10-Q 1 hbiform10q05102017.htm


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

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

For the quarterly period ended March 31, 2017

[   ] 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, smaller reporting company, or an emerging growth company.  See the definitions of "large accelerated filer," "accelerated filer," "smaller reporting company," and "emerging growth company" in Rule 12b-2 of the Exchange Act.
Large accelerated filer    Accelerated filer  Non-accelerated filer  (Do not check if a smaller reporting company) Smaller reporting company  Emerging growth company 
If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes [  ] No [X ]
Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date.
 
8,199,228 shares of common stock, par value $0.625 per share, outstanding as of May 10, 2017
 




Highlands Bankshares, Inc.

FORM 10-Q
For the Quarter Ended March 31, 2017

INDEX
     
PART I. FINANCIAL INFORMATION       
PAGE
 
     
Item 1.  Financial Statements
   
     
Consolidated Balance Sheets
  at March 31, 2017 (Unaudited) and December 31, 2016
   
3
 
     
Consolidated Statements of Income (Unaudited)
  for the Three Months Ended March 31, 2017 and 2016
4
 
     
 
Consolidated Statements of Comprehensive Income (Unaudited)
for the Three Months Ended March 31, 2017 and 2016
5
 
 
Consolidated Statements of Cash Flows (Unaudited)
  for the Three Months Ended March 31, 2017 and 2016
6
 
     
Consolidated Statements of Changes in
  Stockholders' Equity (Unaudited) for the Three Months
  Ended March 31, 2017 and 2016
7
 
     
Notes to Consolidated Financial Statements (Unaudited)
8-32
 
     
Item 2. Management's Discussion and Analysis of
              Financial Condition and Results of Operations
33-35
 
     
Item 3. Quantitative and Qualitative Disclosures About Market Risk
36
 
     
Item 4.  Controls and Procedures
36
 
     
PART II.  OTHER INFORMATION
   
     
Item 1.  Legal Proceedings
36
 
     
Item 1A. Risk Factors
36
 
     
Item 2.  Unregistered Sales of Equity Securities and Use of Proceeds
36
 
     
Item 3.  Defaults Upon Senior Securities
36
 
     
Item 4.  Mine Safety Disclosures
36
 
     
Item 5.  Other Information
36
 
     
Item 6.  Exhibits
36
 
     
SIGNATURES AND CERTIFICATIONS
37
 
 

 

PART I.
FINANCIAL INFORMATION
 ITEM 1.  Financial Statements
Consolidated Balance Sheets
(Amounts in thousands)

 
   
       (Unaudited)
  March 31, 2017
 
(Note 1)
December 31, 2016
 
                                              ASSETS
         
Cash and due from banks
 
$     22,122
 
     $      27,391
 
Federal funds sold
 
      34,066
 
  22,994
 
           
   Total Cash and Cash Equivalents
 
      56,188
 
50,385
 
           
Investment securities available for sale (amortized cost $98,149 at March 31, 2017, $96,930 at December 31, 2016)
 
96,384
 
95,073
 
Other investments, at cost
 
6,385
 
6,637
 
Loans Held for Sale
 
3,063
 
1,255
 
Loans, net of allowance for loan losses of  $4,728 at March 31, 2017, $4,829 at December 31, 2016
 
404,383
 
404,838
 
Premises and equipment, net
 
17,843
 
17,814
 
Real Estate held for Sale
 
1,662
 
1,680
 
Deferred tax assets
 
12,519
 
12,989
 
Interest receivable
 
1,845
 
2,047
 
Bank owned life Insurance
 
14,409
 
14,314
 
Other real estate owned
 
2,741
 
2,768
 
Other assets
 
       2,114
 
        2,878
 
           
    Total Assets
 
$   619,536
 
$    612,678
 
           
LIABILITIES AND STOCKHOLDERS' EQUITY
         
           
LIABILITIES
         
           
Deposits:
         
  Non-interest bearing
 
$    140,616
 
$      134,488
 
  Interest bearing
 
    354,851
 
     355,381
 
           
    Total Deposits
 
    495,467
 
     489,869
 
           
Interest, taxes and other liabilities
 
1,477
 
1,353
 
Other short-term borrowings
 
27,552
 
27,552
 
Long-term debt
 
40,133
 
40,146
 
           
    Total Other Liabilities
 
      69,162
 
       69,051
 
           
    Total Liabilities
 
    564,629
 
     558,920
 
           
STOCKHOLDERS' EQUITY
         
Common stock (8,199 shares issued and outstanding at March 31, 2017 and December 31, 2016, respectively)
 
5,124
 
5.124
 
Preferred Stock (2,092 shares issued and outstanding)
 
4,184
 
4,184
 
Additional paid-in capital
 
 18,946
 
18.891
 
Retained earnings
 
27,817
 
26,785
 
Accumulated other comprehensive income
 
(1,164)
 
      (1.226)
 
         Total Stockholders' Equity
 
      54,907
 
      53,758
 
           
    Total Liabilities and Stockholders' Equity
 
$  619,536
 
$   612,678
 
 
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, 2017
 
Three Months Ended March 31, 2016
 
INTEREST INCOME
       
Loans receivable and fees on loans
$    5,049
 
$    5,478
 
Securities available for sale:
       
  Taxable
435
 
297
 
  Exempt from taxable income
86
 
78
 
Other investment income
61
 
57
 
Federal funds sold
          50
 
          26
 
         
    Total Interest Income
     5,681
 
     5,936
 
         
INTEREST EXPENSE
       
Deposits
446
 
453
 
Other borrowed funds
         585
 
         592
 
         
    Total Interest Expense
      1,031
 
      1,045
 
         
    Net Interest Income
      4,650
 
      4,891
 
         
Provision for Loan Losses
      17
 
      224
 
         
    Net Interest Income after Provision for                   Loan Losses
         4,633
 
         4,667
 
         
NON-INTEREST INCOME
       
Mortgage Banking Income
226
 
-
 
Securities gains, net
-
 
35
 
Service charges on deposit accounts
397
 
398
 
Other service charges, commissions and fees
498
 
441
 
Other  operating income
166
 
284
 
         
    Total Non-Interest Income
         1,287
 
         1,158
 
         
NON-INTEREST EXPENSE
       
Salaries and employee benefits
2,493
 
2,919
 
Occupancy expense of bank premises
323
 
313
 
Furniture and equipment expense
346
 
351
 
Other operating expense
1,267
 
1,302
 
Foreclosed Assets – Write-down and Operating Expenses
      20
 
      219
 
         
    Total Non-Interest Expense
      4,449
 
      5,104
 
         
    Income Before Income Taxes
1,471
 
721
 
         
Income Tax Expense (Note 3)
    439
 
    191
 
         
    Net Income
$     1,032
 
$     530
 
         
Basic Earnings  Per Common Share (Note 6)
$     0.13
 
$     0.07
 
         
Earnings Per Common Share – Assuming Dilution
$      0.10
 
$      0.05
 
         
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, 2017
 
Three Months Ended  March 31, 2016
 
         
         
Net Income
$     1,032
 
$     530
 
         
     Other Comprehensive Income
       
  Unrealized gains on securities during  the period
94
 
880
 
  Less: reclassification adjustment for (gains)  included in net income
-
 
(35)
 
          Other Comprehensive Income, before tax
94
 
845
 
           Income tax expense related to other
           comprehensive income
32
 
287
 
    Other Comprehensive Income
62
 
558
 
Comprehensive Income
$     1,094
 
$     1,088
 
         

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, 2017
   
March 31, 2016
 
CASH FLOWS FROM OPERATING  ACTIVITIES:
           
Net income
 
$
1,032
   
$
530
 
Adjustments to reconcile net income  to net cash provided by operating activities
               
Provision for loan losses
   
17
     
224
 
Depreciation and amortization
   
241
     
243
 
 
Net realized gains on available for sale securities
   
-
     
(35)
 
Net amortization on securities
   
163
     
221
 
Restricted Stock Expense
   
55
     
-
 
Origination of Loans held for sale
   
(7,386)
 
   
-
 
Proceeds from loans held for sale
   
5,578
     
-
 
            (Increase) decrease in interest receivable
   
202
     
(50)
 
Valuation adjustment of other real estate owned
   
-
     
166
 
Decrease in other assets
   
1,266
     
1,010
 
Increase in interest, taxes and other liabilities
   
124
     
479
 
                 
Net cash provided by operating activities
   
1,292
     
2,788
 
                 
CASH FLOWS FROM INVESTING ACTIVITIES:
               
Securities available for sale:
               
       Proceeds from sale of securities
   
-
     
11,549
 
Proceeds from maturities of securities
   
3,910
     
3,457
 
Purchase of debt and equity securities
   
(5,293)
 
   
(18,082)
 
(Purchases) redemptions of other investments
   
252
     
(19)
 
Net decrease in loans
   
212
     
3,725
 
Proceeds from sales of other real estate owned
   
255
     
328
 
Proceeds from cash surrender value of life insurance
   
-
     
93
 
Premises and equipment expenditures
   
(410)
 
   
(114)
 
                 
Net cash provided by (used in) investing activities
   
(1,074)
 
   
937
 
                 
CASH FLOWS FROM FINANCING ACTIVITIES:
               
 
Net decrease in time deposits
   
(1,966)
 
   
(3,890)
 
Net increase in demand, savings and other deposits
   
7,564
     
2,075
 
Decrease in short-term borrowings
   
-
     
(1)
 
Decrease in long-term debt
   
(13)
 
   
(12)
 
Issuance of common stock
   
-
     
1,110
 
                 
Net cash provided by (used in) financing activities
   
5,585
     
(718)
 
                 
Net increase in cash and cash equivalents
   
5,803
     
3,007
 
CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD
   
50,385
     
46,891
 
                 
CASH AND CASH EQUIVALENTS AT END OF PERIOD
 
$
56,188
   
$
49,898
 
                 
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION
               
Cash paid during the period for:
               
Interest
 
$
1,047
   
$
1,059
 
Income taxes
 
$
-
   
$
-
 
                 
     SUPPLEMENTAL DISCLOSURE OF NONCASH TRANSACTIONS
               
Transfer of loans to other real estate owned
 
$
228
   
$
153
 
Loans originated from sales of other real estate owned
 
$
-
   
$
10
 

See accompanying Notes to Consolidated Financial Statements


6

 

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, 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
 
Other
Comprehensive
Income
                                                   
558
     
558
 
Balance
March 31, 2016
.
   
8,113
   
$
5,070
     
2,092
   
$
4,184
   
$
18,891
   
$
27,303
   
$
310
   
$
55,758
 
                                                                 
Balance
December 31, 2016
   
8,199
   
$
5,124
     
2,092
   
$
4,184
   
$
18,891
   
$
26,785
   
$
(1,226
)
 
$
53,758
 
 
Net Income
                                           
1,032
             
1,032
 
Other
Comprehensive
Income
                                                   
62
     
62
 
Compensation Expense on Restricted Stock
                                   
55
                     
55
 
Balance
March 31, 2017
   
8,199
   
$
5,124
     
2,092
   
$
4,184
   
$
18,946
   
$
27,817
   
$
(1,164
)
 
$
54,907
 
                                                                 
 
See accompanying Notes to Consolidated Financial Statements





7

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

Note 1  -  General

The consolidated financial statements of Highlands Bankshares, Inc. (the "Company") conform to United States generally accepted accounting principles and to banking industry practices. The accompanying consolidated interim financial statements are unaudited. In the opinion of management, all adjustments necessary for a fair presentation of the consolidated financial statements have been included. All such adjustments are of a normal and recurring nature. The consolidated balance sheet as of December 31, 2016 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, 2016 (the "2016 Form 10-K"). The notes included herein should be read in conjunction with the notes to consolidated financial statements included in the 2016 Form 10-K. The results of operations for the three-month period ended March 31, 2017, 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, 2017
 
December 31, 2016
 
Real Estate Secured:
       
Residential 1-4 family
$ 183,080
 
$   186,695
 
Multifamily
22,723
 
22,630
 
Construction and Land Loans
16,521
 
15,978
 
Commercial, Owner Occupied
69,298
 
72,383
 
Commercial, Non-owner occupied
29,404
 
28,818
 
Second mortgages
6,195
 
6,934
 
Equity lines of credit
          19,882
 
13,395
 
Farmland
12,283
 
12,194
 
 
359,386
 
359,027
 
         
Secured (other) and unsecured
       
Personal
16,777
 
17,745
 
Commercial
30,238
 
29,977
 
Agricultural
3,169
 
3,490
 
 
50,184
 
51,212
 
         
Overdrafts
260
 
142
 
         
 
409,830
 
410,381
 
Less:
       
  Allowance for loan losses
            4,728
 
          4,829
 
  Net deferred fees
719
 
             714
 
 
5,447
 
5,543
 
         
Loans, net
$ 404,383
 
$    404,838
 



8

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

The following table is an analysis of past due loans as of March 31, 2017


   
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
 
 $ 388
 
 $    39
 
 $  819
 
 $  1,246
 
 $  181,834
 
 $  183,080
 
 $         -
Equity lines of credit
 
 -
 
 -
 
10
 
 10
 
 19,872
 
 19,882
 
-
Multifamily
 
 -
 
 -
 
 -
 
 -
 
 22,723
 
 22,723
 
-
Farmland
 
411
 
 -
 
 193
 
604
 
 11,679
 
12,283
 
-
Construction, Land Development, Other Land Loans
 
143
 
 -
 
-
 
143
 
 16,378
 
 16,521
 
 -
Commercial Real Estate- Owner Occupied
 
 -
 
 -
 
1,643
 
 1,643
 
 67,655
 
 69,298
 
 -
Commercial Real Estate- Non Owner Occupied
 
 -
 
-
 
 346
 
 346
 
 29,058
 
 29,404
 
 -
Second Mortgages
 
 -
 
 -
 
 18
 
18
 
 6,177
 
 6,195
 
 -
Non Real Estate Secured
                           
Personal
 
 115
 
 30
 
 26
 
 171
 
 16,866
 
 17,037
 
 -
Commercial
 
 40
 
 38
 
397
 
 475
 
 29,763
 
 30,238
 
 -
Agricultural
 
 -
 
 -
 
 -
 
  -
 
 3,169
 
 3,169
 
 -
                             
          Total
 
 $  1,097
 
 $    107
 
 $   3,452
 
 $  4,656
 
 $  405,174
 
 $  409,830
 
 $          -
                             




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 December 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
 
 $    841
 
 $    242
 
 $    1,000
 
 $    2,083
 
 $  184,612
 
 $  186,695
 
 $          -
Equity lines of credit
 
 -
 
 30
 
 10
 
 40
 
 13,355
 
 13,395
 
-
Multifamily
 
 -
 
-
 
 -
 
 -
 
 22,630
 
 22,630
 
-
Farmland
 
 -
 
 47
 
 564
 
 611
 
 11,583
 
 12,194
 
-
Construction,  Land Development, Other Land Loans
 
 39
 
 -
 
 -
 
 39
 
 15,939
 
 15,978
 
 -
Commercial Real Estate- Owner Occupied
 
 14
 
 -
 
 3,868
 
 3,882
 
 68,501
 
 72,383
 
 2,210
Commercial Real Estate- Non Owner Occupied
 
 -
 
 -
 
 -
 
 -
 
 28,818
 
 28,818
 
 -
Second Mortgages
 
 160
 
 1
 
 18
 
179
 
 6,755
 
 6,934
 
 -
Non Real Estate Secured
                           
Personal
 
 118
 
 23
 
12
 
 153
 
 17,734
 
 17,887
 
 -
Commercial
 
 142
 
54
 
 462
 
 658
 
 29,319
 
 29,977
 
 -
Agricultural
 
 -
 
 7
 
 -
 
 7
 
 3,483
 
 3,490
 
 -
                             
          Total
 
 $    1,314
 
 $    404
 
 $   5,934
 
 $   7,652
 
 $  402,729
 
 $  410,381
 
 $       2,210
                             




10


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, 2017 and December 31, 2016:
 
 
March 31, 2017
 
December 31, 2016
 
Real Estate Secured
       
Residential 1-4 Family
                                                       $           819
 
 $       1,275
 
Multifamily
                                          -
 
-
 
Construction and Land Loans
-
 
-
 
Commercial-Owner Occupied
1,643
 
1,658
 
Commercial- Non Owner Occupied
346
 
-
 
Second Mortgages
18
 
18
 
Equity Lines of Credit
10
 
10
 
Farmland
193
 
564
 
Secured (other) and Unsecured
       
Personal
26
 
12
 
Commercial
397
 
462
 
Agricultural
            -
 
             -
 
         
Total
$             3,452
 
$     3,999
 

 

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, 2017.

 
Number
03/31/17 Balance
 
Residential real estate in the process of foreclosure
 
4
 
$     678
 
Foreclosed residential real estate
6
$     334
 


11

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, 2017 and December 31, 2016.  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, 2017
 
Grade (1)
 
Residential 1-4 Family
 
Multifamily
 
Farmland
 
Construction, Land Loans
 
Commercial Real Estate- Owner Occupied
 
Commercial Real Estate Non-Owner Occupied
                         
Quality
 
32,409
 
-
 
 18
 
1,714
 
 3,823
 
 363
Satisfactory
 
 102,826
 
 18,147
 
 7,955
 
 5,129
 
 36,625
 
 16,799
Acceptable
 
 40,789
 
 1,716
 
 3,441
 
 7,744
 
 21,838
 
 8,236
Special Mention
 
 3,191
 
 1,880
 
 -
 
 -
 
 4,401
 
 126
Substandard
 
 3,865
 
 980
 
 869
 
 1,934
 
 2,611
 
 3,880
Doubtful
 
 -
 
 -
 
 -
 
 -
 
 -
 
 -
                         
     Total
 
$   183,080
 
$     22,723
 
$     12,283
 
$        16,521
 
$     69,298
 
$     29,404


Credit Risk Profile by Internally Assigned Grade as of December 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
 
$      32,054
 
$                -
 
$            19
 
$            1,941
 
$        3,686
 
$         387
Satisfactory
 
 106,154
 
 18,335
 
 7,823
 
 5,969
 
 36,806
 
 15,198
Acceptable
 
 41,369
 
 1,410
 
 3,474
 
 5,961
 
 22,767
 
 5,119
Special Mention
 
 3,399
 
1,896
 
 -
 
 -
 
 4,435
 
 4,221
Substandard
 
3,719
 
 989
 
 878
 
2,107
 
 4,689
 
 3,893
Doubtful
 
 -
 
 -
 
 -
 
 -
 
 -
 
 -
                         
     Total
 
$   186,695
 
$     22,630
 
$     12,194
 
$        15,978
 
$     72,383
 
$      28,818


(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.  

12

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.


13

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, 2017

   
Consumer - Non Real Estate
 
Equity Line of Credit /Second Mortgages
 
Commercial - Non Real Estate
 
Agricultural - Non Real Estate
                 
Performing
 
$        17,011
 
$          26,049
 
$             29,841
 
$            3,169
Nonperforming (>90 days past due)
 
26
 
 28
 
 397
 
 -
                 
     Total
 
$       17,037
 
$         26,077
 
$             30,238
 
$           3,169
                 


Credit Risk Profile based on payment activity as of December 31, 2016

   
Consumer - Non Real Estate
 
Equity Line of Credit /Second Mortgages
 
Commercial - Non Real Estate
 
Agricultural - Non Real Estate
                 
Performing
 
$        17,875
 
$          20,301
 
$             29,515
 
$            3,490
Nonperforming (>90 days past due)
 
 12
 
 28
 
 462
 
 -
                 
     Total
 
$       17,887
 
$         20,329
 
$             29,977
 
$           3,490
                 



14


 
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, 2017:
 
 
March 31, 2017
 
Recorded Investment
 
Unpaid Principal Balance
 
Related Allowance
 
Average Recorded Investment
 
Interest Income Recognized
With No Related Allowance
                   
Real Estate Secured
                   
Residential 1-4 family
 
$      5,699
 
$      5,699
 
$          -
 
$     5,273
 
$       70
Equity lines of credit
 
-
 
-
 
-
 
12
 
-
Multifamily
 
980
 
980
 
-
 
984
 
13
Farmland
 
582
 
582
 
-
 
633
 
13
Construction, Land Development, Other Land Loans
 
1,536
 
1,536
 
-
 
                   1,638
 
23
Commercial Real Estate- Owner Occupied
 
                        826
 
                      826
 
-
 
              3,314
 
5
Commercial Real Estate- Non Owner Occupied
 
346
 
346
 
-
 
1,114
 
-
Second Mortgages
 
64
 
64
 
-
 
125
 
1
Non Real Estate Secured
                   
Personal /Consumer
 
-
 
-
 
-
 
7
 
-
Commercial
 
-
 
-
 
-
 
21
 
-
Agricultural
 
-
 
-
 
-
 
-
 
-
                     
          Total
 
$    10,033
 
$    10,033
 
$          -
 
$   13,121
 
$       125



 
 
March 31, 2017
 
Recorded Investment
 
Unpaid Principal Balance
 
Related Allowance
 
Average Recorded Investment
 
Interest Income Recognized
With an Allowance Recorded
                   
Real Estate Secured
                   
Residential 1-4 family
 
$     697
 
$     697
 
$       47
 
$     578
 
$       7
Equity lines of credit
 
-
 
-
 
-
 
-
 
-
Multifamily
 
-
 
-
 
-
 
-
 
-
Farmland
 
191
 
191
 
20
 
191
 
2
Construction, Land Development, Other Land Loans
 
366
 
366
 
20
 
366
 
6
Commercial Real Estate- Owner Occupied
 
3,437
 
4,437
 
960
 
2,288
 
49
Commercial Real Estate- Non Owner Occupied
 
3,879
 
3,879
 
768
 
2,944
 
46
Second Mortgages
 
-
 
-
 
-
 
9
 
-
Non Real Estate Secured
                   
Personal /Consumer
 
-
 
-
 
-
 
25
 
-
Commercial
 
466
 
466
 
280
 
550
 
1
Agricultural
 
-
 
-
 
-
 
-
 
-
                     
          Total
 
$    9,036
 
$    10,036
 
$     2,095
 
$    6,951
 
$         111


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 December 31, 2016:

 
 
December 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
 
$      4,848
 
$      4,848
 
$          -
 
$     5,963
 
$      200
Equity lines of credit
 
25
 
25
 
-
 
38
 
1
Multifamily
 
989
 
989
 
-
 
1,005
 
1
Farmland
 
685
 
685
 
-
 
750
 
24
Construction, Land Development, Other Land Loans
 
1,741
 
1,741
 
-
 
1,643
 
114
Commercial Real Estate- Owner Occupied
 
5,802
 
5,802
 
-
 
5,685
 
390
Commercial Real Estate- Non Owner Occupied
 
1,883
 
1,883
 
-
 
941
 
39
Second Mortgages
 
186
 
186
 
-
 
292
 
8
Non Real Estate Secured
                   
Personal
 
14
 
14
 
-
 
41
 
1
Commercial
 
43
 
43
 
-
 
179
 
3
Agricultural
 
-
 
-
 
-
 
-
 
-
                     
          Total
 
$    16,216
 
$    16,216
 
$          -
 
$   16,537
 
$       781

 
 
December 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
 
$     460
 
$     460
 
$       36
 
$     1,153
 
$       14
Equity lines of credit
 
-
 
-
 
-
 
-
 
-
Multifamily
 
-
 
-
 
-
 
-
 
-
Farmland
 
192
 
192
 
16
 
96
 
11
Construction, Land Development, Other Land Loans
 
                366
 
                 366
 
20
 
406
 
22
Commercial Real Estate- Owner Occupied
 
1,139
 
2,139
 
558
 
1,629
   
Commercial Real Estate- Non Owner Occupied
 
         2,009
 
            2,009
 
314
 
1,947
 
41
Second Mortgages
 
18
 
18
 
9
 
18
 
-
Non Real Estate Secured
                   
Personal
 
51
 
51
 
29
 
82
 
3
Commercial
 
634
 
634
 
365
 
652
 
16
Agricultural
 
-
 
-
 
-
 
-
 
-
                     
          Total
 
$    4,869
 
$    5,869
 
$     1,347
 
$    5,983
 
$       107









16

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


The following tables present the balance in the allowance for loan losses and the recorded investment in loans by loan category and is segregated by impairment
evaluation method as of March 31, 2017 and March 31, 2016.

Three  months ended March 31, 2017
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,  2016
$  371
$   -
$   21
$  1,339
$   445
$   15
$   27
$   16
$   802
$    535
$   1,258
$   4,829
Provision for Credit Losses
(16)
-
(1)
350
403
(11)
4
37
204
(99)
(854)
17
Charge-offs
14
-
-
-
-
-
-
-
79
59
-
152
Recoveries
(3)
-
(1)
-
(1)
-
-
(1)
(25)
(3)
-
(34)
Net Charge-offs
11
            -
            (1)
-
(1)
-
-
(1)
54
56
-
118
Ending Balance
 March 31, 2017
344
-
21
1,689
849
4
31
54
952
380
404
4,728
Ending Balance: Individually evaluated for impairment
47
-
20
960
768
-
-
20
-
280
-
2,095
Ending Balance: Collectively evaluated for impairment
297
-
1
729
81
4
31
34
952
100
404
2,633
Loans:
                       
Ending Balance: Individually Evaluated for Impairment
6,396
980
1,902
4,263
4,225
64
-
773
260
466
-
19,329
Ending Balance: Collectively Evaluated for Impairment
176,684
21,743
14,619
65,035
25,179
6,131
19,882
11,510
16,777
32,941
-
390,501
Ending Balance: March 31, 2017
$183,080
$22,723
$16,521
$69,298
$29,404
$6,195
$19,882
$12,283
$17,037
$33,407
-
$409,830


17





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

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, 2017 and December 31, 2016, all of the total impaired loans were evaluated based on either the fair value of the collateral or the discounted cash flows. 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 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 $11,773 and $12,660 of loans categorized as troubled debt restructurings as of March 31, 2017 and December 31, 2016, 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, 2017 and 2016.
There were no new TDRs in the first quarter of 2017.



19


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



Troubled Debt Restructurings –Three months ended March 31, 2017
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
     
Commercial Real Estate-  Non Owner Occupied
     
Second Mortgages
     
Non Real Estate Secured
     
Personal / Consumer
     
Commercial
     
Agricultural
     
       
Total
-
-
-
 

 
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
     
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
-
-
-



20


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
-
-
-
 

 
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
-
-
-



21


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




22

 

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


Troubled Debt Restructurings
Loan term extension
Number of Contracts
Pre- Modification  Outstanding Recorded Investment
Post - Modification Recorded Investment
                                                                 Real Estate Secured
     
Residential 1-4 family
     
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
-
-
-


23



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 Officer or the individual Loan 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.




24


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 Senior Loan Officer, CEO, CFO, and Senior Lending Officers, including Credit Review personnel.  The Company's controller also performs a detailed review of the computations, estimates, etc. included in the ALLL calculation. The ALLL is then reviewed and approved by the Board of Directors.



25


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

Loans Held for Sale

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

Three-months ended March 31
 
2017
   
2016
 
             
Loans held for sale at end of period
 
$
3,063
   
$
-
 
Proceeds from sales of mortgage loans originated for sale
   
5,578
         
Gain on sales of mortgage loans originated for sale
 
$
226
     
-
 


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:

   
2017
   
2016
 
             
Tax expense at statutory rate
 
$
500
   
$
245
 
Reduction in taxes from:
               
Tax-exempt interest
   
(29)
 
   
(26)
 
Other, net
   
(32)
 
   
(28)
 
                 
Income tax expense
 
$
439
   
$
191
 




26

 

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

Note 4  - Capital Requirements

Regulators of the Company and its subsidiary, Highlands Union Bank (the "Bank"), have implemented risk-based capital guidelines which require compliance with certain minimum capital ratios as a percent of assets and other certain off-balance sheet items that are adjusted for predefined credit risk factors.  On July 7, 2013 the Federal Reserve Board approved Basel III Final Rules to begin implementation January 1, 2015. The desired overall objective of Basel III is to improve the banking sector's ability to absorb shocks arising from financial and economic stress.  The Final Rule includes a new Common Equity Tier 1 (CET1) minimum ratio and raises the Tier 1 Risk Weighted Assets ratio to 6% from 4%.  In addition, the new rules require a bank to maintain a capital conservation buffer of between 2 and 2 ½ % beginning in 2016.  Additionally, the new rules increase the risk weighting of various assets. The new rules will be phased in beginning in 2015 with complete compliance required by 2019.  Generally, the Basel III Final Rule requires 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, 2017
 
Entity
                                     Tier 1
Total Risk Based
Leverage
 CET 1
         
Highlands Union Bank
12.15%
13.37%
          7.80%
             12.15%

                                                                   December 31, 2016
 
Entity
                                    Tier 1
Total Risk Based
Leverage
CET 1
         
         
Highlands Union Bank
11.78%
13.02%
             7.59%
                  11.78%

 

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

Note 5.  Capital Issuances / Awards

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 Mr. Schools' purchase. The company down-streamed $1,150 to the Bank.

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

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, 2017 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 restricted stock awards issued by the Company to Mr. Schools are also included in the diluted shares total. 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
 
2017
   
2016
 
             
Income available to common stockholders
 
$
1,032
   
$
530
 
Weighted average shares outstanding
   
8,113
     
8,089
 
Shares outstanding including assumed conversion
   
10,292
     
10,205
 
Basic earnings per common share
 
$
0.13
   
$
0.07
 
Fully diluted earnings per share (including convertible preferred shares outstanding and restricted stock)
 
$
0.10
   
$
0.05
 


27


 
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, 2017, these commitments included: standby letters of credit of $843; equity lines of credit of $15,155; credit card lines of credit of $6,729; commercial real estate, construction and land development commitments of $1,980; and other unused commitments to fund interest earning assets of $21,491.

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.


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, 2017 and December 31, 2016, segregated by the level of the valuation inputs within the fair value hierarchy.

March 31, 2017
 
Level 1
Level 2
Level 3
Total Fair Value
Available for Sale Securities
       
State and Political Subdivisions
$          -
$     12,903
$          -
$     12,903
Mortgage Backed Securities
          -
    75,431
          -
    75,431
SBA Pools
          -
       8,050
          -
       8,050
Total AFS Securities
$          -
$   96,384
    $         -
$   96,384



December 31, 2016
 
Level 1
Level 2
Level 3
Total Fair Value
Available for Sale Securities
       
State and Political Subdivisions
$          -
$     12,451
$          -
$     12,451
Mortgage Backed Securities
          -
    74,288
          -
    74,288
SBA Pools
          -
       8,334
          -
       8,334
Total AFS Securities
$          -
$   95,073
    $         -
$   95,073




28


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, 2017 and December 31, 2016, all of the total impaired loans were evaluated based on the fair value of the collateral or the present value of the future cash flows.  The Company frequently obtains appraisals prepared by external professional appraisers and applies discounts ranging from 8% to 40% depending on type of property, condition, location, etc. The Company also, in certain instances, prepares internally generated valuations from on-site inspections, third-party valuation models or other information.

Non Recurring – Loans Held for Sale

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

Non Recurring –Other Real Estate Owned  / Repossessions / Real estate held for sale

Other Real Estate Owned and repossessions are adjusted to fair value upon transfer of the loans to Other Real Estate Owned 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 as 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 records the foreclosed assets within Level 3 of the fair value hierarchy. Real estate held for sale is adjusted to fair value upon transfer from fixed assets or when no longer being used for banking purposes.

The following table summarizes the Company's assets at fair value on a non - recurring basis as of March 31, 2017 and December 31, 2016 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, 2017
 
Level 1
   
Level 2
   
Level 3
   
Total Fair Value
 
Impaired Loans
 
$
-
   
$
-
   
$
9,036
   
$
9,036
 
Loans held for Sale
           
3,063
     
-
   
$
3 ,063
 
Repossessions/OREO, net
 
$
-
   
$
-
   
$
2,741
   
$
2,741
 
Real Estate Held for sale
 
$
-
   
$
-
   
$
1,662
   
$
1,662
 


December 31, 2016
 
Level 1
   
Level 2
   
Level 3
   
Total Fair Value
 
Impaired Loans
 
$
-
   
$
-
   
$
4,869
   
$
4,869
 
Loans held for sale
           
1,255
     
-
     
1,255
 
Repossessions/OREO, net
 
$
-
   
$
-
   
$
2,768
   
$
2,768
 
Real Estate Held for sale
 
$
-
   
$
-
   
$
1,680
   
$
1,680
 


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

The following table presents additional quantitative information about assets measured at fair value on a nonrecurring basis for which the Company uses Level 3 inputs to determine fair value (dollars in thousands):
 
 
 
 
 
Quantitative Information about Level 3 Fair Value Measurements
 
 
 
March 
 
 
 
Valuation
 
Unobservable
 
Range
 
 
 
12/31/16
 
3/31/17
 
Techniques
 
Input (2)
 
(Weighted Average)
 
OREO, net
 
$
2,768
 
$
2,741
 
Appraisal of collateral (1)
 
Appraisal adjustments
 
0% to 45% (13%)
 
 
 
 
 
 
 
 
 
Liquidation expenses
 
0% to 10% (9%)
 
Real Estate held for sale
 
$         1,680
  $                               1,662  
Appraisal of collateral (1)
 
Appraisal adjustments
 
0% to 50% (40%)
 
               
Liquidation expenses
 
0% to 10% (8%)
 
Impaired loans
 
$
4,869
 
$
9,036
 
Fair value of collateral –real estate  (1), (3)
 
Appraisal adjustments
 
0% to 10% (9%)
 
 
 
 
 
 
 
 Fair value of collateral –equipment, inventory, other  (1), (3)
 
Appraisal adjustments
 
25% to 50% (33%)
 
               
Liquidation expenses
 
0% to 10% (9%)
 




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


29


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

General

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

Fair Value of Financial Instruments

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

Cash and Cash Equivalents

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

Securities Available for Sale

Fair values are determined in the manner as described above.

Other Investments

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

Loans

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

Deposits

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

Other Short-Term Borrowings

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


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


Long-term Debt and Capital Securities

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

Off-Balance Sheet Instruments

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

The carrying amounts and fair values of the Company's financial instruments at March 31, 2017 and December 31, 2016 were as follows:



 
March 31, 2017
 
December 31, 2016
 
 
Carrying Amount
Fair Value
 
Carrying Amount
Fair Value
 
     
             
Cash and cash equivalents
$    56,188
$    56,188
 
$    50,385
$    50,385
 
Securities available for
 sale
96,384
96,384
 
95,073
95,073
 
Other investments
6,385
6,385
 
6,637
6,637
 
Loans, net
404,383
404,043
 
404,838
406,851
 
Deposits
(495,467)
(427,552)
 
(489,869)
(422,730)
 
Other short-term
  borrowings
(27,552)
(27,781)
 
(27,552)
(27,958)
 
Long-term debt
(40,133)
(41,555)
 
(40,146)
(41,825)
 


30


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

Note  9 -Investment Securities Available For Sale

The amortized cost and market value of securities available for sale are as follows:
 
March 31, 2017
 
Amortized Cost
 
Gross Unrealized Gains
 
Gross Unrealized Losses
 
Fair Value
 
               
State and political subdivisions
$     13,455
 
$     31
 
$         583
 
$      12,903
Mortgage backed securities
76,478
 
86
 
1,133
 
75,431
SBA Pools
8,216
 
4
 
170
 
8,050
 
$    98,149
 
$       121
 
$    1,886
 
$    96,384

 
December 31, 2016
 
Amortized Cost
 
Gross Unrealized Gains
 
Gross Unrealized Losses
 
Fair Value
 
               
State and political subdivisions
$     13,013
 
$       41
 
$          603
 
$      12,451
Mortgage backed securities
75,384
 
93
 
1,189
 
74,288
SBA Pools
8,533
 
6
 
205
 
8,334
 
$    96,930
 
$       140
 
$     1,997
 
$    95,073


Investment securities available for sale with a carrying value of $31,442 and $33,238 at March 31, 2017 and December 31, 2016 respectively, and a market value of $30,961 and $32,698 at March 31, 2017 and December 31, 2016, respectively, were pledged as collateral on public deposits, FHLB advances and for other purposes as required or permitted by law.
 

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

The following table presents the age of gross unrealized losses and fair value by investment category:
 
March 31, 2017
 
Less Than 12 months
12 Months or More
Total
 
Fair Value
Unrealized Losses
Fair Value
Unrealized Losses
Fair Value
Unrealized Losses
             
State and political subdivisions
$    9,907
$      583
$           -
$         -
$   9,907
$       583
Mortgage-backed securities
66,109
1,077
1,286
56
67,395
1,133
SBA Pools
7,106
154
554
16
7,660
170
             
  Total
$  83,122
$   1,814
$  1,840
 $    72
$84,962
$    1,886

 
December 31, 2016
 
Less Than 12 months
12 Months or More
Total
 
Fair Value
Unrealized Losses
Fair Value
Unrealized Losses
Fair Value
Unrealized Losses
             
State and political subdivisions
$    9,191
$      603
$          -
$          -
$  9,191
$      603
Mortgage-backed securities
66,878
1,189
-
-
66,878
1,189
SBA Pools
7,587
205
-
-
7,587
205
             
  Total
$  83,656
$   1,997
$            -
 $    -
$83,656
$   1,997


The Company assesses its securities for OTTI quarterly by reviewing credit ratings, financial and regulatory reports as well as other pertinent published financial data. As of March 31, 2017 and December 31, 2016, the Company's assessment revealed no impairment other than that deemed temporary on those securities.

The amortized cost and estimated fair value of securities available for sale at March 31, 2017 by contractual maturity are shown below. Expected maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.

 
Amortized Cost
 
Approximate
Market Value
   
Due in one year or less
$            555
 
$            558
Due after one year through five years
1,431
 
1,446
Due after five years through ten years
3
 
3
Due after ten years
19,682
 
18,946
 
21,671
 
20,953
       
Mortgage-backed securities
76,478
 
75,431
 
$     98,149
 
$     96,384


31

 

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

Note 10–Formal Written Agreement

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

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

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


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

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

In May 2014, the FASB issued ASU No. 2014-09, Revenue from Contracts with Customers (Topic 606). ASU 2014-09 is a comprehensive new revenue recognition model that requires a company to recognize revenue to depict the transfer of goods or services to a customer at an amount that reflects the consideration it expects to receive in exchange for those goods or services. ASU 2014-09 also requires additional disclosure about the nature, amount, timing and uncertainty of revenue and cash flows arising from customer contracts, including significant judgments and changes in judgments and assets recognized from costs incurred to obtain or fulfill a contract. ASU 2014-09 was effective for annual reporting periods, and interim periods within that period, beginning after December 15, 2016. ASU No. 2015-14 issued in August 2015 deferred the effective date of this Update to annual reporting periods beginning after December 15, 2017, including interim reporting periods within that reporting period. Earlier application is permitted only as of annual reporting periods beginning after December 15, 2016, including interim reporting periods within that reporting period.  The adoption of this ASU is not expected to have a material effect on the Company's current financial position or results of operations; however, it may impact the reporting of future financial statement disclosures.

In January 2016, ASU No. 2016-01 Financial Instruments--Overall (Subtopic 825-10) was issued by the FASB.  The amendments address certain aspects of recognition, measurement, presentation, and disclosure of financial instruments.  The amendments will be effective for fiscal years beginning after December 15, 2017, including interim periods within those fiscal years. The Company does not expect this ASU to have a material effect on its financial statements.

In June 2016, ASU No. 2016-13, "Measurement of Credit Losses on Financial Instruments" was issued by the FASB.   This ASU significantly changes how entities will measure credit losses for most financial assets and certain other instruments that aren't measured at fair value through net income.  The ASU is intended to improve financial reporting by requiring timelier recording of credit losses on loans and other financial instruments.  ASU No. 2016-13 is effective for interim and annual reporting periods beginning after December 15, 2019; early adoption is permitted for interim and annual reporting periods beginning after December 15, 2018. Entities will apply the standard's provisions as a cumulative-effect adjustment to retained earnings as of the beginning of the first reporting period in which the guidance is effective (i.e., modified retrospective approach). The Company is currently evaluating the effect that implementation of the new standard will have on its financial position, results of operations, and cash flows.

In March 2017, the FASB issued ASU No. 2017-07, "Improving the Presentation of Net Periodic Pension Cost and Net Periodic Postretirement Benefit Cost".  The amendments require that an employer report the service cost component in the same line item or items as other compensation costs arising from services rendered by the pertinent employees during the period. The other components of net benefit cost are required to be presented in the income statement separately from the service cost component and outside a subtotal of income from operations, if one is presented. The amendments are effective for public business entities for annual periods beginning after December 15, 2017, including interim periods within those annual periods.  The Company is currently evaluating the effect that implementation of the new standard will have on its financial position, results of operations, and cash flows.

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



32



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

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

The Company generates a significant amount of its income from the net interest income earned by the Bank. Net interest income is the difference between interest income and interest expense. Interest income depends on the amount of interest-earning assets outstanding during the period and the interest rates earned thereon. The Company's cost of money is a function of the average amount of deposits and borrowed money outstanding during the period and the interest rates paid thereon. The quality of the assets further influences the amount of interest income lost on non-accrual loans and the amount of additions to the allowance for loan losses. Highlands Union Insurance Services and Highlands Union Financial Services, which are subsidiaries of Highlands Union Bank, generate fee income by providing insurance and financial service products to its clients. Russell Road Properties, LLC is also an entity in which the Bank has a significant interest and was created to hold and manage certain properties acquired by the Bank through foreclosure or deed in lieu of foreclosure.

Critical Accounting Policies

The financial condition and results of operations presented in the Consolidated Financial Statements, accompanying Notes to Consolidated Financial Statements and management's discussion and analysis are, to a large degree, dependent upon the accounting policies of the Company.  The selection and application of these accounting policies involve judgments, estimates, and uncertainties that are susceptible to change.  For a discussion of the Company's critical accounting policies related to its allowance for loan losses and other than temporary impairment, see the Company's Annual Report on Form 10-K for the year ended December 31, 2016.

Formal Written Agreement
As discussed in Note 10, on October 13, 2010, the Company and Bank entered into a written agreement ("Written Agreement") with the Federal Reserve Bank of Richmond (the "Reserve Bank").  Under the terms of the Written Agreement, the Bank has agreed to develop and submit to the Reserve Bank for approval within the time periods specified therein written plans or programs to:

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


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

Results of Operations

Results of operations for the three-month periods ended March 31, 2017 and March 31, 2016 reflected net income of $1.03 million and $530 thousand, respectively. For the first three months of 2017, provisions for loan loss reserves decreased $207 thousand over the corresponding period in 2016.

Net interest income for the three-month period ended March 31, 2017 decreased $241 thousand or 4.93% compared to the three months ended March 31, 2016 primarily due to the reduction in loan balances compared to the prior period.  Average interest-earning assets decreased $530 thousand from the three-month period ended March 31, 2016 to the current three-month period, while average interest-bearing liabilities decreased $11.47 million over the same period. Average loan balances for the three months ended March 31, 2017 decreased $23.06 million compared to the three month period ended March 31, 2016. Average securities balances increased $15.93 million during the same period. The tax-equivalent yield on average interest-earning assets was 4.22% for the three-month period ended March 31, 2017 representing a decrease of 18 basis points from the same period in 2016.  The average balance of federal funds sold during the quarter was $26.90 million as compared to $22.31 million for quarter ended March 31, 2016. The rate on average interest-bearing liabilities increased 2 basis points to 0.98% for the three-month period ended March 31, 2017 as compared to 0.96% for the same period in 2016.

Total interest income for the three months ended March 31, 2017 was $255 thousand less than the comparable 2016 period due primarily to the decrease in loans as compared to the prior period.

The Company's total interest expense decreased by $14 thousand for the three months ended March 31, 2017 as compared to the same period in 2016.

33

During the first three months of 2017, the Company's non-interest income increased by $129 thousand over the corresponding period for 2016. During the second quarter of 2016, the Company began originating loans held for sale through its mortgage division, Highlands Home Mortgage. This division originates loans to be sold on a servicing - released basis throughout its branch footprint and also throughout North and South Carolina. Income from the gain on sale of loans totaled $226 during the first quarter of 2017. Other service charges, commissions and fees increased $57 thousand as compared to the first three months of 2016.

Total non-interest expense for the three-month period ended March 31, 2017 decreased $655 thousand from the comparable period in 2016. Salaries and employee benefits decreased $426 thousand for the three months ended March 31, 2017 as compared to the prior year period. The Company has reduced its number of employees by approximately 40 FTEs over the past 15 months.

Foreclosed property expenses and write-downs also decreased $199 for the first three months of 2017 compared to the prior period.

For the three months ended March 31, 2017, other operating expenses that exceeded 1% of total interest income and other operating income were FDIC premiums totaling $126 thousand, accounting and auditing expense totaling $69 thousand, charges for other contracted services totaling $75 thousand, software licensing and maintenance costs totaling $272 thousand, postage and freight totaling $62 thousand, other loan expense totaling $121 thousand, and bank franchise tax expense totaling $113 thousand.

For the three months ended March 31, 2016, other operating expenses that exceeded 1% of total interest income and other operating income were FDIC premiums totaling $205 thousand, charges for other contracted services totaling $154 thousand, software licensing and maintenance costs totaling $224 thousand, legal expenses totaling $89 thousand, other loan expense totaling $70 thousand, and bank franchise tax expense totaling $96 thousand.

Operating results of the Company when measured as a percentage of average equity reveals an increase in return on average equity to 7.67% for the three-month period ended March 31, 2017 from 3.87% for the corresponding period in 2016. Return on average assets for the three months ended March 31, 2017 was 0.67% compared to 0.34% for the three months ended March 31, 2016.The provision for loan losses for the three-month period ended March 31, 2017 totaled $17 thousand, a $207 thousand decrease as compared to the corresponding period in 2016. The Company continually monitors the loan portfolio for signs of credit weaknesses or developing collection problems. Loan loss provisions for each period are determined after evaluating the loan portfolio and determining the level necessary to absorb current charge-offs and maintain the reserve at adequate levels.  Net charge-offs for the first three months of 2017 were $116 thousand compared with $53 thousand for the first three months of 2016. Year–to–date net charge-offs were 0.03% and 0.01% of total loans for the periods ended March 31, 2017 and March 31, 2016, respectively. Loan loss reserves decreased 18.83% to $4.73 million at March 31, 2017 from March 31, 2016.  The Company's allowance for loan loss reserves at March 31, 2017 decreased to 1.16% of total loans versus 1.36% at March 31, 2016.  At December 31, 2016, the allowance for loan loss reserve as a percentage of total loans was 1.18%.
Financial PositionTotal loans, net of deferred fees, decreased from $428.15 million at March 31, 2016 to $409.11 million at March 31, 2017.  Total loans, net of fees, at December 31, 2016 were $409.67 million. The loan to deposit ratio decreased from 86.83% at March 31, 2016 to 82.57% at March 31, 2017. The loan to deposit ratio at December 31, 2016 was 83.63%. Deposits at March 31, 2017 have increased $2.37 million since March 31, 2016 and have increased $5.59 million since December 31, 2016. During the last several years, the Company has continued to lower the interest rates paid on time deposits in a continuing effort to reduce its cost of funds. Non-interest bearing deposits increased $6.13 million during the first quarter of 2017.

The Company currently has approximately $67.68 million in outstanding FHLB advances. No new advances were originated during the last 12 months. The Company secures all of its existing and future advances from the FHLB with a selected group of in-house residential and commercial real estate secured loans and a selected group of securities that are held in safekeeping by the FHLB.

Non-performing assets are comprised of loans on non-accrual status, loans contractually past due 90 days or more and still accruing interest, other real estate owned and repossessions. Non-performing assets were $6.19 million or 1.00% of total assets at March 31, 2017, compared with $6.77 million or 1.10% of total assets at December 31, 2016 and $14.85 million or 2.40% of total assets at March 31, 2016.  The Company continues to focus its efforts on reducing its NPAs, primarily by reducing non-accrual loans and selling OREO property.

The adequacy of the allowance for loan losses is based on management's judgment and analysis of current and historical loss experience, risk characteristics of the loan portfolio, concentrations of credit and asset quality, as well as other internal and external factors, such as general economic conditions.  The internal credit review department performs pre-approval analyses of large credits and also conducts credit review activities that provide management with an early warning of loan deterioration. The senior credit administration officer prepares quarterly analyses of the adequacy of the allowance for loan losses. These analyses include individual loans considered impaired for direct exposure. In addition, potential losses on loan pools and pool allocations are based upon historical losses and other factors, as adjusted, for various loan types. The calculation for allowance for loan losses is reviewed by the Senior Credit Officer, Chief Risk Officer, Senior Financial Officers and the Board of Directors.

At March 31, 2017 and December 31, 2016, management determined that the Company's allowance for loan losses is sufficient and is appropriate based on the requirements of U.S. Generally Accepted Accounting Principles.

At March 31, 2017, OREO balances were $2,741 and consisted of 22 relationships. At December 31, 2016 OREO balances were $2,768 and consisted of 22 relationships. The following chart details each category type, number of relationships, and balance.


OREO Property at 3/31/17
           
             
OREO Description
 
Number
   
Balance at 3/31/17
 
         
(in thousands)
 
Land Development  - Vacant Land
   
9
   
$
576
 
1-4 Family
   
6
     
334
 
Commercial Real Estate
   
7
     
1,831
 
                 
Total
   
22
   
$
2,741
 
                 
                 
OREO Property at 12/31/2016
               
                 
OREO Description
 
Number
   
Balance at 12/31/16
 
           
(in thousands)
 
Land Development  - Vacant Land
   
9
   
$
597
 
1-4 Family
   
6
     
340
 
Commercial Real Estate
   
7
     
1,831
 
                 
Total
   
22
   
$
2,768
 
                 

 
34

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


     
March 31, 2017
 
December 31, 2016
               
 
Geographic Area
 
Number
Value (in thousands)
 
Number
Value (in thousands)