance, December 31, 2014
   
7,851
   
$
4,907
     
2,092
   
$
4,184
   
$
18,180
   
$
25,436
   
$
95
   
$
52,802
 
                                                                 
                                                                 
Net income
   
-
     
-
                     
-
     
2,143
     
-
     
2,143
 
                                                                 
Additional Paid In Capital
                                   
(233)
 
   
-
     
-
     
(233)
 
                                                                 
Other comprehensive income
   
-
     
-
                     
-
     
-
     
34
     
34
 
                                                                 
 
Balance, September 30, 2015
   
7,851
   
$
4,907
     
2,092
   
$
4,184
   
$
17,947
   
$
27,579
   
$
129
   
$
54,746
 
                                                                 
                                                                 
 
 
Balance, December 31, 2015
   
7,851
   
$
4,907
     
2,092
   
$
4,184
   
$
17,944
   
$
26,773
   
$
(248)
)
 
$
53,560
 
                                                                 
                                                                 
Net income
   
-
     
-
                     
-
     
(143)
 
   
-
     
(143)
 
                                                                 
Common Stock Issuance
   
262
     
163
     
-
     
-
     
947
     
-
     
-
     
1,110
 
                                                                 
Grant of Restricted Stock
   
86
     
54
                     
(54)
 
                   
-
 
                                                                 
Other comprehensive income (loss)
   
-
     
-
                     
-
     
-
     
872
     
872
 
                                                                 
 
Balance, September 30, 2016
   
8,199
   
$
5,124
     
2,092
   
$
4,184
   
$
18,837
   
$
26,627
   
$
624
   
$
54,396
 
                                                                 

See accompanying Notes to Consolidated Financial Statements


9

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, 2015 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, 2015 (the "2015 Form 10-K"). The notes included herein should be read in conjunction with the notes to consolidated financial statements included in the 2015 Form 10-K. The results of operations for the three-month and nine-month periods ended September 30, 2016, 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:

   
September 30,
2016
   
December 31, 2015
 
Real Estate Secured:
           
Residential 1-4 family
 
$
190,603
   
$
194,287
 
Multifamily
   
22,719
     
23,895
 
Construction and Land Loans
   
16,994
     
19,163
 
Commercial, Owner Occupied
   
69,407
     
73,031
 
Commercial, Non-owner occupied
   
32,078
     
38,025
 
Second mortgages
   
7,226
     
8,169
 
Equity lines of credit
   
6,795
     
6,000
 
Farmland
   
12,498
     
11,283
 
     $
358,320
     $
373,853
 
                 
Secured (other) and unsecured
               
Personal
   
18.096
     
20,775
 
Commercial
   
31,276
     
35,144
 
Agricultural
   
3,004
     
2,959
 
     $
52,376
     $
58,878
 
                 
Overdrafts
   
135
     
139
 
                 
     $
410,831
     $
432,870
 
Less:
               
  Allowance for loan losses
   
5,004
     
5,654
 
  Net deferred fees
   
738
     
787
 
     
5,742
     
6,441
 
                 
Loans, net
 
$
405,089
   
$
426,429
 


10



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 September 30, 2016

   
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
 
$
1,563
   
$
818
   
$
1,124
   
$
3,505
   
$
187,098
   
$
190,603
   
$
-
 
Equity lines of credit
   
50
     
26
     
-
     
76
     
6,719
     
6,795
     
-
 
Multifamily
   
-
     
-
     
-
     
-
     
22,719
     
22,719
     
-
 
Farmland
   
420
     
3
     
-
     
423
     
12,075
     
12,498
     
-
 
Construction, Land Development, Other Land Loans
   
22
     
-
     
-
     
22
     
16,972
     
16,994
     
-
 
Commercial Real Estate- Owner Occupied
   
151
     
-
     
3,927
     
4,078
     
65,329
     
69,407
     
-
 
Commercial Real Estate- Non Owner Occupied
   
-
     
-
     
-
     
-
     
32,078
     
32,078
     
-
 
Second Mortgages
   
1
     
-
     
30
     
31
     
7,195
     
7,226
     
-
 
Non Real Estate Secured
                                                       
Personal
   
139
     
42
     
30
     
211
     
18,020
     
18,231
     
-
 
Commercial
   
64
     
30
     
441
     
535
     
30,741
     
31,276
     
-
 
Agricultural
   
-
     
-
     
-
             
3,004
     
3,004
     
-
 
                                                         
          Total
 
$
2,410
   
$
919
   
$
5,552
   
$
8,881
   
$
401,950
   
$
410,831
   
$
-
 
                                                         

11



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 December 31, 2015:


   
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
 
$
4,193
   
$
1,580
   
$
2,545
   
$
8,318
   
$
185,969
   
$
194,287
   
$
-
 
Equity lines of credit
   
24
     
-
     
17
     
41
     
5,959
     
6,000
     
-
 
Multifamily
   
-
     
-
     
-
     
-
     
23,895
     
23,895
     
-
 
Farmland
   
56
     
7
     
303
     
366
     
10,917
     
11,283
     
-
 
Construction,  Land Development, Other Land Loans
   
49
     
61
     
37
     
147
     
19,016
     
19,163
     
-
 
Commercial Real Estate- Owner Occupied
   
514
     
485
     
5,014
     
6,013
     
67,018
     
73,031
     
-
 
Commercial Real Estate- Non Owner Occupied
   
-
     
-
     
-
     
-
     
38,025
     
38,025
     
-
 
Second Mortgages
   
88
     
37
     
5
     
130
     
8,039
     
8,169
     
-
 
Non Real Estate Secured
                                                       
Personal
   
264
     
141
     
163
     
568
     
20,346
     
20,914
     
-
 
Commercial
   
590
     
217
     
366
     
1,173
     
33,971
     
35,144
     
-
 
Agricultural
   
45
     
-
     
-
     
45
     
2,914
     
2,959
     
-
 
                                                         
          Total
 
$
5,823
   
$
2,528
   
$
8,450
   
$
16,801
   
$
416,069
   
$
432,870
   
$
-
 
                                                         


12


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.  Additionally, in certain instances, loans that have been restructured or modified may also be classified as non-accrual per regulatory guidance until a satisfactory payment history has been established. 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 September 30, 2016 and December 31, 2015:
 
   
September 30, 2016
   
December 31, 2015
 
                 Real Estate Secured
           
Residential 1-4 Family
 
$
1,124
   
$
2,675
 
Multifamily
   
-
     
-
 
Construction and Land Loans
   
-
     
71
 
Commercial-Owner Occupied
   
3,927
     
5,856
 
Commercial- Non Owner Occupied
   
-
     
-
 
Second Mortgages
   
30
     
5
 
Equity Lines of Credit
   
-
     
17
 
Farmland
   
-
     
303
 
               Secured (other) and Unsecured
               
Personal
   
30
     
163
 
Commercial
   
441
     
366
 
Agricultural
   
-
     
-
 
                 
Total
 
$
5,552
   
$
9,456
 


The following is a summary of residential real estate currently in the process of foreclosure as well as foreclosed residential real estate as of September 30, 2016.


   
Number
   
Balance
 
Residential real estate in the process of foreclosure
   
1
   
$
48
 
Foreclosed residential real estate
   
10
   
$
641
 



13


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 September 30, 2016 and December 31, 2015.  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 September 30, 2016
Grade (1)
 
Residential 1-4 Family
   
Multifamily
   
Farmland
   
Construction, Land Loans
   
Commercial Real Estate- Owner Occupied
   
Commercial Real Estate Non-Owner Occupied
 
                                     
Quality
   
27,420
     
-
     
-
     
2,813
     
2,392
     
289
 
Satisfactory
   
109,847
     
19,528
     
8,087
     
5,984
     
37,466
     
14,902
 
Acceptable
   
44,232
     
1,436
     
3,529
     
6,308
     
21,696
     
6,672
 
Special Mention
   
4,433
     
763
     
-
     
77
     
3,669
     
6,307
 
Substandard
   
4,671
     
992
     
882
     
1,812
     
4,184
     
3,908
 
Doubtful
   
-
     
-
     
-
     
-
     
-
     
-
 
                                                 
     Total
 
$
190,603
   
$
22,719
   
$
12,498
   
$
16,994
   
$
69,407
   
$
32,078
 

Credit Risk Profile by Internally Assigned Grade as of December 31, 2015
Grade (1)
 
Residential 1-4 Family
   
Multifamily
   
Farmland
   
Construction, Land Loans
   
Commercial Real Estate- Owner Occupied
   
Commercial Real Estate Non-Owner Occupied
 
                                     
Quality
   
25,939
     
-
     
25
     
3,036
     
2,870
     
1,481
 
Satisfactory
   
109,993
     
20,271
     
6,323
     
7,406
     
38,926
     
19,979
 
Acceptable
   
46,639
     
1,811
     
3,922
     
6,420
     
21,671
     
12,157
 
Special Mention
   
3,133
     
792
     
195
     
397
     
2,552
     
2,523
 
Substandard
   
8,583
     
1,021
     
818
     
1,904
     
7,012
     
1,885
 
Doubtful
   
-
     
-
     
-
     
-
     
-
     
-
 
                                                 
     Total
 
$
194,287
   
$
23,895
   
$
11,283
   
$
19,163
   
$
73,031
   
$
38,025
 


(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


14


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

·
underwriting and approval process have been adequately mitigated by other factors.
·
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 historic) 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.
15



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.
The following categories of loans are primarily evaluated according to whether or not they are performing or non-performing. Management considers loans 90 days or more past due to be non-performing.
Credit Risk Profile based on payment activity as of September 30, 2016
   
Consumer - Non Real Estate
   
Equity Line of Credit / Second Mortgages
   
Commercial - Non Real Estate
   
Agricultural - Non Real Estate
 
                         
Performing
 
$
18,201
   
$
13,884
   
$
30,300
   
$
3,004
 
Nonperforming (>90 days past due)
   
30
     
30
     
441
     
-
 
                                 
     Total
 
$
18,231
   
$
13,914
   
$
30,741
   
$
3,004
 
                                 


Credit Risk Profile based on payment activity as of December 31, 2015
   
Consumer - Non Real Estate
   
Equity Line of Credit /Jr. liens
   
Commercial - Non Real Estate
   
Agricultural - Non Real Estate
 
                         
Performing
 
$
20,751
   
$
14,147
   
$
34,778
   
$
2,959
 
Nonperforming (>90 days past due)
   
163
     
22
     
366
     
-
 
                                 
     Total
 
$
20,914
   
$
14,169
   
$
35,144
   
$
2,959
 
                                 


16


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 September 30, 2016:
 
 
September 30, 2016
 
Recorded Investment
   
Unpaid Principal Balance
   
Related Allowance
   
Average Recorded Investment
   
Interest Income Recognized
 
With No Related Allowance
                             
Real Estate Secured
                             
Residential 1-4 family
 
$
4,674
   
$
4,674
   
$
-
   
$
5,876
   
$
155
 
Equity lines of credit
   
15
     
15
     
-
     
33
     
1
 
Multifamily
   
992
     
992
     
-
     
1,007
     
39
 
Farmland
   
690
     
690
     
-
     
753
     
25
 
Construction, Land Development, Other Land Loans
   
1,447
     
1,447
     
-
     
1,497
     
66
 
Commercial Real Estate- Owner Occupied
   
3,708
     
3,708
     
-
     
4,639
     
169
 
Commercial Real Estate- Non Owner Occupied
   
1,887
     
1,887
     
-
     
944
     
12
 
Second Mortgages
   
89
     
89
     
-
     
244
     
4
 
Non Real Estate Secured
                                       
Personal /Consumer
   
30
     
30
     
-
     
49
     
1
 
Commercial
   
114
     
114
     
-
     
215
     
3
 
Agricultural
   
-
     
-
     
-
     
-
     
-
 
                                         
          Total
 
$
13,646
   
$
13,646
   
$
-
   
$
15,257
   
$
475
 



 
 
September 30, 2016
 
Recorded Investment
   
Unpaid Principal Balance
   
Related Allowance
   
Average Recorded Investment
   
Interest Income Recognized
 
With an Allowance Recorded
                             
Real Estate Secured
                             
Residential 1-4 family
 
$
600
   
$
600
   
$
176
   
$
1,223
   
$
19
 
Equity lines of credit
   
-
     
-
     
-
     
-
     
-
 
Multifamily
   
-
     
-
     
-
     
-
     
-
 
 
Farmland
   
193
     
193
     
17
     
97
     
8
 
Construction, Land Development, Other Land Loans
   
366
     
366
     
19
     
406
     
17
 
Commercial Real Estate- Owner Occupied
   
1,139
     
2,139
     
558
     
1,629
     
-
 
Commercial Real Estate- Non Owner Occupied
   
2,020
     
2,020
     
324
     
1,953
     
22
 
Second Mortgages
   
212
     
212
     
55
     
115
     
7
 
Non Real Estate Secured
                                       
Personal /Consumer
   
59
     
59
     
33
     
87
     
2
 
Commercial
   
618
     
618
     
377
     
644
     
8
 
Agricultural
   
-
     
-
     
-
     
-
     
-
 
                                         
          Total
 
$
5,207
   
$
6,207
   
$
1,559
   
$
6,154
   
$
83
 


17


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 December 31, 2015:


 
 
December 31, 2015
 
Recorded Investment
   
Unpaid Principal Balance
   
Related Allowance
   
Average Recorded Investment
   
Interest Income Recognized
 
With no Related Allowance
                             
Real Estate Secured
                             
Residential 1-4 family
 
$
7,078
   
$
7,078
   
$
-
   
$
7,533
   
$
247
 
Equity lines of credit
   
51
     
51
     
-
     
38
     
2
 
Multifamily
   
1,021
     
1,021
     
-
     
1,137
     
60
 
Farmland
   
816
     
816
     
-
     
829
     
38
 
Construction, Land Development, Other Land Loans
   
1,547
     
1,547
     
-
     
1,643
     
92
 
Commercial Real Estate- Owner Occupied
   
5,569
     
5,569
     
-
     
7,379
     
132
 
Commercial Real Estate- Non Owner Occupied
   
-
     
-
     
-
     
-
     
-
 
Second Mortgages
   
398
     
398
     
-
     
508
     
14
 
Non Real Estate Secured
                                       
Personal
   
68
     
68
     
-
     
61
     
4
 
Commercial
   
315
     
315
     
-
     
338
     
13
 
Agricultural
   
-
     
-
     
-
     
-
     
-
 
                                         
          Total
 
$
16,863
   
$
16,863
   
$
-
   
$
19,466
   
$
602
 


 
 
December 31, 2015
 
Recorded Investment
   
Unpaid Principal Balance
   
Related Allowance
   
Average Recorded Investment
   
Interest Income Recognized
 
With an Allowance Recorded
                             
Real Estate Secured
                             
Residential 1-4 family
 
$
1,846
   
$
1,846
   
$
249
   
$
2,497
   
$
93
 
Equity lines of credit
   
-
     
-
     
-
     
-
     
-
 
Multifamily
   
-
     
-
     
-
     
-
     
-
 
Farmland
   
-
     
-
     
-
     
-
     
-
 
Construction, Land Development, Other Land Loans
   
446
     
446
     
32
     
406
     
25
 
Commercial Real Estate- Owner Occupied
   
2,119
     
2,119
     
799
     
1,761
     
9
 
Commercial Real Estate- Non Owner Occupied
   
1,885
     
1,885
     
290
     
1,901
     
56
 
Second Mortgages
   
18
     
18
     
10
     
9
     
1
 
Non Real Estate Secured
                                       
Personal
   
114
     
114
     
45
     
184
     
4
 
Commercial
   
670
     
670
     
512
     
736
     
28
 
Agricultural
   
-
     
-
     
-
     
4
     
-
 
                                         
          Total
 
$
7,098
   
$
7,098
   
$
1,937
   
$
7,498
   
$
216
 









18

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 September 30, 2016 and September 30, 2015.



Nine  months ended September 30, 2016
 
Residential
1-4 Family
   
Multifamily
   
Construction and Land Loans
   
Commercial R./E Owner Occupied
   
Commercial R/E 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,  2015
 
$
654
   
$
-
   
$
37
   
$
1,012
   
$
748
   
$
43
   
$
20
   
$
7
   
$
704
   
$
886
   
$
1,543
   
$
5,654
 
Provision for Credit Losses
   
(107)
 
   
-
     
(3)
 
   
1,583
     
(236)
 
   
16
     
5
     
10
     
921
     
(243)
 
   
(460))
 
   
1,486
 
Charge-offs
   
108
     
-
     
29
     
1,246
     
-
     
-
     
9
     
-
     
915
     
166
     
-
     
2,473
 
Recoveries
   
(3)
 
   
-
     
(14)
 
   
(7)
 
   
(8)
 
   
-
     
(2)
 
   
-
     
(176)
 
   
(127)
 
   
-
     
(337)
 
Net Charge-offs
   
105
     
-
     
15
     
1,239
     
(8)
 
   
-
     
7
     
-
     
739
     
39
     
-
     
2,136
 
Ending Balance
 September 30, 2015
   
442
     
-
     
19
     
1,356
     
520
     
59
     
18
     
17
     
886
     
604
     
1,083
     
5,004
 
Ending Balance: Individually evaluated for impairment
   
176
     
-
     
19
     
558
     
324
     
55
     
-
     
17
     
33
     
377
     
-
     
1,559
 
Ending Balance:  Collectively Evaluated for Impairment
   
266
     
-
     
-
     
798
     
196
     
4
     
18
     
-
     
853
     
227
     
1,083
     
3,445
 
Loans:
                                                                                               
Ending Balance: Individually Evaluated for Impairment
   
5,274
     
992
     
1,813
     
4,847
     
3,907
     
301
     
15
     
883
     
89
     
732
     
-
     
18,853
 
Ending Balance: Collectively Evaluated for Impairment
   
185,329
     
21,727
     
15,181
     
64,560
     
28,171
     
6,925
     
6,780
     
11,615
     
18,142
     
33,548
     
-
     
391,978
 
Ending Balance: September 30, 2016
 
$
190,603
   
$
22,719
   
$
16,994
   
$
69,407
   
$
32,078
   
$
7,226
   
$
6,795
   
$
12,498
   
$
18,231
   
$
34,280
     
-
   
$
410,831
 
19


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

Nine  months ended September 30, 2015
 
Residential
1-4 Family
   
Multifamily
   
Construction and Land Loans
   
Commercial R./E Owner Occupied
   
Commercial R/E 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,  2014
 
$
995
   
$
20
   
$
87
   
$
409
   
$
1,063
   
$
67
   
$
74
   
$
12
   
$
665
   
$
982
   
$
1,103
   
$
5,477
 
Provision for Credit Losses
   
(159
)
   
(20
)
   
(70
)
   
(164
)
   
(259
)
   
9
     
(90
)
   
(4
)
   
649
     
130
     
675
     
697
 
Charge-offs
   
105
     
-
     
-
     
12
     
407
     
3
     
-
     
-
     
634
     
205
     
-
     
1,366
 
Recoveries
   
(1
)
   
-
     
(34
)
   
(6
)
   
(376
)
   
-
     
(41
)
   
(2
)
   
(59
)
   
(7
)
   
-
     
(526
)
Net Charge-offs
   
104
     
-
     
(34
)
   
6
     
31
     
3
     
(41
)
   
(2
)
   
575
     
198
     
-
     
841
 
Ending Balance
 September 30, 2015
   
732
     
-
     
51
     
239
     
773
     
73
     
25
     
10
     
739
     
914
     
1,777
     
5,333
 
Ending Balance: Individually evaluated for impairment
   
405
     
-
     
31
     
-
     
300
     
29
     
-
     
-
     
69
     
525
     
-
     
1,359
 
Ending Balance:  Collectively Evaluated for Impairment
   
327
     
-
     
20
     
239
     
473
     
44
     
25
     
10
     
670
     
389
     
1,777
     
3,974
 
Loans:
                                                                                               
Ending Balance: Individually Evaluated for Impairment
   
9,186
     
1,123
     
2,002
     
7,672
     
1,895
     
254
     
50
     
826
     
177
     
1,034
     
-
     
24,219
 
Ending Balance: Collectively Evaluated for Impairment
   
185,226
     
22,877
     
15,834
     
61,718
     
31,899
     
7,757
     
6,053
     
10,696
     
20,971
     
35,659
     
-
     
398,690
 
Ending Balance: September 30, 2015
 
$
194,412
   
$
24,000
   
$
17,836
   
$
69,390
   
$
33,794
   
$
8,011
   
$
6,103
   
$
11,522
   
$
21,148
   
$
36,693
     
-
   
$
422,909
 












20


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

A loan is considered impaired and an allowance for loan losses is established on loans for which it is probable that the full collection of principal and interest 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 September 30, 2016 and December 31, 2015, 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", require additional analysis 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 warrant further analysis before completing an assessment of 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 ("TDRs"). 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 $12,420 and $12,060 of loans categorized as troubled debt restructurings as of September 30, 2016 and December 31, 2015, 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 probable.

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.

The following tables summarize the troubled debt restructurings during the nine months ended September 30, 2016 and 2015.




21


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


Troubled Debt Restructurings –Nine months ended September 30, 2016
Interest only
Number of Contracts
Pre- Modification  Outstanding Recorded Investment
Post - Modification Recorded Investment
         Real Estate Secured
     
Residential 1-4 family
1
180
180
Equity lines of credit
     
Multifamily
     
Farmland
1
57
57
Construction, Land Development,
Other Land Loans
     
Commercial Real Estate-  Owner Occupied
3
2,400
2,400
Commercial Real Estate-  Non Owner Occupied
 
1
 
1,887
 
1,887
Second Mortgages
1
64
64
Non Real Estate Secured
     
Personal / Consumer
     
Commercial
     
Agricultural
     
       
Total
7
4,588
4,588
 

 
Troubled Debt Restructurings
Below Market Rate
Number of Contracts
Pre- Modification  Outstanding Recorded Investment
Post - Modification Recorded Investment
        Real Estate Secured
     
Residential 1-4 family
1
848
848
Equity lines of credit
     
Multifamily
     
Farmland
     
Construction, Land Development,
Other Land Loans
     
Commercial Real Estate-  Owner Occupied
  1
1,516
1,516
Commercial Real Estate-  Non Owner Occupied
     
Second Mortgages
     
Non Real Estate Secured
     
Personal / Consumer
     
Commercial
     
Agricultural
     
       
Total
2
2,364
2,364

22



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

Troubled Debt Restructurings
Loan term extension
Number of Contracts
Pre- Modification  Outstanding Recorded Investment
Post - Modification Recorded Investment
                Real Estate Secured
     
Residential 1-4 family
2
192
192
Equity lines of credit
     
Multifamily
     
Farmland
1
50
50
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
3
242
242
 
Troubled Debt Restructurings
All
Number of Contracts
Pre- Modification  Outstanding Recorded Investment
Post - Modification Recorded Investment
Total Restructurings
12
7,194
7,194
 
 

 
Troubled Debt Restructurings
That subsequently defaulted
 
Number of Contracts
 
Pre- Modification  Outstanding Recorded Investment
Post - Modification Recorded Investment
                                                                   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
     
Commercial
     
Agricultural
     
       
Total
-
-
-



23



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


Troubled Debt Restructurings –Nine months ended September 30, 2015
Interest only
Number of Contracts
Pre- Modification  Outstanding Recorded Investment
Post - Modification Recorded Investment
                                                                  Real Estate Secured
     
Residential 1-4 family
1
188
188
Equity lines of credit
     
Multifamily
     
Farmland
     
Construction, Land Development,
Other Land Loans
     
Commercial Real Estate-  Owner Occupied
2
2,203
2,203
Commercial Real Estate-  Non Owner Occupied
     
Second Mortgages
1
68
68
Non Real Estate Secured
     
Personal / Consumer
     
Commercial
     
Agricultural
     
       
Total
4
2,459
2,459
 

 
Troubled Debt Restructurings
Below Market Rate
Number of Contracts
Pre- Modification  Outstanding Recorded Investment
Post - Modification Recorded Investment
        Real Estate Secured
     
Residential 1-4 family
1
863
863
Equity lines of credit
     
Multifamily
     
Farmland
     
Construction, Land Development,
Other Land Loans
     
Commercial Real Estate-  Owner Occupied
1
1,547
1,547
Commercial Real Estate-  Non Owner Occupied
     
Second Mortgages
     
Non Real Estate Secured
     
Personal / Consumer
     
Commercial
     
Agricultural
     
       
Total
2
2,410
2,410
24


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

Troubled Debt Restructurings
Loan term extension
Number of Contracts
Pre- Modification  Outstanding Recorded Investment
Post - Modification Recorded Investment
                                                               Real Estate Secured
     
Residential 1-4 family
1
131
131
Equity lines of credit
     
Multifamily
     
Farmland
     
Construction, Land Development,
Other Land Loans
 
1
 
35
 
35
Commercial Real Estate-  Owner Occupied
     
Commercial Real Estate-  Non Owner Occupied
     
Second Mortgages
     
                                                             Non Real Estate Secured
     
Personal / Consumer
     
Business Commercial
     
Agricultural
     
       
Total
2
166
166
 
Troubled Debt Restructurings
All
Number of Contracts
Pre- Modification  Outstanding Recorded Investment
Post - Modification Recorded Investment
Total Restructurings
8
5,035
5,035
 

 
Troubled Debt Restructurings
That subsequently defaulted
Number of Contracts
 
Pre- Modification  Outstanding Recorded Investment
Post - Modification Recorded Investment
                 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
     
Commercial
     
Agricultural
     
       
Total
-
-
-

25



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

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.  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 securitized.  Collateral is discounted, when appropriate, to determine a "stressed" loan to value (LTV) ratio.   In addition to annual loan relationship reviews, quarterly reviews on all loan relationships over $100 that are graded Substandard, Doubtful and Loss are also completed.  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  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 segments of the Company's loan portfolio are disaggregated to a level that allows management to monitor risk and performance. In reviewing risk, management has determined there to be several different risk categories within the loan portfolio. The allowance for loan losses consists of amounts applicable to: (i) the commercial loan portfolio; (ii) the commercial real estate loan portfolio; (iii) the construction loan portfolio; (iv) the consumer loan portfolio; and, (v) the residential loan portfolio. The commercial real estate ("CRE") loan segment is further disaggregated into two classes. Non-owner occupied CRE loans, which include loans secured by non-owner occupied nonfarm nonresidential properties, generally have a greater risk profile than all other CRE loans, which include multifamily structures and owner-occupied commercial structures. The construction loan segment is further disaggregated into two classes. One-to-four family residential construction loans are generally made to individuals for the acquisition of and/or construction on a lot or lots on which a residential dwelling is to be built. Commercial construction loans are generally made to developers or investors for the purpose of acquiring, developing and constructing residential or commercial structures. Construction lending is generally considered to involve a higher degree of credit risk than long-term permanent financing.

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 ASC 310.  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 impaired under ASC 310. 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.

26


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

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.  The total balance of unsecured loans is considered as direct exposure.

ASC 450 Loan Loss:

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 Company 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 Company'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 Company begins with the net loss in each category for each of the last twelve quarters. The Company uses a rolling twelve quarter weighted historical loss average where the most recent quarters are weighted heavier than the earlier quarters so that the calculation reflects current risk trends within the portfolio.  The weighting used by the Company is similar to the Rule of 78's with the net losses of the most recent quarter weighted at 12/78ths and those in the first quarter in the twelve quarter period weighted at 1/78th.   Therefore, the net losses of the most recent year represent approximately 54% of the calculation compared with 33% if a simple average of losses over the three-year period was used.  The total of weighted factors for each call report category is applied to the current outstanding loan balance in each category to calculate expected loss based on historical data for a group of loans with similar risk characteristics.  The same weighting is applied to all loan types.

(2) External economic factors:  Economic conditions have a significant impact on Company'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

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

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

d.
Past-Due Loans
e.
Non-Accrual Loans
f.
CRE Concentrations
g.
Loan Volume Level
h.
Level and Trend of Classified Loans

  The values for internal factors are updated on a quarterly basis based on current portfolio metrics.

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.

27



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

Loans Held for Sale

The Company's mortgage division, Highlands Home Mortgage, originates certain single family, residential first mortgage loans for sale on a presold basis. Loan sale activity is summarized below. This division began operations in the second quarter of 2016. Loans are typically sold to one of the various investors within 20 days of closing. Management feels the carrying amounts approximate the fair values of loans held for sale.

Nine-months ended September 30
 
2016
   
2015
 
             
Loans held for sale at end of period
 
$
2,760
   
$
-
 
Proceeds from sales of mortgage loans originated for sale
   
6,334
         
Gain on sales of mortgage loans originated for sale
 
$
361
     
-
 

Note 3  -  Income Taxes

Income tax expense (benefit) for the nine months ended September 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:

   
2016
   
2015
 
             
Tax expense (benefit) at statutory rate
 
$
(161
)
 
$
475
 
Reduction in taxes from:
               
Tax-exempt interest
   
(84
)
   
(95
)
Valuation adjustment for deferred tax assets
   
-
     
(1,000
)
   Other, net
   
(85
)
   
(126
)
Income tax benefit
 
$
(330
)
 
$
(746
)

In the second quarter of 2015, the Company reversed the remaining balance of the valuation allowance that was established against the deferred tax assets ("DTA") during the fourth quarter of 2011. The valuation allowance was established during 2011 due to uncertainty at the time regarding the ability to generate sufficient future taxable income to fully realize the benefit of the net DTA. Subsequent to 2011, earnings performance and asset quality have improved resulting in greater expected realization of the DTA. In addition, the Company raised $16,123 in net proceeds of new capital in 2014 which allowed the Company to payoff two high rate debt instruments (the Company's Community Bankers Bank note and Trust Preferred Securities) improving future earnings potential.  As a result of these factors, the Company reversed $1,000 of the DTA in the second quarter of 2014, and due to the continued improvements in asset quality and earnings performance the remaining $1,000 of the DTA valuation allowance was reversed in the second quarter of 2015. In assessing the realizability of DTA, management considers whether it is more likely than not that some portion or all of the DTA will not be realized. The Company evaluates the carrying amount of its DTA on a quarterly basis in accordance with the guidance provided in FASB ASC Topic 740 ("ASC 740"), in particular, applying the criteria set forth therein to determine whether it is more likely than not (i.e., a likelihood of more than 50%) that some portion, or all, of the DTA will not be realized within its life cycle, based on the weight of available evidence. In most cases, the realization of the DTA is dependent upon the Company generating a sufficient level of taxable income in future periods, which can be difficult to predict.  If the Company's forecast of taxable income within the carry forward periods available under applicable law is not sufficient to cover the amount of net deferred assets, such assets may be impaired. Management considers the reversal of deferred tax liabilities (including the impact of available carry-back and carry-forward periods), projected future taxable income and tax-planning strategies in making this assessment.

 
28

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

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.  On July 7, 2013 the Federal Reserve Board approved Basel III Final Rules to begin implementation January 1, 2015. The desired overall objective of Basel III is to improve the banking sector's ability to absorb shocks arising from financial and economic stress.  The Final Rule includes a new Common Equity Tier 1 (CET1) minimum ratio and raises the Tier 1 Risk Weighted Assets ratio to 6% from 4%.  In addition, the new rules require a bank to maintain a capital conservation buffer of between 2 and 2 ½ % beginning in 2016.  Additionally, the new rules increase the risk weighting of various assets. The new rules will be phased in beginning in 2015 with complete compliance required by 2019.  Generally, the Basel III Final Rule will require banks to maintain higher levels of common equity and regulatory capital. On December 18, 2014, the President of the United States signed
into law Public Law 113-250 (the "Act"), which directs the Board of Governors of the Federal Reserve System (Board) to propose revisions to the Small Bank Holding Company Policy Statement (Policy Statement) to raise the total consolidated asset limit in the Policy Statement from $500 million to $1 billion. On February 5, 2015 the Company received notification from the Federal Reserve Bank that it would no longer be required to report holding company consolidated capital ratios. The following tables present the capital ratios for the Bank only.


                                                                      September 30, 2016
 
Entity
Tier 1
Total Risk Based
Leverage
 CET 1
         
Highlands Union Bank
                11.85%
13.12%
            7.60%
               11.75%

                                                                   December 31, 2015
 
Entity
Tier 1
Total Risk Based
Leverage
CET 1
         
         
Highlands Union Bank
                11.28%
12.55%
             7.33%
               11.28%

Note 5.  Capital Issuances / Awards

On April 16, 2014, management and board of directors of Highlands Bankshares, Inc. announced the completion of a $16,525 private placement capital raise. Purchasers in the private placement included outside investors, as well as certain directors and executive officers of the Company. The Company sold 2,673,249 newly issued shares of the Company's common stock at $3.50 per share, and 2,048,179 shares of Series-A convertible perpetual preferred stock at $3.50 per share. The private placement was disclosed on Form 8-K on April 16, 2014. The Company immediately paid off a Holding Company Loan in the amount of $3,440 to Community Bankers Bank on April 16, 2014 with the funds received from the capital raise. The Company also paid off the remaining $3,150 of its trust preferred securities including accrued interest. The payoff totaling $4,802 was completed on July 15, 2014. The Company down-streamed to the subsidiary Bank in June 2014 $7,500 of funds received from the capital raise. During the third quarter of 2014, the Company also conducted a rights offering to its existing shareholders other than directors and executive officers. The Company raised a total of $556 as a result of the offering. The Company immediately down-streamed $400 of the $556 to the
Bank in September of 2014. In October 2014, one of the private placement purchasers, TNH Financial Fund, LP, purchased another $183 of common and preferred stock which allowed them to maintain the same ownership percentage that was held immediately prior to the rights offering. Net proceeds received from the private placement issues and rights offering totaled $16,123. In January of 2016, the Company's CEO, Timothy K. Schools purchased 235,294 shares of the Company's common stock at a price of $4.25 per share


29

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

in a private placement as disclosed on Form 4 on January 12, 2016.  In February 2016, two of the private placement purchasers participating in the capital raise in 2014, MFP Partners LP and Deerhill Pond Investment Partners, LP, each purchased another 12,744 shares of common stock at $4.25 per share which allowed them to maintain the same ownership percentage that was held immediately prior to Mr. Schools' purchase. The company down-streamed $1,150 to the Bank.

Effective September 6, 2016, the Company and Timothy K. Schools, the Company's President and Chief Executive Officer, executed an amendment to Mr. Schools' employment agreement. The amendment provides for the grant of 86,667 restricted shares of the Company's common stock. The Restricted Shares will vest 50% on the first anniversary of the Award Date and 50% on the second anniversary of the Award Date. The restricted shares will be expensed over the 2 year vesting period based on the grant date fair value of the shares.

Note 6 – Per Share Amounts

Earnings per common share is computed using the weighted average outstanding shares for the three months and nine months ended September 30, 2015 and 2016.  During 2014, the Company issued a total of 2,092,287 shares of Series A preferred stock (See Note 5). These preferred shares are non-voting mandatorily convertible non-cumulative preferred shares which are entitled to receive dividends equal to dividends paid on the Company's common shares. The Series A preferred shares will rank pari passu with the common stock with respect to all terms (other than voting), including, the payment of dividends or distributions, and payments and rights upon liquidation and dissolution. In the computation of diluted earnings per share for the nine months ended 2016, the 2,092,287 shares of preferred stock and the 86,667 restricted shares were not included, as the effect of their conversion would have been anti-dilutive. The following is a reconciliation of the numerators and the denominators of the basic and diluted earnings per common share computation:

For the three months ended September 30
 
2016
    2015  
             
Income available to common stockholders
 
$
1
    $ 429  
Weighted average shares outstanding
   
8,113
      7,851  
Shares outstanding including assumed conversion
   
10,292
      9,943  
Basic earnings per common share
 
$
0.00
    $ 0.05  
Fully diluted earnings per share (including convertible preferred shares outstanding and restricted stock)
 
$
0.00
    $ 0.04  
                     
For the nine months ended September 30
   
2016
      2015        
                       
Income available to common stockholders
 
$
(143)
 
  $ 2,143        
Weighted average shares outstanding
   
8,105
      4,851        
Shares outstanding including assumed conversion
   
8,105
      9,943        
Basic earnings per common share
 
$
(0.02)
 
  $ 0.27    
 
   
Fully diluted earnings per share
 
$
(0.02)
 
  $ 0.22      
 
 

30


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 September 30, 2016, these commitments included: standby letters of credit of $273; equity lines of credit of $8,519; credit card lines of credit of $6,571 commercial real

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

estate, construction and land development commitments of $1,780; and other unused commitments to fund interest earning assets of $24,874.

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.


31


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. 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.

The following tables summarize the Company's available for sale securities portfolio measured at fair value on a recurring basis as of September 30, 2016 and December 31, 2015, segregated by the level of the valuation inputs within the fair value hierarchy.


September 30, 2016
 
 
Level 1
 
Level 2
 
Level 3
 
Total Fair Value
 
Available for Sale Securities
               
State and Political Subdivisions
 
$
-
   
$
12,679
   
$
-
   
$
12,679
 
Mortgage Backed Securities
 
$
-
   
$
75,012
   
$
-
   
$
75,012
 
SBA Pools
 
$
-
   
$
9,169
   
$
-
   
$
9,169
 
Total AFS Securities
 
$
-
   
$
96,860
   
$
-
   
$
96,860
 



December 31, 2015
 
 
Level 1
 
Level 2
 
Level 3
 
Total Fair Value
 
Available for Sale Securities
               
State and Political Subdivisions
 
$
-
   
$
6,958
   
$
-
   
$
6,958
 
Mortgage Backed Securities
 
$
-
   
$
62,593
   
$
-
   
$
62,593
 
SBA Pools
 
$
-
   
$
10,309
   
$
-
   
$
10,309
 
Total AFS Securities
 
$
-
   
$
79,860
   
$
-
   
$
79,860
 



32



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

Non Recurring - 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 recently appraised collateral value and /or tax assessed value, liquidation value and 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 September 30, 2016 and December 31, 2015, all of the total impaired loans were evaluated based on the fair value of the collateral.  The Company frequently obtains appraisals prepared by external professional appraisers and applies discounts ranging from 8% to 40% depending on type of property, condition, location, etc. The Company also, in certain instances, prepares internally generated valuations from on-site inspections, third-party valuation models or other information.

Non Recurring – Loans Held for Sale

Loans held for sale are carried at the lower of cost or market value. The fair value of loans held for sale is based on what secondary markets are currently offering for loans with similar characteristics. As such, the Company considers loans held for sale as nonrecurring Level 2.

Non Recurring -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 recent appraised values of the collateral, which the Company considers to be nonrecurring Level 2.  When the current appraised value is not available and /or further discounted below the most recent appraised value less selling costs due to such things as absorption rates and market conditions, the Company classifies the foreclosed assets within Level 3 of the fair value hierarchy.

The following table summarizes the Company's assets at fair value on a non - recurring basis as of September 30, 2016 and December 31, 2015 segregated by the level of the valuation inputs within the fair value hierarchy. The tables disclose the recorded investment of impaired loans requiring a specific allowance.

September 30, 2016
 
Level 1
   
Level 2
   
Level 3
   
Total Fair Value
 
Impaired Loans
 
$
-
   
$
-
   
$
5,207
   
$
5,207
 
Loans held for sale
 
$
-
   
$
2,760
   
$
-
   
$
2,760
 
Repossessions/OREO, net
 
$
-
   
$
-
   
$
3,288
   
$
3,288
 

December 31, 2015
 
Level 1
   
Level 2
   
Level 3
   
Total Fair Value
 
Impaired Loans
 
$
-
   
$
-
   
$
7,098
   
$
7,098
 
Loans held for sale
 
$
-
   
$
-
   
$
-
   
$
-
 
Repossessions/OREO, net
 
$
-
   
$
-
   
$
5,724
   
$
5,724
 


33



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

The following table presents additional quantitative information about assets measured at fair value on a nonrecurring basis for which the Company uses Level 3 inputs to determine fair value (dollars in thousands):
 
 
 
       
Quantitative Information about Level 3 Fair Value Measurements
 
 
 
 
September 30,
   
December 31,
 
Valuation
Unobservable
Range
   
2016
   
2015
 
 
Techniques
Input (2)
(Weighted Average)
OREO,Repossessions
 
$
3,288
   
$
5,724
 
Appraisal of collateral (1)
Appraisal adjustments
0% to 45% (13%)
 
               
         
Liquidation expenses
0% to 10% (9%)
 
               
 
 
             
Impaired loans
 
$
5,207
   
$
7,098
 
Fair value of collateral –real estate  (1), (3)
Appraisal adjustments
0% to 10% (9%)
 
               
 Fair value of collateral –equipment, inventory, other  (1), (3)
Appraisal adjustments
25% to 50% (33%)
                            
Liquidation expenses
0% to 10% (9%)



Valuation adjustments and liquidation cost adjustments represent unobservable inputs for OREO and impaired loans.  The ranges of discounts applied are based on age of independent appraisals, type and condition of collateral, current market conditions, and experience with the local market.
(1)  Fair value is generally determined through independent appraisals of the underlying collateral, which generally include various Level 3 inputs which are not identifiable.
(2)  Appraisals may be adjusted by management for qualitative factors such as economic conditions and estimated liquidation expenses.  The range and weighted average of liquidation expenses and other appraisal adjustments are presented as a percent of the appraisal.
(3)  Includes qualitative adjustments by management.



34



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 recurring or 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.
35


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.

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 September 30, 2016 and December 31, 2015 were as follows:



   
September 30, 2016
   
December 31, 2015
 
   
Carrying Amount
   
Fair Value
   
Carrying Amount
   
Fair Value
 
 
                         
Cash and cash equivalents
 
$
47,203
   
$
47,203
   
$
46,891
   
$
46,891
 
Securities available for
 sale
   
96,860
     
96,860
     
79,860
     
79,860
 
Other investments
   
6,636
     
6,636
     
6,592
     
6,592
 
Loans held for sale
   
2,760
     
2,760
     
-
     
-
 
Loans, net
   
405,089
     
400,740
     
426,429
     
419,907
 
Deposits
   
(488,064)
 
   
(446,35)
 
   
(494,912)
 
   
(472,197)
 
Other short-term
  borrowings
   
(27,551)
 
   
(28,354)
 
   
(20,052)
 
   
(21,970)
 
Long-term debt
   
(40,160)
 
   
(42,550)
 
   
(47,698)
 
   
(50,313)
 


36



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:
   
September 30, 2016
 
   
Amortized Cost
   
Gross Unrealized Gains
   
Gross Unrealized Losses
   
Fair Value
 
 
                         
State and political subdivisions
 
$
12,525
   
$
158
   
$
4
   
$
12,679
 
Mortgage backed securities
   
74,254
     
816
     
58
     
75,012
 
SBA Pools
   
9,135
     
43
     
9
     
9,169
 
   
$
95,914
   
$
1,017
   
$
71
   
$
96,860
 


   
December 31, 2015
 
   
Amortized Cost
   
Gross Unrealized Gains
   
Gross Unrealized Losses
   
Fair Value
 
 
                         
State and political subdivisions
 
$
6,834
   
$
124
   
$
-
   
$
6,958
 
Mortgage backed securities
   
62,911
     
160
     
478
     
62,593
 
SBA Pools
   
10,494
     
9
     
194
     
10,309
 
   
$
80,239
   
$
293
   
$
672
   
$
79,860
 

Investment securities available for sale with a carrying value of $35,154 and $31,422 at September 30, 2016 and December 31, 2015, respectively, and a market value of $35,490 and $31,355 at September 30, 2016 and December 31, 2015, respectively, were pledged as collateral on public deposits, FHLB advances and for other purposes as required or permitted by law.



37



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:
   
September 30, 2016
 
   
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
 
$
1,326
   
$
4
   
$
-
   
$
-
   
$
1,326
   
$
4
 
Mortgage-backed securities
   
11,053
     
58
     
-
     
-
     
11,053
     
58
 
SBA Pools
   
1,706
     
9
     
-
     
-
     
1,706
     
9
 
                                                 
  Total
 
$
14,085
   
$
71
   
$
-
   
$
-
   
$
14,085
   
$
71
 


   
December 31, 2015
 
   
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
 
$
-
   
$
-
   
$
-
   
$
-
   
$
-
   
$
-
 
Mortgage-backed securities
   
45,790
     
363
     
4,589
     
115
     
50,379
     
478
 
SBA Pools
   
157
     
3
     
9,110
     
191
     
9,267
     
194
 
                                                 
  Total
 
$
45,947
   
$
366
   
$
13,699
   
$
306
   
$
59,646
   
$
672
 

The Company assesses its securities for OTTI quarterly by reviewing credit ratings, financial and regulatory reports as well as other pertinent published financial data. As of September 30, 2016 and December 31, 2015, 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 September 30, 2016 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
 
$
555
   
$
569
 
Due after one year through five years
   
2,262
     
2,298
 
Due after five years through ten years
   
3
     
3
 
Due after ten years
   
18,840
     
18,978
 
     
21,660
     
21,848
 
                 
Mortgage-backed securities
   
74,254
     
75,012
 
   
$
95,914
   
$
98,860
 


38



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

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.

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.


39



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

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

In January 2016, the FASB issued ASU No. 2016-01 Financial Instruments—Overall .  The amendments address certain aspects of recognition, measurement, presentation, and disclosure of financial instruments. The amendments will be effective for public companies for fiscal years beginning after December 15, 2017, includ-ing interim periods within those fiscal years.  The Company is currently evaluating the impact of these amendments on its consolidated financial statements.

In February 2016, the FASB issued ASU No. 2016-02 Leases.  This amended the Leases topic of the Accounting Standards Codification to revise certain aspects of recognition, measurement, presentation, and disclosure of leasing transactions. The amendments will be effective for public companies for fiscal years beginning after December 15, 2018, includ-ing interim periods within those fiscal years. The Company is currently evaluating the effect that implementation of the new standard will have on its financial position, results of operations, and cash flows.

In March 2016, the FASB has issued Accounting Standards Update ASU No. 2016-09, Compensation - Stock Compensation: Improvements to Employee Share-Based Payment Accounting. The amendments are intended to improve the accounting for employee share-based payments and affect all organizations that issue share-based payment awards to their employees.  For public companies, the amendments are effective for annual periods beginning after December 15, 2016, and interim periods within those annual periods.  Early adoption is permitted for any organization in any interim or annual period.  The Company does not expect these amendments to have a material effect on its financial statements.

In June 2016, the FASB issued ASU No. 2016-13, "Measurement of Credit Losses on Financial Instruments."  The ASU is intended to improve financial reporting by requiring timelier recording of credit losses on loans and other financial instruments held by financial institutions and other organizations.  The ASU is effective for SEC filers for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2019 (i.e., January 1, 2020, for calendar year entities).  Early application will be permitted for all organizations for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2018.  The Company is currently evaluating the effect that implementation of the new standard will have on its financial position, results of operations, and cash flows.

In August 2016, the FASB issued ASU No. 2016-15, "Classification of Certain Cash Receipts and Cash Payments."
This ASU is intended to clarify how certain cash receipts and cash payments are presented and classified in the statement of cash flows. The amendments will be effective for the Company for fiscal years beginning after December 15, 2017.  The Company does not expect these amendments to have a material effect on consolidated financial statements.

Other accounting standards have been issued by the FASB that are not currently applicable to the Company or are not expected to have a material impact on the Company's financial statements


40



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. Russell Road Properties, LLC is an entity in which the Bank has a 50% interest and was created to hold and manage certain properties acquired by the Bank through foreclosure or deed in lieu of foreclosure.

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, 2015.

Formal Written Agreement
As discussed in Note 10, 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.

41


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 September 30, 2016.

·
A new board oversight policy has been approved and implemented;
·
Completed revising the Bank's loan grading system and ALLL methodology;
·
Implemented Problem Loan Action reports and Problem Asset reports for all assets over $500,000;
·
Completed revising the written contingency funding plan;
·
Implemented stress testing of the loan portfolio;
·
Completed revising the investment policy;
·
Completed a three year capital plan targeted to improve the Company's and Bank's capital levels; Completed a Business Continuity Plan and Disaster Recovery Plan; and,
·
Formed a Directors' compliance committee to monitor the progress of each item in the written agreement. The committee meets at least quarterly and files a report with the Federal Reserve Bank.


Results of Operations

Results of operations for the three-month and nine-month periods ended September 30, 2016 reflect earnings of $1 thousand and  a loss of $143 thousand, respectively, compared to earnings of $429 thousand and $2.14 million for the corresponding periods in 2015.

Net interest income for the three-month period ended September 30, 2016 increased $104 thousand or 2.24% compared to the three months ended September 30, 2015. For the nine-month period ended September 30, 2016 net interest income increased $510 thousand or 3.68% as compared to the nine month period ended September 30, 2015.  Average interest-earning assets increased $297 thousand from the nine month period ended September 30, 2015 to the current nine month period, while average interest-bearing liabilities decreased $9.65 million over the same period. The tax-equivalent yield on average interest-earning assets was 4.35% for the nine month period ended September 30, 2016 representing an increase of 5 basis points from the same period in 2015.  The rate on average interest-bearing liabilities decreased 8 basis points to 0.97% for the nine month period ended September 30, 2016 as compared to 1.05% for the same period in 2015.

Total interest income for the three and nine months ended September 30, 2016 was $2 thousand and $197 thousand greater than the comparable 2015 periods primarily due to increased loan and securities balances in 2016 compared to the prior period. Average loan balances for the nine month period ended September 30, 2016 increased approximately $10.96 million over the same period in 2015. The average balance of federal funds sold was $19.50 million during the nine month period ended September 30, 2016 compared to $34.25 million for the previous year. The average yield on federal funds sold was .47% during the period. Loan balances have declined from December 31, 2015 by approximately $21.3 million.
42


The Company's total interest expense decreased by $102 thousand for the three-months and $313 thousand for the nine-months from the same periods in 2015, due primarily to the overall reduction in time deposit balances. Also new interest-bearing time deposits are continuing to be recorded at lower rates and existing interest-bearing time deposits and other liabilities are re-pricing lower as they renew.

During the first nine months of 2016, the Company's non-interest income increased by $588 thousand over the corresponding period for 2015. In October 2015, concerning the matter of Angela Welch, as Chapter 7 trustee for the bankruptcy estate of Frank Michael Mongeluzzi, the Bank settled the claims for $425 thousand. The $425 thousand payment was reflected in other operating expenses (non-interest expense) for the year ended December 31, 2015.  The Company received an insurance settlement totaling $148 thousand related to this matter in March 2016. Total non-interest income for the three months ended September 30, 2016 increased $366 thousand over the three month period ended September 30, 2015 due primarily to the gains on loans held for sale. During the second quarter of 2016, the Company began originating loans held for sale through its mortgage division, Highlands Home Mortgage. This division plans to originate loans to be sold on a servicing - released basis throughout its branch footprint and also throughout North and South Carolina.

Total non-interest expense for the nine-month period ended September 30, 2016 increased $2.18 million as compared to the nine-month period ended June 30, 2015. Foreclosed asset expenses, write-downs and losses on the sale of OREO and repossessions in the amount of $1.53 million increased $846 thousand for the nine-month period ended September 30, 2016 compared to the nine-months ended September 30, 2015. Salaries and employee benefits increased $1.25 million for the nine-months ended September 30, 2016 as compared to the prior year period primarily due to both the initial staffing of the Company's new mortgage division and severance payments paid during the first nine-months of the year as part of the Company's strategy to reduce its staffing levels. Furniture and equipment expense increased $122 thousand for the nine-months ended September 30, 2016 compared to the prior period primarily due to increases in equipment maintenance and data connectivity costs. Total non-interest expense for the three-month period ended September 30, 2016 increased $1.13 million compared to the three-month period ended September 30, 2015.

In addition to FDIC insurance premiums which totaled $616 thousand for the nine months ended September 30, 2016, other operating expenses that exceeded 1% of total interest income and other operating income were charges for other contracted services totaling $527 thousand, software licensing and maintenance costs totaling $697 thousand, legal expenses totaling $262 thousand, other loan expenses totaling $252 thousand, and bank franchise taxes totaling $310 thousand.

In addition to FDIC insurance premiums, for the nine months ended September 30, 2015, other operating expenses that exceeded 1% of total interest income and other operating income were charges for other contracted services totaling $589 thousand, advertising costs totaling $229 thousand, software licensing and maintenance costs totaling $532 thousand, legal expenses totaling $230 thousand, other loan expenses totaling $256 thousand, bank franchise taxes totaling $271 thousand, other losses totaling $401 thousand and postage and freight expenses totaling $208 thousand.

For the three month period ended September 30, 2016, other operating expenses that exceeded 1% of total interest income and other operating income were charges for FDIC insurance totaling $206 thousand, legal expenses totaling $136 thousand, other loan expense of $105 thousand, other contracted services totaling $201 thousand, software licensing and maintenance totaling $251 thousand, other losses totaling $64 thousand and bank franchise taxes totaling $112 thousand.

For the three month period ended September 30, 2015, other operating expenses that exceeded 1% of total interest income and other operating income were charges for FDIC insurance totaling $206 thousand, legal expenses totaling $90 thousand, other loan expense of $84 thousand, postage and freight expenses totaling $74 thousand, other contracted services totaling $203 thousand, software licensing and maintenance totaling $188 thousand, other losses totaling $362 thousand and bank franchise taxes totaling $96 thousand.
43


Operating results of the Company when measured as a percentage of average equity reveals a decrease in return on average equity to -0.34% for the nine-month period ended September 30, 2016 from 5.32% for the corresponding period in 2015. Return on average assets for the nine months ended September 30, 2016 decreased to -0.03% compared to 0.47% for the nine months ended September 30, 2015.The provision for loan losses for the three-month and nine-month periods ended September 30, 2016 totaled $173 thousand and $1.49 million thousand, respectively, a $42 thousand decrease and $789 thousand increase as compared to the corresponding periods in 2015. This increased provision during the first nine months of 2016 as compared to the first nine months of 2015 was primarily due to three large charge-offs occurring during the second quarter of 2016 in the Company's Tri-Cities TN / VA market area. These three charge-offs totaled $1.7 million. Net charge-offs (inclusive of recoveries) for the first nine months of 2016 were $2.13 million compared with $840 thousand for the first nine months of 2015. Year–to–date net charge-offs were 0.52% and 0.20% of total loans for the periods ended September 30, 2016 and September 30, 2015, respectively. 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.  Loan loss reserves decreased 6.17% to $5.00 million at September 30, 2016 from $5.33 million at September 30, 2015.  The Company's allowance for loan loss reserves at September 30, 2016 decreased to 1.22% of total loans versus 1.26% at September 30, 2015.  At December 31, 2015, the allowance for loan loss reserve as a percentage of total loans was 1.31%.
In the second quarter of 2015, the Company reversed the remaining balance of the valuation allowance that was established against the deferred tax assets ("DTA") during the fourth quarter of 2011. The valuation allowance was established during 2011 due to uncertainty at the time regarding the ability to generate sufficient future taxable income to fully realize the benefit of the net DTA. Subsequent to 2011, earnings performance and asset quality improved resulting in greater expected realization of the DTA. In addition, the Company raised $16.1 million in net proceeds of new capital in 2014 which allowed the Company to payoff two high rate debt instruments (the Company's Community Bankers Bank note and Trust Preferred Securities) improving future earnings potential.  As a result of these factors, the Company reversed $1 million of the DTA in the second quarter of 2014, and due to the continued improvements in asset quality and earnings performance the remaining $1 million of the DTA valuation allowance was reversed in the second quarter of 2015. In assessing the realizability of DTA, management considered whether it was more likely than not that some portion or all of the DTA would not be realized. The Company evaluates the carrying amount of its DTA on a quarterly basis in accordance with the guidance provided in FASB ASC Topic 740 ("ASC 740"), in particular, applying the criteria set forth therein to determine whether it is more likely than not (i.e., a likelihood of more than 50%) that some portion, or all, of the DTA will not be realized within its life cycle, based on the weight of available evidence. In most cases, the realization of the DTA is dependent upon the Company generating a sufficient level of taxable income in future periods, which can be difficult to predict.  If the Company's forecast of taxable income within the carry forward periods available under applicable law is not sufficient to cover the amount of net deferred assets, such assets may be impaired. Management considers the reversal of deferred tax liabilities (including the impact of available carry-back and carry-forward periods), projected future taxable income and tax-planning strategies in making this assessment.

Management, in conjunction with the board of directors, will continue to evaluate the carrying value of the Company's DTA on a quarterly basis, in accordance with ASC 740, and will determine any need for a future valuation allowance based upon circumstances and expectations then in existence. 
44


Financial PositionTotal loans, net of deferred fees, decreased to $410.09 million at September 30, 2016 from $422.15 million at September 30, 2015.  Total loans, net of fees, at December 31, 2015 were $432.08 million. The loan to deposit ratio decreased to 84.02% at September 30, 2016 from 85.91% at September 30, 2015. The loan to deposit ratio at December 31, 2015 was 87.31%. Deposits at September 30, 2016 have decreased $3.31 million since September 30, 2015 and have decreased $6.85 million since December 31, 2015. During the last several years, the Company has continued to lower the interest rates paid on time deposits in a continuing effort to reduce its cost of funds.

The Company currently has approximately $67.71 million in outstanding FHLB advances. No new advances were originated during the last 12 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. Non-performing assets were $8.84 million or 1.44% of total assets at September 30, 2016, compared with $15.18 million or 2.47% of total assets at December 31, 2015 and $13.81 million or 2.24% of total assets at September 30, 2015. 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.  The internal credit review department performs pre-approval analyses of large credits and also conducts credit review activities that provide management with an early warning of loan deterioration. The senior credit administration officer prepares quarterly analyses of the adequacy of the allowance for loan losses. These analyses include individual loans considered impaired for direct exposure. In addition, potential losses on loan pools and pool allocations are based upon historical losses and other factors, as adjusted, for various loan types. The calculation for allowance for loan losses is reviewed by both the Credit Administration Committee and the Board of Directors.

At September 30, 2016 and December 31, 2015, 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 U.S. Generally Accepted Accounting Principles.
45


At September 30, 2016, OREO balances were $3,288 and consisted of 28 relationships. At December 31, 2015 OREO balances were $5,694 and consisted of 28 relationships. The following chart details each category type, number of relationships, and balance.

OREO Property at 9/30/16
           
             
OREO Description
 
Number
   
Balance at 9/30/16
 
         
(in thousands)
 
Land Development  - Vacant Land
   
11
   
$
690
 
1-4 Family
   
10
     
641
 
Commercial Real Estate
   
7
     
1,957
 
                 
Total
   
28
   
$
3.288
 
                 

OREO Property at 12/31/2015
           
             
OREO Description
 
Number
   
Balance at 12/31/15
 
         
(in thousands)
 
Land Development  - Vacant Land
   
11
   
$
1,287
 
1-4 Family
   
10
     
1,295
 
Commercial Real Estate
   
7
     
3,112
 
                 
Total
   
28
   
$
5,694
 
                 

The Company's major markets are Southwestern Virginia, Tri-city Tennessee, Sevierville and Knoxville, Tennessee, Boone and Banner Elk, North Carolina. The following table provides information about properties owned in each geographic area, the number of individual properties and book value.

   
September 30, 2016
   
December 31, 2015
 
                         
Geographic Area
 
Number
   
Value (in thousands)
   
Number
   
Value (in thousands)
 
                         
Sevierville and Knoxville TN Area
   
5
   
$
215
     
8
   
$
1,179
 
Southwest VA and Tri-city TN Area
   
18
     
2,864
     
17
     
4,248
 
Boone and Banner Elk NC Area
   
5
     
209
     
3
     
267
 
                                 
Total
   
28
   
$
3,288
     
28
   
$
5,694
 

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 which has been negatively affected by the current economic climate and the resulting reduction of non-performing assets, will to a large degree, depend on how quickly specific market areas rebounds. Management has allocated significant resources to facilitate sales of OREO to reduce the Company's non-performing assets.

Investment securities and other investments totaled $103.49 million (market value) at September 30, 2016 which reflects an increase of $12.43 million from the December 31, 2015 total of $86.45 million. Investment securities available for sale and other investments at September 30, 2016 were comprised of mortgage backed securities / CMOs (72.48% of the total securities portfolio), municipal issues (12.25%), and SBAs pools (8.86 %).  The Company's entire securities portfolio was classified as available for sale at both September 30, 2016 and December 31, 2015.
Other investments include holdings of Federal Reserve, Federal Home Loan Bank, Pacific Coast Bankers Bank, and Community Bankers Bank stock. These investments (carrying value of $4.39 million) 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 are 9 certificates of deposit purchased from other FDIC insured institutions.  The balance of these CDs totaled $2.24 million at September 30, 2016.

Liquidity and Capital Resources
Total stockholders' equity of the Company was $55.40 million at September 30, 2016 representing an increase of $650 thousand or 1.19% from September 30, 2015. Total stockholders' equity at December 31, 2015 was $53.56 million. The increase in stockholders' equity from September 30, 2015 to September 30, 2016 is primarily due to the funds received from the CEO's purchase of common stock in the first quarter of 2016 and the increase in other accumulated comprehensive income related to the market value of its investment securities available for sale.

Quantitative measures established by regulation to ensure capital adequacy require the Bank to maintain minimum amounts and ratios of total risk-based capital to risk-weighted assets (as defined in the regulations), Tier I capital to risk-weighted assets (as defined in the regulations), Common Equity Tier 1 to risk-weighted assets (as defined in the regulations), and Tier I capital to adjusted total assets (as defined).  See Note 4 for a more detailed discussion of the Bank's regulatory capital ratios. The Board of Directors and management are committed to further increasing our capital levels and we are continuing to explore options to increase our 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 ($48.20 million as of September 30, 2016) and unrestricted investment securities available for sale ($61.37 million).  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. Unencumbered investment securities available for sale represent a secondary level of liquidity available for conversion to liquid funds in the event of extraordinary needs.

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.


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

·
adverse economic conditions in the market area and the impact on credit quality and risks inherent in the loan portfolio such as repayment risk and fluctuating collateral values;
·
our inability to manage, dispose of and properly value non-performing assets and other real estate owned;
·
further deterioration in the housing market and collateral values;
·
our inability to assess the creditworthiness of our loan portfolio and maintain a sufficient allowance for loan losses;
·
our inability to maintain adequate sources of funding and liquidity, including secondary sources such as Federal Home Loan Bank advances;
·
our ability to attract and maintain capital levels adequate to support our asset levels and risk profile;
·
our inability to comply with the written agreement, dated October 13, 2010, with the Federal Reserve Bank of Richmond;
·
our successful management of interest rate risk and changes in interest rates and interest rate policies;
·
reliance on our management team, including our ability to attract and retain key personnel;
·
our ability to successfully manage our strategic plan;
·
difficult market conditions in our industry;
·
problems with technology utilized by us;
·
our ability to successfully manage third-party vendors upon whom we are dependent;
·
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;
·
potential impact on us of recently enacted legislation and future regulation;
·
changes in accounting policies or standards;
·
demand, development and acceptance of new products and services; and,
·
changing trends in customer profiles and behavior.



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 and Chief Financial Officer, 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 and Chief Financial Officer 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 and Chief Financial Officer, 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 third quarter of 2016 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

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PART II. OTHER INFORMATION

Item 1.  Legal Proceedings

On December 23, 2015, James M. Brock and Jean W. Brock (together, "Brock") filed a complaint in the Circuit Court of Grayson County, Virginia, alleging that the Bank acted negligently when it foreclosed on property adjacent to the Brock's property and allegedly failed to remediate the foreclosed property, allegedly causing damage to Brock's property. Brock seeks damages of $200,000 plus prejudgment interest, attorneys' fees, and costs.  The Bank denies any wrongdoing in this matter and intends to vigorously defend itself.  No trial date has yet been set.  The Company is unable to estimate the likelihood of an unfavorable outcome or the amount or range of potential loss.

Item 1A. Risk Factors
Not applicable

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

Item 3.  Defaults Upon Senior Securities

None
 
Item 4.  Mine Safety Disclosures

Not Applicable

Item 5.  Other Information

None

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Item 6.  Exhibits

   Exhibit No.
 Description
 
 
10.1
First Amendment to Employment Agreement by and between Timothy K. Schools and Highlands Bankshares, Inc. dated September 6, 2016 (attached as Exhibit 10.1 to the Current Report on Form 8-k filed September 22, 2016 and incorporated herein by reference.
 
10.2
Restricted Stock Award Agreement by and between Timothy K. Schools and Highlands Bankshares, Inc., dated September 6, 2016 (attached as Exhibit 10.2 to the Current Report on Form 8-k filed September 22, 2016 and incorporated herein by reference).
 
31.1
Rule 13a-14(a) Certification of President and Chief Executive Officer
 
31.2
Rule 13a-14(a) Certification of Chief Financial Officer
 
32.1
Certification Statement of 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.
 
101
The following materials from the Registrant's Quarterly Report on Form 10-Q for the quarter ended September 30, 2016, 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:  November 14, 2016
By:
 /s/ Timothy K. Schools
 
   
Timothy K. Schools
 
   
President and Chief Executive Officer
 
       
       
Date:  November 14, 2016
By:
 /s/ James R. Edmondson
 
   
James R. Edmondson
 
   
Chief Financial Officer
 


49

Exhibits Index
 

   Exhibit No.
 Description
 
 
10.1
First Amendment to Employment Agreement by and between Timothy K. Schools and Highlands Bankshares, Inc. dated September 6, 2016 (attached as Exhibit 10.1 to the Current Report on Form 8-k filed September 22, 2016 and incorporated herein by reference.
 
10.2
Restricted Stock Award Agreement by and between Timothy K. Schools and Highlands Bankshares, Inc., dated September 6, 2016 (attached as Exhibit 10.2 to the Current Report on Form 8-k filed September 22, 2016 and incorporated herein by reference).
 
31.1
Rule 13a-14(a) Certification of President and Chief Executive Officer
 
31.2
Rule 13a-14(a) Certification of Chief Financial Officer
 
32.1
Certification Statement of 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.
 
101
The following materials from the Registrant's Quarterly Report on Form
10-Q for the quarter ended September 30, 2016, 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).







50