10-Q 1 a2018q310-q.htm 10-Q Document


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

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

For the quarterly period ended September 30, 2018

[   ] 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  þ
 (Do not check if a smaller reporting company)
Smaller reporting company  þ
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: 8,250,728 shares of common stock, par value $0.625 per share, outstanding as of November 13, 2018.





Highlands Bankshares, Inc.
Form 10-Q
For the Quarter Ended September 30, 2018

INDEX
PAGE
 
 

2



PART I.
FINANCIAL INFORMATION
ITEM 1.  Financial Statements
Consolidated Balance Sheets
(Amounts in thousands) 
 
 
(Unaudited)
September 30, 2018
 
December 31, 2017
ASSETS
 
 
 
 
Cash and due from banks
 
$
23,258

 
$
15,179

Federal funds sold
 
791

 
15,618

Total cash and cash equivalents
 
24,049

 
30,797

Investment securities available for sale (amortized cost $73,822 at September 30, 2018, $79,990 at December 31, 2017)
 
70,149

 
78,527

Other investments, at cost
 
3,199

 
3,116

Loans held for sale
 
1,614

 
4,808

Loans
 
452,566

 
431,574

Allowance for loan losses
 
(4,226
)
 
(3,954
)
Net loans
 
448,340

 
427,620

Premises and equipment, net
 
17,687

 
18,332

Real estate held for sale
 
817

 
1,430

Deferred tax assets
 
6,984

 
7,161

Interest receivable
 
1,904

 
1,987

Bank-owned life insurance
 
14,940

 
14,679

Other real estate owned
 
2,242

 
2,350

Other assets
 
1,684

 
3,290

Total assets
 
$
593,609

 
$
594,097

LIABILITIES AND STOCKHOLDERS' EQUITY
 
 
 
 
LIABILITIES
 
 
 
 
Deposits:
 
 
 
 
Non-interest bearing
 
$
154,196

 
$
148,633

Interest bearing
 
340,410

 
350,150

Total deposits
 
494,606

 
498,783

Interest, taxes and other liabilities
 
1,937

 
1,364

Short-term borrowings
 
42,120

 
10,000

Long-term debt
 
107

 
30,146

Total liabilities
 
538,770

 
540,293

STOCKHOLDERS' EQUITY
 
 
 
 
Common stock (8,249 shares and 8,199 shares issued and outstanding at September 30, 2018 and December 31, 2017)
 
5,156

 
5,124

Preferred stock (2,092 shares issued and outstanding for each period presented)
 
4,184

 
4,184

Additional paid-in capital
 
19,246

 
19,113

Retained earnings
 
29,163

 
26,539

Accumulated other comprehensive loss
 
(2,910
)
 
(1,156
)
Total stockholders' equity
 
54,839

 
53,804

Total liabilities and stockholders' equity
 
$
593,609

 
$
594,097

 
See accompanying Notes to Consolidated Financial Statements

3



Consolidated Statements of Income
(Amounts in thousands, except per share data)
(Unaudited)
 
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
 
 
2018
 
2017
 
2018
 
2017
 
INTEREST INCOME
 
 
 
 
 
 
 
 
 
Loans receivable and fees on loans
 
$
5,558

 
$
5,207

 
$
16,149

 
$
15,258

 
Investment securities
 
434

 
521

 
1,350

 
1,675

 
Federal funds sold
 
17

 
33

 
144

 
157

 
Total interest income
 
6,009

 
5,761

 
17,643

 
17,090

 
INTEREST EXPENSE
 
 
 
 
 
 
 
 
 
Deposits
 
497

 
478

 
1,423

 
1,389

 
Other borrowed funds
 
294

 
469

 
981

 
1,655

 
Total interest expense
 
791

 
947

 
2,404

 
3,044

 
Net interest income
 
5,218

 
4,814

 
15,239

 
14,046

 
Provision for loan losses
 
198

 
19

 
542

 
71

 
Net interest income after provision for loan losses
 
5,020

 
4,795

 
14,697

 
13,975

 
NONINTEREST INCOME
 
 
 
 
 
 
 
 
 
Mortgage banking income
 
116

 
655

 
268

 
1,607

 
Securities gains, net
 

 
19

 

 
19

 
Service charges on deposit accounts
 
396

 
392

 
1,075

 
1,184

 
Other service charges, commissions and fees
 
404

 
479

 
1,251

 
1,440

 
Other operating income
 
152

 
155

 
545

 
410

 
Total noninterest income
 
1,068

 
1,700

 
3,139

 
4,660

 
NONINTEREST EXPENSE
 
 
 
 
 
 
 
 
 
Salaries and employee benefits
 
2,347

 
2,623

 
7,130

 
8,044

 
Occupancy and equipment expense
 
607

 
641

 
2,088

 
2,033

 
Foreclosed assets – write-down and operating expenses
 
89

 
69

 
366

 
263

 
Other operating expense
 
1,665

 
1,588

 
4,922

 
4,294

 
Total noninterest expense
 
4,708

 
4,921

 
14,506

 
14,634

 
Income before income taxes
 
1,380

 
1,574

 
3,330

 
4,001

 
Income tax expense (Note 5)
 
289

 
554

 
706

 
1,313

 
Net income
 
$
1,091

 
$
1,020

 
$
2,624

 
$
2,688

 
Net income per common share (Note 7)
 
 
 
 
 
 
 
 
 
Basic
 
0.13

 
0.12

 
0.32

 
0.33

 
Fully diluted
 
0.11

 
0.10

 
0.25

 
0.26

 

See accompanying Notes to Consolidated Financial Statements

4



Consolidated Statements of Comprehensive Income
(Amounts in thousands)
(Unaudited) 
 
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
 
 
2018
 
2017
 
2018
 
2017
 
Net income
 
$
1,091

 
$
1,020

 
$
2,624

 
$
2,688

 
Other comprehensive (loss) income
 
 
 
 
 
 
 
 
 
Unrealized (losses) gains on securities during the period
 
(913
)
 
141

 
(2,210
)
 
767

 
Less: reclassification adjustment
 

 
(19
)
 

 
(19
)
 
Other comprehensive (loss) income before tax
 
(913
)
 
122

 
(2,210
)
 
748

 
Income tax benefit (expense) related to other comprehensive (loss) income
 
185

 
(34
)
 
456

 
(244
)
 
Other comprehensive (loss) income
 
(728
)
 
88

 
(1,754
)
 
504

 
Comprehensive income
 
$
363

 
$
1,108

 
$
870

 
$
3,192

 

See accompanying Notes to Consolidated Financial Statements

5



Consolidated Statements of Cash Flows
(Amounts in thousands)
(Unaudited) 
 
 
Nine Months Ended September 30,
 
 
2018
 
2017
CASH FLOWS FROM OPERATING  ACTIVITIES:
 
 
 
 
Net income
 
$
2,624

 
$
2,688

Adjustments to reconcile net income to net cash provided by operating activities:
 
 

 
 

Provision for loan losses
 
542

 
71

Depreciation and amortization
 
1,161

 
764

Provision for deferred tax assets
 
633

 
1,317

Net realized gains on available for sale securities
 

 
(19
)
Restricted stock expense
 
165

 
166

Loss on sale of premises and equipment
 

 
34

Originations of loans held for sale
 
(10,661
)
 
(42,104
)
Proceeds from loans held for sale
 
13,855

 
39,074

Decrease in interest receivable
 
83

 
(63
)
Valuation adjustment of real estate held for sale
 
250

 
187

Valuation adjustment of other real estate owned
 
215

 

(Increase) decrease in other assets
 
1,345

 
(1,289
)
Increase in interest, taxes and other liabilities
 
573

 
386

Net cash provided by operating activities
 
10,785

 
1,212

CASH FLOWS FROM INVESTING ACTIVITIES:
 
 

 
 

Securities available for sale:
 
 

 
 

Proceeds from sale of securities
 

 
6,624

Proceeds from maturities of securities
 
8,405

 
14,172

Purchase of debt and equity securities
 
(2,706
)
 
(6,938
)
Redemptions of other investments
 
19

 
2,918

Net increase in loans
 
(21,728
)
 
(23,492
)
Proceeds from sales of other real estate owned
 
359

 
712

Proceeds from sale of real estate held for sale
 
378

 
250

Premises and equipment expenditures
 
(164
)
 
(1,680
)
Disposition of premises and equipment
 

 
174

Net cash used in investing activities
 
(15,437
)
 
(7,260
)
CASH FLOWS FROM FINANCING ACTIVITIES:
 
 

 
 

Net decrease in time deposits
 
(4,687
)
 
(5,180
)
Net increase in demand, savings and other deposits
 
510

 
15,402

Net change in short-term borrowings
 
2,120

 
(27,543
)
Decrease in long-term debt
 
(39
)
 

Net cash used in financing activities
 
(2,096
)
 
(17,321
)
Net change in cash and cash equivalents
 
(6,748
)
 
(23,369
)
Cash and cash equivalents at beginning of period
 
30,797

 
50,385

Cash and cash equivalents at end of period
 
$
24,049

 
$
27,016

SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION
 
 

 
 

Cash payments during the period for interest
 
$
2,376

 
$
2,981

Cash payments during the period for income taxes
 
65

 

SUPPLEMENTAL DISCLOSURE OF NONCASH TRANSACTIONS
 
 

 
 

Transfer of loans to other real estate owned
 
466

 
481

Reclassification of long-term debt to short-term borrowings
 
30,000

 

See accompanying Notes to Consolidated Financial Statements

6



Consolidated Statements of Changes in Stockholders' Equity
(Amounts in thousands)
(Unaudited)
 
 
Common stock shares
 
Common stock 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, 2016
 
8,199

 
$
5,124

 
2,092

 
$
4,184

 
$
18,891

 
$
26,785

 
$
(1,226
)
 
$
53,758

Net income
 

 

 

 

 

 
2,688

 

 
2,688

Other comprehensive income
 

 

 

 

 

 

 
491

 
491

Stock-based compensation
 

 

 

 

 
166

 

 

 
166

Balance September 30, 2017
 
8,199

 
$
5,124

 
2,092

 
$
4,184

 
$
19,057

 
$
29,473

 
$
(735
)
 
$
57,103

Balance December 31, 2017
 
8,199

 
$
5,124

 
2,092

 
$
4,184

 
$
19,113

 
$
26,539

 
$
(1,156
)
 
$
53,804

Net income
 

 

 

 

 

 
2,624

 

 
2,624

Other comprehensive loss
 

 

 

 

 

 

 
(1,754
)
 
(1,754
)
Restricted stock award
 
50

 
32

 

 

 
(32
)
 

 

 

Stock-based compensation
 

 

 

 

 
165

 

 

 
165

Balance September 30, 2018
 
8,249

 
$
5,156

 
2,092

 
$
4,184

 
$
19,246

 
$
29,163

 
$
(2,910
)
 
$
54,839

 
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, 2017 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, 2017 (the "2017 Form 10-K"). The notes included herein should be read in conjunction with the notes to consolidated financial statements included in the 2017 Form 10-K. The results of operations for the nine-month period ended September 30, 2018, 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 – 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. ASU 2014-09 is a comprehensive 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, as subsequently amended by ASU No. 2015-14 issued in August 2015, required adoption in annual reporting periods beginning after December 15, 2017, including interim reporting periods within that reporting period. Earlier application was permitted only as of annual reporting periods beginning after December 15, 2016, including interim reporting periods within that reporting period. The Company adopted ASU 2014-09 effective January 1, 2018.

Application of ASU 2014-09 requires identification of customer contracts, identification of the performance obligations within those contracts, identification of the transaction price, allocation of the transaction price to the performance obligations, and recognition of revenue once the performance obligation is satisfied. ASU 2014-09 requires disclosure regarding 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.
 
The Company’s primary source of revenue is interest income, which is excluded from the scope of this guidance; however, the Company evaluated the impact on noninterest income, which includes fees for services, commissions on sales, and various deposit service charges. The Company concluded that no cumulative-effect adjustment to retained earnings was necessary. The adoption of the standard did not have a material effect on the Company’s financial position or results of operations.

In January 2016, ASU No. 2016-01 Financial Instruments--Overall (ASU 2016-01) was issued by the FASB.  ASU 2016-01 addresses certain aspects of recognition, measurement, presentation, and disclosure of financial instruments. The Company adopted ASU 2016-01 on January 1, 2018. The adoption of ASU 2016-01 did not have a material effect on the Company's consolidated 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 continues to evaluate 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.

8



Note 3 - Investment Securities Available For Sale

The amortized cost and market value of securities available for sale are as follows:
 
 
September 30, 2018
 
 
Amortized cost
 
Gross unrealized gains
 
Gross unrealized losses
 
Fair value
State and political subdivisions
 
$
13,596

 
$
8

 
$
904

 
$
12,700

Mortgage backed securities
 
54,502

 
6

 
2,559

 
51,949

SBA pools
 
5,724

 

 
224

 
5,500

 
 
$
73,822

 
$
14

 
$
3,687

 
$
70,149


 
 
December 31, 2017
 
 
Amortized cost
 
Gross unrealized gains
 
Gross unrealized losses
 
Fair value
State and political subdivisions
 
$
12,766

 
$
44

 
$
299

 
$
12,511

Mortgage backed securities
 
60,383

 
12

 
1,088

 
59,307

SBA pools
 
6,841

 
1

 
133

 
6,709

 
 
$
79,990

 
$
57

 
$
1,520

 
$
78,527


Investment securities available for sale with a fair value of $36,168 and $26,856 at September 30, 2018 and December 31, 2017, respectively, were pledged as collateral on public deposits, FHLB advances and for other purposes as required or permitted by law.
The following table presents the age of gross unrealized losses and fair value by investment category:
 
 
September 30, 2018
 
 
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
 
$
3,696

 
$
138

 
$
8,421

 
$
767

 
$
12,117

 
$
904

Mortgage-backed securities
 
3,403

 
32

 
39,944

 
2,049

 
43,347

 
2,559

SBA pools
 
1,528

 
43

 
11,127

 
658

 
12,655

 
224

Total
 
$
8,627

 
$
213

 
$
59,492

 
$
3,474

 
$
68,119

 
$
3,687


 
 
December 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
 
$
1,744

 
$
18

 
$
7,158

 
$
281

 
$
8,902

 
$
299

Mortgage-backed securities
 
14,540

 
177

 
42,415

 
911

 
56,955

 
1,088

SBA pools
 
176

 
1

 
6,206

 
132

 
6,382

 
133

Total
 
$
16,460

 
$
196

 
$
55,779

 
$
1,324

 
$
72,239

 
$
1,520


The Company assesses its securities for OTTI quarterly by reviewing credit ratings, financial and regulatory reports as well as other pertinent published financial data. As of September 30, 2018 and December 31, 2017, the Company's assessment revealed no impairment other than that deemed temporary on those securities.

The amortized cost and estimated fair value of securities available for sale at September 30, 2018 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.

9




 
 
 
Amortized cost
 
Fair value
 
 
Investment securities with scheduled maturities:
 
 
 
 
 
Due in one year or less
 
$
98

 
$
101

 
Due after one year through five years
 
367

 
365

 
Due after five years through ten years
 
2,842

 
2,659

 
Due after ten years
 
16,013

 
15,075

 
Total investment securities with scheduled maturities
 
19,320

 
18,200

 
Mortgage-backed securities
 
54,502

 
51,949

 
Total investment securities available for sale
 
$
73,822

 
$
70,149


There were no gains or losses on the sales of investment securities during the first nine months of 2018. The following table summarizes the securities gains (losses) recognized for the period presented:
 
 
Three months ended September 30,
 
Nine months ended September 30,
 
 
2018
 
2017
 
2018
 
2017
Gross gains
 
$

 
$
32

 
$

 
$
32

Gross losses
 

 
(13
)
 

 
(13
)
Securities gains, net
 
$

 
$
19

 
$

 
$
19







Note 4  -  Loans and Allowance for Loan Losses
 The composition of net loans is as follows:
 
 
September 30, 2018
 
December 31, 2017
Real estate secured:
 
 
 
 
Residential 1-4 family
 
$
177,614

 
$
174,889

Multifamily
 
17,311

 
19,469

Construction and land loans
 
22,474

 
15,907

Commercial, owner occupied
 
90,852

 
82,121

Commercial, non-owner occupied
 
36,511

 
33,748

Second mortgages
 
4,332

 
4,684

Equity lines of credit
 
31,492

 
34,378

Farmland
 
12,535

 
13,188

Total real estate secured
 
393,121

 
378,384

Non-real estate secured
 
 
 
 
Personal
 
13,470

 
14,192

Commercial
 
43,903

 
36,785

Agricultural
 
2,756

 
2,950

Total non-real estate secured
 
60,129

 
53,927

Gross loans
 
453,250

 
432,311

Less:
 
 
 
 
Allowance for loan losses
 
4,226

 
3,954

Net deferred fees
 
684

 
737

Loans, net
 
$
448,340

 
$
427,620


10




The following table is an analysis of past due loans as of September 30, 2018:
 
 
Past Due
 
 
 
 
 
 
 
 
30-89 days
 
90 days and over
 
Total
 
Current
 
Total
 
> 90 Days and Accruing
Real estate secured
 
 
 
 
 
 
 
 
 
 
 
 
Residential 1-4 family
 
$
1,133

 
$
1,779

 
$
2,912

 
$
174,702

 
$
177,614

 
$
54

Equity lines of credit
 
75

 

 
75

 
31,417

 
31,492

 

Multifamily
 

 

 

 
17,311

 
17,311

 

Farmland
 
344

 

 
344

 
12,191

 
12,535

 

Construction, land development, other land loans
 
114

 

 
114

 
22,360

 
22,474

 

Commercial real estate:
 
 
 
 
 
 
 
 
 
 
 
 
Owner-occupied
 

 
756

 
756

 
90,096

 
90,852

 

Non-owner-occupied
 
1,862

 

 
1,862

 
34,649

 
36,511

 

Second mortgages
 

 

 

 
4,332

 
4,332

 

Non-real estate secured
 
 
 
 
 
 
 
 
 
 
 
 
Personal
 
116

 
28

 
144

 
13,326

 
13,470

 

Commercial
 
124

 
107

 
231

 
43,672

 
43,903

 
99

Agricultural
 

 

 

 
2,756

 
2,756

 

Total
 
$
3,768

 
$
2,670

 
$
6,438

 
$
446,812

 
$
453,250

 
$
153


The following table is an analysis of past due loans as of December 31, 2017:
 
 
Past Due
 
 
 
 
 
 
 
 
30-89 days
 
90 days and over
 
Total
 
Current
 
Total
 
> 90 Days and Accruing
Real estate secured
 
 
 
 
 
 
 
 
 
 
 
 
Residential 1-4 family
 
$
1,092

 
$
566

 
$
1,658

 
$
173,231

 
$
174,889

 
$

Equity lines of credit
 

 

 

 
34,378

 
34,378

 

Multifamily
 

 

 

 
19,469

 
19,469

 

Farmland
 
234

 
50

 
284

 
12,904

 
13,188

 

Construction, land development, other land loans
 

 

 

 
15,907

 
15,907

 

Commercial real estate:
 
 
 
 
 
 
 
 
 
 
 
 
Owner-occupied
 
11

 
708

 
719

 
81,402

 
82,121

 

Non-owner-occupied
 

 

 

 
33,748

 
33,748

 

Second mortgages
 

 

 

 
4,684

 
4,684

 

Non-real estate secured
 
 
 
 
 
 
 
 
 
 
 
 
Personal
 
211

 
23

 
234

 
13,958

 
14,192

 

Commercial
 
502

 
279

 
781

 
36,004

 
36,785

 
26

Agricultural
 
49

 

 
49

 
2,901

 
2,950

 

Total
 
$
2,099

 
$
1,626

 
$
3,725

 
$
428,586

 
$
432,311

 
$
26


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.

11



The following is a summary of non-accrual loans at September 30, 2018 and December 31, 2017
 
 
September 30, 2018
 
December 31, 2017
Real estate secured
 
 
 
 
Residential 1-4 family
 
$
1,726

 
$
887

Construction and land loans
 
9

 

Commercial real estate:
 
 
 
 
Owner-occupied
 
756

 
708

Non-owner-occupied
 
1,861

 

Farmland
 
142

 
193

Non-real estate secured
 
 
 
 
Personal
 
29

 
23

Commercial and agricultural
 
7

 
254

Total
 
$
4,530

 
$
2,065


The following is a summary of residential real estate currently in the process of foreclosure as well as foreclosed residential real estate as of September 30, 2018.
 
 
Number
 
Balance
Residential real estate in the process of foreclosure
 
4

 
$
786

Foreclosed residential real estate
 
5

 
480


The following tables represent a summary of credit quality indicators of the Company's loan portfolio at September 30, 2018 and December 31, 2017. 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.

The following tables provide the credit risk profile by internally assigned grade as of September 30, 2018 and December 31, 2017
September 30, 2018
 
Residential 1-4 Family
 
Multifamily
 
Farmland
 
Construction, Land Loans
 
Commercial Real Estate- Owner Occupied
 
Commercial Real Estate Non-Owner Occupied
Quality
 
$
40,297

 
$

 
$

 
$
2,451

 
$
3,317

 
$
817

Satisfactory
 
87,693

 
7,764

 
3,134

 
6,104

 
36,029

 
12,543

Acceptable
 
40,782

 
9,145

 
3,567

 
12,275

 
44,509

 
17,496

Special Mention
 
1,705

 
402

 
3,142

 
1,565

 
2,745

 
3,647

Substandard
 
7,137

 

 
2,692

 
79

 
4,252

 
2,008

Doubtful
 

 

 

 

 

 

Total
 
$
177,614

 
$
17,311

 
$
12,535

 
$
22,474

 
$
90,852

 
$
36,511

December 31, 2017
 
Residential 1-4 Family
 
Multifamily
 
Farmland
 
Construction, Land Loans
 
Commercial Real Estate- Owner Occupied
 
Commercial Real Estate Non-Owner Occupied
Quality
 
$
33,107

 
$

 
$
13

 
$
2,870

 
$
3,535

 
$
295

Satisfactory
 
95,659

 
10,653

 
4,419

 
5,445

 
45,906

 
13,602

Acceptable
 
40,487

 
8,816

 
3,333

 
5,906

 
28,344

 
15,609

Special Mention
 
388

 

 
3,206

 
1,565

 
2,542

 
2,226

Substandard
 
5,248

 

 
2,217

 
121

 
1,661

 
2,016

Doubtful
 

 

 

 

 
133

 

Total
 
$
174,889

 
$
19,469

 
$
13,188

 
$
15,907

 
$
82,121

 
$
33,748


12




Explanation of credit grades:
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.  
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

13



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.
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 September 30, 2018:

 
 
Consumer - Non Real Estate
 
Equity Line of Credit /Second Mortgages
 
Commercial - Non Real Estate
 
Agricultural - Non Real Estate
Performing
 
$
13,442

 
$
35,824

 
$
43,796

 
$
2,756

Nonperforming (>90 days past due)
 
28

 

 
107

 

Total
 
$
13,470

 
$
35,824

 
$
43,903

 
$
2,756


Credit Risk Profile based on payment activity as of December 31, 2017:

 
 
Consumer - Non Real Estate
 
Equity Line of Credit /Second Mortgages
 
Commercial - Non Real Estate
 
Agricultural - Non Real Estate
Performing
 
$
14,169

 
$
39,062

 
$
36,506

 
$
2,950

Nonperforming (>90 days past due)
 
23

 

 
279

 

Total
 
$
14,192

 
$
39,062

 
$
36,785

 
$
2,950


14




The following tables reflect the Bank's impaired loans at September 30, 2018:
September 30, 2018
 
Recorded Investment
 
Unpaid Principal Balance
 
Related Allowance
 
Average Recorded Investment
 
Interest Income Recognized
With no related allowance
 
 
 
 
 
 
 
 
Real estate secured
 
 
 
 
 
 
 
 
 
 
Residential 1-4 family
 
$
5,188

 
$
5,188

 
$

 
$
5,943

 
$
525

Equity lines of credit
 
33

 
33

 

 
38

 

Multifamily
 

 

 

 

 

Farmland
 
2,577

 
2,577

 

 
1,198

 

Construction, land development, other land loans
 
1,635

 
1,635

 

 
1,678

 

Commercial real estate- owner occupied
 
4,404

 
4,404

 

 
2,375

 

Commercial real estate- non owner occupied
 

 

 

 
16

 
36

Second mortgages
 

 

 

 
83

 

Non-real estate secured
 
 

 
 
 
 
 
 
 
 
Personal
 

 

 

 
24

 
4

Commercial and agricultural
 
1,324

 
1,324

 

 
996

 
2

Total
 
$
15,161

 
$
15,161

 
$

 
$
12,351

 
$
567


September 30, 2018
 
Recorded Investment
 
Unpaid Principal Balance
 
Related Allowance
 
Average Recorded Investment
 
Interest Income Recognized
With an allowance recorded
 
 
 
 
 
 
 
 
Real estate secured
 
 
 
 
 
 
 
 
 
 
Residential 1-4 family
 
$
1,719

 
$
1,719

 
$
202

 
$
891

 
$

Equity lines of credit
 
77

 
77

 
165

 
19

 

Multifamily
 

 

 

 

 

Farmland
 
166

 
166

 
4

 
1,233

 

Construction, land development, other land loans
 
31

 
31

 

 
8

 

Commercial real estate- owner occupied
 
1,745

 
1,745

 
354

 
1,686

 

Commercial real estate- non owner occupied
 
3,540

 
3,540

 
847

 
3,292

 

Second mortgages
 

 

 

 

 

Non-real estate secured
 
 
 
 
 
 
 
 
 
 
Personal
 
1

 
1

 
1

 
6

 

Commercial and agricultural
 
397

 
397

 
264

 
973

 

Total
 
$
7,676

 
$
7,676

 
$
1,837

 
$
8,108

 
$



15




The following tables reflect the Bank's impaired loans at December 31, 2017:
December 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
 
$
7,398

 
$
7,398

 
$

 
$
6,123

 
$
279

Equity lines of credit
 
49

 
49

 

 
37

 

Multifamily
 

 

 

 
495

 
56

Farmland
 
486

 
486

 

 
586

 
42

Construction, land development, other land loans
 
1,765

 
1,765

 

 
1,753

 
67

Commercial real estate- owner occupied
 
1,552

 
1,552

 

 
3,677

 
22

Commercial real estate- non owner occupied
 
63

 
63

 

 
973

 
19

Second mortgages
 
209

 
209

 

 
198

 
3

Non real estate secured
 
 
 
 
 
 
 
 
 
 
Personal
 
95

 
95

 

 
55

 

Commercial and agricultural
 
504

 
504

 

 
274

 

Total
 
$
12,121

 
$
12,121

 
$

 
$
14,171

 
$
488


December 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
 
$
74

 
$
74

 
$
11

 
$
267

 
$
24

Equity lines of credit
 

 

 

 

 

Multifamily
 

 

 

 

 

Farmland
 
1,731

 
1,731

 
257

 
962

 
13

Construction, land development, other land loans
 

 

 

 
183

 
24

Commercial real estate- owner occupied
 
1,873

 
1,873

 
465

 
1,506

 
196

Commercial real estate- non owner occupied
 
3,892

 
3,892

 
955

 
2,951

 
141

Second mortgages
 

 

 

 
9

 

Non real estate secured
 
 
 
 
 
 
 
 
 
 
Personal
 
2

 
2

 
2

 
27

 

Commercial and agricultural
 
502

 
502

 
418

 
568

 
4

Total
 
$
8,074

 
$
8,074

 
$
2,108

 
$
6,473

 
$
402




16



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 and for the three- and nine- month periods ended September 30, 2018 and September 30, 2017.

Nine months ended September 30, 2018
 
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 loan losses:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Balance at December 31,  2017
 
$
133

 
$

 
$
1

 
$
1,636

 
$
955

 
$
12

 
$

 
$
54

 
$
265

 
$
383

 
$
515

 
$
3,954

Provision expense (credit) for credit losses
 
254

 

 
(5
)
 
(86
)
 
(108
)
 
(11
)
 
490

 
(51
)
 
18

 
(68
)
 
109

 
542

Charge-offs
 
80

 

 

 
123

 

 
5

 

 
1

 
224

 
231

 

 
664

Recoveries
 
(38
)
 

 
(5
)
 
(18
)
 

 
(5
)
 
(1
)
 
(2
)
 
(127
)
 
(198
)
 

 
(394
)
Net charge-offs (recoveries)
 
42

 

 
(5
)
 
105

 

 

 
(1
)
 
(1
)
 
97

 
33

 

 
270

Balance at September 30, 2018
 
$
345

 
$

 
$
1

 
$
1,445

 
$
847

 
$
1

 
$
491

 
$
4

 
$
186

 
$
282

 
$
624

 
$
4,226

Allowance allocated by impairment method:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Individually evaluated
 
$
202

 
$

 
$

 
$
354

 
$
847

 
$

 
$
165

 
$
4

 
$
1

 
$
264

 
$

 
$
1,837

Collectively evaluated
 
143

 

 
1

 
1,091

 

 
1

 
326

 

 
185

 
18

 
624

 
2,389

Loan balances by impairment method used:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Individually evaluated
 
$
6,907

 
$

 
$
1,667

 
$
6,149

 
$
3,539

 
$

 
$
110

 
$
2,744

 
$
1

 
$
1,720

 
$

 
$
22,837

Collectively evaluated
 
170,707

 
17,311

 
20,807

 
84,703

 
32,972

 
4,332

 
31,382

 
9,791

 
13,469

 
44,939

 

 
430,413

Balance at September 30, 2018
 
$
177,614

 
$
17,311

 
$
22,474

 
$
90,852

 
$
36,511

 
$
4,332

 
$
31,492

 
$
12,535

 
$
13,470

 
$
46,659

 

 
$
453,250

Three months ended September 30, 2018
 
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 loan losses:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Balance at June 30, 2018
 
$
230

 
$

 
$
58

 
$
993

 
$
397

 
$
1

 
$
357

 
$
296

 
$
216

 
$
643

 
$
947

 
$
4,138

Provision for credit losses
 
166

 

 
(60
)
 
478

 
450

 
(1
)
 
134

 
(292
)
 
20

 
(374
)
 
(323
)
 
198

Charge-offs
 
55

 

 

 
27

 

 

 

 

 
91

 
4

 

 
177

Recoveries
 
(4
)
 

 
(3
)
 
(1
)
 

 
(1
)
 

 

 
(41
)
 
(17
)
 

 
(67
)
Net charge-offs (recoveries)
 
51

 

 
(3
)
 
26

 

 
(1
)
 

 

 
50

 
(13
)
 

 
110

Balance at
 September 30, 2018
 
$
345

 
$

 
$
1

 
$
1,445

 
$
847

 
$
1

 
$
491

 
$
4

 
$
186

 
$
282

 
$
624

 
$
4,226


17




Nine months ended September 30, 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 loan losses:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Balance at December 31, 2016
 
$
371

 
$

 
$
21

 
$
1,339

 
$
445

 
$
15

 
$
27

 
$
16

 
$
802

 
$
535

 
$
1,258

 
$
4,829

Provision for credit losses
 
(92
)
 

 
(24
)
 
1,139

 
568

 
(14
)
 
(27
)
 
39

 
(195
)
 
(204
)
 
(1,119
)
 
71

Charge-offs
 
40

 

 

 
100

 

 

 

 

 
255

 
331

 

 
726

Recoveries
 
(27
)
 

 
(3
)
 

 
(1
)
 
(1
)
 

 
(2
)
 
(158
)
 
(424
)
 

 
(616
)
Net charge-offs (recoveries)
 
13

 

 
(3
)
 
100

 
(1
)
 
(1
)
 

 
(2
)
 
97

 
(93
)
 

 
110

Reclassification of reserve for unfunded commitments
 

 

 

 

 

 

 

 

 

 

 
(97
)
 
(97
)
Balance at September 30, 2017
 
$
266

 
$

 
$

 
$
2,378

 
$
1,014

 
$
2

 
$

 
$
57

 
$
510

 
$
424

 
$
42

 
$
4,693

Allowance allocated by impairment method:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Individually evaluated
 
$
28

 
$

 
$

 
$
1,698

 
$
1,014

 
$

 
$

 
$
57

 
$

 
$
409

 
$

 
$
3,206

Collectively evaluated
 
238

 

 

 
680

 

 
2

 

 

 
510

 
15

 
42

 
1,487

Loan balances by impairment method used:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Individually evaluated
 
$
5,260

 
$
1,101

 
$
142

 
$
5,939

 
$
3,510

 
$
190

 
$

 
$
835

 
$
80

 
$
479

 
$

 
$
17,536

Collectively evaluated
 
175,209

 
25,082

 
14,497

 
68,294

 
29,958

 
5,108

 
31,307

 
12,586

 
15,693

 
37,926

 

 
415,660

Balance at September 30, 2017
 
$
180,469

 
$
26,183

 
$
14,639

 
$
74,233

 
$
33,468

 
$
5,298

 
$
31,307

 
$
13,421

 
$
15,773

 
$
38,405

 

 
$
433,196



18



Three months ended September 30, 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 loan losses:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Balance at June 30, 2017
 
$
295

 
$

 
$

 
$
1,979

 
$
1,116

 
$
2

 
$
32

 
$
19

 
$
522

 
$
541

 
$
165

 
$
4,671

Provision for credit losses
 
(29
)
 

 
(1
)
 
499

 
(101
)
 
(1
)
 
(32
)
 
37

 
22

 
(349
)
 
(26
)
 
19

Charge-offs
 
4

 

 

 
100

 
1

 

 

 

 
129

 
138

 

 
371

Recoveries
 
(4
)
 

 
(1
)
 

 

 
(1
)
 

 

 
(95
)
 
(370
)
 

 
(471
)
Net charge-offs (recoveries)
 

 

 
(1
)
 
100

 
1

 
(1
)
 

 

 
34

 
(232
)
 

 
(100
)
Reclassification of reserve for unfunded commitments
 

 

 

 

 

 

 

 

 

 

 
(97
)
 
(97
)
Balance at
 September 30, 2017
 
$
266

 
$

 
$

 
$
2,378

 
$
1,014

 
$
2

 
$

 
$
57

 
$
510

 
$
424

 
$
42

 
$
4,693


19



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 $11,937 and $8,005 of loans categorized as troubled debt restructurings as of September 30, 2018 and December 31, 2017, 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 table identifies restructurings completed during the nine-month period ended September 30, 2018 that represent new TDRs.
 
Number
Pre-Modification Recorded Investment
Post-Modification Recorded Investment
Below Market Rate
 
 
 
Residential 1-4 family
3

$
549

$
549

Farmland
1

115

115

Commercial real estate-owner occupied
2

1,023

1,023

Commercial real estate-non-owner occupied
4

2,524

2,524

Total below market rate
10

4,211

4,211

Total restructurings
10

$
4,211

$
4,211

 
There were no new TDRs in the nine-month period ended September 30, 2017. There were no defaults in the three- or nine- month periods ending September 30, 2018 and September 30, 2017 of TDRs modified in the previous 12 months.
 
 
 
 
The Bank has engaged an external third party to perform its loan review function in order to identify weaknesses within the loan portfolio. The review, which seeks to cover 50 percent of loan balances each year, considers collateral, repayment history, guarantor strength, debt service coverage, and other relevant information on an individual and global level. These reviews consider borrower cash flow capacity, using financial statements, income tax returns and internally prepared interim statements for borrowers and guarantors. 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 properly secured. Collateral is discounted, when appropriate, to determine a stressed loan to value (LTV) ratio. 
The Company also seeks to identify potential problem relationships through a monthly watch list review, which includes a review of past due loans, as well as any other information that might be presented by loan officers, regarding a particular loan relationship that is exhibiting stress. Watch list relationships display distinct characteristics including, but 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 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

20



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.

A loan is considered impaired and an allowance for loan losses is established on loans for which it is probable that the full collection of principal and interest is in doubt. Once a loan is identified as individually impaired, management measures impairment using one of several methods, including collateral value based on recent appraisal and /or tax assessment value, liquidation value and/or discounted cash flows. Those impaired loans not requiring an allowance represent loans for which the fair value of the expected repayments or collateral exceed the recorded investments in such loans. At September 30, 2018 and December 31, 2017, all impaired loans were evaluated based on either the fair value of the collateral or the discounted cash flows.

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

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

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

Historical loss factors - 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 .

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:

National GDP growth rate
Local unemployment rates
Prime interest rate

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

21




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

Past-due loans
Non-accrual loans
Commercial real estate concentrations
Loan volume, including significant loan growth among specific classes of loans
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 management. The ALLL is then reviewed by the Board of Directors.

Loans Held for Sale

The Company's mortgage division originates certain single family, residential first mortgage loans for sale to a third party broker. Loan sale activity is summarized below. Loans are typically sold to investors within 20 days of closing. Management feels the carrying amounts approximate the fair values of loans held for sale.
 
 
Nine months ended September 30
 
 
2018
 
2017
Loans held for sale at end of period
 
$
1,614

 
$
4,285

Proceeds from sales of mortgage loans originated for sale
 
13,855

 
39,074

Gain on sales of mortgage loans originated for sale
 
268

 
1,607



Note 5  -  Income Taxes

Income tax expense for the three- and nine-month periods ended September 30, is different than the amount computed by applying the appropriate statutory corporate federal income tax rate to income before taxes. The reasons for these differences are as follows:

 
 
Three months ended September 30,
 
Nine months ended September 30,
 
 
2018
 
2017
 
2018
 
2017
Tax expense (benefit) at statutory rate
 
$
290

 
$
535

 
$
699

 
$
1,360

Increase (decrease) in tax expense resulting from:
 
 
 
 
 
 
 
 
Tax-exempt interest
 
(27
)
 
(29
)
 
(85
)
 
(58
)
Other, net
 
26

 
48

 
92

 
11

Income tax expense
 
$
289

 
$
554

 
$
706

 
$
1,313

Statutory corporate federal income tax rate
 
21
%
 
34
%
 
21
%
 
34
%



Note 6  - 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 improve the banking sector's ability to absorb shocks arising from financial and economic stress. The final rules include a new common equity tier 1 minimum ratio and raise the tier 1 risk-weighted assets ratio to 6 percent from 4 percent. In addition, beginning in 2016, the new rules required banks to maintain a capital conservation buffer between 2 and 2 ½ %. Additionally, the new rules increased the risk weighting of various assets. The new rules are being phased in between 2015 and 2019. Generally, the Basel III final rules require banks to maintain higher levels of common equity and regulatory capital.


22



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 table presents the capital ratios for the Bank only.
 
 
September 30, 2018
 
December 31, 2017
 
Tier 1 leverage
 
9.14
%
 
8.36
%
 
Tier 1 risk-based
 
12.30
%
 
12.15
%
 
Total risk-based
 
13.28
%
 
13.11
%
 
Common equity tier 1
 
12.30
%
 
12.15
%
 



Note 7 – Stock and Earnings Per Share

Earnings per common share is computed using the weighted average outstanding shares for the three- and nine month periods ended September 30, 2018 and 2017. The following is a reconciliation of the numerators and the denominators of the basic and diluted earnings per common share computation:
 
 
Three months ended September 30,
 
Nine months ended September 30,
 
(thousands, except per share information)
 
2018
 
2017
 
2018
 
2017
 
Net income available to common stockholders
 
$
1,091

 
$
1,020

 
$
2,624

 
$
2,688

 
Weighted average common shares outstanding
 
8,211

 
8,199

 
8,224

 
8,199

 
Total shares outstanding including assumed conversion of preferred securities
 
10,303

 
10,292

 
10,326

 
10,292

 
Basic earnings per common share
 
$
0.13

 
$
0.12

 
$
0.32

 
$
0.33

 
Fully diluted earnings per share (including convertible preferred shares outstanding and restricted stock)
 
0.11

 
0.10

 
0.25

 
0.26

 
At the 2018 annual meeting, Stockholders approved the 2018 Restricted Stock Plan, which authorized the board's Compensation Committee to issue up to 250,000 shares of Common Stock in grants of restricted stock and restricted stock unit awards to eligible employees. A total of 51,500 shares have been issued under the 2018 Restricted Stock Plan as of September 30, 2018.

Note 8 – Commitments and Contingencies

The Bank is a party to various financial instruments with off-balance sheet risk arising in the normal course of business to meet the financing needs of its customers. Those financial instruments include commitments to extend credit and standby letters of credit.
At September 30, 2018, unused commitments totaled $59,548, compared to $55,038 at December 31, 2017. Standby letters of credit totaled $973 at September 30, 2018 and December 31, 2017.


Note 9 – 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 financial instruments at fair value 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.

23




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 determine fair value. These adjustments may include amounts to reflect counterparty credit quality, the borrower'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.

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

The following tables summarize the Company's available for sale securities portfolio measured at fair value on a recurring basis as of September 30, 2018 and December 31, 2017, segregated by the level of the valuation inputs within the fair value hierarchy.
September 30, 2018
 
 
Level 1
 
Level 2
 
Level 3
 
Total Fair Value
 
 
 
 
 
 
 
 
 
State and political subdivisions
 
$

 
$
12,700

 
$

 
$
12,700

Mortgage backed securities
 

 
51,949

 

 
51,949

SBA pools
 

 
5,500

 

 
5,500

Total available for sale securities
 
$

 
$
70,149

 
$

 
$
70,149

December 31, 2017
 
 
Level 1
 
Level 2
 
Level 3
 
Total Fair Value
 
 
 
 
 
 
 
 
 
State and political subdivisions
 
$

 
$
12,511

 
$

 
$
12,511

Mortgage backed securities
 

 
59,307

 

 
59,307

SBA pools
 

 
6,709

 

 
6,709

Total available for sale securities
 
$

 
$
78,527

 
$

 
$
78,527


Recurring - Derivatives
Beginning in 2017, the Company entered into interest rate swaps related to customer loan transactions to manage its interest rate risk. These interest rate swaps, which had a notional value of $12,890 and $7,902 as of September 30, 2018 and December 31, 2017, respectively, are recorded at fair value, based on third party pricing models that are sensitive to market observable data and are therefore classified as level 2 values. The fair value of derivative financial instruments as of September 30, 2018 totaled $216, compared to $45 at December 31, 2017.


24



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 loss is established. Loans for which it is probable that payment of interest and principal will not be made in accordance with the contractual terms of the loan agreement are considered impaired. Once a loan is identified as individually impaired, management measures impairment using one of several methods, including recently appraised collateral value and /or tax assessed value, liquidation value and discounted cash flows. Those impaired loans not requiring an allowance represent loans for which the fair value of the expected repayments or collateral exceed the recorded investments in such loans. At September 30, 2018 and December 31, 2017, 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 inputs derived from secondary markets for loans with similar characteristics. The Company considers loans held for sale as non-recurring 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 or is further discounted below the most recent appraised value less selling costs due to 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 September 30, 2018 and December 31, 2017, segregated by the level of the valuation inputs within the fair value hierarchy. The tables disclose the recorded investment of impaired loans requiring a specific allowance.
September 30, 2018
 
Level 1
 
Level 2
 
Level 3
 
Fair Value
Impaired loans
 
$

 
$

 
$
5,839

 
$
5,839

OREO
 

 

 
2,242

 
2,242

Real estate held for sale
 

 

 
817

 
817

December 31, 2017
 
Level 1
 
Level 2
 
Level 3
 
Fair Value
Impaired loans
 
$

 
$

 
$
5,967

 
$
5,967

OREO
 

 

 
2,350

 
2,350

Real estate held for sale
 

 

 
1,430

 
1,430



25



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
 
 
12/31/17
 
9/30/2018
 
Valuation
Techniques
 
Unobservable
Input (2)
 
Range
(Weighted Average)
OREO, net
 
$
2,350

 
$
2,242

 
Appraisal of collateral (1)
 
Appraisal adjustments
 
0% to 45% (13%)
 
 

 
 

 
 
 
Liquidation expenses
 
0% to 10% (9%)
Real estate held for sale
 
$
1,430

 
$
817

 
Appraisal of collateral (1)
 
Appraisal adjustments
 
0% to 50% (40%)
 
 
 
 
 
 
 
Liquidation expenses
 
0% to 10% (8%)
Impaired loans
 
$
5,967

 
$
5,839

 
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 20% (12%)

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.


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.

26




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.

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

The carrying amounts and fair values of the Company's financial instruments at September 30, 2018 and December 31, 2017 were as follows:
 
 
September 30, 2018
 
December 31, 2017
 
 
Carrying Amount
 
Fair Value
 
Carrying Amount
 
Fair Value
Cash and cash equivalents
 
$
24,049

 
$
24,049

 
$
30,797

 
$
30,797

Securities available for sale
 
70,149

 
70,149

 
78,527

 
78,527

Other investments
 
3,199

 
3,199

 
3,116

 
3,116

Loans, net
 
448,340

 
441,706

 
427,620

 
429,467

Interest rate swaps
 
216

 
216

 
45

 
45

Deposits
 
494,606

 
405,899

 
498,783

 
424,664

Other short-term borrowings
 
42,120

 
42,120

 
10,000

 
10,000

Long-term debt
 
107

 
81

 
30,243

 
30,780




27



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 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.


28




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. Asset quality affects the amount of interest income lost on non-accrual loans and the amount of 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, 2017.


Results of Operations

Consolidated net income totaled $1.1 million for the three-month period ended September 30, 2018, compared to $1.0 million for the three-month period ended September 30, 2017. Consolidated net income was $2.6 million and $2.7 million for the nine-month periods ended September 30, 2018 and September 30, 2017.

The following table provides summarized income statements for the three- and nine-month periods ended September 30, 2018 and September 30, 2017.
 
 
Three months ended September 30,
 
Nine months ended September 30,
 
 
 
2018
 
2017
 
2018
 
2017
 
Net interest income
 
$
5,218

 
$
4,814

 
$
15,239

 
$
14,046

 
Provision expense
 
198

 
19

 
542

 
71

 
Noninterest income
 
1,068

 
1,700

 
3,139

 
4,660

 
Noninterest expense
 
4,708

 
4,921

 
14,506

 
14,634

 
Income before income taxes
 
1,380

 
1,574

 
3,330

 
4,001

 
Income tax expense
 
289

 
554

 
706

 
1,313

 
Net income
 
$
1,091

 
$
1,020

 
$
2,624

 
$
2,688

 

Comparison of Third Quarter 2018 to Third Quarter 2017

Net interest income for the three-month period ended September 30, 2018 increased $404,000 or 8.4 percent compared to the three months ended September 30, 2017 primarily due to improved loan interest income and lower FHLB interest expense, partially offset by lower investment interest income. 

Average loan balances for the three months ended September 30, 2018 increased $23.0 million or 5.6 percent compared to the three month period ended September 30, 2017. Average securities balances declined $23.6 million or 23.8 percent during the

29



same period. The yield on average interest-earning assets was 4.57 percent for the three-month period ended September 30, 2018 compared to 4.24 percent in the same period of 2017

Average interest-bearing liabilities decreased $41.5 million for the three months ended September 30, 2018,when compared to the same period of 2017 due to repayments of FHLB advances. The average rate on interest-bearing liabilities declined from 0.99 percent in the three month period ended September 30, 2017, to 0.83 percent for the three months ended September 30, 2018 due to FHLB advance repayment and changes in deposit mix.

The net interest margin improved from 3.57 percent in the three month period ended September 30, 2017, to 3.97 percent for the three months ended September 30, 2018, the combined impact of repayment of the FHLB advances, favorable changes in both asset mix and liability mix, and higher market rates.

The provision for loan losses for the three-month period ended September 30, 2018 totaled $198,000, compared to $19,000 during the corresponding period of 2017. Net charge-offs for the three-month period ended September 30, 2018 totaled $110,000 compared to net recoveries of $100,000 recorded during the same period of 2017. Net charge-offs during the third quarter of 2018 represent 0.10 percent of loans outstanding.

During the third quarter of 2018, noninterest income decreased $632,000 compared to the corresponding period for 2017, primarily due to lower mortgage banking income. Income from the gain on sale of loans totaled $116,000 during the third quarter of 2018, compared to $655,000 during the same period of 2017. The Company's mortgage division originates loans to be sold on a servicing-released basis through its branch footprint and in North and South Carolina. During late 2017, the Company transitioned its mortgage banking operation from a correspondent basis to a broker, which has resulted in narrower margins on originated loans, but has also contributed to lower noninterest expenses associated with the mortgage banking operation. Due to softening demand for closed-end residential mortgage loans, the Company also reduced the size of the mortgage origination staff, further contributing to the reduction in noninterest income. Other service charges, commissions and fees decreased $75,000 as compared to the same period of 2017, primarily due to lower financial services income.

Total noninterest expense for the three-month period ended September 30, 2018 decreased $213,000 from the comparable period in 2017, due to reductions in salaries and employee benefits and various other operating expenses resulting from the changes in the mortgage division. Salaries and employee benefits decreased $276,000 for the three months ended September 30, 2018 as compared to the prior year period, resulting from the changes in the mortgage division. The favorable benefit of these reductions was partially offset by a $175,000 writedown of real estate held for sale, higher OREO-related expenses and legal expense.

The annualized return on average equity was 7.94 percent for the three-month period ended September 30, 2018, compared to 7.25 percent for the corresponding period of 2017. Annualized return on average assets for the three months ended September 30, 2018 was 0.74 percent compared to 0.68 percent for the three months ended September 30, 2017. While both operating ratios remain below peer averages, the improvements reflect ongoing efforts to achieve stable and increasing profitability. The Company continues to identify and implement strategies to improve core operating results.

Comparison of Year-to-Date 2018 to Year-to-Date 2017
Net interest income increased $1.2 million during the first nine months of 2018 when compared to the same period of 2017, the net result of higher loan interest income and lower FHLB interest expense, partially offset by lower investment interest income resulting from a reduction in the investment securities portfolio.

The provision for loan losses was $542,000 during the first nine months of 2018, compared to $71,000 during the same period of 2017. Higher provision expense during 2018 results from exposures associated with recent loan growth, particularly construction and commercial loans. Net charge-offs for the first nine months of 2018 totaled $270,000 or 0.08 percent of loans held for investment, compared to $110,000 during the same period of 2017.

Noninterest income declined $1.5 million during the first nine months of 2018, primarily due to a $1.3 million reduction in mortgage income resulting from the reorganization and shrinkage of the mortgage division. Service charge income declined $109,000 due to lower NSF income, while other service charges and fees declined $189,000 primarily due to lower financial services income.

Noninterest expense decreased $128,000 during the first nine months of 2018, when compared to the same period of 2017. Salaries and employee benefits declined $914,000 during the first nine months of 2018, the result of earlier workforce reductions and the more recent reorganization within the mortgage division, net of higher health care costs. Occupancy expense increased $55,000 due to higher depreciation and insurance expense. OREO-related expenses increased $103,000 due to writedowns resulting from updated appraisals and losses recorded upon liquidation of foreclosed properties. Other noninterest expense increased $628,000

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during the first nine months of 2018, which includes $235,000 of writedowns of real estate held for sale. Other noninterest expense also increased due to higher legal expense and software-related expenses, partially offset by lower telephone expense.

Income tax expense declined $607,000 during the first nine months of 2018 due to a reduction in the federal corporate tax rate and lower pre-tax income.

The annualized return on average equity was 6.48 percent for the nine-month period ended September 30, 2018, compared to 7.25 percent for the corresponding period of 2017. Annualized return on average assets for the nine months ended September 30, 2018 was 0.60 percent compared to 0.68 percent for the nine months ended September 30, 2017. While both operating ratios are below peer averages, the Company continues to identify strategies to improve core operating results.


Financial Position

Investment securities available for sale totaled $70.1 million at September 30, 2018, compared to $78.5 million at December 31, 2017. Investment securities available for sale at September 30, 2018 were comprised of mortgage backed securities/CMOs (74.1 percent of the total securities portfolio), municipal issues (18.1 percent), and SBAs pools (7.8 percent).  There were no investment securities held to maturity at September 30, 2018 or December 31, 2017.

Other investments include investments in the Federal Reserve Bank of Richmond, Federal Home Loan Bank of Atlanta, Pacific Coast Bankers Bank, and Community Bankers Bank. These investments had a carrying value of $3.2 million at September 30, 2018, and are considered to be non-marketable as the Company is required to hold these investments and the only market for these investments is the issuer.

Loans, net of deferred fees, totaled $452.6 million at September 30, 2018, compared to $431.6 million at December 31, 2017. After relatively weak loan demand during the prior two quarters, the Company experienced renewed growth among commercial loans and equity lines of credit, partially offset by declines in 1-4 family residential mortgage loans and personal loans, during the second and third quarters of 2018.

Deposits at September 30, 2018 totaled $494.6 million, a $4.2 million reduction since December 31, 2017. Despite the reduction in total deposits during 2018, the Company has experienced growth among noninterest bearing deposits, which have increased $5.6 million since December 31, 2017.

The Company's loan to deposit ratio was 91.5 percent at September 30, 2018 compared to 86.5 percent at December 31, 2017, reflecting the combined impact of loan growth and a smaller balance sheet following repayment of the FHLB advances during the first quarter.

As of September 30, 2018, the Company has $42.1 million in short-term borrowings, primarily FHLB advances with scheduled maturities within the next twelve months. During the first quarter of 2018, the Company elected to utilize existing liquidity to repay $10.0 million of FHLB advances prior to their scheduled maturity during the third quarter of 2018. The Company secures all of its existing and future advances from the FHLB with 1-4 family residential mortgage, commercial real estate, equity lines of credit and multi-family loans.

Non-performing assets include non-accrual loans, loans contractually past due 90 days or more and still accruing interest and other real estate owned. Non-performing assets were $6.8 million or 1.49 percent of loans held for investment and OREO at September 30, 2018, compared to $4.4 million or 1.02 percent of loans held for investment and OREO at December 31, 2017.  The $2.3 million increase in nonperforming assets since December 31, 2017 reflects a significant increase in non-accrual loans primarily resulting from a large, isolated borrower that reached 90-day delinquency status during the second quarter and was therefore placed on non-accrual status. Notwithstanding the recent increase in nonperforming assets, the Company continues its efforts to manage non-accrual exposures and liquidate other real estate owned.

At September 30, 2018, other real estate owned totaled $2.2 million and consisted of 16 relationships. At December 31, 2017 OREO balances were $2.4 million and consisted of 15 relationships. The following chart details each category type, number of relationships, and balance.

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September 30, 2018
 
December 31, 2017
 
Balance in thousands
 
Number
 
Balance
 
Number
 
Balance
 
Land development/vacant land
 
8

 
$
308

 
10

 
$
663

 
1-4 family residential mortgage
 
5

 
481

 
2

 
142

 
Commercial real estate
 
3

 
1,453

 
3

 
1,545

 
Total
 
16

 
$
2,242

 
15

 
$
2,350

 
 
 
 

 
 

 
 
 
 
 

The Company's major markets include: Southwestern Virginia; the Tri-City region of Eastern Tennessee; Sevierville and Knoxville, Tennessee; and Boone/Banner Elk, North Carolina. The following table provides information about properties owned in each geographic area, the number of individual properties and book value.
 
 
September 30, 2018
 
December 31, 2017
 
Balance in thousands
 
Number
 
Balance
 
Number
 
Balance
 
Sevierville and Knoxville TN Area
 
1

 
$
71

 
1

 
$
71

 
Southwest VA and Tri-city TN Area
 
13

 
2,119

 
12

 
2,209

 
Boone and Banner Elk NC Area
 
2

 
52

 
2

 
70

 
Total
 
16

 
$
2,242

 
15

 
$
2,350

 

As of September 30, 2018, the Company had loans with a total balance of $2.8 million that were in process of foreclosure. The Company expects the balance of other real estate owned will increase significantly during the fourth quarter as these foreclosures occur. The Company believes the loans are generally well-secured, and any anticipated deficiencies in collateral values are offset by specific loan allowances that have been previously established. However, the ability to sell other real estate owned continues to be negatively affected by limited demand in certain of the Company's market areas, and future appraisal values may require additional writedowns once the properties are foreclosed.

The allowance for loan losses is calculated 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, including general economic conditions. The calculation of the allowance for loan losses is reviewed by the senior credit officers, the chief risk officer, senior financial officers and the board of directors.

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. The Company's allowance for loan losses at September 30, 2018 was 0.93 percent of total loans compared to 0.92 percent at December 31, 2017 and 1.09 percent at September 30, 2017. The reduction in the allowance for loan losses since September 30, 2017 reflects the impact of charge-offs of previously impaired loans recorded during late 2017. At September 30, 2018, management concluded that the Company's allowance for loan losses is adequate based on the requirements of accounting principles generally accepted in the United States of America.


Liquidity and Capital Resources

Total stockholders' equity of the Company was $54.8 million at September 30, 2018, compared to $53.8 million at December 31, 2017. The change in stockholders' equity during 2018 reflects current retained earnings, net of an increase in accumulated other comprehensive loss related to the market value of the Company's available for sale securities portfolio.

Quantitative measures established by regulation to ensure capital adequacy require the Bank to maintain minimum amounts and ratios of total risk-based capital and tier 1 capital to risk-weighted assets (as defined in the regulations), tier 1 capital to adjusted total assets (as defined), and tier 1 common equity (as defined). As of September 30, 2018, each of the Bank's capital ratios exceeded the required level to be classified as well-capitalized. See Note 6 for a more detailed discussion of the Bank's regulatory capital ratios.

Liquidity is the ability to provide sufficient cash levels to meet financial commitments and to fund loan demand and deposit withdrawals. The Company and subsidiary Bank maintain a significant level of liquidity in the form of cash and cash equivalents ($24.0 million as of September 30, 2018) and unrestricted investment securities available for sale ($34.0 million as of September 30, 2018). Cash and cash equivalents are immediately available for satisfaction of deposit withdrawals, customer credit needs, and

32



operations of the Bank. The Bank also maintains access to credit with both the Federal Home Loan Bank and a correspondent financial institution. Unencumbered investment securities available for sale represent a secondary level of liquidity available for conversion to liquid funds in the event of extraordinary needs. The Company believes that it maintains sufficient liquidity to meet its current and projected requirements and needs.

Risk Management

The Company is exposed to various risks resulting from its normal operations, including, but not limited to, credit risk, liquidity risk, interest rate risk, compliance risk and other operational risks. Through its reliance on technology, the Company has risks related to the performance of its technology and information security risks related to customer information and other data. Through its reliance on third parties, the Company also has vendor risk, and, by extension, exposure to the technology and information security risks of its vendors. Collectively, all of these risks contribute to the Company’s reputational risk. The Company seeks to manage and mitigate each of these risks and other risks through various risk management techniques including effective policies and procedures, internal and external monitoring, and risk transfer.

Despite these efforts, the volume of business conducted through electronic devices, our internet presence, and reliance on external vendors expose the Company to various attacks, including cybersecurity attacks from both domestic and international sources that seek to obtain customer information for fraudulent purposes or to disrupt business activities. During the second quarter of 2018, the Company identified an incident that was limited to a portion of the Company’s email system. The incident did not result in a direct financial loss, although the Company elected to engage professional advisors to investigate and remediate the incident. The Company has taken steps to prevent a similar situation from occurring in the future and continues to dedicate significant attention to risk management.


Caution About Forward-Looking Statements

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

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

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



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


ITEM 4. Controls and Procedures

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

There have not been any changes in the Company's internal controls over financial reporting during the third quarter of 2018 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.


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PART II. OTHER INFORMATION

Item 1.  Legal Proceedings

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

Item 1A. Risk Factors

Not applicable

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

None

Item 3.  Defaults Upon Senior Securities

None

Item 4.  Mine Safety Disclosures

Not Applicable

Item 5.  Other Information

None
 
Item 6.  Exhibits
 
Exhibit Index
31.1
Rule 13a-14(a) Certification of President and Chief Executive Officer
312
Rule 13a-14(a) Certification of Chief Financial Officer
32.1
Certification Statement of President and Chief Executive Officer pursuant to 18 U.S.C. Section 1350.
32.2
Certification Statement of Chief Financial Officer pursuant to 18 U.S.C. Section 1350.
101
The following materials from the Registrant's Quarterly Report on Form 10-Q for the quarter ended September 30, 2018, formatted in Extensible Business Reporting Language (XBRL), include: (i) the Consolidated Balance Sheets, (ii) the Consolidated Statements of Income, (iii) the Consolidated Statements of Comprehensive Income, (iv) Consolidated Statements of Cash Flows; (v) Consolidated Statements of Changes in Stockholders' Equity and (vi) related notes (furnished herewith).
 
 
 
 

35



SIGNATURES

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


 
HIGHLANDS BANKSHARES, INC
 
(Registrant)
 
 
 
 
 
Date: November 13, 2018
By:
/s/ Timothy K. Schools
 
 
 
Timothy K. Schools
 
 
 
President and Chief Executive Officer
 
 
 
 
 
 
 
 
Date: November 13, 2018
 
/s/ John H. Gray
 
 
 
John H. Gray
 
 
 
Chief Financial Officer
 


36




Exhibit Index
 
31.1
31.2
32.1
32.2
101
The following materials from the Registrant's Quarterly Report on Form 10-Q for the quarter ended September 30, 2018, formatted in Extensible Business Reporting Language (XBRL), include: (i) the Consolidated Balance Sheets, (ii) the Consolidated Statements of Income, (iii) the Consolidated Statements of Comprehensive Income, (iv) Consolidated Statements of Cash Flows; (v) Consolidated Statements of Changes in Stockholders' Equity and (vi) related notes (furnished herewith).
 
 
 
 


37