10-K

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

Annual Report Pursuant to Section 13 or 15(d)

of the Securities Exchange Act of 1934

For the fiscal year ended December 31, 2008

Commission File Number 000-27622

HIGHLANDS BANKSHARES, INC.

(Exact name of registrant as specified in its charter)

Virginia (State or other jurisdiction of incorporation or organization)	54-1796693 (I.R.S. Employer Identification No.)
340 West Main Street Abingdon, Virginia (Address of principal executive offices)	24210-1128 (Zip Code)

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

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

Common Stock, $0.625 par value

(Title of class)

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yeso  No x

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

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

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

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

Large Accelerated Filer o                                              Accelerated Filer o

Non-Accelerated Filer o                                              Smaller Reporting Company x

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act) Yes o No x

State the aggregate market value of the voting and non-voting common equity held by non-affiliates computed by reference to the price at which the common equity was last sold, or the average bid and asked price of such common equity, as of the last business day of the registrant’s most recently completed second fiscal quarter. $64,917,492.

Indicate the number of shares outstanding of each of the registrant’s classes of common stock as of the latest practicable date. As of March 11, 2009, there were 5,001,136 shares of Common Stock outstanding.

DOCUMENTS INCORPORATED BY REFERENCE

Annual Financial Statements – Part II

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

	Table of Contents
		Page Number
Part I
Item 1.	Business	2
Item 1A.	Risk Factors	16
Item 1B.	Unresolved Staff Comments	19
Item 2.	Properties	19
Item 3.	Legal Proceedings	19
Item 4.	Submission of Matters to a Vote of Security Holders	20
Part II
Item 5.	Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities	20
Item 6.	Selected Financial Data	21
Item 7.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	21
Item 7A.	Quantitative and Qualitative Disclosures About Market Risk	41
Item 8.	Financial Statements and Supplementary Data	43
Item 9	Changes in and Disagreements with Accountants on Accounting and Financial Disclosure	43
Item 9A(T).	Controls and Procedures	43
Item 9B.	Other Information	44
Part III
Item 10.	Directors, Executive Officers and Corporate Governance	44
Item 11.	Executive Compensation	44
Item 12.	Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters	44
Item 13.	Certain Relationships and Related Transactions, and Director Independence	45
Item 14.	Principal Accounting Fees and Services	45
Part IV
Item 15.	Exhibits, Financial Statement Schedules	46

Part I.

Item I. Business

History and Business

Highlands Bankshares, Inc. (the “Company”) is a one-bank holding company organized under the laws of Virginia in 1995 and registered under the Bank Holding Company Act (BHCA). The Company conducts the majority of its business operations through its wholly-owned bank subsidiary, Highlands Union Bank (the “Bank”). The Company has two direct subsidiaries as of December 31, 2008: the Bank, which was formed in 1985, and Highlands Capital Trust I (HCTI), a statutory business trust (the “Trust”) which was formed in 1998.

Highlands Union Bank

The Bank is a Virginia state chartered bank that was incorporated in 1985. The Bank operates a full-service banking business from its headquarters in Abingdon, Virginia, and its twelve area full service branch offices. The Bank offers general retail and commercial banking services to individuals, businesses and local government unit customers. These products and services include accepting deposits in the form of checking accounts, money market deposit accounts, interest-bearing demand deposit accounts, savings accounts and time deposits; making real estate, commercial, revolving, consumer, credit card and agricultural loans; offering letters of credit; providing other consumer financial services, such as automatic funds transfer, collections, night depository, safe deposit, travelers checks and savings bond sales; and providing other miscellaneous services normally offered by commercial banks. The Bank makes loans in all major loan categories, including commercial, commercial and residential real estate, construction and consumer loans.

Highlands Union Insurance Services, Inc.

Highlands Union Insurance Services, Inc., a wholly owned subsidiary of the Bank, was formed in 1999. The Bank, through HUIS, joined a consortium of approximately forty-seven other financial institutions to form Bankers’ Insurance, LLC. Bankers’ Insurance, LLC, as of December 31, 2008, had purchased eight full service insurance agencies across the state of Virginia. HUIS is used to sell insurance services through Bankers’ Insurance, LLC. The number of owner banks involved with Bankers’ Insurance, LLC was forty-two as of December 31, 2008.

Highlands Union Financial Services, Inc.

The Bank operated a financial services department for the purpose of brokering various investment vehicles until January 2, 2001. At that time, Highlands Union Financial Services, Inc., a wholly-owned subsidiary of the Bank, was created to convert that department into a separate legal entity in order to offer third –party mutual funds and other financial services to its customers in all market areas served. During 2004, changes to the NASD rules required financial services to be operated underneath the bank structure once again. The only activity in Highlands Union Financial Services now relates to commissions from the sale of life insurance

In February 2005, the Bank became an equity owner in Bankers’ Investments, LLC, headquartered in Richmond, Virginia. The Bank’s equity investment was $250,000 for two units

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of ownership. Bankers’ Investments, LLC was formed for the purpose of providing owner banks the ability to offer a full line of financial services to their customers. During 2007, Bankers Investments was acquired by Infinex, LLC, a full service provider of a wide array of investment sevices. Infinex, LLC is owned by member banks and banking associations.

Lending Activities

Commercial Loans

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

Residential Real Estate Loans

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

Construction Loans

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

Consumer Loans

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

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Participation Loans

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

The following table sets forth, for the two fiscal years ended December 31, 2008 and 2007, the percentage of total operating revenue contributed by each class of similar services which contributed 15% or more of total operating revenues of the Company during such periods.

Period	Class of Service	Percentage of Total Revenues
December 31, 2008	Interest and Fees on Loans	86.76%
December 31, 2007	Interest and Fees on Loans	73.03%

Market Area

Highlands Union Bank Market Area

The Bank’s primary market area consists of:

•    all of Washington County, Virginia

•    portions of Smyth County, Virginia

•    the City of Bristol, Virginia

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

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

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

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

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

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

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

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

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The independent city of Bristol, Virginia is located in far southwestern Virginia and lies directly on the Virginia-Tennessee state line. Washington County surrounds Bristol to the west, north and east. In the Bristol/Washington County community, manufacturing, trade, and services sectors are the largest industries, in terms of total number of jobs in as of 2007. The educational , health and social services sector provides the most jobs and contributes 17.80% of the total city/county employment. The latest unemployment figures as of December 2008 reflect an unemployment rate of 8.3% and 6.9% for the Bristol, Virginia and Washington County, Virginia respectively.

The Bank has a branch office located in Marion which is the county seat of Smyth County, Virginia. Marion is approximately 30 miles northeast of Abingdon, Virginia. The latest unemployment figures reflect an unemployment rate of 6.8% reported as of December 2008. In Smyth County, manufacturing is the largest employment industry and makes up 33.3% of all jobs throughout the County, totaling 4,958 individuals. The educational, health and social services sector accounts for 18.5% of the total jobs, totaling 2,756 individuals.

Bristol, Tennessee is located in Sullivan County, Tennessee and is Bristol, Virginia’s twin city. Bristol, Tennessee’s three largest employment sectors are services, manufacturing and retail trade. The latest unemployment figures reflect an unemployment rate of 5.8% as of December 2008.

Rogersville, Tennessee is located in Hawkins County approximately 45 miles southwest of Bristol, Tennessee. Rogersville is the county seat for Hawkins County. Rogersville’s three largest employment sectors are services, manufacturing and retail trade. The latest unemployment figures reflect an unemployment rate of 7.6% as of December 2008. In Hawkins County, manufacturing, and retail trade are the largest sectors, in terms of total employment. Manufacturing is the major employer in the county making up 53.9% percent of all jobs throughout the County.

Sevierville, Tennessee is located in Sevier County, Tennessee. Sevierville, Tennessee is located approximately 20 miles east of Knoxville, Tennessee. Sevierville serves as the county seat and is the largest city located in Sevier County. Major employers for the county include tourism, retail, and service related industries. There is some industrial base that mitigates some of the seasonal employment fluctuation from the tourism and related businesses. The latest unemployment figures reflect an unemployment rate of 8.5% as of December 2008. The total population has increased sharply, since its 2000 population of 71,709.

Knoxville, Tennessee is located in Knox County, Tennessee. Knoxville, Tennessee is located approximately 20 miles west of Sevierville, Tennessee. Knoxville serves as the county seat and is the third largest city in the state of Tennessee. Major employers for the county include manufacturing, retail, entertainment industries, and warehousing and distribution industries. The latest unemployment figures reflect an unemployment rate of 5.7% as of December 2008. Knox County had a population that was estimated at 411,967 for the year 2007 and Knoxville had an estimated population of 187,337 for the year 2007. Knoxville’s central location to two major interstate highways which link the eastern half of the United States continues to provide many opportunities for economic growth in the future.

Boone, North Carolina is located in Watauga County in the northwestern mountains of North Carolina. Watauga County, North Carolina has an estimated population of 42,700 as of December 2007. Watauga County’s three largest employment sectors are private industry, education services and retail trade. The latest unemployment figures reflect an unemployment rate of 5.7% as of December 2008. Watauga County, North Carolina’s largest employer is Appalachian State University. Appalachian State is the sixth largest university in the University of North Carolina system. Employment at Appalachian State University has remained relatively stable over the past four years.

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Banner Elk, North Carolina is located in Avery County in the northwestern mountains of North Carolina. Avery County, North Carolina had an estimated population of 17,674 as of December 2007. In Avery County, education, health and social services, retail trade, and the accommodation and food services sectors are the largest industries, in terms of total number of jobs in 2007. The latest unemployment figures reflect an unemployment rate of 7.6% as of December 2008.

West Jefferson, North Carolina is located in Ashe County in the northwestern mountains of North Carolina. Ashe County, North Carolina had a population that was estimated at 25,499 as of December 2007. In Ashe County, manufacturing, education and health services, and public administration are the largest employment industries. The latest unemployment figures reflect an unemployment rate of 10.1% as of December 2008.

Competition

The banking and financial service business in Virginia, generally, and in the Bank’s market areas specifically, is highly competitive. The increasingly competitive environment is a result of changes in regulation, changes in technology and product delivery systems and new competition from non-traditional financial services. The Bank competes for loans and deposits with other commercial banks, savings and loan associations, securities and brokerage companies, mortgage companies, money market funds, credit unions and other non-bank financial service providers. Many of these competitors are much larger in total assets and capitalization, have greater access to capital markets and offer a broader array of financial services than the Bank. In order to compete, the Bank relies upon service-based business philosophies, personal relationships with customers, specialized services tailored to meet customers' needs and the convenience of office locations and extended hours of operation. In addition, the Bank is generally competitive with other financial institutions in its market areas with respect to interest rates paid on deposit accounts, interest rates charged on loans and other service charges on loans and deposit accounts. Deposit market share for each of the Bank’s market areas can be found on the FDIC’s website at www.fdic.gov under the Industry Analysis/Summary of Deposits section.

Certain Regulatory Considerations

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

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

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Highlands Bankshares, Inc.

The Company is a bank holding company within the meaning of the Bank Holding Company Act of 1956 and Chapter 13 of the Virginia Banking Act, as amended (the Virginia Banking Act). The activities of the Company also are governed by the Gramm-Leach-Bliley Act of 1999.

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

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

Under the BHCA, a bank holding company is generally prohibited from engaging in, or acquiring direct or indirect control of more than 5% of the voting shares of any company engaged in non-banking activities, unless the Federal Reserve Board, by order or regulation, has found those activities to be so closely related to banking or managing or controlling banks as to be incident to banking. The Federal Reserve Board imposes certain capital requirements on the Company under the BHCA, including a minimum leverage ratio and a minimum ratio of "qualifying" capital to risk-weighted assets. Subject to its capital requirements and certain other restrictions, the Company can borrow money to make a capital contribution to the Bank, and these loans may be repaid from dividends paid from the Bank to the Company (although the ability of the Bank to pay dividends are subject to regulatory restrictions). The Company can raise capital for contribution to the Bank by issuing securities without having to receive regulatory approval, subject to compliance with federal and state securities laws.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Highlands Union bank.

General. The Bank, as a state chartered member of the Federal Reserve, is subject to regulation and examination by the Virginia State Corporation Commission and the Federal Reserve Board. In addition, the Bank is subject to the rules and regulations of the Federal Deposit Insurance Corporation. Deposits in the Bank are insured by the FDIC up to a maximum amount (generally $250,000 per depositor, subject to aggregation rules through December 31, 2009). The Federal Reserve Board and the Virginia Bureau of Financial Institutions regulate or monitor all areas of the Bank’s operations, including security devices and procedures, adequacy of capitalization and loss reserves, loans, investments, borrowings, deposits, mergers, issuances of securities, payment of dividends, interest rates paid on deposits, interest rates or fees chargeed on loans, establishment of branches, corporate reorganizations and maintenance of books and records. The Federal Reserve Board requires the Bank to maintain certain capital ratios. The Bank is required by the Federal Reserve Board to prepare quarterly reports on the Bank’s financial condition and to conduct an annual audit of its financial affairs in compliance with minimum standards and procedures prescribed by the Federal Reserve Board. The Bank also is required by

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the Federal Reserve Board to adopt internal control structures and procedures in order to safeguard assets and monitor and reduce risk exposure. While appropriate for safety and soundness of banks, these requirements impact banking overhead costs.

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

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

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

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

FDICIA requires each federal banking regulatory agency to prescribe, by regulation, standards for all insured depository institutions and depository institution holding companies relating to (i) internal controls, information systems and audit systems; (ii) loan documentation; (iii) credit underwriting; (iv) interest rate exposure; (v) asset growth; (vi) compensation, fees and benefits; and (vii) such other operational and managerial standards as the agency determines to be appropriate. The compensation standards would prohibit employment contracts, compensation or

11

benefit arrangements, stock option plans, fee arrangements or other compensatory arrangements that provide excessive compensation, fees or benefits or could lead to material financial loss. In addition, each federal banking regulatory agency must prescribe by regulation standards specifying (i) a maximum ratio of classified assets to capital; (ii) minimum earnings sufficient to absorb losses without impairing capital; (iii) to the extent feasible, a minimum ratio of market value to book value for publicly traded shares of depository institutions and depository institution holding companies; and (iv) such other standards relating to asset quality, earnings and valuation as the agency determines to be appropriate. If an insured institution fails to meet any of the standards promulgated by regulation, then such institution will be required to submit a plan to its federal regulatory agency specifying the steps it will take to correct the deficiency.

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

The Bank met the requirements at December 31, 2008 to be classified as “well capitalized.” This classification is determined solely for the purposes of applying the prompt corrective action regulations and may not constitute an accurate representation of the Bank’s overall financial condition.

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

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

1. Audited comparative annual financial statements.

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

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

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

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

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

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

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

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

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

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

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

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

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

In addition, the Federal Reserve Board is authorized to determine, under certain circumstances relating to the financial condition of a state member bank, that the payment of dividends would be an unsafe or unsound practice and to prohibit payment thereof. The payment

14

of dividends that depletes a bank's capital base could be deemed to constitute such an unsafe or unsound practice. The Federal Reserve Board has indicated that banking organizations should generally pay dividends only out of current operating earnings.

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

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

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

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

Other Legislative and Regulatory Concerns

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

Registrant's Organization and Employment

The Company, the Bank, HCTI, HUFS and HUIS are organized in a holding company/subsidiary structure. As of December 31, 2008, the Company had no employees, except

15

for officers, and it conducted substantially all of its operations through its subsidiaries. All cash compensation paid to the Company’s officers was paid by the subsidiary bank, including fees paid to its directors. In previous years, stock based compensation, through the form of stock options, is paid/granted through the Company. During 2007, compensation paid to HUFS officers and employees was paid through the Bank. At December 31, 2008, the Bank employed 249 full time equivalent employees at its main office, operations center and branch offices. The Company, HCTI, HUFS and HUIS had no employees at this time.

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

Company Website

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

Item 1A. Risk Factors

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

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

•  Economic conditions that negatively affect housing prices and the job market have resulted, and may continue to result, in a deterioration in credit quality of the Company’s loan portfolios, and such deterioration in credit quality has had, and could continue to have, a negative impact on the Company’s business.

•  Market developments may affect consumer confidence levels and may cause adverse changes in payment patterns, causing increases in delinquencies and default rates on loans and other credit facilities.

•  The processes the Company uses to estimate allowance for loan losses and reserves may no longer be reliable because they rely on complex judgments, including forecasts of economic conditions, which may no longer be capable of accurate estimation.

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•  The Company’s ability to assess the creditworthiness of its customers may be impaired if the models and approaches it uses to select, manage, and underwrite its customers become less predictive of future charge-offs.

•  The Company expects to face increased regulation of its industry, and compliance with such regulation may increase our costs, limit our ability to pursue business opportunities, and increase compliance challenges.

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

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

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

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

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

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

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

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

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

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other obligations which could adversely affect our performance. If more competitors come into our market area, our business could suffer.

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

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

Inadequate disaster recovery plans could significantly impact our operations.

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

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

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

Our liquidity is dependent on dividends from the Bank.

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

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

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

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

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

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

Item 1B. Unresolved Staff Comments

Not Applicable

Item 2. Properties

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

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

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

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

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

Item 3. Legal Proceedings

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

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

None.

Part II

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

Common Stock Information and Dividends

Trades in the Company’s common stock are reported on the Over-The-Counter Bulletin Board (OTCBB) and in the Pinksheets by at least five broker dealers under the symbol HBKA.OB. In addition, the Company maintains a list of individuals who are interested in purchasing its common stock and connects these people with shareholders who are interested in selling their stock. These parties negotiate the per share price independent of the Company. The stock transfer agent of the Company attempts to keep a record of stock sales by asking the parties about the trade price per share. Please refer to the table below entitled Common Stock Performance for a summary of sales prices known to the Company for each of the four quarters of 2008 and 2007.

Common Stock Performance – December 31, 2008
	High	Low	Quarterly Average	Dividends per Share
First Quarter	$17.00	$14.25	$16.94	$ -
Second Quarter	$18.00	$13.20	$16.77	$ 0.22
Third Quarter	$17.00	$ 8.50	$15.79	$ -
Fourth Quarter	$17.00	$ 8.16	$10.79	$ -
Common Stock Performance – December 31, 2007
	High	Low	Quarterly Average	Dividends per Share
First Quarter	$16.50	$15.35	$16.41	$ -
Second Quarter	$16.50	$15.10	$16.29	$ 0.20
Third Quarter	$17.00	$14.50	$16.32	$ -
Fourth Quarter	$17.00	$13.10	$16.74	$ -

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

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

Issuer Repurchases of Equity Securities

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

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

Item 6. Selected Financial Data

Not Applicable

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

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

Caution About Forward-Looking Statements

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

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

• Difficult market conditions in our industry;

• Unprecedented levels of market volatility;

• Effects of soundness of other financial institutions;

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

• Potential impact on us of recently enacted legislation;

• Further deterioration in the housing market;

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

• Unemployment continuing to rise;

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

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

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

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

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

• The successful management of interest rate risk;

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

• Changes in interest rates and interest rate policies;

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

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

• Demand, development and acceptance of new products and services;

• Problems with technology utilized by the Company;

• Changing trends in customer profiles and behavior; and

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

Overview

The Company is a bank holding company located in southwest Virginia. It conducts commercial banking operations primarily through its full service banking subsidiary, Highlands Union Bank (the “Bank”). The Bank has two wholly owned subsidiaries, Highlands Union Insurance Services, Inc. (HUIS), which was formed in 1999, and Highlands Union Financial Services, Inc. (HUFS), which was formed in 2001. These two subsidiaries offer investment and insurance products. Revenues and net income derived from these two sources are not significant at this time. Management characterizes the Bank as a "community bank".

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

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

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

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Critical Accounting Policies

General

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

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

Allowance for Loan Losses

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

Performance Summary

The following table shows the Company’s key performance ratios for the years ended December 31, 2008 and 2007:

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

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Fully Diluted Earnings Per Share	$        0.02	$    0.94
Dividend Payout Ratio	960.00%	21.06%
Average Equity to Average     Assets	6.30%	7.13%
Net Interest Margin (1)	3.41%	3.43%
(1) Net Interest Margin - Year-to-date tax equivalent net interest income divided by year-to-        date average earning assets.

Growth

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

(dollar amounts in thousands)

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

Asset Quality

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

(dollar amounts in thousands)

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

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

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

2008 Economic Environment

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

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

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

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

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

Results of Operations

Net Interest Income

(dollar amounts in thousands)

2008 versus 2007

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

Analysis of Net Interest Earnings

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

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	Year Ended December 31,
	2008				2007
	(Dollars in Thousands)
	Average Balance	Interest Income/Expense		Yield/ Rate	Average Balance	Interest Income/Expense	Yield/ Rate
ASSETS
Interest earning assets (taxable-equivalent basis):
Loans (net of unearned discount (1)	$  477,027	$ 32,937		6.90%	$   441,308	$ 32,832	7.44%
Securities (2)(3)	137,664	6,296		5.60	148,500	7,175	5.89
Federal funds sold	4,163	85		2.04	6,521	338	5.18
Total interest-earning assets	$618,854	$ 39,318		6.58%	$  596,329	$ 40,345	7.03%
LIABILITIES
Interest bearing liabilities:
Interest bearing deposits	$  430,347	$ 14,823		3.44%	$  426,116	$ 16,886	3.96%
Other interest bearing liabilities	107,876	4,800		4.45	88,694	4,555	5.14
Total interest-bearing liabilities	$  538,223	$ 19,623		3.65%	$  514,810	$ 21,441	4.16%
Net interest income			$ 19,964			$ 18,904
Net margin on interest earning assets on a tax equivalent basis				3.41%			3.43%
Average interest spread				2.93%			2.87%
(1)    For the purposes of these computations, non-accruing loans are included in the daily average loan amounts outstanding.
(2)    Tax equivalent adjustments (using 34% federal tax rates) have been made in calculating yields on tax-free investments. Virginia banks are exempt from state income tax.
(3)    The yield on securities classified as available for sale is computed based on the average balance of the historical amortized cost balance without the effects of the fair value adjustment required by Financial Accounting Standard 115.

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Analysis of Changes in Interest Income and Interest Expense

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

Increase/(Decrease) Due to Volume and Rate

Increase (Decrease) in	Increase (decrease) due to change in volume	2008 Compared to 2007	Net increase (decrease)
		Increase (decrease) due to change in rate
	(Dollars in Thousands)
INTEREST INCOME Securities	$    (607)	$     (272)	$      (879)
Federal funds sold	(48)	(205)	(253)
Loans	2,466	(2,361)	105
Total Income Change	$   1,811	$  (2,838)	$  (1,027)
INTEREST EXPENSE Savings and time deposits	$     146	$   (2,209)	$   (2,063)
Other interest-bearing liabilities	853	(608)	245
Total Expense Change	$    999	$  (2,817)	$   (1,818)
Increase (Decrease) in Net Interest Income	$    812	$     (21)	$       791

Non-interest Income

(dollar amounts in thousands)

2008 versus 2007

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

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

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

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

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

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

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

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

Non-interest Expense

(dollar amounts in thousands)

2008 versus 2007

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

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Income Taxes

(dollar amounts in thousands)

2008 vs. 2007

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

Provision and Allowance for Loan Losses

(dollar amounts in thousands)

2008 vs. 2007

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

The internal credit review department as well as management has determined that the Company's allowance for loan losses is sufficient.

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

	Years Ended December 31, (Dollars in Thousands)
	2008	2007	2006	2005	2004
Allowance for loan losses at beginning of year	$   4,630	$  4,565	$  4,359	$     4,181	$    4,274
Loans charged off:
Commercial	195	47	206	131	219
Real Estate – mortgage	283	99	58	205	192
Consumer	607	444	539	791	1,089
Other	231	242	277	0	0
Total	$   1,316	$     832	$  1,080	$    1,127	$   1,500
Recoveries of loans previously charged off:
Commercial	$       122	$       36	$       14	$        17	$          2
Real Estate – mortgage	1	54	10	10	1
Consumer	144	121	115	123	104
Other	0	1	0	0	0
Total	$       267	$      212	$      139	$      150	$       107
Net loans charged off	$    1,049	$      620	$      941	$      977	$    1,393
Provision for loan losses	1,590	685	1,147	1,155	1,300
Allowance for loan losses end of year	$    5,171	$    4,630	$    4,565	$    4,359	$     4,181
Average total loans (net of unearned income)	$ 477,027	$ 441,308	$ 422,525	$ 400,759	$  385,434
Total loans (net of unearned income) at year-end	$ 490,425	$ 451,291	$ 437,599	$ 411,633	$  391,314
Ratio of net charge-offs to average loans	0.220%	0.140%	0.223%	0.244%	0.361%
Ratio of provision for loan losses to average loans	0.333%	0.155%	0.271%	0.288%	0.337%
Ratio of provision for loan losses to net charge-off	151.573%	110.484%	121.892%	118.219%	123.973%
Allowance for loan losses to year-end loans	1.054%	1.026%	1.043%	1.059%	1.068%

Non-performing loans

(dollar amounts in thousands)

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

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

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

	2008	2007	2006	2005	2004
	(Amounts in thousands)
Non-performing loans	$ 6,934	$ 8,117	$ 3,400	$ 4,201	$ 4,653
Non-accrual loans	$ 6,278	$ 7,849	$ 2,696	$ 2,920	$ 3,902
Loans past-due 90 days   and more and still   accruing	$ 656	$ 268	$ 704	$ 1,281	$ 661
Interest income lost on   non-accruing loans	$ 417	$ 333	$ 234	$ 227	$ 237

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

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Allocation of the allowance for loan losses

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

	December 31, Percent of Loans on each Category (Dollars in Thousands)
	2008			2007			2006
	Allowance for Loan Loss	Percentage of Total Allowance	Percentage of Total Loans	Allowance for Loan Loss	Percentage of Total Allowance	Percentage of Total Loans	Allowance for Loan Loss	Percentage of Total Allowance	Percentage of Total Loans
Commercial	$    262	5.07%	9.83%	$   1,005	21.71%	9.46%	$   1,691	37.04%	9.76%
Real Estate	3,401	65.78	82.79	2,187	47.22	81.94	593	12.99	80.77
Consumer	455	8.79	6.35	589	12.72	7.42	768	16.82	8.14
Other / Unallocated	1,053	20.36	1.03	849	18.35	1.18	1,513	33.15	1.33
Total	$  5,171	100.00%	100.00%	$   4,630	100.00%	100.00%	$   4,565	100.00%	100.00%

	2005			2004
	Allowance for Loan Loss	Percentage of Total Allowance	Percentage of Total Loans	Allowance for Loan Loss	Percentage of Total Allowance	Percentage of Total Loans
Commercial	$  710	16.29%	9.38%	$      705	16.86%	9.13%
Real Estate	1,255	28.79	79.42	1,302	31.16	76.40
Consumer	858	19.68	10.07	953	22.79	13.25
Other / Unallocated	1536	35.24	1.13	1,221	29.19	1.22
Total	$ 4,359	100.00%	100.00%	$    4,181	100.00%	100.00%

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Financial Condition

Balance Sheet

(dollar amounts in thousands)

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

Loans

(dollar amounts in thousands)

Loans net of unearned income and deferred fees increased by $39,134 or 8.67% in 2008. The majority of the increase was related to the Company’s continued growth in market share in North Carolina and Tennessee. Loans secured by real estate increased approximately $36,322, whereas loans secured by collateral other than real estate and unsecured loans increased approximately $3,492.

The Company’s portfolio of commercial, construction and land development loans has also experienced significant growth over the past few years. During 2008, this segment of loans grew $19,544 or 12.23%. This is primarily attributable to the North Carolina and Tennessee markets the Company has entered and the amount of growth occurring in these particular areas. The Company continues to see more loan growth in commercial real estate as opposed to residential activity.

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

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Loan Portfolio

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

	December 31, (Dollars in thousands)
	2008		2007		2006		2005		2004
	Amount	Percentage	Amount	Percentage	Amount	Percentage	Amount	Percentage	Amount	Percentage
Real Estate Secured:
Residential 1-4 family	$ 176,239	35.89%	$163,918	36.28%	$ 156,753	35.77%	$151,815	36.88%	$ 146,970	37.54%
Multi-family	13,114	2.67	9,420	2.08	10,520	2.40	4,148	1.01	3,379	0.86
Commercial, Construction and Land Development	179,339	36.52	159,795	35.35	152,491	34.80	140,178	34.05	122,997	31.42
Second Mortgages	18,499	3.77	17,964	3.97	15,305	3.49	10,962	2.66	7,419	1.89
Equity Line of Credit	9,984	2.03	9,782	2.16	9,493	2.17	9,800	2.38	8,981	2.29
Farmland	9,501	1.93	9,475	2.10	9,343	2.13	10,015	2.43	9,347	2.39
	$ 406,676	82.81%	$ 370,354	81.94%	$ 353,905	80.77%	$ 326,918	79.41%	$ 299,093	76.39%
Secured, Other:
Personal	$ 21,854	4.45%	$ 24,741	5.47%	$ 27,384	6.25%	$ 33,395	8.11%	$ 44,222	11.30%
Commercial	32,725	6.66	26,433	5.85	26,943	6.15	25,628	6.23	24,992	6.38
Agricultural	4,319	0.88	4,232	0.94	5,093	1.16	3,653	.89	4,024	1.03
	$ 58,898	11.99%	$ 55,406	12.26%	$ 59,420	13.56%	$ 62,676	15.23%	$ 73,238	18.71%
Unsecured:	$ 25,497	5.20%	$ 26,192	5.80%	$ 24,845	5.67%	$ 22,048	5.36%	$ 19,176	4.90%
Loans, gross	$ 491,071	100.00%	$ 451,952	100.00%	$ 438,170	100.00%	$ 411,642	100.00%	$ 391,507	100.00%

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

	December 31, 2008 (Amounts in Thousands)
	Within One Year		After One Year But Within Five Years		After Five Years
	Fixed	Floating	Fixed	Floating	Fixed	Floating	Total
Real Estate Secured:
Residential 1-4 Family	$  11,090	$  5,204	$  41,576	$  6,960	$  56,899	$  54,510	$  176,239
Multi-family	6,464	49	2,854	235	1,889	1,623	13,114
Commercial, Construction & Land Development	44,945	23,817	79,124	6,851	18,169	6,433	179,339
Second Mortgages	2,405	1,049	5,688	119	8,507	731	18,499
Equity Line of Credit	0	799	0	3,604	0	5,581	9,984
Farmland	1,464	2,146	5,264	34	434	159	9,501
Secured, Other:
Personal	9,387	4	12,000	4	415	44	21,854
Commercial	10,289	6,723	14,978	80	655	0	32,725
Agricultural	1,148	1,950	773	59	389	0	4,319
Unsecured	9,252	9,572	1,995	1,442	3,236	0	25,497
Loans, Gross	$  96,444	$  51,313	$  164,252	$  19,388	$  90,593	$  69,081	$  491,071

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Securities

(dollar amounts in thousands)

2008 vs. 2007

Investment securities available for sale decreased $24,485 (market value) from December 31, 2007 to December 31, 2008 as a result of maturities and prepayments. The Company made fewer purchases during 2008 primarily due to the Company being able to lend out its excess funds during the year. The Company also made a concerted effort to keep its excess funds in overnight investment due to the worsening credit crisis and the need for liquidity. Purchases during the year consisted primarily in fixed rate agency notes and fixed rate mortgage backed securities. During the year, management has continued its investment strategy to purchase securities that will not only blend in with the Company’s overall asset liability strategy but also maximize yield. The majority of the pay downs were contractual amortization and prepayments on variable rate securities as a result of prepayments occurring on the underlying mortgages.

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

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

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

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

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

Investment Portfolio

The following table presents the maturity distribution, market value, amortized cost and approximate tax equivalent yield (assuming a 34% federal income tax rate) of the investment portfolio at December 31, 2008.

	(Dollars in Thousands)
	Within One Year	One Year Through Five Years		Five Years Through Ten Years		After Ten Years		Yield		Market Value		Amortized Cost
Mortgage-backed Sec – fixed rate	$         -		$ 3,050		$   1,746		$ 14,295		5.32%		$ 19,091		$ 18,810
Mtg.-backed Sec – variable rate	-		-		198		19,422		4.62		19,620		19,912
State & Municipal’s – tax exempt	-		-		872		48,415		6.05		49,289		50,820
State & Municipal’s – taxable	706		318		204		475		4.84		1,703		1,716
U.S. Agencies – fixed rate			-		-		11,439		6.12		11,439		11,377
Agency Preferred – variable rate	-		-		-		51		0.00		51		262
Corporate bonds – fixed rate	-		-		-		1,121		6.87		1,121		1,434
Corporate bonds – variable rate	-		-		266		3,825		4.41		4,091		12,318
SBA bonds – variable rate	-		-		-		53		2.47		53		54
CMO’s – fixed rate	-		-		-		177		4.93		177		176
CMO’s – variable rate	-		-		-		12		3.93		12		12
TOTAL	706		$  3,368		$   3,286		$ 99,285				$ 106,647		$116,891
Total fixed rate securities	$     706		$  3,368		$   2,822		$ 75,922				$  82,818		$ 84,333
Total variable rate securities	$         -		$         -		$      464		$ 23,363				$  23,829		$ 32,558

Deposits

(dollar amounts in thousands)

2008 vs. 2007

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

38

challenge of gathering deposits, especially non-interest bearing deposits. The Company has continued to use its alternative funding sources (primarily FHLB advances) to help facilitate growth. During 2008, the Company increased its net borrowings from the FHLB by $8,000. The total amount of FHLB borrowings as of December 31, 2008 was $99,097. See Footnotes 9 and 10 in the Company’s Consolidated Financial Statements for a description of the Bank’s outstanding FHLB advances. The Company secures the FHLB advances with a selected group of residential mortgage loans and commercial real estate loans as well as a specific group of securities available for sale. During 2008, the Company also joined the “CDARS” network. This deposit placement service allows banks to swap funds with each other while still allowing their customers only one institution to deal with. All of the funds placed in the CDARS network are fully insured by the FDIC. The Company also participates in the FDIC’s Temporary Liquidity Guarantee program that was implemented in the fourth quarter of 2008. Under this program, non-interest bearing transaction accounts and transaction accounts earning a rate of up to 0.50% are fully insured above and beyond the existing FDIC insurance coverage amount.

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

	December 31,
	(Amounts in Thousands)
	2008	2007
Non-interest bearing demand deposits	$   80,169	$   83,986
Interest bearing demand deposits	66,023	61,284
Savings deposits	49,805	46,931
Time deposits	326,739	320,546
Total Deposits	$ 522,736	$ 512,747

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

	Year Ended December 31, (Dollars in Thousands)
	2008		2007
	Amount	Rate	Amount	Rate
Non-interest bearing demand deposits	$  85,719	0.00%	$  81,746	0.00%
Interest-bearing demand deposits	62,300	1.53	59,468	1.92
Savings deposits	50,389	0.98	50,497	1.25
Time deposits	317,656	4.21	316,151	4.78
Total	$ 516,064		$ 507,862

39

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

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

Effects of Inflation

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

Liquidity and Capital Resources

(dollar amounts in thousands)

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

Management of the Bank continuously monitors and plans the Bank’s liquidity position for the future. Liquidity is provided from cash and due from banks, federal funds sold, loan and investment security payments, core deposits, the national certificate of deposit market, lines of credit with correspondent banks and lines of credit with the Federal Home Loan Bank. Management believes that these sources of funds provide sufficient and timely liquidity for the foreseeable future. The Company has also implemented a contingency funding plan due to the current economic crisis as an additional measure of liquidity management.

Recent Accounting Pronouncements

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

Off-Balance Sheet Arrangements

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

40

Item 7A. Quantitative and Qualitative Disclosures About Market Risk

Interest Rate Sensitivity Analysis

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

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

There are several common components of interest rate risk that must be effectively managed to maintain minimal impact on the Company’s earnings and capital. Re-pricing risk comes largely from timing differences in the pricing of interest-earning assets and interest-bearing liabilities. Reinvestment risk refers to the reinvestment of cash flows from interest and principal payments and maturing assets at lower or higher rates. Basis risk arises when different yield curves or pricing indices do not change at precisely the same moment in time or magnitude so that earning assets and interest-bearing liabilities with the same maturity are not affected equally. Yield curve risk refers to unequal movements in short-term and long-term interest rates.

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

The following table provides the maturities or re-pricing of investment securities, loans, and deposits as of December 31, 2008, and measures the interest rate sensitivity gap for each range of maturity indicated. The table presents the carrying amount of assets and liabilities in the periods they are expected to re-price or mature. The amounts below also reflect various prepayment assumptions.

41

	December 31, 2008 (Dollars in Thousands) Maturing / Re-pricing
	Within One Year	After One But Within Five Years	After Five Years	Total
ASSETS
Interest-bearing Investment Securities	$ 39,808	$ 10,636	$ 62,679	$ 113,123
Fed Funds Sold	3,736	-	-	3,736
Loans	231,853	216,443	42,130	490,426
Non-interest bearing Other Assets	-	-	61,711	61,711
Total Assets	$ 275,397	$ 227,079	$ 166,520	$ 668,996
LIABILITIES AND SHARE- HOLDERS’ EQUITY
Interest-bearing
(1) All Interest- bearing Deposits	$ 338,517	$ 103,367	$ 308	$ 442,192
Other Interest- bearing Liabilities	75,545	24,103	3,771	103,419
Non-interest-bearing
Demand Deposits	-	-	80,543	80,543
Other Liabilities	-	-	3,795	3,795
Shareholders’ Equity	-	-	39,047	39,047
Total Liabilities and Shareholders’ Equity	$ 414,062	$ 127,470	$ 127,464	$ 668,996
Interest Rate Sensitivity GAP	$(138,665)	$ 99,609	$ 39,056	$ -
(1)    For purposes of this schedule, the Company includes 100% of its statement savings, NOW and MMDA in the one year column.

Asset Liability Management

The Company’s primary objectives for asset and liability management are to establish internal controls and procedures that will result in managing interest rate risk, liquidity management, capital planning, asset mix and volume control, and loan and deposit pricing. The Asset and Liability Committee (ALCO) is headed by the CEO and includes management personnel from the different areas of the Bank. The ALCO meets on a monthly basis.

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

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

42

The following table shows the estimated cumulative impact on net interest income (NII) for the next 12 months as of December 31, 2008, subject to the specified interest rate changes. For purposes of this schedule the Company used a parallel rate shock on its interest earning assets and interest bearing liabilities. A parallel rate shock means that a 100 basis point increase in the rate index (prime rate) would result in an immediate 100 basis point increase on interest earning assets and interest bearing liabilities subject to the interest rate reset date. The Company uses a 50 basis point slope for its computation. The slope is the number of basis points per month that an index can increase or decrease until it reaches the target rate.

Rate change increment	% change in NII	$ change in NII
Up 100 basis points	-2.79%	-708,000
Up 200 basis points	-5.08%	-1,287,000
Down 100 basis points	1.52%	385,000
Down 200 basis points	0.44%	113,000

The above schedule assumes that 100% of the Company’s interest bearing checking accounts and 100% of its statement savings accounts would re-price according to the above increments. The above schedule also assumes an approximate growth in assets of 5% over the next 12 months. The above changes are within the acceptable parameters established by management and approved by the Board of Directors.

Item 8. Financial Statements and Supplementary Data

The following financial statements are incorporated by reference from the Annual Report to Shareholders for the fiscal year ended December 31, 2008:

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

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

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

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

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

Notes to Consolidated Financial Statements for December 31, 2008

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

None.

Item 9A(T). Controls and Procedures

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

43

discussed in detail with the Company’s Audit Committee.

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

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

Item 9B. Other Information

None

Part III.

Item 10. Directors, Executive Officers and Corporate Governance

Pursuant to General Instruction G(3) of Form 10-K, the information contained under the headings “The Nominees,” “Executive Officers Who Are Not Directors,” “Section 16(a) Beneficial Ownership Reporting Compliance,” “The Board of Directors and its Committees” and “Code of Ethics” in the Company’s Proxy Statement for the 2009 Annual Meeting of Shareholders is incorporated herein by reference.

Item 11. Executive Compensation

Pursuant to General Instruction G(3) of Form 10-K, the information contained under the headings “Executive Compensation” in the Company’s Proxy Statement for the 2009 Annual Meeting of Shareholders is incorporated herein by reference.

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

Pursuant to General Instruction G(3) of Form 10-K, the information contained under the heading “Security Ownership of Management and Certain Beneficial Owners” in the Company’s Proxy Statement for the 2009 Annual Meeting of Shareholders is incorporated herein by reference.

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

44

Equity Compensation Plan Information

Plan Category	Number of Securities to Be Issued upon Exercise of Outstanding Options, Warrants and Rights		Weighted Average Exercise Price of Outstanding Options, Warrants and Rights		Number of Securities Remaining Available for Future Issuance Under Equity Compensation Plans (a)
Equity Compensation Plans Approved by Shareholders	280,585		$ 13.28		--
Equity Compensation Plans Not Approved by Shareholders (b)	_______		$        -		200,000
Total		280,585		$13.28		200,000

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

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

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

Pursuant to General Instruction G(3) of Form 10-K, the information contained under the heading “Transactions with Related Parties” and “The Board of Directors and its Committees” in the Company’s Proxy Statement for the 2009 Annual Meeting of Shareholders is incorporated herein by reference.

Item 14. Principal Accounting Fees and Services

Pursuant to General Instruction G(3) of Form 10-K, the information contained under the headings “Services and Fees” and “Pre-Approved Policies and Procedures” in the Company’s Proxy Statement for the 2009 Annual Meeting of Shareholders is incorporated herein by reference.

45

Part IV.

Item 15. Exhibits, Financial Statement Schedules

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

(2) All applicable financial statement schedules required by Regulation S-X are included in the Notes to the 2008 Consolidated Financial Statements.

(3) Exhibits:

3.1 Articles of Incorporation of Highlands Bankshares, Inc. (as restated in electronic format only as of July 27, 2005), filed as Exhibit 3.1 to the Current Report on Form 8-K, File No. 000-27622, filed with the Commission on August 2, 2005, incorporated herein by reference.

3.2 Bylaws of Highlands Bankshares, Inc. attached as Exhibit 3.2 to the Registration Statement on Form 8-A, File No. 000-27622, filed with the Commission on January 24, 1996, incorporated herein by reference.

10.1 Highlands Union Bank 1995 Stock Option Plan, attached as Exhibit 10.1 to the Annual Report on Form 10-K for the fiscal year ended December 31, 2002, File No. 000-27622, incorporated herein by reference.

10.2 Highlands Bankshares, Inc. 2006 Equity Compensation Plan, filed as Exhibit 3.1 to the Current Report on Form 8-K, File No. 000-27622, filed with the Commission on September 20, 2006, incorporated herein by reference

11 Statement regarding computation of per share earnings (included as Note 13 of the Notes to Consolidated Financial Statements in the 2008 Annual Report to Shareholders and incorporated herein by reference).

13.1 Annual Report to Shareholders – Financial Statements

21 Subsidiaries of the Corporation.

23.1 Consent of Brown, Edwards & Company, L.L.P.

31.1 Section 302 Certification of Chief Executive Officer.

31.2 Section 302 Certification of Chief Financial Officer of the Corporation

31.3 Section 302 Certification of Vice President of Accounting

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

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

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

46

(b) Exhibits.

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

(c) Financial Statement Schedules.

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

47

SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

		HIGHLANDS BANKSHARES, INC.
Date: March 27, 2009	BY:	/s/ Samuel L. Neese
		Samuel L. Neese
		Executive Vice President and
		Chief Executive Officer

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

Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated on March 27, 2009.

Signature	Title	Date
/s/ James D. Morefield James D. Morefield	Chairman of the Board, and Director	March 27, 2009
/s/ Dr. James D. Moore, Jr. Dr. James D. Moore, Jr.	President	March 27, 2009
/s/ J. Carter Lambert J. Carter Lambert	Vice Chairman	March 27, 2009
/s/ Samuel L. Neese Samuel L. Neese	Executive Vice President, and Chief Executive Officer (principal executive officer)	March 27, 2009

48

/s/ William E. Chaffin William E. Chaffin	Director	March 27, 2009
/s/ E. Craig Kendrick E. Craig Kendrick	Director	March 27, 2009
_______________  Clydes B. Kiser	Direc­tor
/s/ Charles P. Olinger Charles P. Olinger	Direc­tor	March 27, 2009
/s/ William J. Singleton William J. Singleton	Direc­tor	March 27, 2009
/s/ Dr. H. Ramsey White, Jr. Dr. H. Ramsey White, Jr.	Direc­tor	March 27, 2009

49

EXHIBIT INDEX

Exhibit No. Description

3.1 Articles of Incorporation of Highlands Bankshares, Inc. (as restated in electronic format only as of July 27, 2005), filed as Exhibit 3.1 to the Current Report on Form 8-K, File No. 000-27622, filed with the Commission on August 2, 2005, incorporated herein by reference.

3.2 Bylaws of Highlands Bankshares, Inc. attached as Exhibit 3.2 to the Registration Statement on Form 8-A, File No. 000-27622, filed with the Commission on January 24, 1996, incorporated herein by reference.

10.1 Highlands Union Bank 1995 Stock Option Plan, attached as Exhibit 10.1 to the Annual Report on Form 10-K for the fiscal year ended December 31, 2002, File No. 000-27622, incorporated herein by reference.

10.2 Highlands Bankshares, Inc. 2006 Equity Compensation Plan, filed as Exhibit 3.1 to the Current Report on Form 8-K, File No. 000-27622, filed with the Commission on September 20, 2006, incorporated herein by reference

11 Statement regarding computation of per share earnings (included as Note 1 of the Notes to Consolidated Financial Statements in the 2008 Annual Report to Shareholders and incorporated herein by reference).

13.1 Annual Report to Shareholders – Financial Statements

21 Subsidiaries of the Corporation.

23.1 Consent of Brown, Edwards & Company, L.L.P.

31.1 Section 302 Certification of Chief Executive Officer.

31.2 Section 302 Certification of Chief Financial Officer of the Corporation

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

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

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

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

50

EX-13

Exhibit 13.1

HIGHLANDS BANKSHARES, INC. AND SUBSIDIARY

CONSOLIDATED FINANCIAL REPORT

DECEMBER 31, 2008

C O N T E N T S

Page

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM 2

Management’s Annual Report on Internal Control over Financial Reporting 3

FINANCIAL STATEMENTS

Consolidated Balance Sheets 4

Consolidated Statements of Income 5

Consolidated Statements of Stockholders' Equity 6

Consolidated Statements of Cash Flows 7

Notes to Consolidated Financial Statements 8 – 44

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Board of Directors and Stockholders

Highlands Bankshares, Inc and Subsidiaries

Abingdon, Virginia

We have audited the accompanying consolidated balance sheets of Highlands Bankshares, Inc. and Subsidiaries as of December 31, 2008 and 2007, and the related consolidated statements of income, stockholders' equity, and cash flows for each of the years in the two-year period ended December 31, 2008. The Company's management is responsible for these consolidated financial statements. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstance, but not for the purpose of expressing an opinion on the effectiveness of the Company's internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Highlands Bankshares, Inc. and Subsidiaries as of December 31, 2008 and 2007, and the consolidated results of its operations and its cash flows for each of the years in the two-year period ended December 31, 2008 in conformity with accounting principles generally accepted in the United States of America.

 

CERTIFIED PUBLIC ACCOUNTANTS

Bluefield, West Virginia

January 30, 2009

2

Management's Annual Report on Internal Control Over Financial Reporting.

Management is responsible for establishing and maintaining adequate internal control over financial reporting (as such term is defined in Rule 13a-15(f) under the Exchange Act). Our internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of our assets; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that our receipts and expenditures are being made only in accordance with authorizations of our management and directors; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of our assets that could have a material effect on the financial statements.

Because of the inherent limitations in any internal control, no matter how well designed, misstatements may occur and not be prevented or detected. Accordingly, even effective internal control over financial reporting can provide only reasonable assurance with respect to financial statement preparation. Further, the evaluation of the effectiveness of internal control over financial reporting was made as of a specific date, and continued effectiveness in future periods is subject to the risks that controls may become inadequate because of changes in conditions or that the degree of compliance with the policies and procedures may decline.

Management conducted an evaluation of the effectiveness of our system of internal control over financial reporting as of December 31, 2008 based on the framework set forth in "Internal Control - Integrated Framework" issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on its evaluation, management concluded that, as of December 31, 2008, Highlands Bankshares, Inc.’s internal control over financial reporting was effective.

This annual report does not include an attestation report of the Company's independent registered public accounting firm regarding internal control over financial reporting for the year ended December 31, 2008. The Company's registered public accounting firm was not required to issue an attestation on its internal controls over financial reporting pursuant to temporary rules of the Securities and Exchange Commission.

3

HIGHLANDS BANKSHARES, INC. AND SUBSIDIARY

CONSOLIDATED BALANCE SHEETS

December 31, 2008 and 2007

(Amounts in thousands)

ASSETS	2008	2007
Cash and due from banks	$ 12,846	$ 23,998
Federal funds sold	3,736	8,129
Total Cash and Cash Equivalents	16,582	32,127
Investment securities available-for-sale (Note 2)	106,647	131,132
Other Investments, at cost (Note 3)	6,476	5,735
Loans, net of allowance for loan losses of $5,171 and $4,630 in 2008 and 2007, respectively (Note 4)	485,254	446,661
Premises and equipment, net (Note 5)	24,192	23,162
Interest receivable	3,698	4,079
Other assets	26,147	17,898
Total Assets	$ 668.996	$ 660,794
LIABILITIES AND STOCKHOLDERS' EQUITY
Deposits (Note 8)
Noninterest bearing	$ 80,169	$ 83,986
Interest bearing	442,567	428,761
Total Deposits	522,736	512,747
Interest, taxes and other liabilities	3,794	3,662
Short term borrowings (Note 9)	75,608	44,105
Long-term debt (Note 10)	24,660	47,269
Capital securities (Note 11)	3,150	6,300
	107,212	101,336
Total Liabilities	629,948	614,083
STOCKHOLDERS' EQUITY
Common stock, 5,001 and 5,109 shares issued and outstanding as of December 31, 2008 and 2007, respectively. Authorized 40,000 shares, par value $0.625 per share (Notes 13 and 15)	3,126	3,193
Additional paid-in capital	7,688	7,405
Retained Earnings	34,994	38,247
Accumulated other comprehensive (loss)	(6,760)	(2,134)
Total Stockholders' Equity	39,048	46,711
Total Liabilities and Stockholders' Equity	$ 668,996	$ 660,794

The Notes to Consolidated Financial Statements are an integral part of these statements.

4

HIGHLANDS BANKSHARES, INC. AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF INCOME

Years Ended December 31, 2008 and 2007

(Amounts in thousands, except per share data)

INTEREST INCOME	2008	2007
Loans receivable and fees on loans	$ 32,937	$ 32,832
Securities available for sale:
Taxable	3,359	3,652
Tax-exempt	2,658	3,047
Other Investment Income	279	476
Federal funds sold	84	338
Total Interest Income	39,317	40,345
INTEREST EXPENSE
Deposits	14,823	16,886
Federal funds purchased	46	84
Other borrowed funds	4,754	4,471
Total interest expense	19,623	21,441
Net interest income	19,694	18,904
PROVISION FOR LOAN LOSSES (Note 4)	1,590	685
Net interest income after provision for loan losses	18,104	18,219
NON-INTEREST INCOME
Securities gains	137	80
Service charges on deposit accounts	2,414	2,369
Other service charges, commissions and fees	1,392	1,364
Other operating income	690	800
Other than temporary impairment charge	(5,988)	--
Total Non-Interest Income	(1,355)	4,613
NON-INTEREST EXPENSE
Salaries and employee benefits (Note 14 and 15)	10,259	9,879
Occupancy expense of bank premises	1,085	997
Furniture and equipment expense	1,700	1,524
Other operating expenses (Note 23)	5,133	4,720
Total Non-Interest Expenses	18,177	17,120
(Loss) Income Before Income Taxes	(1,428)	5,712
Income Tax Expense (Note 7)	(1,543)	811
Net Income	$ 115	$ 4,901
Earnings Per Common Share (Note 13)	$ 0.02	$ 0.95
Earnings Per Common Share - assuming dilution (Note 13)	$ 0.02	$ 0.94

The Notes to Consolidated Financial Statements are an integral part of these statements.

5

HIGHLANDS BANKSHARES, INC. AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY

Years Ended December 31, 2008 and 2007

(Amounts in thousands)

			Additional Paid-in Capital	Retained Earnings	Accumulated Other Comprehensive Income	Total Stockholders' Equity
	Common Stock
	Shares	Par Value
Balance, December 31, 2006	5,187	$ 3,242	$  7,026	$ 36,267	$    (828)	$ 45,707
Comprehensive income:
Net income	-	-	-	4,901	-	4,901
Change in unrealized gain (loss) on securities available-   for-sale, net of deferred income tax benefit of $645	-	-	-	-	(1,253)	(1,253)
Less: reclassification adjustment, net of income tax   expense of $27	-	-	-	-	(53)	(53)
Total comprehensive income	-	-	-	-	-	3,595
Common stock issued for stock options exercised	40	25	379	-	-	404
Cash dividend				(1,032)		(1,032)
Repurchase Common Stock	(118)	(74)	-	(1,889)	-	(1,963)
Balance, December 31, 2007	5,109	$ 3,193	$  7,405	$ 38,247	$ (2,134)	$ 46,711
Comprehensive income:
Net income	-	-	-	115	-	115
Change in unrealized gain (loss) on securities available-   for-sale, net of deferred income tax benefit of $2,336	-	-	-	-	(4,536)	(4,536)
Less: reclassification adjustment, net of income tax   expense of $47	-	-	-	-	(90)	(90)
Total comprehensive income	-	-	-	-	-	(4,511)
Common stock issued for stock options exercised	31	20	283	-	-	303
Cash dividend				(1,104)		(1,104)
Repurchase Common Stock	(139)	(87)	-	(2,264)	-	(2,351)
Balance, December 31, 2008	5,001	$ 3,126	$ 7,688	$ 34,994	$ (6,760)	$ 39,048

The Notes to Consolidated Financial Statements are an integral part of these statements

6

HIGHLANDS BANKSHARES, INC. AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF CASH FLOWS

Years Ended December 31, 2008 and 2007

(Amount in thousands)

	2008	2007
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income	$         115	$      4,901
Adjustments to reconcile net income to net cash
provided by operating activities:
Provision for loan losses	1,590	685
Provision for deferred income taxes	(2,280)	(69)
Depreciation and amortization	1,344	1,245
Net realized gains on available-for-sale securities	(137)	(80)
Net amortization on securities	339	407
Amortization of capital issue costs	116	27
Other than temporary impairment charge	5,988	--
Increase (decrease) in interest receivable	381	--
(Increase) decrease in other assets	(3,724)	(1,935)
Increase (decrease) in interest, taxes and other
liabilities	132	(396)
Net Cash provided by operating activities	3,864	4,785
CASH FLOWS FROM INVESTING ACTIVITIES:
Securities available for sale:
Proceeds from sale of debt and equity securities	19,182	3,246
Proceeds from maturities of debt and equity securities	20,652	25,412
Purchase of debt and equity securities	(28,548)	(24,112)
Purchase of other investments	(741)	(766)
Net increase in loans	(40,183)	(14,311)
Premises and equipment expenditures	(2,352)	(5,052)
Net Cash used in investing activities	(31,990)	(15,583)
CASH FLOWS FROM FINANCING ACTIVITIES:
Net increase in certificates of deposit	6,084	11,633
Net increase in demand, savings and other deposits	3,905	1,005
Net increase (decrease) in short term borrowings	31,503	8,504
Net increase (decrease) in long-term debt	(22,609)	6,395
Cash dividends paid	(1,104)	(1,032)
Redemption of Capital Securities	(3,150)	--
Proceeds from exercise of common stock options	303	404
Repurchase of common stock	(2,351)	(1,963)
Net Cash provided by financing activities	12,581	24,946
Net increase in cash and cash equivalents	(15,545)	14,148
CASH AND CASH EQUIVALENTS AT BEGINNING OF YEAR	32,127	17,979
CASH AND CASH EQUIVALENTS AT END OF YEAR	$     16,582	$    32,127
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:
Cash paid during the year for:
Interest	$     20,219	$    21,282
Income taxes	$          400	$      1,540

The Notes to Consolidated Financial Statements are an integral part of these statements

7

HIGHLANDS BANKSHARES, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2008

(Amounts in thousands)

Note 1. Summary of Significant Accounting Policies

Basis of Presentation and Consolidation

The accompanying consolidated financial statements include the accounts of Highlands Bankshares, Inc., (the “Parent Company”) and its wholly-owned subsidiary, Highlands Union Bank (the "Bank"). The statements also include Highlands Union Insurance Services, Inc., (the “Insurance Services”), and Highlands Union Financial Services, Inc., (the “Financial Services”) which are both wholly-owned subsidiaries of the Bank. All significant intercompany balances and transactions have been eliminated in consolidation. The accounting and reporting policies of Highlands Bankshares, Inc. and Subsidiaries, (the “Company”) conform to U.S. generally accepted accounting principles and to predominate practices within the banking industry.

Nature of Operations

The Company operates in Abingdon, Virginia, and surrounding southwest Virginia, eastern Tennessee, and western North Carolina under the laws of the Commonwealth of Virginia. The Parent Company was organized on December 29, 1995. The Parent Company is supervised by the Federal Reserve Bank under the Bank Holding Company Act of 1956, as amended. The Bank began banking operations on April 27, 1985 under a state bank charter and provides a full line of financial services to individuals and businesses. The Bank’s primary lending products include mortgage, consumer and commercial loans, and its primary deposit products are checking, savings, and certificates of deposit. As a state bank and a member of the Federal Reserve Bank of Richmond, the Bank is subject to regulation by the Virginia State Bureau of Financial Institutions, the Federal Deposit Insurance Corporation, and the Federal Reserve Bank. Highlands Capital Trust I became effective January 14, 1998. The nature of the trust is described more fully in Note 11. Highlands Union Insurance Services, Inc. became effective October 8, 1999 for the purpose of selling insurance through Bankers Insurance LLC. The only activity in Highlands Union Financial Services is the receipt of life insurance commissions.

Cash and Cash Equivalents

For purposes of the consolidated statements of cash flows, cash and cash equivalents include cash and due from banks and federal funds sold, all of which mature within ninety days. The Company maintains its cash in bank deposit accounts which, at times, may exceed federally insured limits. The Company has not experienced any losses in such accounts. The Company believes it is not exposed to any significant credit risk on cash and cash equivalents.

Securities Available-for-Sale

Securities classified as available-for-sale are those debt and equity securities that the Company intends to hold for an indefinite period of time, but not necessarily to maturity. Any decision to sell a security classified as available-for-sale would be based on various factors, including significant movements in interest rates, changes in the maturity mix of the Company's assets and liabilities, liquidity needs, regulatory capital considerations, and other similar factors.

8

HIGHLANDS BANKSHARES, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2008

(Amounts in thousands)

Note 1. Summary of Significant Accounting Policies (Continued)

Securities Available-for-Sale (Continued)

Securities available-for-sale are carried at fair value. Unrealized gains or losses are reported as increases or decreases in other comprehensive income, net of the related deferred income tax effect. Realized gains or losses are included in earnings on the trade date and are determined on the basis of the amortized cost of specific securities sold. Realized gains or losses are included in earnings. Premiums and discounts are recognized in interest income using the interest method over the period to maturity.

Loans

The Company makes mortgage, commercial and consumer loans to customers. A substantial portion of the loan portfolio is represented by mortgage loans throughout southwest Virginia. The ability of the Company’s debtors to honor their contracts is dependent upon the real estate and general economic conditions in this area.

Loans that management has the intent and ability to hold for the foreseeable future or until maturity or pay-off generally are reported at their outstanding unpaid principal balances adjusted for charge-offs, the allowance for loan losses, and any deferred fees or costs on originated loans. Interest income is accrued on the unpaid balance. Loan origination fees, net of certain direct origination costs, are deferred and amortized to income over the estimated lives of the loans using the straight-line method which is not materially different from the interest method. The accrual of interest on loans is discontinued at the time the loan is 90 days delinquent unless the credit is well-secured and in process of collection. Credit card loans and other personal loans are typically charged off no later than 180 days past due. In all cases, loans are placed on non-accrual or charged-off at an earlier date if collection of principal or interest is considered doubtful.

All interest accrued but not collected for loans that are placed on non-accrual or charged off is reversed against interest income. The interest on these loans is accounted for on the cash-basis or cost-recovery method, until qualifying for return to accrual. Loans are returned to accrual status when all the principal and interest amounts contractually due are brought current and future payments are reasonably assured.

Allowance for Loan Losses

The Company monitors and maintains an allowance for loan losses to absorb an estimate of probable losses inherent in the loan portfolio. The Company maintains policies and procedures that address the systems of controls over the following areas of maintenance of the allowance: the systematic methodology used to determine the appropriate level of the allowance to provide assurance the loan loss reserve is maintained in accordance with accounting principles generally accepted in the United States of America; the accounting policies for loan charge-offs and recoveries; the assessment and measurement of impairment in the loan portfolio; and the loan grading system.

The Company’s Credit Review and Analysis Department evaluates various loans individually for impairment as required by Statement of Financial Accounting Standards (“SFAS”) No. 114, Accounting by Creditors for Impairment of a Loan, and SFAS No. 118, Accounting by Creditors for Impairment of a Loan – Income Recognition and Disclosures. Loans evaluated individually for impairment include non-performing loans, such as loans on non-accrual, loans past due by 90 days or more, restructured loans and other loans selected by management. The evaluations are based

9

HIGHLANDS BANKSHARES, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2008

(Amounts in thousands)

Note 1. Summary of Significant Accounting Policies (Continued)

Allowance for Loan Losses (Continued)

upon discounted expected cash flows or collateral valuations. If the evaluation shows that a loan is individually impaired, then a specific reserve is established for the amount of impairment. If a loan evaluated individually is not impaired, then the loan is considered for impairment under SFAS No. 5, Accounting for Contingencies, with a group of loans that have similar characteristics.

For loans without individual measures of impairment, the Company makes estimates of losses for groups of loans as required by SFAS No. 5. Loans are grouped by similar characteristics, including the type of loan, the assigned loan grade and the general collateral type. A loss rate reflecting the expected loss inherent in a group of loans is derived based upon estimates of default rates for a given loan grade, the predominant collateral type for the group and the terms of the loan. The resulting estimate of losses for groups of loans are adjusted for relevant environmental factors and other conditions of the portfolio of loans, including: borrower and industry concentrations; levels and trends in delinquencies, charge-offs and recoveries; changes in underwriting standards and risk selection; level of experience and ability of lending management; and national and local economic conditions.

The amounts of estimated impairment for individually evaluated loans and groups of loans are added together for a total estimate of loan losses. This estimate of losses is compared to the allowance for loan losses of the Company as of the evaluation date and, if the estimate of losses is greater than the allowance, an additional provision to the allowance would be made. If the estimate of losses is less than the allowance, the degree to which the allowance exceeds the estimate is evaluated to determine whether the allowance falls outside a range of estimates. If the estimate of losses is below the range of reasonable estimates, the allowance would be reduced by a credit to the provision for loan losses. The Company recognizes the inherent imprecision in estimates of losses due to various uncertainties and variability related to the factors used, and therefore a reasonable range around the estimate of losses is derived and used to ascertain whether the allowance is too high or too low. If different assumptions or conditions were to prevail and it is determined that the allowance is not adequate to absorb the new estimate of probable losses, an additional provision for loan losses would be made, which amount may be material to the consolidated financial statements.

Premises and Equipment

Land is carried at cost. Premises and equipment are stated at cost less accumulated depreciation. Depreciation is computed on the straight-line method over estimated useful lives. Maintenance and repairs are charged to current operations while improvements are capitalized. Disposition gains and losses are reflected in current operations. Purchased software costs are included in other assets and expensed over periods ranging from 3-5 years.

Intangible Assets

Capital issue costs relating to the junior subordinated debt securities are stated at cost less accumulated amortization. Amortization is computed on the straight-line method over the life of the securities - 30 years.

Foreclosed Assets

Assets acquired through, or in lieu of, loan foreclosure or repossession are held for sale and are initially recorded at fair value at the date of foreclosure or repossession, establishing a new cost

10

HIGHLANDS BANKSHARES, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2008

(Amounts in thousands)

Note 1. Summary of Significant Accounting Policies (Continued)

Foreclosed Assets (Continued)

basis. Subsequent to foreclosure or repossession, valuations are periodically performed by management and the assets are carried at the lower of carrying amount or fair value less cost to sell. Revenue and expenses from operations and changes in the valuation allowance are included in net expenses from foreclosed and repossessed assets. Foreclosed and repossessed assets at December 31, 2008 and 2007 were $3,945 and $1,176 respectively.

Income Taxes

Under the asset and liability method, deferred income taxes are recognized for the tax consequences of “temporary differences” by applying enacted statutory tax rates to the differences between the financial statement carrying amounts and the tax bases of existing assets and liabilities. Under SFAS No. 109, the effect on deferred taxes of a change in tax rates is recognized in income in the period that includes the enactment date.

Earnings Per Common Share

Earnings per common share are calculated based on the weighted average outstanding shares during the year. Earnings per common share assuming dilution are calculated based on the weighted average outstanding shares during the year plus common stock equivalents at year end.

Stock Compensation Plans

The Company accounts for stock compensation plans under the guidance of SFAS No. 123(R) which requires all share-based payments to employees, including grants of employee stock options, to be recognized in the income statement based on their grant-date fair values. No options were granted during 2008 or 2007 so no compensation has been recognized.

Use of Estimates

In preparing consolidated financial statements in conformity with U.S. generally accepted accounting principles, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities as of the date of the balance sheet and reported amounts of revenue and expenses during the reporting period. Actual results could differ from those estimates. Material estimates that are particularly susceptible to significant change in the near term relate to the determination of the allowance for loan losses, and the valuation of foreclosed real estate, deferred tax assets and investment securities.

11

HIGHLANDS BANKSHARES, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2008

(Amounts in thousands)

Note 1. Summary of Significant Accounting Policies (Continued)

Business Segments

The Company reports its activities as a single business segment. In determining the appropriateness of segment definition, the Company considers components of the business about which financial information is available and regularly evaluated relative to resource allocation and performance assessment.

Recent Accounting Pronouncements

SFASNo.157, “Fair Value Measurements” - The Bank implemented the provisions of Financial Accounting Standards Board (FASB) Statement No. 157 on January 1, 2008. In accordance with FASB Statement of Position No. 157-2,Effective Date of FASB Statement No. 157, the Bank has delayed application of Statement No. 157 for non-financial assets and non-financial liabilities until January 1, 2009. This Statement provides guidance for using fair value to measure assets and liabilities and requires expanded disclosures about the extent to which companies measure assets and liabilities at fair value, and the effect of fair value measurements on earnings. This standard applies whenever other standards require or permit assets or liabilities to be measured at fair value. The standard does not expand the use of fair value in any new circumstances.   Implementation of this statement had no practical impact on our financial position or results of operations, because there was no substantive change in our accounting for the financial instruments we report at fair value. Fair value is based upon quoted market prices, where available. If listed prices or quotes or third-party valuations are not available, fair value is based upon internally developed models that use primarily market-based or independently-sourced market parameters, including interest rate yield curves. SFAS 157 establishes a three-level valuation hierarchy for disclosure of fair value measurements. The valuation hierarchy is based upon the transparency of inputs to the valuation of an asset or liability as of the measurement date. A financial instrument’s categorization within the valuation hierarchy is based upon the lowest level of input that is significant to the fair value measurement. The three levels are defined as follows:

Level 1 – inputs to the valuation methodology are quoted prices (unadjusted) for identical assets or liabilities in active markets

Level 2 – inputs to the valuation methodology include quoted prices for similar assets and liabilities in active markets, and inputs that are observable for the asset or liability, either directly or indirectly, for substantially the full term of the financial instrument

Level 3 – inputs to the valuation methodology are unobservable and significant to the fair value measurement.

SFAS No.159, “The Fair Value Option for Financial Assets and Financial Liabilities - Including an amendment of FASB Statement No.115.” - The FASB issued Statement No. 159 in February 2007. This Statement permits entities to choose to measure many financial instruments and certain other items at fair value. The objective is to improve financial reporting by providing entities with the opportunity to mitigate volatility in reported earnings caused by measuring related assets and liabilities differently without having to apply complex hedge accounting provisions. This Statement was effective for the Bank on January 1, 2008. Adoption of the Statement had no impact on the financial position or results of operations of the Bank as management did not make a fair value election for eligible items. Except for instruments explicitly required to be measured at fair value the Bank does not use fair value to measure its financial instruments.

12

HIGHLANDS BANKSHARES, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2008

(Amounts in thousands)

Note 1. Summary of Significant Accounting Policies (Continued)

SFASNo.141, “Business Combinations (Revised 2007).”- SFAS 141R replaces SFAS 141, “Business Combinations,” and applies to all transactions and other events in which one entity obtains control over one or more other businesses. SFAS 141R requires an acquirer, upon initially obtaining control of another entity, to  recognize the assets, liabilities and any non-controlling interest in the acquiree at fair value as of the acquisition date. Contingent consideration is required to be recognized and measured at fair value on the date of acquisition rather than at a later date when the amount of that consideration may be determinable beyond a reasonable doubt. This fair value approach replaces the cost-allocation process required under SFAS 141 whereby the cost of an acquisition was allocated to the individual assets acquired and liabilities assumed based on their estimated fair value. SFAS 141R requires acquirers to expense acquisition-related costs as incurred rather than allocating such costs to the assets acquired and liabilities assumed, as was previously the case under SFAS 141. Under SFAS 141R, the requirements of SFAS 146, “Accounting for Costs Associated with Exit or Disposal Activities,” would have to be met in order to accrue for a restructuring plan in purchase accounting. Pre-acquisition contingencies are to be recognized at fair value, unless it is a non-contractual contingency that is not likely to materialize, in which case, nothing should be recognized in purchase accounting and, instead, that contingency would be subject to the probable and estimable recognition criteria of SFAS 5, “Accounting for Contingencies.” SFAS 141R will have a significant impact on the Bank’s accounting for any business combinations that are completed after January 1, 2009.

SFAS No.160, “Noncontrolling Interest in Consolidated Financial Statements, an amendment of ARB Statement No.51.” - SFAS 160 amends Accounting Research Bulletin (ARB) No. 51, “Consolidated Financial Statements,” to establish accounting and reporting standards for the non-controlling interest in a subsidiary and for the deconsolidation of a subsidiary. SFAS 160 requires consolidated net income to be reported at amounts that include the amounts attributable to both the parent and the non-controlling interest. It also requires disclosure, on the face of the consolidated income statement, of the amounts of consolidated net income attributable to the parent and to the non-controlling interest. SFAS 160 is effective for the Bank on January 1, 2009 and is not expected to have a significant impact on the Bank’s financial statements.

SFAS No.162, “The Hierarchy of Generally Accepted Accounting Principles.” - SFAS 162 identifies the sources of accounting principles and the framework for selecting the principles to be used in the preparation of financial statements of nongovernmental entities that are presented in conformity with generally accepted accounting principles (GAAP) in the United States (the GAAP hierarchy). The hierarchical guidance provided by SFAS 162 did not have a significant impact on the Bank’s financial statements.

13

HIGHLANDS BANKSHARES, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2008

(Amounts in thousands)

Note 1. Summary of Significant Accounting Policies (Continued)

FSP No.132(R)-1 “Employers’ Disclosures about Postretirement Benefit Plan Assets.”- FSP 132(R)-1 provides guidance related to an employer’s disclosures about plan assets of defined benefit pension or other post-retirement benefit plans. Under FSP 132(R)-1, disclosures should provide users of financial statements with an understanding of how investment allocation decisions are made, the factors that are pertinent to an understanding of investment policies and strategies, the major categories of plan assets, the inputs and valuation techniques used to measure the fair value of plan assets, the effect of fair value measurements using significant unobservable inputs on changes in plan assets for the period and significant concentrations of risk within plan assets. The disclosures required by FSP 132(R)-1 will be included in the Bank’s financial statements beginning with the financial statements for the year-ended December 31, 2009.

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

14

HIGHLANDS BANKSHARES, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2008

(Amounts in thousands)

Note 2. Investment Securities Available-For-Sale

The amortized cost and market value of securities available-for-sale are as follows:

	2008
	Amortized Cost	Gross Unrealized Gains	Gross Unrealized Losses	Fair Value
U.S Government agencies and corporations	$   11,377	$    62	$          --	$   11,439
State and political subdivisions	52,537	247	1,793	50,991
Mortgage backed securities	38,910	320	330	38,900
Other securities	14,067	5	8,756	5,317
	$ 116,891	$  635	$ 10,879	$ 106,647

15

HIGHLANDS BANKSHARES, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2008

(Amounts inthousands)

Note 2. Investment Securities Available-For-Sale (Continued)

	2007
	Amortized Cost	Gross Unrealized Gains	Gross Unrealized Losses	Fair Value
U.S Government agencies and corporations	$   15,272	$       97	$          1	$    15,368
State and political subdivisions	63,761	423	823	63,361
Mortgage backed securities	35,160	107	290	34,977
Other securities	20,172	14	2,761	17,426
	$  134,365	$    641	$   3,875	$   131,132

The following table presents the age of gross unrealized losses and fair value by investment category.

	------------------------------------------------December 31, 2008---------------------------------------------
	Less Than 12 months		12 Months or More		Total
	Fair Value	Unrealized Losses	Fair Value	Unrealized Losses	Fair Value	Unrealized Losses
Mortgage-backed securities	$   13,695	$     168	$   6,572	$      162	$    20,267	$         330
States and pol. subdivisions	21,874	1,356	5,479	433	27,353	1,789
Other securities	843	1,281	3,454	7,478	4,297	8,759
Total	$   36,412	$  2,805	$  15,505	$   8,073	$    51,917	$    10,878

Management does not believe any individual unrealized loss as of December 31, 2008 represents an other-than-temporary impairment. The unrealized losses are primarily attributable to changes in market interest rates and current market illiquidity.. The Company has both the intent and ability to hold the securities contained in the previous table for a time necessary to recover the amortized cost.

During 2008 the Company recorded and “other-than-temporary-impairment charge” in the amount of $5.99 million on our investment in preferred stock of the Federal Home Loan Mortgage Corporation (“Freddie Mac”) and the Federal National Mortgage Corporation (Fannie Mae”), both government sponsored enterprises (“GSE”). The decision to recognize the unrealized mark-to-market loss on these securities as an “other-than-temporary impairment (“OTTI”) is based on the significant decline in the market value of the securities caused by recent events. Prior to this charge, impairment was recorded as an unrealized mark-to-market loss on securities available-for-sale and reflected as a reduction to equity through other comprehensive income. 

16

HIGHLANDS BANKSHARES, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2008

(Amounts in thousands)

Note 2. Investment Securities Available-For-Sale (Continued)

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

Included in “other securities” is approximately $13.25 million in book value of Trust Preferred Securities. As of December 31, 2008, the unrealized loss in these instruments was approximately $8.30 million. These securities are backed by trust preferred securities issued primarily by banks nationwide and a limited number of insurance companies. The current credit and liquidity crisis in the banking sector has caused the markets for these securities and similar securities to become almost non-existent. The market values for these securities are very depressed relative to historical levels. No new pooled trust preferred issuances have been done since 2007. Although the Company has both the ability and intent to hold these securities to maturity, the Company is closely monitoring this portfolio due to substantial market discounts. The market discounts reflect the current illiquidity and the negative credit events within the banking sector. Continuing bank losses and failures could result in changes in the Company’s evaluation of these securities.

Investment securities available-for-sale with a carrying value of $75,239 and $60,832 at December 31, 2008 and 2007 respectively, and a market value of $74,078 and $60,705 at December 31, 2008 and 2007, respectively were pledged as collateral on public deposits, FHLB advances and for other purposes as required or permitted by law.

17

HIGHLANDS BANKSHARES, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2008

(Amounts in thousands)

Note 2. Investment Securities Available-For-Sale (Continued)

The amortized cost and estimated fair value of securities available-for-sale at December 31, 2008 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	$        700	$           705
Due after one year through five years	309	318
Due after five years through ten years	1,087	1,076
Due after ten years	61,817	60,331
	63,913	62,430
Mortgage-backed securities	38,910	38,900
Other securities	14,067	5,317
	$ 116,890	$   106,647

For the years ended December 31, 2008 and 2007, proceeds from sale of securities were $19,182 and $3,246, respectively. Gross realized gains and losses on investment securities available for sale were as follows:

	2008	2007
Realized gains	$  154	$  80
Realized losses	$ (17)	$   --
Tax provision	$ 47	$ 27

Note 3. Other Investments

Federal Home Loan Bank (FHLB) stock, Federal Reserve Bank (FRB) stock, Bankers’ Bank stock (TBB), Pacific Coast Bankers’ Bank and Community Bankers’ Bank stock with a carrying value of $6,476 and $5,735 at December 31, 2008 and 2007, respectively are stated at cost and included as “ Other Investments” on the Company’s Balance Sheets. These investments are considered to be restricted as the Company is required by these agencies to hold these investments, and the only market for this stock is the issuing agency.

18

HIGHLANDS BANKSHARES, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2008

(Amounts in thousands)

Note 4. Loans

The composition of net loans is as follows:

	2008	2007
Real Estate Secured:
Residential 1-4 family	$  176,239	$  163,917
Multifamily	13,115	9,420
Commercial, Construction and Land Development	179,338	159,794
Second mortgages	18,499	17,965
Equity lines of credit	9,984	9,783
Farmland	9,501	9,475
	406,676	370,354
Secured, Other:
Personal	21,854	24,741
Commercial	32,725	26,433
Agricultural	4,319	4,232
	58,898	55,406
Unsecured	25,251	25,828
Overdrafts	246	364
	25,497	26,192
	491,071	451,952
Less:
Allowance for loan losses	5,171	4,630
Net deferred fees	646	661
	5,817	5,291
Loans, net	$  485,254	$  446,661

Activity in the allowance for loan losses is as follows:

	2008	2007
Balance, beginning	$     4,630	$    4,565
Provision charged to operations	1,590	685
Loans charged to reserve	(1,316)	(832)
Recoveries	267	212
Balance, ending	$    5,171	$    4,630

19

HIGHLANDS BANKSHARES, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2008

(Amounts in thousands)

Note 4. Loans (Continued)

The following is a summary of information pertaining to impaired loans:

	December 31,
	2008	2007
Impaired loans without a valuation allowance	$         -	$         -
Impaired loans with a valuation allowance	5,421	7,649
Total impaired loans	$ 5,421	$ 7,649
Valuation allowance related to impaired loans	$ 1,225	$ 1,646
Total non-accrual loans	$ 6,278	$ 7,849
Total loans past due 90 days or more and still accruing	$    656	$    268
Average investment in impaired loans	$ 6,520	$ 5,874
Interest income recognized on impaired loans	$    127	$    136
Interest income recognized on a cash basis on impaired loans	$        -	-

No additional funds are committed to be advanced in connection with impaired loans.

Note 5. Premises and Equipment

Premises and equipment are comprised of the following:

	2008	2007
Land	$ 10,050	$ 10,024
Bank Premises	13,927	12,854
Equipment	11,536	10,348
	35,513	33,226
Less: accumulated depreciation	11,389	10,102
	24,124	23,124
Construction in Progress	68	38
	$ 24,192	$ 23,162

Depreciation expense was $1,322 and $1,206 for 2008 and 2007, respectively.

20

HIGHLANDS BANKSHARES, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2008

(Amounts in thousands)

Note 6. Bank Owned Life Insurance

The Company maintains insurance on the lives of certain key directors and officers. As beneficiary, the Company receives the cash surrender value if the policy is terminated, and upon death of the insured, receives all benefits payable. The current value of the policies at December 31, 2008 and 2007 was $12,476 and $11,977, respectively and are included in “Other Assets” in the balance sheet.

Note 7. Income Taxes

The components of the net deferred tax asset, included in other assets, are as follows:

	2008	2007
Deferred tax assets:
Allowance for loan loss	$    1,758	$      1,574
Prior Year AMT credit	136	-
Other than temporary impairment charge on AFS securities	2,036
Net unrealized loss on securities available-for-sale	3,483	1,100
	7,413	2,674
Deferred tax liability:
Depreciation	(452)	(511)
	(452)	(511)
Net deferred tax asset	$    6,961	$    2,163

The components of income tax expense related to continuing operations are as follows:

	2008	2007
Federal:
Current	$       737	$       880
Deferred	(2,280)	(69)
Total	$ (1,543)	$      811

The Company’s income tax expense differs from the expected tax expense at the statutory federal rate of 34% as follows:

	2008	2007
Statutory rate applied to earnings before income taxes	$   (486)	$   1,942
Tax exempt interest	(931)	(1036)
Other, net	(126)	(95)
Total	$ (1,543)	$     811

21

HIGHLANDS BANKSHARES, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2008

(Amounts in thousands)

Note 8. Deposits

The composition of deposits is as follows:

	2008	2007
Non-interest bearing demand	$   80,169	$   83,986
Interest bearing demand	66,023	61,284
Savings deposits	49,805	46,931
Time deposits, in amounts of $100,000 or more	119,623	112,150
Other time deposits	207,116	208,396
Total deposits	$ 522,736	$  512,747

The scheduled maturities of time deposits at December 31, 2008 are as follows:

2009	$ 222,276
2010	58,327
2011	15,011
2012	24,156
2013	6,241
Thereafter	728
	$ 326,739

Note 9. Other Short-Term Borrowings

Other short-term borrowings in the balance sheet consist of nine Federal Home Loan Bank advances that are secured by a lien on a specific class of residential and commercial mortgage loans of the Bank. The advances are also secured by a specific group of available for sale securities held in safekeeping by the FHLB. The Federal Home Loan Bank has the option to convert 8 of these advances which total $70.5 million to a three month LIBOR-based floating rate advance. These eight notes carry interest rates of 6.280%, 6.170%, 3.44%, 4.47%, 4.80%, 4.328%, 4.341% and 3.84%. The ninth advance which totals $4 million has a final maturity in August of 2009 and carries a rate of 6.385%. Also included in other short-term borrowing are the contractual principal payments due over the next 12 months on two seller financed mortgages secured by Bank property and an FHLB advance granted through the FHLB’s Affordable Housing Program. The remaining balances on these three borrowings are included in long-term debt. Also included in other short-term borrowings are funds drawn on a line of credit issued to the Company by one of its Correspondent Banks. The rate on the line of credit is Prime minus .50% and floats with Prime. This 2 million line is unsecured and as of December 31, 2008 carried a balance of 1 million.

22

HIGHLANDS BANKSHARES, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2008

(Amounts in thousands)

Note 10. Long-Term Debt

At December 31, Highlands Bankshares, Inc. and its Subsidiary had the following long-term debt agreements:

	2008	2007
Note payable FHLB dated 08/13/99 for $4 million with an annual interest rate of 6.385%, due 08/13/09. The note requires quarterly interest payments and had an early conversion option at 08/13/04. The loan is secured by a floating blanket lien on a specific class of mortgage loans of the Bank and a specific group of securities available for sale.	Included in short term borrowings	4,000
Note payable FHLB dated 03/04/05 for $5 million with an annual interest rate of 4.165%, due 03/04/2015. The note requires quarterly interest payments and has an early conversion option at 03/04/2010. The loan is secured by a floating blanket lien on a specific class of mortgage loans of the Bank and a specific group of securities available for sale.	5,000	5,000
Note payable FHLB dated 06/29/05 for $5 million with an annual interest rate of 3.760%, due 06/29/2015. The note requires quarterly interest payments and has an early conversion option at 06/29/2010. The loan is secured by a floating blanket lien on a specific class of mortgage loans of the Bank and a specific group of securities available for sale.	5,000	5,000
Note payable FHLB dated 05/16/06 for $12.5 million with an annual interest rate of 4.80%, due 05/16/2016. The note requires quarterly interest payments and has an early conversion option at 05/18/2009. The loan is secured by a floating blanket lien on a specific class of mortgage loans of the Bank and a specific group of securities available for sale.	Included in short term borrowings	12,500

23

HIGHLANDS BANKSHARES, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2007

(Amounts in thousands)

Note 10. Long-Term Debt (Continued)

	2008	2007
Note payable FHLB dated 05/18/07 for $5 million with an annual interest rate of 4.341%, due 05/18/2017. The note requires quarterly interest payments and has an early conversion option at 05/18/2009. The loan is secured by a floating blanket lien on a specific class of mortgage loans of the Bank and a specific group of securities available for sale.	Included in short term  borrowings	5,000
Note payable FHLB dated 09/13/07 for $15 million with an annual interest rate of 3.84%, due 09/13/2017. The note requires quarterly interest payments and has an early conversion option at 09/13/2009. The loan is secured by a floating blanket lien on a specific class of mortgage loans of the Bank and a specific group of securities available for sale.	Included in short term borrowings	15,000
Note payable FHLB dated 02/28/08 for $6 million with an annual interest rate of 2.66%, due 02/28/2018. The note requires quarterly interest payments and has an early conversion option at 02/26/2010. The loan is secured by a floating blanket lien on a specific class of mortgage loans of the Bank and a specific group of securities available for sale.	6,000	--
Note payable FHLB dated 03/12/2008 for $8 million with an annual interest rate of 2.61%, due 03/12/2018. The note requires quarterly interest payments and has an early conversion option at 03/14/2011. The loan is secured by a floating blanket lien on a specific class of mortgage loans of the Bank and a specific group of securities available for sale.	8,000	--

24

HIGHLANDS BANKSHARES, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2008

(Amounts in thousands)

Note 10. Long-Term Debt (Continued)

	2008	2007
Note payable FHLB dated 08/23/05 for $750,000 with an annual interest rate of 0%, due 08/24/2020. The note requires monthly principal payments and was granted as part of the FHLB’s affordable housing program. The loan is secured by a floating blanket lien on a specific class of mortgage loans of the Bank and a specific group of securities available for sale.	$ 548	$ 597
Other notes payable resulting from seller-financing transactions for $500 with annual interest rates ranging from 3.2% to 8.0%, and due dates ranging from 2010-2013. The notes require monthly installments of principal and interest of $6. The loans are secured by a first deed of trust on real estate.	112	172
Total long-term debt	$ 24,660	$ 47,269

Contractual principal maturities of long-term debt at December 31, 2008 are as follows:

2009	$ -
2010	86
2011	76
2012	78
2013	68
Thereafter	24,352
	$ 24,660

25

HIGHLANDS BANKSHARES, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2008

(Amounts in thousands, except per share data)

Note 11. Capital Securities

On January 21, 1998, Highlands Capital Trust I, issued $7,500 of 9.25% Capital Securities which will mature on January 15, 2028. The principal asset of the Trust is $7,500 of the Parent Company’s junior subordinated debt securities with like maturities and like interest rates to the Capital Securities. Additionally, the Trust has issued 9,000 shares of common securities to the Parent Company. The 9.25% Capital Securities had $6,300 outstanding at December 31, 2007 and an estimated fair value of $6,590. The related junior subordinated debt securities had an estimated fair value of $6,590. Highlands Bankshares, Inc. repurchased 48,000 or 16% of the shares of Highlands Capital Trust I on April 18, 2003, on the open market, at $26.15 per share. The price paid per share corresponds to the January 2008 call price. The premium paid of $55 is being expensed over the period to the January 2008 call date.

The Capital Securities, the assets of the Trust and the common securities issued by the Trust are redeemable in whole or in part on or after January 15, 2008, or at any time in whole but not in part from the date of issuance on the occurrence of certain events.

The Capital Securities may be included in Tier I capital for regulatory capital adequacy determination purposes up to 25% of Tier I capital after its inclusion. The portion of the Capital Securities not considered as Tier I capital may be included in Tier II capital. Distributions to the holders of the Capital Securities are included in interest expense.

The obligations of the Parent Company with respect to the issuance of the Capital Securities

constitute a full and unconditional guarantee by the Parent Company of the Trust’s obligations with respect to the Capital Securities.

Subject to certain exceptions and limitations, the Parent Company may elect from time to time to defer interest payments on the junior subordinated debt securities, which would result in a deferral of distribution payments on the related Capital Securities.

On January 15, 2008 (the “Redemption Date”), after receiving regulatory approval, Highlands Bankshares, Inc. (the “Company”) redeemed $3,862,500 in principal amount of its Junior Subordinated Debt Securities due January 15, 2028 (the “Debt Securities”). All of the Debt Securities are held by Highlands Capital Trust I (the “Trust”), the Company’s partially-owned subsidiary. The redemption price paid for the Debt Securities was 104.625% of the principal amount of the Debt Securities redeemed, plus accrued and unpaid interest to but excluding the Redemption Date.

Simultaneously, Wilmington Trust Company, the trustee of the Trust, used the proceeds received from the redemption of the Debt Securities to redeem a “like amount” of the Trust’s outstanding Common Securities and Preferred Securities (the “Preferred Securities”). The Trust redeemed $3,750,000 in principal amount of the Preferred Securities (50% of the total outstanding) at a price equal to 104.625% of the $25.00 liquidation amount per redeemed Preferred Security, plus accumulated distributions thereon to but excluding the Redemption Date (the “Preferred Securities Redemption”). Prior to the Preferred Securities Redemption, the Company held $1,200,000 in liquidation amount of the Preferred Securities then outstanding. In connection with the Preferred Securities Redemption, 50% or $600,000 in liquidation amount of the Preferred Securities held by the Company were redeemed.

The Trust also redeemed $112,500 in liquidation amount or 50% of its outstanding Common Securities, all of which were held by the Company. The redemption price paid for the Common

26

HIGHLANDS BANKSHARES, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2008

(Amounts in thousands, except per share data)

Note 11. Capital Securities (continued)

Securities was 104.625% of the $25.00 liquidation amount per redeemed Common Security, plus accumulated distributions thereon to but excluding the Redemption Date.

As a result of these transactions, the Company incurred a charge to earnings of approximately $168,000, net of tax, during the first quarter of 2008. This charge included the early redemption premium and the impairment of unamortized debt issuance costs relating to the redeemed Debt Securities.

Note 12. Operating Leases

The Company currently has no operating leases that have initial or remaining non-cancelable terms in excess of one year.

Total operating lease expense was $49 and $66 for December 31, 2008 and 2007, respectively.

Note 13. Common Stock and Earnings Per Common Share

Earnings per common share is computed using the weighted average outstanding shares for the years ended December 31. Outstanding stock options (Note 15) have a dilutive effect on earnings per share, which is determined using the treasury stock method.

The following is a reconciliation of the numerators and the denominators of the basic and diluted earnings per common share computation:

	2008	2007
Income available to common stockholders	$ 115	$ 4,901
Weighted average shares outstanding	5,023	5,155
Shares outstanding including assumed conversion	5,077	5,223
Basic earnings per share	$ 0.02	$ 0.95
Fully diluted earnings per share	$ 0.02	$ 0.94

Highlands Bankshares, Inc. paid dividends of $1,104 and $1,032 or $0.22 per share and $0.20 per share in 2008 and 2007, respectively.

27

HIGHLANDS BANKSHARES, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2008

(Amounts in thousands, except per share data)

Note 14. Profit Sharing and Retirement Savings Plan

The Bank has a 401(K) savings plan available to substantially all employees meeting minimum eligibility requirements. The Bank makes a discretionary 2% profit sharing contribution to all employees exclusive of employee contributions and employer matching. Employees may elect to make voluntary contributions to the plan up to 15% of their base pay. In addition to the 2% profit sharing contribution, the Bank matches 50% of the employee’s initial 6% contribution; therefore, the maximum employer matching contribution per employee could be 3% of base pay. The cost of Bank contributions under the savings plan was $332 and $313 in 2008 and 2007 respectively.

Note 15. Stock Option Plan and Equity Compensation Plan

In 1996, Highlands Bankshares, Inc. adopted a 10 year non-qualified stock incentive option plan, for key employees, officers, and directors and reserved 150,000 shares of common stock for issuance thereunder. This number of shares increased to 600,000 as a result of the 1999 two-for-one stock split and the 2005 two-for-one stock split. The plan is identical to and replaced the plan previously adopted by Highlands Union Bank. The exercise price of each option equals the market price of the Company’s stock on the date of grant and an option’s maximum term is ten years. Option exercise prices are determined by the Board of Directors based on recent open market sales, but shall not be less than the greater of the par value of such stock or 100% of the book value of such stock as shown by the Company’s last published statement prior to granting of the option. Proceeds received upon exercise of options are credited to common stock, to the extent of par value of the related shares, and the balance is credited to surplus. Shares under options which are canceled are available for subsequent grant.

The Company sponsors an equity compensation plan, adopted by the Board of Directors in 2006, which provides for the granting of nonqualified stock options, stock appreciation rights, stock awards and stock units. Under the plan, the Company may grant options to its directors, officers and employees for up to 200,000 shares of common stock. The Company did not grant any equity compensation in 2008 or 2007.

28

HIGHLANDS BANKSHARES, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2008

(Amounts in thousands, except per share data)

Note 15. Stock Option Plan (Continued)

A summary of the status of the Company’s stock option plan is presented below:

	2008		2007
	Weighted Average Exercise Price	Number of Shares	Weighted Average Exercise Price	Number of Shares
Options outstanding at January 1	$ 12.86	314,321	$ 12.58	353,752
Granted	-	-	-	-
Exercised	9.53	(31,736)	10.31	(39,431)
Expired	7.54	(2,000)	-	-
Options outstanding and exercisable at December 31	$ 13.28	280,585	$ 12.86	314,321
Weighted-average fair value of options granted during the year	$ -		$ -

Information pertaining to options outstanding at December 31, 2008 is as follows:

	Options Outstanding and Exercisable
Range of Exercise Prices	Number Outstanding	Weighted Average Remaining Contractual Life	Weighted Average Exercise Price
$ 9.50 - $12.50	84,500	2.06 years	$ 11.67
$ 13.00 - $15.00	196,085	5.37 years	$ 13.97
Outstanding at end of year	280,585	4.37 years	$ 13.28

29

HIGHLANDS BANKSHARES, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2008

(Amounts in thousands)

Note 16. Off-Balance Sheet Activities

The Bank is party to various financial instruments with off-balance sheet risk arising in the normal course of business to meet the financing needs of their customers. Those financial instruments include commitments to extend credit and commercial letters of credit of approximately $2,576 and $3,155, unfunded commitments under lines of credit of $44,766 and $47,070 and commitments to grant loans of $3,064 and $6,513 for the years ended December 31, 2008 and 2007 respectively. These instruments contain various elements of credit and interest rate risk in excess of the amount recognized in the statements of financial condition.

The Bank's exposure to credit loss, in the event of non-performance by the other party to the financial instrument for commitments to extend credit and standby letters of credit, is the contractual amount of those instruments. The Bank uses the same credit policies in making commitments and conditional obligations that they do for on-balance sheet instruments.

Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. The commitments for equity lines of credit may expire without being drawn upon. Therefore, the total commitment amounts do not necessarily represent future cash requirements. The amount of collateral obtained, if it is deemed necessary by the Company, is based on management’s credit evaluation of the customer.

Unfunded commitments under lines of credit, revolving credit lines and overdraft protection agreements are commitments for possible future extensions of credit to existing customers. These lines of credit usually do not contain a specified maturity date and may not be drawn upon to the total extent to which the Company is committed.

Standby letters of credit are conditional commitments issued by the Company to guarantee the performance of a customer to a third party. Those letters of credit are primarily issued to support public and private borrowing arrangements. Essentially all letters of credit issued have expiration dates within one year. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. The Company holds collateral supporting those commitments if deemed necessary.

Note 17. Commitments and Contingencies

The Bank has made arrangements with and has available from corresponding banks, approximately $185,060 of lines of credit to fund any necessary cash requirements. The Bank has $99,097 of Federal Home Loan Bank advances outstanding as of December 31, 2008. A specific class of commercial and residential mortgage loans, with a balance of $207,142 at December 31, 2008 and a specific group of securities available for sale with a lendable collateral value of $46,350 at December 31, 2008 were pledged to the FHLB as collateral.

30

HIGHLANDS BANKSHARES, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2008

(Amounts in thousands)

Note 18. Financial Instruments

The fair value of a financial instrument is the current amount that would be exchanged between willing parties, other than in a forced liquidation. 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 of the instrument. SFAS 107 excludes certain financial instruments and all non-financial instruments from its disclosure requirements. Accordingly, the aggregate fair value amounts presented may not necessarily represent the underlying fair value of the Company.

The following methods and assumptions were used by the Company in estimating fair value disclosures for financial instruments:

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 value for securities are based on quoted market prices or other independent pricing mechanisms.

Other Investments

Other investments include Federal Home Loan Bank, Federal Reserve Bank, Community Bankers Bank, Silverton Bank and Pacific Coast Bankers Bank. The carrying value of those securities approximates fair value based on the redemption provisions of those Banks.

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.

Deposits

The fair value of deposits represent the amount at which the deposit liabilities of the Bank could be exchanged on the open market, based upon the current deposit rates for similar types of deposit arrangements discounted over the remaining life of the deposits.

Other Short-Term Borrowings

The carrying amounts of borrowings under repurchase agreements, and other short-term borrowings maturing within ninety days approximate their fair values. Fair values of other short-

31

HIGHLANDS BANKSHARES, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2008

(Amounts in thousands)

Note 18. Financial Instruments (Continued)

Other Short-Term Borrowings (Continued)

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.

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 December 31 were as follows:

	2008		2007
	Carrying Amount	Fair Value	Carrying Amount	Fair Value
Cash and cash equivalents	$ 16,582	$ 16,582	$ 32,127	$ 32,127
Securities available   for sale	106,647	106,647	131,132	131,132
Other investments	6,476	6,476	5,735	5,735
Loans, net	485,254	480,180	446,661	446,296
Deposits	(522,736)	(526,780)	(512,747)	(515,344)
Other short-term borrowings	(75,608)	(83,844)	(44,105)	(45,722)
Long-term debt	(24,660)	(26,468)	(47,269)	(48,950)
Capital Securities	(3,150)	(2,758)	(6,300)	(6,590)

32

HIGHLANDS BANKSHARES, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2008

(Amounts in thousands)

Note 19. Related Party Transactions

In the normal course of business, the Bank has made loans to its directors and officers and their affiliates. All loans and commitments made to such officers and directors and to companies in which they are officers or have significant ownership interest have been made on substantially the same terms, including interest rates and collateral, as those prevailing at the time for comparable transactions with unrelated persons, and did not, in the opinion of management, involve more than normal credit risk or present other unfavorable features. The activity in such loans is as follows:

	2008	2007
Balance, beginning	$ 11,264	$ 10,889
Additions	6,805	5,152
Reductions	(1,814)	(4,777)
Balance, ending	$ 16,255	$ 11,264
Unused commitments	$ 1,397	$ 865

Deposits from related parties held by the Bank at December 31, 2008 and 2007 were $4,714 and $4,995, respectively.

Note 20. Restrictions on Cash

The Bank is required to maintain reserve balances in cash with the Federal Reserve Bank. The total of those reserve balances at December 31, 2008 and 2007 were $7,969 and $7,634, respectively.

Note 21. Minimum Regulatory Capital Requirements

The Company and the Bank are subject to various regulatory capital requirements administered by its primary regulator, the Federal Reserve Bank of Richmond. Failure to meet the minimum regulatory capital requirements can initiate certain mandatory and possible additional discretionary actions by regulators, that if undertaken, could have a direct material effect on the Company and Bank and the consolidated financial statements. Under the regulatory capital adequacy guidelines and the regulatory framework for prompt corrective action, the Company and the Bank must meet specific capital guidelines involving quantitative measures of their assets, liabilities, and certain off-balance-sheet items as calculated under regulatory accounting practices. The capital amounts and classification under the prompt corrective action guidelines are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors. Prompt corrective action provisions are not applicable to bank holding companies.

33

HIGHLANDS BANKSHARES, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2008

(Amounts in thousands)

Note 21. Minimum Regulatory Capital Requirements (Continued)

Quantitative measures established by regulation to ensure capital adequacy require the Company and the Bank to maintain minimum amounts and ratios of total risk-based capital and Tier I capital to risk-weighted assets (as defined in the regulations), and Tier I capital to adjusted total assets (as defined). Management believes, as of December 31, 2008 and 2007, that the Company and the Bank met all the capital adequacy requirements to which they are subject.

As of December 31, 2008 the most recent notification from the Federal Reserve Bank of Richmond categorized the Bank as well capitalized under the regulatory framework for prompt corrective action. To remain categorized as well capitalized, the Bank will have to maintain minimum total risk-based capital to risk-weighted assets, Tier I capital to risk-weighted assets, and Tier I capital to adjusted total assets ratios as disclosed in the table below. There are no conditions or events since the most recent notification that management believes have changed the Bank’s category.

The Company’s actual and required capital amounts and ratios are as follows:

	Actual		For Capital Adequacy Purposes
	Amount	Ratio	Amount	Ratio
As of December 31, 2008:
Total Risk-Based Capital (to Risk-Weighted Assets)	$ 53,784	11.15%	$ 38,596	=,> 8%
Tier 1 Capital (to Risk-Weighted Assets)	48,613	10.08%	19,298	=,> 4%
Tier 1 Capital (to Adjusted Total Assets)	48,613	7.20%	27,008	=,> 4%
As of December 31, 2007:
Total Risk-Based Capital (to Risk-Weighted Assets)	$ 57,507	12.63%	$ 36,438	=,> 8%
Tier 1 Capital (to Risk-Weighted Assets)	52,877	11.61%	18,219	=,> 4%
Tier 1 Capital (to Adjusted Total Assets)	52,877	8.01%	26,410	=,> 4%

34

HIGHLANDS BANKSHARES, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2008

(Amounts in thousands)

Note 21. Minimum Regulatory Capital Requirements (Continued)

The Bank’s actual and required capital amounts and ratios are as follows:

	Actual		For Capital Adequacy Purposes		To be Well Capitalized under the Prompt Corrective Action Provisions
	Amount	Ratio	Amount	Ratio	Amount	Ratio
As of December 31, 2008:
Total Risk-Based Capital (to Risk-Weighted Assets)	$ 52,775	11.00%	$ 38,396	=,> 8%	$ 47,995	=,> 10%
Tier 1 Capital (to Risk-Weighted Assets)	47,603	9.92%	19,198	=,> 4%	28,797	=,> 6%
Tier 1 Capital (to Adjusted Total Assets)	47,603	7.08%	26,905	=,> 4%	33,632	=,> 5%
As of December 31, 2007:
Total Risk-Based Capital (to Risk-Weighted Assets)	$ 49,807	11.04%	$ 36,080	=,> 8%	$ 45,100	=,> 10%
Tier 1 Capital (to Risk-Weighted Assets)	45,177	10.02%	18,040	=,> 4%	27,060	=,> 6%
Tier 1 Capital (to Adjusted Total Assets)	45,177	6.89%	26,230	=,> 4%	32,789	=,> 5%

Note 22. Restrictions on Dividends

The Parent Company’s principal asset is its investment in the Bank, its wholly-owned consolidated subsidiary. The primary source of income for the Parent Company historically has been dividends from the Bank. Regulatory agencies limit the amount of funds that may be transferred from the Bank to the Parent Company in the form of dividends, loans or advances.

Under applicable laws and without prior regulatory approval, the total dividend payments of the Bank in any calendar year are restricted to the net profits of that year, as defined, combined with the retained net profits for the two preceding years. The total dividends that may be declared in 2009 without regulatory approval total $3,571 plus year-to-date 2009 net profits as of the declaration date.

35

HIGHLANDS BANKSHARES, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2008

(Amounts in thousands)

Note 23. Other Operating Income and Expenses

Other operating income and expenses that exceed 1% of the total of interest income and other income presented separately consist of the following:

	2008	2007
BOLI income	$ 499	$ 483
Other Contracted Services	$ 514	$ 519
Bank Franchise Taxes	$ 482	$ 438

Note 24. Condensed Parent Company Financial Statements

The condensed financial statements below relate to Highlands Bankshares, Inc., as of December 31, 2008 and 2007 and for the years then ended. Equity in undistributed earnings of subsidiary includes the change in unrealized gains or losses on securities, net of tax.

CONDENSED BALANCE SHEETS
	2008	2007
ASSETS
Cash	$ 184	$ 4,553
Capital securities repurchased	600	1,200
Other investments	254	152
Equity in subsidiary	41,186	45,310
Premises and equipment, net	1,532	2,897
Other assets	123	252
Total Assets	$ 43,879	$ 54,364
LIABILITIES AND STOCKHOLDERS’ EQUITY
Interest, taxes and other liabilities	$ 81	$ 153
Other short term borrowings	1,000
Capital securities	3,750	7,500
Total Liabilities	4,831	7,653
STOCKHOLDERS’ EQUITY	39,048	46,711
Total Liabilities and Stockholders’ Equity	$ 43,879	$ 54,364

36

HIGHLANDS BANKSHARES, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2008

(Amounts in thousands)

Note 24. Condensed Parent Company Financial Statements (Continued)

CONDENSED STATEMENTS OF INCOME
	2008	2007
Dividends from subsidiary	$ 2,500	$ 5,000
Interest income	58	128
Other income	226	226
Interest expense	(376)	(694)
Operating expense	(483)	(204)
	1,925	4,456
Income tax benefit	196	185
Equity in undistributed earnings of subsidiary	(2,006)	260
Net income	$ 115	$ 4,901

37

HIGHLANDS BANKSHARES, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2008

(Amounts in thousands)

Note 24. Condensed Parent Company Financial Statements (Continued)

CONDENSED STATEMENTS OF CASH FLOWS
	2008	2007
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income	$ 115	$ 4,901
Adjustments to reconcile net income to net cash Provided by operating activities:
Depreciation and amortization	172	93
Provision for loan losses	-	(25)
Provision for deferred income taxes	3	3
Equity in undistributed earnings of subsidiary	2,006	(260)
Increase in other assets	(189)	(179)
Increase (decrease) in other liabilities	(72)	4
Net cash provided by operating activities	2,035	4,537
CASH FLOWS FROM INVESTING ACTIVITIES:
(Purchase) sale of other investments	(102)	(152)
Net (increase) decrease in loans	-	2,105
Premises and equipment expenditures	-	(7)
Capital contributed to subsidiary bank	(1,000)
Net cash provided by (used in) investing activities	(1,102)	1,946
CASH FLOWS FROM FINANCING ACTIVITIES:
Net increase in Short Term Borrowings	1,000
Cash dividends paid	(1,104)	(1,032)
Repurchase of capital securities	(3,150)	-
Proceeds from exercise of common stock options	303	404
Repurchase of Common Stock	(2,351)	(1,963)
Net cash used in financing activities	(5,302)	(2,591)
Net increase in cash and cash equivalents	(4,369)	3,892
CASH AND CASH EQUIVALENTS AT BEGINNING OF YEAR	4,553	661
CASH AND CASH EQUIVALENTS AT END OF YEAR	$ 184	$ 4,553
SUPPLEMENTAL SCHEDULE OF NONCASH INVESTIN ACTIVITIES
Capital contributed to subsidiary bank-land and buildings	$ 1,311	--

38

HIGHLANDS BANKSHARES, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2008

(Amounts in thousands)

Note 25. Quarterly Data (Unaudited)

Consolidated quarterly results of operations were as follows:
	2008
	March 31	June 30	Sept. 30	Dec. 31
Interest Income	$ 10,114	$ 9,879	$ 9,790	$ 9,535
Interest Expense	(5,307)	(4,907)	(4,733)	(4,677)
Net interest income	4,807	4,972	5,057	4,858
Provision for loan losses	(410)	(432)	(509)	(239)
Net interest income after provision for possible loan losses	4,397	4,540	4,548	4,619
Other income	1,069	1,333	(4,830)	1,073
Other expenses	(4,470)	(4,486)	(4,470)	(4,751)
Income before income taxes	996	1,387	4,752	941
Income taxes	(47)	(190)	1,850	(70)
Net income	$ 949	$ 1,197	$ (2,902)	$ 871
Earnings per common share:
Basic	$ 0.19	$ 0.24	$ (0.58)	$ 0.17
Diluted	$ 0.18	$ 0.24	$ (0.58)	$ 0.17
	2007
	March 31	June 30	Sept. 30	Dec. 31
Interest Income	$ 9,960	$ 10,081	$ 10,031	$ 10,273
Interest Expense	(5,221)	(5,279)	(5,458)	(5,483)
Net interest income	4,739	4,802	4,573	4,790
Provision for loan losses	(190)	(143)	(93)	(259)
Net interest income after provision for possible loan losses	4,549	4,659	4,480	4,531
Other income	1,052	1,147	1,201	1,213
Other expenses	(4,139)	(4,237)	(4,285)	(4,459)
Income before income taxes	1,462	1,569	1,396	1,285
Income taxes	(229)	(248)	(180)	(154)
Net income	$ 1,233	$ 1,321	$ 1,216	$ 1,131
Earnings per common share:
Basic	$ 0.24	$ 0.26	$ 0.24	$ 0.22
Diluted	$ 0.23	$ 0.25	$ 0.23	$ 0.22

39

HIGHLANDS BANKSHARES, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2008

(Amounts in thousands)

Note 26. Fair Value Disclosures

Effective January 1, 2008, the Company adopted the provisions of SFAS No. 157, “Fair Value Measurements,” (“SFAS 157”) for financial assets and financial liabilities. In accordance with FASB Staff Position No. 157-2, “Effective Date of FASB Statement No. 157,” the Company will delay application of FASB 157 for non- financial assets and non-financial liabilities until January 1, 2009. In October of 2008, the FASB issued Staff Position No. 157-3 ("FSP 157-3") to clarify the application of SFAS 157 in a market that is not active and to provide key considerations in determining the fair value of a financial asset when the market for that financial asset is not active. FSP 157-3 was effective upon issuance, including prior periods for which financial statements were not issued. SFAS 157 defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles and expands disclosures about fair value measurements.

SFAS 157 defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants. A fair value measurement assumes that the transaction to sell the asset or transfer the liability occurs in the principal market for the asset or liability or, in the absence of a principal market, the most advantageous market for the asset or liability. The price in the principal, or most advantageous, market used to measure the fair value of the asset or liability shall not be adjusted for transaction costs. An orderly transaction is a transaction that assumes exposure to the market for a period prior to the measurement date to allow for marketing activities that are usual and customary for transactions involving such assets and liabilities; it is not a forced transaction. Market participants are buyers and sellers in the principal market that are (i) independent, (ii) knowledgeable, (iii) able to transact, and (iv) willing to transact.

SFAS 157 requires the use of valuation techniques that are consistent with the market approach, the income approach and/or the cost approach. The market approach uses prices and other relevant information generated by market transactions involving identical or comparable assets and liabilities. The income approach uses valuation techniques to convert future amounts, such as cash flows or earnings, to a single present value amount on a discounted basis. The cost approach is based on the amount that currently would be required to replace the service capacity of an asset, or the replacement cost. Valuation techniques should be consistently applied. Inputs to valuation techniques refer to the assumptions that market participants would use in pricing the asset or liability. Inputs may be observable, meaning those that reflect the assumptions market participants would use in pricing the asset or liability developed based on market data obtained from independent sources, or unobservable, meaning those that reflect the reporting entity’s own assumptions about the assumptions market participants would use in pricing the asset or liability developed based on the best information available in the circumstances. In that regard, SFAS 157 establishes a fair value hierarchy for valuation inputs that gives the highest priority to quoted prices in active markets for identical assets or liabilities and the lowest priority to unobservable inputs. The fair value hierarchy is as follows:

40

HIGHLANDS BANKSHARES, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2008

(Amounts in thousands)

Note 26. Fair Value Disclosures (continued)

Level 1 Inputs —	Unadjusted quoted prices in active markets for identical assets or liabilities that the reporting entity has the ability to access at the measurement date.
Level 2 Inputs —	Inputs other than quoted prices included in Level 1 that are observable for the asset or liability, either directly or indirectly. These might include quoted prices for similar assets or liabilities in active markets, quoted prices for identical or similar assets or liabilities in markets that are not active, inputs other than quoted prices that are observable for the asset or liability, such as interest rates, volatilities, prepayment speeds, and credit risks, or inputs that are derived principally from or corroborated by market data by correlation or other means.
Level 3 Inputs —	Unobservable inputs for determining the fair values of assets or liabilities that reflect an entity’s own assumptions about the assumptions that market participants would use in pricing the assets or liabilities.

A description of the valuation methodologies used for instruments measured at fair value, as well as the general classification of such instruments pursuant to the valuation hierarchy, is set forth below. These valuation methodologies were applied to all of the Company’s financial assets and financial liabilities carried at fair value effective January 1, 2008.

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.

Securities Available-for-Sale . Securities classified as available-for-sale are reported at fair value utilizing Level 1, Level 2 and Level 3 inputs. For Level 1 securities, the Company obtains fair value measurements from active exchanges. For Level 2 securities, the Company obtains fair value measurements from an independent pricing service. 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.

We own approximately 11.82 million in collateralized debt obligation securities that are backed by trust preferred securities issued by banks, thrifts, and insurance companies (TRUP CDOs). The market for these securities at December 31, 2008 is not active and markets for similar securities are also not active. The inactivity was evidenced first by a significant widening of the bid-ask spread in the brokered markets in which TRUP CDOs trade and then by a significant decrease in the volume of trades relative to historical levels. The new issue market is also inactive as no new

41

HIGHLANDS BANKSHARES, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2008

(Amounts in thousands)

Note 26. Fair Value Disclosures (continued)

TRUP CDOs have been issued since 2007. There are currently very few market participants who are willing and or able to transact for these securities.

The market values for these securities (and any securities other than those issued or guaranteed by the US Treasury) are very depressed relative to historical levels. For example, the yield spreads for the broad market of investment grade and high yield corporate bonds reached all time wide levels versus Treasuries at the end of November and remain near those levels today. Thus in today’s market, a low market price for a particular bond may only provide evidence of stress in the credit markets in general versus being an indicator of credit problems with a particular issuer.

Given conditions in the debt markets today and the absence of observable transactions in the secondary and new issue markets, we determined:

§          The few observable transactions and market quotations that are available are not reliable for purposes of determining fair value at December 31, 2008,

§          An income valuation approach technique (present value technique) that maximizes the use of relevant observable inputs and minimizes the use of unobservable inputs will be equally or more representative of fair value than the market approach valuation technique used at prior measurement dates and

§          Our TRUP CDOs will be classified within Level 3 of the fair value hierarchy because we determined that significant adjustments are required to determine fair value at the measurement date.

Our TRUP CDO valuations were prepared by an independent third party. Their approach to determining fair value involved these steps:

• The credit quality of the collateral is estimated using average probability of default values for each issuer (adjusted for rating levels)

• The default probabilities also considered the potential for correlation among issuers within the same industry (e.g. banks with other banks).

• The loss given default was assumed to be 95% (i.e. a 5% recovery).

• The cash flows were forecast for the underlying collateral and applied to each CDO tranche to determine the resulting distribution among the securities

• The expected cash flows were discounted to calculate the present value of the security

• The calculations were modeled in several thousand scenarios using a Monte Carlo engine and the average price was used for valuation purposes

• The effective discount rates on an overall basis range from (4% to 36 %) and are highly dependent upon the credit quality of the collateral, the relative position of the tranche in the capital structure of the CDO and the prepayment assumptions.

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

42

HIGHLANDS BANKSHARES, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2008

(Amounts in thousands)

Note 26. Fair Value Disclosures (continued)

The following table summarizes the Company’s available for sale securities portfolio measured at fair value on a recurring basis as of December 31, 2008, segregated by the level of the valuation inputs within the fair value hierarchy.

	Level 1	Level 2	Level 3	Total Fair Value
Available for Sale Securities
TRUP CDO’s	--	--	$ 5,436	$ 5,436
State and Political Subdivisions		$ 50,990		$ 50,990
Mortgage Backed Securities	--	$ 38,901	--	$ 38,901
Other		$ 11,320		$ 11,320
Total AFS Securities	--	$ 101,211	$ 5,436	$ 106,647

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 in accordance with SFAS 114, “Accounting by Creditors for Impairment of a Loan,” (SFAS 114). The fair value of impaired loans is estimated using one of several methods, including collateral value, recent appraisal 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 December 31, 2008, all of the total impaired loans were evaluated based on the fair value of the collateral. In accordance with SFAS 157, impaired loans where an allowance is established based on the fair value of collateral require classification in the fair value hierarchy. Fair value is based upon independent market prices or appraised values of the collateral which the Company considers as nonrecurring Level 2. At December 31, 2008, the aggregate carrying amount of impaired loans was $4,196

Foreclosed Assets / Repossessions

Foreclosed assets and repossessions are adjusted to fair value upon transfer of the loans to foreclosed assets and repossessions. Subsequently, foreclosed assets and repossessions are carried at the lower of carrying value or fair value. Fair value is based upon independent market prices or appraised values of the collateral which the Company considers as nonrecurring Level 2. The aggregate carrying amount of foreclosed assets and repossessions at December 31, 2008 was $3,945.

The Company has no liabilities carried at fair value or measured at fair value on a nonrecurring basis. FASB Staff Position No. FAS 157-2 delays the implementation of SFAS 157 until the first quarter of 2009 with respect to goodwill, other intangible assets, real estate and other assets acquired through foreclosure and other non-financial assets measured at fair value on a nonrecurring basis.

43

HIGHLANDS BANKSHARES, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2008

(Amounts in thousands)

Note 27. Recent Market Developments (Unaudited)

In response to the financial crises affecting the banking system and financial markets and going concern threats to investment banks and other financial institutions, on October 3, 2008, the Emergency Economic Stabilization Act of 2008 (the “EESA”) was signed into law. Pursuant to the EESA, the U.S. Treasury was given the authority to, among other things, purchase up to $700 billion of mortgages, mortgage-backed securities and certain other financial instruments from financial institutions for the purpose of stabilizing and providing liquidity to the U.S. financial markets.

On October 14, 2008, the Secretary of the Department of the Treasury announced that the Department of the Treasury will purchase equity stakes in a wide variety of banks and thrifts. Under the program, known as the Troubled Asset Relief Program Capital Purchase Program (the “TARP Capital Purchase Program”), from the $700 billion authorized by the EESA, the Treasury made $250 billion of capital available to U.S. financial institutions in the form of preferred stock, warrants to purchase common stock and warrants to purchase additional preferred stock. Participating financial institutions were required to adopt the Treasury’s standards for executive compensation and corporate governance for the period during which the Treasury holds equity issued under the TARP Capital Purchase Program. On December 30, 2008, the Company received preliminary approval from the U. S. Treasury to participate in the Program up to $14.4 million. To participate in the Program, however, the Company must be authorized to issue Preferred Stock. The Company’s existing Articles of Incorporation do not allow for Preferred Stock. On February 9^th, 2009 the Company filed with the SEC and mailed to its shareholders proxy materials requesting approval to amend its Articles of Incorporation to allow for the issuance of preferred stock. This amendment provides the Board of Directors the authority to issue Preferred Stock in one or more series in the future.

On November 21, 2008, the Board of Directors of the Federal Deposit Insurance Bank (“FDIC”) adopted a final rule relating to the Temporary Liquidity Guarantee Program (“TLGP”). The TLGP was announced by the FDIC on October 14, 2008, preceded by the determination of systemic risk by the Secretary of the Department of Treasury (after consultation with the President), as an initiative to counter the system-wide crisis in the nation’s financial sector. Under the TLGP, the FDIC will (i) guarantee, through the earlier of maturity or June 30, 2012, certain newly issued senior unsecured debt issued by participating institutions on or after October 14, 2008, and before June 30, 2009 and (ii) provide full FDIC deposit insurance coverage for non-interest bearing transaction deposit accounts, Negotiable Order of Withdrawal (“NOW”) accounts paying less than 0.5% interest per annum and Interest on Lawyers Trust Accounts (“IOLTA”) accounts held at participating FDIC- insured institutions through December 31, 2009. Coverage under the TLGP was available for the first 30 days without charge. The fee assessment for coverage of senior unsecured debt ranges from 50 basis points to 100 basis points per annum, depending on the initial maturity of the debt. The fee assessment for deposit insurance coverage is 10 basis points on amounts in covered accounts exceeding $250,000. On December 3, 2008, the Bank elected to participate in both guarantee programs.

Also, on February 27^th, 2009, the FDIC also approved a special assessment to all banks payable on September 30^th, 2009 to replenish the insurance fund to an acceptable level during this time of economic crisis and numerous bank failures. It is estimated that this special assessment will be approximately $500 thousand dollars.

44

EX-21

Exhibit 21

Subsidiaries of Highlands Bankshares, Inc.

Name of Subsidiary	State of Incorporation
Highlands Union Bank	Virginia
-- Highlands Union Insurance Services, Inc.	Virginia
-- Highlands Union Financial Services, Inc.	Virginia
Highlands Capital Trust I	Delaware

EX-23

Exhibit 23.1

CONSENT OF INDEPENDENT

CERTIFIED PUBLIC ACCOUNTANTS

We consent to the incorporation by reference in the Highlands Bankshares, Inc. registration statement on Form S-3D (Registration No. 333-83618) of our report dated January 30, 2009 on our audits of the consolidated financial statements of Highlands Bankshares, Inc. and Subsidiaries as of December 31, 2008 and 2007, and for the periods then ended. Such report is included in the Highlands Bankshares, Inc. 2008 Annual Report to Stockholders, which is filed as exhibit 13 to Form 10-K for the year ended December 31, 2008.

                                                                                    /s/Brown, Edwards & Company, L.L.P.

CERTIFIED PUBLIC ACCOUNTANTS

Bluefield, West Virginia

March 27, 2009

EX-31

Exhibit 31.1

Rule 13a-14(a) Certification of Executive Vice President and Chief Executive Officer

I, Samuel L. Neese, certify that:

1. I have reviewed this annual report on Form 10-K of Highlands Bankshares, Inc. for the year ended December 31, 2008.

2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;

3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;

4. The registrant's other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-a5(f)) for the registrant and have:

a) designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;

b) designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles;

c) evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and

d) disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter (the registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and

5. The registrant's other certifying officers and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of the registrant's board of directors (or persons performing the equivalent functions):

a)   all significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and

b)   any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting.

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

EX-31

Exhibit 31.2

Rule 13a-14(a) Certification of Chief Financial Officer

I, Robert M. Little, Jr., certify that:

1. I have reviewed this annual report on Form 10-K of Highlands Bankshares, Inc. for the year ended December 31, 2008.

2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;

3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;

4. The registrant's other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-a5(f)) for the registrant and have:

a) designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;

b) designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles;

c) evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and

d) disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter (the registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and

5. The registrant's other certifying officers and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of the registrant's board of directors (or persons performing the equivalent functions):

a) all significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and

b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting.

Date: March 27, 2009	/s/Robert M. Little, Jr.
	Robert M. Little, Jr.
	Chief Financial Officer

EX-31

Exhibit 31.3

Rule 13a-14(a) Certification of Vice President of Accounting

I, James R. Edmondson, certify that:

1. I have reviewed this annual report on Form 10-K of Highlands Bankshares, Inc. for the year ended December 31, 2008.

2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;

3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;

4. The registrant's other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-a5(f)) for the registrant and have:

a) designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;

b) designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles;

c) evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and

d) disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter (the registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and

5. The registrant's other certifying officers and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of the registrant's board of directors (or persons performing the equivalent functions):

a) all significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and

b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting.

Date: March 27, 2009	/s/James R. Edmondson
	James R. Edmondson
	Vice President of Accounting

EX-32

Exhibit 32.1

Certification

Pursuant To 18 U.S.C. Section 1350,

As Adopted Pursuant to

Section 906 Of The Sarbanes-Oxley Act of 2002

In connection with the Annual Report on Form 10-K of Highlands Bankshares, Inc. (the “Company”) for the period ended December 31, 2008 to be filed with the Securities and Exchange Commission (the “Report”), I, Samuel L. Neese, Executive Vice President and Chief Executive Officer of the Company, certify pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that, to my knowledge:

1. The Report fully complies with the requirements of section 13(a) of the Securities Exchange Act of 1934; and

2. The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company.

/s/Samuel L. Neese

Samuel L. Neese

Executive Vice President and Chief Executive Officer

March 27, 2009

EX-32

Exhibit 32.2

Certification

Pursuant To 18 U.S.C. Section 1350,

As Adopted Pursuant to

Section 906 Of The Sarbanes-Oxley Act of 2002

In connection with the Annual Report on Form 10-K of Highlands Bankshares, Inc. (the “Company”) for the period ended December 31, 2008 to be filed with the Securities and Exchange Commission (the “Report”), I, Robert M. Little, Jr., Chief Financial Officer of the Company, certify pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that, to my knowledge:

1. The Report fully complies with the requirements of section 13(a) of the Securities Exchange Act of 1934; and

2. The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company.

/s/Robert M. Little, Jr.

Robert M. Little, Jr.

Chief Financial Officer

March 27, 2009

EX-32

Exhibit 32.3

Certification

Pursuant To 18 U.S.C. Section 1350,

As Adopted Pursuant to

Section 906 Of The Sarbanes-Oxley Act of 2002

In connection with the Annual Report on Form 10-K of Highlands Bankshares, Inc. (the “Company”) for the period ended December 31, 2008 to be filed with the Securities and Exchange Commission (the “Report”), I, James R. Edmondson, Vice President of Accounting of the Company, certify pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that, to my knowledge:

1. The Report fully complies with the requirements of section 13(a) of the Securities Exchange Act of 1934; and

2. The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company.

/s/James R. Edmondson

James R. Edmondson

Vice President of Accounting

March 27, 2009