10-Q 1 hbi10q05132016.htm FORM 10-Q

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

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

For the quarterly period ended March 31, 2016

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

For the transition period from ____________ to _____________

Commission File Number: 0-27622

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


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

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

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

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

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or smaller reporting company (See definition of "large accelerated filer, accelerated filer and smaller reporting company" in Rule 12b-2 of the Act). Large Accelerated Filer [  ]   Accelerated Filer  [  ]    Non-Accelerated Filer [  ]  Smaller Reporting Company  [X]
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes [ ] No [X ]

Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date.
8,112,562 shares of common stock, par value $0.625 per share,
outstanding as of May 13, 2016
 


 
 

 
Highlands Bankshares, Inc.

FORM 10-Q
For the Quarter Ended March 31, 2016

INDEX
     
PART I. FINANCIAL INFORMATION       
PAGE
 
     
Item 1. Financial Statements
   
     
Consolidated Balance Sheets
  at March 31, 2016 (Unaudited) and December 31, 2015
   
3
 
     
Consolidated Statements of Income (Unaudited)
  for the Three Months Ended March 31, 2016 and 2015
4
 
     
 
Consolidated Statements of Comprehensive Income (Unaudited)
for the Three Months Ended March 31, 2016 and 2015
5
 
Consolidated Statements of Cash Flows (Unaudited)
  for the Three Months Ended March 31, 2016 and 2015
6-7
 
     
Consolidated Statements of Changes in
  Stockholders' Equity (Unaudited) for the Three Months
  Ended March 31, 2016 and 2015
8
 
     
Notes to Consolidated Financial Statements (Unaudited)
9-38
 
     
Item 2. Management's Discussion and Analysis of
              Financial Condition and Results of Operations
39-44
 
     
Item 3. Quantitative and Qualitative Disclosures About Market Risk
44
 
     
Item 4. Controls and Procedures
45
 
     
PART II. OTHER INFORMATION
   
     
Item 1. Legal Proceedings
45
 
     
Item 1A. Risk Factors
45
 
     
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
45
 
     
Item 3. Defaults Upon Senior Securities
45
 
     
Item 4. Mine Safety Disclosures
45
 
     
Item 5. Other Information
46
 
     
Item 6. Exhibits
46
 
     
SIGNATURES AND CERTIFICATIONS
47
 
 

 
2

PART I.
FINANCIAL INFORMATION
ITEM 1.  Financial Statements
   
Consolidated Balance Sheets
(Amounts in thousands)
 
   
       (Unaudited)
  March 31, 2016
 
(Note 1)
December 31, 2015
                                              ASSETS
       
Cash and due from banks
 
$     18,298
 
     $      26,713
Federal funds sold
 
      31,600
 
  20,178
         
   Total Cash and Cash Equivalents
 
      49,898
 
46,891
         
Investment securities available for sale (amortized cost $83,129 at March 31, 2016, $80,239 at December 31, 2015)
 
83,599
 
79,860
Other investments, at cost
 
6,611
 
6,592
Loans, net of allowance for loan losses of  $5,825 at March 31, 2016, $5,654 at December 31, 2015
 
422,327
 
426,429
Premises and equipment, net
 
20,435
 
20,612
Deferred tax assets
 
11,646
 
12,126
Interest receivable
 
1,811
 
1,761
Bank owned life Insurance
 
14,021
 
14,585
Other real estate owned
 
5,346
 
5,694
Other assets
 
       2,138
 
        2,432
         
    Total Assets
 
$   617,832
 
$    616,982
         
LIABILITIES AND STOCKHOLDERS' EQUITY
       
         
LIABILITIES
       
         
Deposits:
       
  Non-interest bearing
 
$    128,122
 
$      129,634
  Interest bearing
 
    364,975
 
     365,278
         
    Total Deposits
 
    493,097
 
     494,912
         
Interest, taxes and other liabilities
 
1,240
 
761
Other short-term borrowings
 
20,051
 
20,052
Long-term debt
 
47,686
 
47,698
         
    Total Other Liabilities
 
      68,977
 
       68,511
         
    Total Liabilities
 
    562,074
 
     563,422
         
STOCKHOLDERS' EQUITY
       
         
Common stock (8,113 and 7,851shares issued and outstanding at March 31, 2016 and December 31, 2015, respectively)
 
5,070
 
4,907
Preferred Stock (2,092 shares issued and outstanding)
 
4,184
 
4,184
Additional paid-in capital
 
 18,891
 
17,944
Retained earnings
 
27,303
 
26,773
Accumulated other comprehensive income
 
310
 
      (248)
         
  Total Stockholders' Equity
 
      55,758
 
      53,560
         
    Total Liabilities and Stockholders' Equity
 
$  617,832
 
$   616,982
 
See accompanying Notes to Consolidated Financial Statements
3

Consolidated Statements of Income
(Amounts in thousands, except per share data)
(Unaudited)
 
 
Three Months Ended                  March 31, 2016
 
Three Months Ended March 31, 2015
INTEREST INCOME
     
Loans receivable and fees on loans
$ 5,478
 
$ 5,298
Securities available for sale:
     
  Taxable
297
 
313
  Exempt from taxable income
78
 
108
Other investment income
57
 
52
Federal funds sold
          26
 
         21
       
    Total Interest Income
     5,936
 
     5,792
       
INTEREST EXPENSE
     
Deposits
453
 
570
Other borrowed funds
         592
 
         585
       
    Total Interest Expense
      1,045
 
      1,155
       
    Net Interest Income
      4,891
 
      4,637
       
Provision for Loan Losses
      224
 
      100
       
    Net Interest Income after Provision for Loan Losses
         4,667
 
         4,537
       
NON-INTEREST INCOME
     
Securities gains (losses), net
35
 
16
Service charges on deposit accounts
398
 
391
Other service charges, commissions and fees
441
 
335
Other operating income
284
 
124
       
    Total Non-Interest Income
         1,158
 
         866
       
NON-INTEREST EXPENSE
     
Salaries and employee benefits
2,919
 
2,446
Occupancy expense of bank premises
313
 
309
Furniture and equipment expense
351
 
340
Other operating expense
1,302
 
1,317
Foreclosed Assets – Write-down and Operating Expenses
      219
 
      234
       
    Total Non-Interest Expense
      5,104
 
      4,646
       
    Income Before Income Taxes
721
 
757
       
Income Tax Expense (Note 3)
    191
 
    177
       
    Net Income
$ 530
 
$ 580
       
Basic Earnings Per Common Share (Note 6)
$ 0.07
 
$ 0.07
       
Earnings Per Common Share – Assuming Dilution
$ 0.05
 
$ 0.06
       
Dividends Per Share
$ -
 
$ -

See accompanying Notes to Consolidated Financial Statements

4

Consolidated Statements of Comprehensive Income
(Amounts in thousands)
(Unaudited)
 
 
Three Months Ended                  March 31, 2016
 
Three Months Ended March 31, 2015
       
       
Net Income
$ 530
 
$ 580
       
     Other Comprehensive Income
     
  Unrealized gains on securities during  the period
880
 
250
  Less: reclassification adjustment for (gains)  included in net income
(35)
 
(16)
          Other Comprehensive Income, before tax
845
 
234
           Income tax expense related to other
           comprehensive income
287
 
80
    Other Comprehensive Income
558
 
154
Comprehensive Income
$     1,088
 
$     734
       

See accompanying Notes to Consolidated Financial Statements




5

Consolidated Statements of Cash Flows
(Amounts in thousands)
(Unaudited)
 
   
Three Months Ended
   
Three Months Ended
 
   
March 31, 2016
   
March 31, 2015
 
CASH FLOWS FROM OPERATING  ACTIVITIES:
           
Net income
 
$
530
   
$
580
 
Adjustments to reconcile net income  to net cash provided by operating activities
               
Provision for loan losses
   
224
     
100
 
Depreciation and amortization
   
243
     
233
 
 
Net realized gains on available for sale securities
   
(35)
 
   
(16)
 
Net amortization on securities
   
221
     
249
 
            (Increase) decrease in interest receivable
   
(50)
 
   
1
 
Valuation adjustment of other real estate owned
   
166
     
20
 
Decrease in other assets
   
1,010
     
174
 
Increase in interest, taxes and other liabilities
   
479
     
303
 
                 
Net cash provided by operating activities
   
2,788
     
1,644
 
                 
CASH FLOWS FROM INVESTING ACTIVITIES:
               
Securities available for sale:
               
       Proceeds from sale of securities
   
11,549
     
1,025
 
Proceeds from maturities of debt and equity securities
   
3,457
     
3,829
 
Purchase of debt and equity securities
   
(18,082)
 
   
(6,045)
 
(Purchases) redemptions of other investments
   
(19)
 
   
168
 
Net (increase) decrease in loans
   
3,725
     
(5,199)
 
Proceeds from sales of other real estate owned
   
328
     
328
 
Proceeds from cash surrender value of life insurance
   
93
     
-
 
Premises and equipment expenditures
   
(114)
 
   
(86)
 
                 
Net cash provided by (used in) investing activities
   
937
     
(5,983
 
 
 
6

 
CASH FLOWS FROM FINANCING ACTIVITIES:
               
 
Net decrease in time deposits
   
(3,890)
 
   
(2,865)
 
Net increase in demand, savings and other deposits
   
2,075
     
7,360
 
Decrease in short-term borrowings
   
(1)
 
   
(1)
 
Decrease in long-term debt
   
(12)
 
   
(12)
 
Issuance of common stock
   
1,110
     
-
 
                 
Net cash provided by (used in) financing activities
   
(718)
 
   
4,482
 
                 
Net increase in cash and cash equivalents
   
3,007
     
143
 
CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD
   
46,891
     
55,810
 
                 
CASH AND CASH EQUIVALENTS AT END OF PERIOD
 
$
49,898
   
$
55,953
 
                 
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION
               
Cash paid during the period for:
               
Interest
 
$
1,059
   
$
1,165
 
Income taxes
 
$
-
   
$
-
 
                 
     SUPPLEMENTAL DISCLOSURE OF NONCASH TRANSACTIONS
               
Transfer of loans to other real estate owned
 
$
153
   
$
2,794
 
Loans originated from sales of other real estate owned
 
$
10
   
$
-
 
 
See accompanying Notes to Consolidated Financial Statements

7




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



 
Common Stock Shares
Par Value
Preferred Stock
Shares
Preferred Stock
Par Value
Additional Paid
In Capital
Retained
Earnings
Accumulated
Other
Comprehensive
Income (Loss)
Stockholders'
Equity
Balance
December 31, 2014
 
7,851
 
$ 4,907
 
2,092
 
$4,184
 
$   18,180
 
 
$  25,436
 
$    95
 
$  52,802
 
Net Income
 
         
 
        580
 
 
580
Other
Comprehensive
Income
 
           
 
154
 
154
 
Additional
Paid In Capital
 
       
 
(233)
   
 
    (233)
Balance
March 31,  2015
 
 
7,851
 
$ 4,907
 
2,092
 
$ 4,184
 
$ 17,947
 
$26,016
 
$      249
 
$ 53,303
Balance
December 31, 2015
 
7,851
 
$ 4,907
 
2,092
 
$ 4,184
 
$ 17,944
 
$26,773
 
$ (248)
 
$ 53,560
 
Net Income
 
         
 
530
 
 
     530
Issuance of
Common Stock
 
 
262
 
163
   
 
947
   
 
1,110
Additional
Paid In Capital
 
               
Other
Comprehensive
Income
 
           
 
     558
 
     558
Balance
March 31, 2016
 
8,113
 
$5,070
 
2,092
 
$ 4,184
 
$ 18,891
 
$ 27,303
 
$    310
 
$ 55,758
                 
                 
                 
 

See accompanying Notes to Consolidated Financial Statements
 


8


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

Note 1 General

The consolidated financial statements of Highlands Bankshares, Inc. (the "Company") conform to United States generally accepted accounting principles and to banking industry practices. The accompanying consolidated interim financial statements are unaudited. In the opinion of management, all adjustments necessary for a fair presentation of the consolidated financial statements have been included. All such adjustments are of a normal and recurring nature. The consolidated balance sheet as of December 31, 2015 has been extracted from the audited financial statements included in the Company's Annual Report on Form 10-K for the year ended December 31, 2015 (the "2015 Form 10-K"). The notes included herein should be read in conjunction with the notes to consolidated financial statements included in the 2015 Form 10-K. The results of operations for the three-month period ended March 31, 2016, are not necessarily indicative of the results to be expected for the full year.

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

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

 
March 31, 2016
 
December 31, 2015
 
Real Estate Secured:
       
Residential 1-4 family
$ 197,778
 
$ 194,287
 
Multifamily
22,884
 
23,895
 
Construction and Land Loans
17,793
 
19,163
 
Commercial, Owner Occupied
72,072
 
73,031
 
Commercial, Non-owner occupied
33,327
 
38,025
 
Second mortgages
8,186
 
8,169
 
Equity lines of credit
            6,280
 
6,000
 
Farmland
12,378
 
11,283
 
 
370,698
 
373,853
 
         
Secured (other) and unsecured
       
Personal
20,284
 
20,775
 
Commercial
34,693
 
35,144
 
Agricultural
3,065
 
2,959
 
 
58,042
 
58,878
 
         
Overdrafts
193
 
139
 
         
 
428,933
 
432,870
 
Less:
       
  Allowance for loan losses
            5,825
 
            5,654
 
  Net deferred fees
781
 
               787
 
 
6,606
 
6,441
 
         
Loans, net
$ 422,327
 
$ 426,429
 





9


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

The following table is an analysis of past due loans as of March 31, 2016

   
30-59 Days Past Due
 
60-89 Days Past Due
 
Greater Than 90 Days
 
Total Past Due
 
Current
 
Total Financing Receivables
 
Recorded Investment > 90 Days and Accruing
                             
Real Estate Secured
                           
Residential 1-4 family
 
 $ 2,616
 
 $    437
 
 $  1,792
 
 $  4,845
 
 $  192,933
 
 $  197,778
 
 $         -
Equity lines of credit
 
 4
 
 -
 
50
 
 54
 
 6,226
 
 6,280
 
-
Multifamily
 
 -
 
 -
 
 -
 
 -
 
 22,884
 
 22,884
 
-
Farmland
 
380
 
 -
 
 246
 
626
 
 11,752
 
12,378
 
-
Construction, Land Development, Other Land Loans
 
250
 
 75
 
46
 
371
 
 17,422
 
 17,793
 
 -
Commercial Real Estate- Owner Occupied
 
 195
 
 127
 
6,653
 
 6,975
 
 65,097
 
 72,072
 
 -
Commercial Real Estate- Non Owner Occupied
 
 -
 
-
 
 -
 
 -
 
 33,327
 
 33,327
 
 -
Second Mortgages
 
 134
 
 -
 
 68
 
202
 
 7,984
 
 8,186
 
 -
Non Real Estate Secured
                           
Personal
 
 133
 
 29
 
 114
 
 276
 
 20,201
 
 20,477
 
 -
Commercial
 
 381
 
 52
 
 524
 
 957
 
 33,736
 
 34,693
 
 -
Agricultural
 
 21
 
 -
 
 -
 
  21
 
 3,044
 
 3,065
 
 -
                             
          Total
 
 $  4,114
 
 $    720
 
 $   9,493
 
 $  14,327
 
 $  414,606
 
 $  428,933
 
 $          -
                             



10


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

The following table is an analysis of past due loans as of December 31, 2015:


   
30-59 Days Past Due
 
60-89 Days Past Due
 
Greater Than 90 Days
 
Total Past Due
 
Current
 
Total Financing Receivables
 
Recorded Investment > 90 Days and Accruing
                             
Real Estate Secured
                           
Residential 1-4 family
 
 $    4,193
 
 $    1,580
 
 $    2,545
 
 $    8,318
 
 $  185,969
 
 $  194,287
 
 $          -
Equity lines of credit
 
 24
 
 -
 
 17
 
 41
 
 5,959
 
 6,000
 
-
Multifamily
 
 -
 
-
 
 -
 
 -
 
 23,895
 
 23,895
 
-
Farmland
 
 56
 
 7
 
 303
 
 366
 
 10,917
 
 11,283
 
-
Construction, Land Development, Other Land Loans
 
 49
 
 61
 
 37
 
 147
 
 19,016
 
 19,163
 
 -
Commercial Real Estate- Owner Occupied
 
 514
 
 485
 
 5,014
 
 6,013
 
 67,018
 
 73,031
 
 -
Commercial Real Estate- Non Owner Occupied
 
 -
 
 -
 
 -
 
 -
 
 38,025
 
 38,025
 
 -
Second Mortgages
 
 88
 
 37
 
 5
 
 130
 
 8,039
 
 8,169
 
 -
Non Real Estate Secured
                           
Personal
 
 264
 
 141
 
163
 
 568
 
 20,346
 
 20,914
 
-
Commercial
 
 590
 
 217
 
 366
 
 1,173
 
 33,971
 
 35,144
 
 -
Agricultural
 
 45
 
 -
 
 -
 
 45
 
 2,914
 
 2,959
 
 -
                             
          Total
 
 $    5,823
 
 $    2,528
 
 $   8,450
 
 $   16,801
 
 $  416,069
 
 $  432,870
 
 $         -
                             

11

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

Loans are considered delinquent when payments have not been made according to the terms of the contract. The accrual of interest on loans is discontinued at the time the loan is 90 days delinquent unless the credit is well-secured and in process of collection.  Additionally, in certain instances, loans that have been restructured or modified may also be classified as non-accrual per regulatory guidance until a satisfactory payment history has been established. Credit card loans and other personal loans are typically charged off no later than 180 days past due. In all cases, loans are placed on non-accrual or charged-off at an earlier date if collection of principal or interest is considered doubtful.

The following is a summary of non-accrual loans at March 31, 2016 and December 31, 2015:
 
   
March 31, 2016
   
December 31, 2015
 
Real Estate Secured
           
Residential 1-4 Family
 
$
1,792
   
$
2,675
 
Multifamily
   
-
     
-
 
Construction and Land Loans
   
46
     
71
 
Commercial-Owner Occupied
   
6,653
     
5,856
 
Commercial- Non Owner Occupied
   
-
     
-
 
Second Mortgages
   
68
     
5
 
Equity Lines of Credit
   
50
     
17
 
Farmland
   
246
     
303
 
Secured (other) and Unsecured
               
Personal
   
114
     
163
 
Commercial
   
524
     
366
 
Agricultural
   
-
     
-
 
                 
Total
 
$
9,493
   
$
9,456
 


The following is a summary of residential real estate currently in the process of foreclosure as well as foreclosed residential real estate as of March 31, 2016.
 
  
Number
  
03/31/16 Balance
 
Residential real estate in the process of foreclosure
 4 
 
$
         371
 
Foreclosed residential real estate
 8 
 
 $
      1,130
 
 
12

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

The following tables represent a summary of credit quality indicators of the Company's loan portfolio at March 31, 2016 and December 31, 2015.  The grades are assigned and/or modified by the Company's credit review and credit analysis departments based on the creditworthiness of the borrower and the overall strength of the loan.

Credit Risk Profile by Internally Assigned Grade as of March 31, 2016
 
Grade (1)
 
Residential 1-4 Family
 
Multifamily
 
Farmland
 
Construction, Land Loans
 
Commercial Real Estate- Owner Occupied
 
Commercial Real Estate Non-Owner Occupied
                         
Quality
 
 25,624
 
-
 
 24
 
3,144
 
 2,513
 
 491
Satisfactory
 
 114,859
 
 19,762
 
 7,439
 
 5,955
 
 35,879
 
 15,724
Acceptable
 
 46,160
 
 1,331
 
 3,910
 
 6,337
 
 24,350
 
 12,872
Special Mention
 
 3,277
 
 782
 
 193
 
 388
 
 2,340
 
 2,362
Substandard
 
 7,858
 
 1,009
 
 812
 
 1,969
 
 6,990
 
 1,878
Doubtful
 
 -
 
 -
 
 -
 
 -
 
 -
 
 -
                         
     Total
 
$ 197,778
 
$     22,884
 
$     12,378
 
$        17,793
 
$     72,072
 
$     33,327

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


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

13

Notes to Consolidated Financial Statements
(Unaudited)
(in thousands, except share, per share and percentage data)
Adequate secondary sources to liquidate the debt, including combinations of liquidity, liquidation of collateral, or liquidation value to the net worth of the borrower or guarantor.
For existing loans, all of the requirements outlined above will apply, plus all payments have been made as agreed, current financial information on all borrowers and guarantors has been obtained and analyzed, and overall business operating trends are stable with any declines considered minor and temporary.
Acceptable-This grade is given to loans that show signs of weakness in either adequate sources of repayment or collateral, but have demonstrated mitigating factors that minimize the risk of delinquency or loss.  Loans assigned this rating may demonstrate some or all of the following characteristics:
Additional exceptions to the Bank's policy requirements, product guidelines or underwriting standards that present a higher degree of risk to the Bank.  Although the combination and/or severity of identified exceptions is greater, all exceptions have been properly mitigated by other factors.
Unproved, insufficient or marginal primary sources of repayment that appear sufficient to service the debt at this time.  Repayment weaknesses may be due to minor operational issues, financial trends, or reliance on projected (not historic) performance.
Marginal or unproven secondary sources to liquidate the debt, including combinations of liquidation of collateral and liquidation value to the net worth of the borrower or guarantor.
For existing loans, payments have generally been made as agreed with only minor and isolated delinquencies.
Special Mention -This grade is given to Watch List loans that include the following characteristics:
Loans with underwriting guideline tolerances and/or exceptions with no identifiable mitigating factors.
Extending loans that are currently performing satisfactorily but with potential weaknesses that may, if not corrected, weaken the asset or inadequately protect the Bank's position at some future date. Potential weaknesses are the result of deviations from prudent lending practices.
Loans where adverse economic conditions that develop subsequent to the loan origination do not jeopardize liquidation of the debt, but do substantially increase the level of risk may also warrant this rating.
Substandard - Loans in this category are characterized by deterioration in quality exhibited by any number of well-defined weaknesses requiring corrective action. A substandard loan is inadequately protected by the current sound net worth and paying capacity of the obligor or of the collateral pledged, if any. Loans classified as substandard must have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt; they are characterized by the distinct possibility that the institution will sustain some loss if the deficiencies are not corrected.
 The weaknesses may include, but are not limited to:
High debt to worth ratios and or declining or negative earnings trends
Declining or inadequate liquidity
Improper loan structure  or questionable repayment sources
Lack of well-defined secondary repayment source, and
Unfavorable competitive comparisons.
Such loans are no longer considered to be adequately protected due to the borrower's declining net worth, lack of earnings capacity, declining collateral margins and/or unperfected collateral positions. A possibility of loss of a portion of the loan balance cannot be ruled out. The repayment ability of the borrower is marginal or weak and the loan may have exhibited excessive overdue status or extensions and/or renewals.
14


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

Doubtful -Loans classified Doubtful have all the weaknesses inherent in loans classified Substandard, plus the added characteristic that the weaknesses make collection or liquidation in full on the basis of currently existing facts, conditions, and values highly questionable and improbable. The ability of the borrower to service the debt is extremely weak, overdue status is constant, the debt has been placed on non-accrual status, and no definite repayment schedule exists.
However, these loans are not yet rated as loss because certain events may occur which would salvage the debt. Among these events are:
Injection of capital
Alternative financing
Liquidation of assets or the pledging of additional collateral.
Credit Risk Profile based on payment activity as of March 31, 2016
 
   
Consumer - Non Real Estate
   
Equity Line of Credit / Second Mortgages
   
Commercial - Non Real Estate
   
Agricultural - Non Real Estate
 
                         
Performing
 
$
20,363
   
$
14,348
   
$
34,169
   
$
3,065
 
Nonperforming (>90 days past due)
   
114
     
118
     
524
     
-
 
                                 
     Total
 
$
20,477
   
$
14,466
   
$
34,693
   
$
3,065
 
                                 


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

15

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

The following tables reflect the Bank's impaired loans at March 31, 2016:
 
 
March 31, 2016
 
Recorded Investment
   
Unpaid Principal Balance
   
Related Allowance
   
Average Recorded Investment
   
Interest Income Recognized
 
With No Related Allowance
                             
       Real Estate Secured
                             
Residential 1-4 family
 
$
6,660
   
$
6,660
   
$
-
   
$
6,869
   
$
77
 
Equity lines of credit
   
50
     
50
     
-
     
50
     
-
 
Multifamily
   
1,009
     
1,009
     
-
     
1,015
     
13
 
Farmland
   
812
     
812
     
-
     
814
     
8
 
Construction, Land Development, Other Land Loans
   
1,550
     
1,550
     
-
     
1,548
     
23
 
Commercial Real Estate- Owner Occupied
   
5,523
     
5,523
     
-
     
5,546
     
12
 
Commercial Real Estate- Non Owner Occupied
   
-
     
-
     
-
     
-
     
-
 
Second Mortgages
   
211
     
211
     
-
     
305
     
2
 
      Non Real Estate Secured
                                       
Personal /Consumer
   
67
     
67
     
-
     
67
     
1
 
Commercial
   
117
     
117
     
-
     
216
     
1
 
Agricultural
   
-
     
-
     
-
     
-
     
-
 
                                         
          Total
 
$
15,999
   
$
15,999
   
$
-
   
$
16,430
   
$
137
 



 
 
March 31, 2016
 
Recorded Investment
   
Unpaid Principal Balance
   
Related Allowance
   
Average Recorded Investment
   
Interest Income Recognized
 
With an Allowance Recorded
                             
     Real Estate Secured
                             
Residential 1-4 family
 
$
1,409
   
$
1,409
   
$
228
   
$
1,628
   
$
23
 
Equity lines of credit
   
-
     
-
     
-
     
-
     
-
 
Multifamily
   
-
     
-
     
-
     
-
     
-
 
Farmland
   
-
     
-
     
-
     
-
     
-
 
Construction, Land Development, Other Land Loans
   
445
     
445
     
21
     
445
     
7
 
Commercial Real Estate- Owner Occupied
   
2,206
     
2,206
     
925
     
2,163
     
-
 
Commercial Real Estate- Non Owner Occupied
   
1,878
     
1,878
     
283
     
1,882
     
15
 
Second Mortgages
   
216
     
216
     
59
     
117
     
2
 
     Non Real Estate Secured
                                       
Personal /Consumer
   
80
     
80
     
42
     
97
     
-
 
Commercial
   
849
     
849
     
599
     
760
     
6
 
Agricultural
   
-
     
-
     
-
     
-
     
-
 
                                         
          Total
 
$
7,083
   
$
7,083
   
$
2,157
   
$
7,092
   
$
53
 

16


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

The following tables reflect the Bank's impaired loans at December 31, 2015:


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


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







17

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


The following tables present the balance in the allowance for loan losses and the recorded investment in loans by loan category and is segregated by impairment
evaluation method as of March 31, 2016 and March 31, 2015.

Three months ended
March 31, 2016
 
Residential
1-4 Family
   
Multifamily
   
Construction and Land Loans
   
Commercial Owner Occupied
   
Commercial Non-Owner Occupied
   
Second Mortgages
   
Equity Line of Credit
   
Farmland
   
Personal and Overdrafts
   
Commercial and Agricultural
   
Unallocated
   
Total
 
Allowance for Credit Losses:
                                                                       
Beginning Balance December 31, 2015
 
$
654
   
$
-
   
$
37
   
$
1,012
   
$
748
   
$
43
   
$
20
   
$
7
   
$
704
   
$
886
   
$
1,543
   
$
5,654
 
Provision for Credit Losses
   
(33)
 
   
-
     
(18)
 
   
97
     
(130)
 
   
40
     
(3)
 
   
(1)
 
   
(94)
 
   
60
     
306
     
224
 
Charge-offs
   
27
     
-
     
-
     
-
     
-
     
-
     
-
     
-
     
139
     
23
     
-
     
189
 
Recoveries
   
(1)
 
   
-
     
(2)
 
   
-
     
-
     
-
     
(1)
 
   
-
     
(131)
 
   
(1)
 
   
-
     
(136)
 
Net Charge-offs
   
26
     
-
     
(2)
 
   
-
     
-
     
-
     
(1)
 
   
-
     
8
     
22
     
-
     
53
 
Ending Balance
 March 31, 2016
   
595
     
-
     
21
     
1,109
     
618
     
83
     
18
     
6
     
602
     
924
     
1,849
     
5,825
 
Ending Balance: Individually evaluated for impairment
   
228
     
-
     
21
     
925
     
283
     
59
     
-
     
-
     
42
     
599
     
-
     
2,157
 
Ending Balance: Collectively Evaluated for Impairment
   
367
     
-
     
-
     
184
     
335
     
24
     
18
     
6
     
560
     
325
     
1,849
     
3,668
 
Loans:
                                                                                               
Ending Balance: Individually Evaluated for Impairment
   
8,069
     
1,009
     
1,995
     
7,729
     
1,878
     
427
     
50
     
812
     
147
     
966
     
-
     
23,082
 
Ending Balance: Collectively Evaluated for Impairment
   
189,709
     
21,875
     
15,798
     
64,343
     
31,449
     
7,759
     
6,230
     
11,566
     
20,330
     
36,792
     
-
     
405,851
 
Ending Balance:
March 31, 2016
 
$
197,778
   
$
22,884
   
$
17,793
   
$
72,072
   
$
33,327
   
$
8,186
   
$
6,280
   
$
12,378
   
$
20,477
   
$
37,758
     $
-
   
$
428,933
 


18



Three months ended
March 31, 2015
 
Residential
1-4 Family
   
Multifamily
   
Construction and Land Loans
   
Commercial Owner Occupied
   
Commercial Non-Owner Occupied
   
Second Mortgages
   
Equity Line of Credit
   
Farmland
   
Personal and Overdrafts
   
Commercial and Agricultural
   
Unallocated
   
Total
 
Allowance for Credit Losses:
                                                                       
Beginning Balance December 31, 2014
 
$
995
   
$
20
   
$
87
   
$
409
   
$
1,063
   
$
67
   
$
74
   
$
12
   
$
665
   
$
982
   
$
1,103
   
$
5,477
 
Provision for Credit Losses
   
42
     
(20)
 
   
(19)
 
   
42
     
(29)
 
   
3
     
(6)
 
   
1
     
31
     
177
     
(122)
 
   
100
 
Charge-offs
   
47
     
-
     
-
     
392
     
-
     
3
     
-
     
-
     
77
     
64
     
-
     
583
 
Recoveries
   
-
     
-
     
7
     
275
     
-
     
-
     
-
     
-
     
12
     
1
     
-
     
295
 
Net Charge-offs
   
47
     
-
     
(7)
 
   
117
     
-
     
3
     
-
     
-
     
65
     
63
     
-
     
288
 
Ending Balance
 March 31, 2015
   
990
     
-
     
75
     
334
     
1,034
     
67
     
68
     
13
     
631
     
1,096
     
981
     
5,289
 
Ending Balance: Individually evaluated for impairment
   
567
     
-
     
20
     
-
     
320
     
-
     
-
     
-
     
144
     
604
     
-
     
1,655
 
Ending Balance: Collectively Evaluated for Impairment
   
423
     
-
     
55
     
334
     
714
     
67
     
68
     
13
     
487
     
492
     
981
     
3,634
 
Loans:
                                                                                               
Ending Balance: Individually Evaluated for Impairment
   
11,731
     
1,260
     
2,123
     
7,964
     
1,999
     
242
     
74
     
826
     
226
     
1,154
     
-
     
27,599
 
Ending Balance: Collectively Evaluated for Impairment
   
177,512
 
19,013
15,302
 
62,376
30,279
7,632
6,165
8,435
20,550
34,945
-
382,209
Ending Balance:
March 31, 2015
 
$
189,243
$
20,273
   
$
17,425
   
$
70,340
   
$
32,278
   
$
7,874
   
$
6,239
   
$
9,261
   
$
20,776
   
$
36,099
     $
-
   
$
409,808














19


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

A loan is considered impaired and an allowance for loan losses is established on loans for which it is probable that the full collection of principal and interest is in doubt. Once a loan is identified as individually impaired, management measures impairment using one of several methods, including collateral value based on recent appraisal and /or tax assessment value, liquidation value and/or discounted cash flows. Those impaired loans not requiring an allowance represent loans for which the fair value of the expected repayments or collateral exceed the recorded investments in such loans. At March 31, 2016 and December 31, 2015, all of the total impaired loans were evaluated based on the fair value of the collateral. On a quarterly basis, the ALLL methodology begins with the determination of individually impaired loans. All loans that are rated "7" (Doubtful) are assessed as impaired based on the expectation that the full collection of principal and interest is in doubt. All loans that are rated "6" (Substandard) or are expected to be downgraded to "6", require additional analysis to determine whether they may be impaired. All loans that are rated "5" (Special Mention) are presumed not to be impaired. However, "5" rated loans with the following characteristics warrant further analysis before completing an assessment of impairment:

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


The Company's credit administration personnel and senior financial officers are responsible for tracking, coding, and monitoring loans that become Troubled Debt Restructurings ("TDRs"). Concessions are made to existing borrowers in the form of modified interest rates and / or payment terms. The loans are segregated for regulatory and external reporting. Each specific TDR is reviewed to determine if the accrual of interest should be discontinued and also reviewed for impairment. The Company's senior credit administration officer performs this analysis on a quarterly basis in addition to determining any other loans that are impaired within the loan portfolio. The Company had a total of $9,826 and $12,060 of loans categorized as troubled debt restructurings as of March 31, 2016 and December 31, 2015, respectively. Interest is accrued on TDRs if the loan is otherwise not impaired and the full collection of principal and interest under the modified terms is still deemed probable.

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

The following tables summarize the troubled debt restructurings during the three months ended March 31, 2016 and 2015.

20

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



Troubled Debt Restructurings –Three months ended March 31, 2016
Interest only
Number of Contracts
Pre- Modification Outstanding Recorded Investment
Post - Modification Recorded Investment
         Real Estate Secured
     
Residential 1-4 family
     
Equity lines of credit
     
Multifamily
     
Farmland
1
57
57
Construction, Land Development,
Other Land Loans
     
Commercial Real Estate- Owner Occupied
1
92
92
Commercial Real Estate- Non Owner Occupied
     
Second Mortgages
     
Non Real Estate Secured
     
Personal / Consumer
     
Commercial
     
Agricultural
     
       
Total
2
149
149
 

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

 
21


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

Troubled Debt Restructurings
Loan term extension
Number of Contracts
Pre- Modification Outstanding Recorded Investment
Post - Modification Recorded Investment
 Real Estate Secured
     
Residential 1-4 family
     
Equity lines of credit
     
Multifamily
     
Farmland
     
Construction, Land Development,
Other Land Loans
     
Commercial Real Estate- Owner Occupied
     
Commercial Real Estate- Non Owner Occupied
     
Second Mortgages
     
Non Real Estate Secured
     
Personal / Consumer
     
Business Commercial
     
Agricultural
     
       
Total
     
Troubled Debt Restructurings
All
Number of Contracts
Pre- Modification Outstanding Recorded Investment
Post - Modification Recorded Investment
Total Restructurings
3
997
997
 
 

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


22


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


Troubled Debt Restructurings –Three months ended March 31, 2015
Interest only
Number of Contracts
Pre- Modification Outstanding Recorded Investment
Post - Modification Recorded Investment
Real Estate Secured
     
Residential 1-4 family
     
Equity lines of credit
     
Multifamily
     
Farmland
     
Construction, Land Development,
Other Land Loans
     
Commercial Real Estate- Owner Occupied
2
2,203
2,203
Commercial Real Estate- Non Owner Occupied
     
Second Mortgages
     
Non Real Estate Secured
     
Personal / Consumer
     
Commercial
     
Agricultural
     
       
Total
2
2,203
2,203
 

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

 
23



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

Troubled Debt Restructurings
Loan term extension
Number of Contracts
Pre- Modification Outstanding Recorded Investment
Post - Modification Recorded Investment
Real Estate Secured
     
Residential 1-4 family
     
Equity lines of credit
     
Multifamily
     
Farmland
     
Construction, Land Development,
Other Land Loans
     
Commercial Real Estate- Owner Occupied
     
Commercial Real Estate- Non Owner Occupied
     
Second Mortgages
     
Non Real Estate Secured
     
Personal / Consumer
     
Business Commercial
     
Agricultural
     
       
Total
     
Troubled Debt Restructurings
All
Number of Contracts
Pre- Modification Outstanding Recorded Investment
Post - Modification Recorded Investment
Total Restructurings
4
4,613
4,613
 

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

24


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

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

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

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

On a quarterly basis, the ALLL methodology begins with the identification of loans subject to ASC 310.  All loans that are rated "7" (Doubtful) are assessed as impaired based on the expectation that the full collection of principal and interest is in doubt. All loans that are rated "6" (Substandard) or are expected to be downgraded to "6", require additional analysis to determine whether they may be impaired under ASC 310. All loans that are rated "5" (Special Mention) are presumed not to be impaired. However, "5" rated loans, together with any Troubled Debt Restructured (TDR) loan, may warrant further analysis before completing an assessment of impairment.

For ASC 310 loans that are individually evaluated and found to be impaired (primarily those designated as Substandard and Doubtful), the associated ALLL will be based upon one of the three impairment measurement methods specified within ASC 310:

(1)
Present value of expected future cash flows discounted at the loan's effective interest rate;
(2)
Loan's observable market price; or
(3)
Fair value of the collateral.
25


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

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

ASC 450 Loan Loss:

For all other loans, including individual loans determined not to be impaired under ASC 310, the associated ALLL is calculated in accordance with ASC 450 that provides for estimated credit losses likely to be realized on groups of loans with similar risk characteristics. The Company uses standard call report categories to segregate loans into groups with similar risk characteristics. Estimated credit losses reflect significant factors that affect the collectability of the portfolio as of the evaluation date. Key factors that influence risk within the Company's loan portfolio are divided into three major categories:

(1) Historical Loss Factor: To calculate the anticipated loan loss in each call report category for ASC 450 loans, the Company begins with the net loss in each category for each of the last twelve quarters. The Company uses a rolling twelve quarter weighted historical loss average where the most recent quarters are weighted heavier than the earlier quarters so that the calculation reflects current risk trends within the portfolio.  The weighting used by the Company is similar to the Rule of 78's with the net losses of the most recent quarter weighted at 12/78ths and those in the first quarter in the twelve quarter period weighted at 1/78th. Therefore, the net losses of the most recent year represent approximately 54% of the calculation compared with 33% if a simple average of losses over the three-year period was used. The total of weighted factors for each call report category is applied to the current outstanding loan balance in each category to calculate expected loss based on historical data for a group of loans with similar risk characteristics. The same weighting is applied to all loan types.

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

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

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

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

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

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

Once the quarterly ALLL is computed, the calculations are reviewed by the Company's credit administration committee which is comprised of the CEO, CFO, and Senior Lending Officers, including Credit Review personnel.  The Company's controller also performs a detailed review of the computations, estimates, etc. included in the ALLL calculation. The ALLL is then reviewed and approved by the Board of Directors.
26

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

Note 3  -  Income Taxes

Income tax expense for the three months ended March 31 is different than the amount computed by applying the statutory corporate federal income tax rate of 34% to income before taxes.  The reasons for these differences are as follows:

   
2016
   
2015
 
             
Tax expense at statutory rate
 
$
245
   
$
257
 
Reduction in taxes from:
               
Tax-exempt interest
   
(26)
 
   
(37)
 
Other, net
   
(28)
 
   
(43)
 
                 
Income tax expense
 
$
191
   
$
177
 

Note 4  - Capital Requirements

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

March 31, 2016
 
 
Entity
Tier 1
Total Risk Based
Leverage
CET 1
         
Highlands Union Bank
11.84%
13.11%
7.60%
11.84%
 
December 31, 2015
 
 
Entity
Tier 1
Total Risk Based
Leverage
CET 1
         
         
Highlands Union Bank
11.28%
12.55%
7.33%
11.28%

 


27

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

Note 5. Private Placement Capital Raise / Rights Offering

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

In January of 2016, the Company's CEO, Timothy K. Schools purchased 235,294 shares of the Company's common stock at a price of $4.25 per share in a private placement as disclosed on Form 4 on January 12, 2016.  In February 2016, two of the private placement purchasers participating in the capital raise in 2014, MFP Partners LP and Deerhill Pond Investment Partners, LP, each purchased another 12,744 shares of common stock at $4.25 per share which allowed them to maintain the same ownership percentage that was held immediately prior to the Mr. Schools' purchase. The company down-streamed $1,150 to the Bank.


Note 6 – Stock and Earnings Per Share

Earnings per common share is computed using the weighted average outstanding shares for the three months ended March 31, 2015 and 2016.  During 2014, the Company issued a total of 2,092,287 shares of Series A preferred stock (See Note 5). These preferred shares are non-voting mandatorily convertible non-cumulative preferred shares which are entitled to receive dividends equal to dividends paid on the Company's common shares. The Series A preferred shares will rank pari passu with the common stock with respect to all terms (other than voting), including, the payment of dividends or distributions, and payments and rights upon liquidation and dissolution. The following is a reconciliation of the numerators and the denominators of the basic and diluted earnings per common share computation:

For the three months ended March 31
 
2016
   
2015
 
             
Income available to common stockholders
 
$
530
   
$
580
 
Weighted average shares outstanding
   
8,089
     
7,851
 
Shares outstanding including assumed conversion
   
10,205
     
9,943
 
Basic earnings per common share
 
$
0.07
   
$
0.07
 
Fully diluted earnings per share (including convertible preferred shares oustanding)
 
$
0.05
   
$
0.06
 

28


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

Note 7 – Commitments and Contingencies

The Bank is a party to various financial instruments with off-balance sheet risk arising in the normal course of business to meet the financing needs of its customers. Those financial instruments include commitments to extend credit and standby letters of credit. At March 31, 2016, these commitments included: standby letters of credit of $255; equity lines of credit of $7,818; credit card lines of credit of $6,561; commercial real estate, construction and land development commitments of $3,051; and other unused commitments to fund interest earning assets of $27,138.

Note  8 – Fair Value

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

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

 
Level 1 
Valuation is based upon quoted prices for identical instruments traded in active markets.
     
 
Level 2
Valuation is based upon quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active, and model-based valuation techniques for which all significant assumptions are observable in the market
     
 
Level 3
Valuation is generated from model-based techniques that use at least one significant assumption not observable in the market. These unobservable assumptions reflect estimates of assumptions that market participants would use in pricing the asset or liability. Valuation techniques include use of option pricing models, discounted cash flow models and similar techniques.

In general, fair value is based upon quoted market prices, where available. If such quoted market prices are not available, fair value is based upon third party models that primarily use, as inputs, observable market-based parameters. Valuation adjustments may be made to ensure that financial instruments are recorded at fair value. These adjustments may include amounts to reflect counterparty credit quality, the Company's creditworthiness, among other things, as well as unobservable parameters. Any such valuation adjustments are applied consistently over time. The Company's valuation methodologies may produce a fair value calculation that may not be indicative of net realizable value or reflective of future fair values. While management believes the Company's valuation methodologies are appropriate and consistent with other market participants, the use of different methodologies or assumptions to determine the fair value of certain financial instruments could result in a different estimate of fair value at the reporting date.
29

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

Recurring - Investment Securities Available for Sale

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

The following tables summarize the Company's available for sale securities portfolio measured at fair value on a recurring basis as of March 31, 2016 and December 31, 2015, segregated by the level of the valuation inputs within the fair value hierarchy.
 
March 31, 2016
 
   
Level 1
   
Level 2
   
Level 3
   
Total Fair Value
 
Available for Sale Securities
                       
State and Political Subdivisions
 
$
-
   
$
7,011
   
$
-
   
$
7,011
 
Mortgage Backed Securities
 
$
-
   
$
66,549
   
$
-
   
$
66,549
 
SBA Pools
 
$
-
   
$
10,039
   
$
-
   
$
10,039
 
Total AFS Securities
 
$
-
   
$
83,599
   
$
-
   
$
83,599
 
 

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





30



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

Non Recurring - Loans

The Company does not record loans at fair value on a recurring basis. However, from time to time, a loan is considered impaired and an allowance for loan losses is established. Loans for which it is probable that payment of interest and principal will not be made in accordance with the contractual terms of the loan agreement are considered impaired. Once a loan is identified as individually impaired, management measures impairment using one of several methods, including recently appraised collateral value and /or tax assessed value, liquidation value and discounted cash flows. Those impaired loans not requiring an allowance represent loans for which the fair value of the expected repayments or collateral exceed the recorded investments in such loans. At March 31, 2016 and December 31, 2015, all of the total impaired loans were evaluated based on the fair value of the collateral. The Company frequently obtains appraisals prepared by external professional appraisers and applies discounts ranging from 8% to 40% depending on type of property, condition, location, etc. The Company also, in certain instances, prepares internally generated valuations from on-site inspections, third-party valuation models or other information.

Non Recurring -Foreclosed Assets / Repossessions

Foreclosed assets and repossessions are adjusted to fair value upon transfer of the loans to foreclosed assets and repossessions. Subsequently, foreclosed assets and repossessions are carried at the lower of carrying value or fair value. Fair value is based upon independent market prices or recent appraised values of the collateral, which the Company considers to be nonrecurring Level 2.  When the current appraised value is not available and /or further discounted below the most recent appraised value less selling costs due to such things as absorption rates and market conditions, the Company classifies the foreclosed assets within Level 3 of the fair value hierarchy.

The following table summarizes the Company's assets at fair value on a non - recurring basis as of March 31, 2016 and December 31, 2015 segregated by the level of the valuation inputs within the fair value hierarchy. The tables disclose the recorded investment of impaired loans requiring a specific allowance.
 
March 31, 2016
 
Level 1
   
Level 2
   
Level 3
   
Total Fair Value
 
 
Impaired Loans
 
$
-