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EX-21 - EXHIBIT 21 - HIGHLANDS BANKSHARES INC /WV/ex21.htm
EX-31.2 - EXHIBIT 31.2 - HIGHLANDS BANKSHARES INC /WV/ex31_2.htm
EX-31.1 - EXHIBIT 31.1 - HIGHLANDS BANKSHARES INC /WV/ex31_1.htm
EX-32.1 - EXHIBIT 32.1 - HIGHLANDS BANKSHARES INC /WV/ex32_1.htm
EX-32.2 - EXHIBIT 32.2 - HIGHLANDS BANKSHARES INC /WV/ex32_2.htm


UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549

FORM 10-K
(Mark One)
x ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 2009

o TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

Commission File Number 0-16761
HIGHLANDS BANKSHARES, INC.
(Exact name of registrant as specified in its charter)
West Virginia
55-0650743
(State or other jurisdiction of incorporation or organization)
(I.R.S. Employer Identification No.)

P.O. Box 929 Petersburg, WV
26847
(Address of principal executive offices)
(Zip Code)

Registrant’s telephone number, including area code:  304-257-4111

Securities registered pursuant to Section 12(b) of the Act: None

Securities registered pursuant to Section 12(g) of the Act:  Common Stock, $5 par value

Indicate by check mark if the registrant is a well-know seasoned issuer, as defined in Rule 405 or the Securities Act    o Yes  x No

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act  o  Yes  x No

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

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

Indicate by checkmark whether the registrant has submitted electronically and posted on its corporate Website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (Section 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 o        No o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. o Large Accelerated Filer o Accelerated Filer o Non-accelerated filer x Smaller Reporting Company

Indicate by check mark whether the registrant is a shell company (as defined in rule 126-2 of the Act)   Yes o        No x

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

The aggregate market value of the 1,234,252 shares of common stock of the registrant, issued and outstanding, held by non- affiliates on June 30, 2009, was approximately $32,707,686 based on the closing sale price of $26.50 per share on June 30, 2009.  For the purposes of this calculation, the term “affiliate” refers to all directors and executive officers of the registrant.
 


 
 

 
Indicate the number of shares outstanding of each of the registrant’s classes of common stock as of the last practicable date: As of March 29, 2010: 1,336,873 shares of common stock.

DOCUMENTS INCORPORATED BY REFERENCE

Part III incorporates certain information by reference from the registrant’s definitive proxy statement for the 2010 annual meeting of stockholders, which proxy statement will be filed on or about April 15, 2010


FORM 10-K INDEX


Part I
 
Page
3
Not applicable
9
9
9
9
     
Part II
   
9
10
11
Item 7A.
Quantitative and Qualitative Disclosures About Market Risk
Not applicable
26
58
58
58
     
Part III
   
59
59
59
59
60
     
Part IV
   
60
     
61


* The information required by Items 10, 11, 12, 13 and 14, to the extent not included in this document, is incorporated herein by reference to the information included under the captions “Compliance with Section 16(a) of the Securities Exchange Act,” “ELECTION OF DIRECTORS,” “INFORMATION CONCERNING DIRECTORS AND NOMINEES,” “REPORT OF THE AUDIT COMMITTEE,” “EXECUTIVE COMPENSATION,” “SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT” and “CERTAIN RELATED TRANSACTIONS” in the registrant’s definitive proxy statement which is expected to be filed on or about April 15, 2010.

 
2

 
PART I

Item 1.
Business

General

Highlands Bankshares, Inc. (hereinafter referred to as “Highlands,” or the “Company”), incorporated under the laws of  the State of West Virginia in 1985, is a multi bank holding company subject to the provisions of the Bank Holding Company Act of 1956, as amended. Highlands owns 100% of the outstanding stock of its subsidiary banks, The Grant County Bank and Capon Valley Bank (hereinafter referred to as the “Banks” or “Capon” and/or “Grant”), and its life insurance subsidiary, HBI Life Insurance Company (hereinafter referred to as “HBI Life”).

The Grant County Bank was chartered on August 6, 1902, and Capon Valley Bank was chartered on July 1, 1918.  Both are state banks chartered under the laws of the State of West Virginia.  HBI Life was chartered in April 1988 under the laws of the State of Arizona.

Services Offered by the Banks

The Banks offer all services normally offered by a full service commercial bank, including commercial and individual demand and time deposit accounts, commercial and individual loans, drive in banking services, internet banking services, and automated teller machines.  No material portion of the Banks' deposits have been obtained from a single or small group of customers and the loss of the deposits of any one customer or of a small group of customers would not have a material adverse effect on the business of the Banks.  Credit life and accident and health insurance are sold to customers of the subsidiary Banks through HBI Life.

Employees

As of December 31, 2009, The Grant County Bank had 69 full time equivalent employees, Capon Valley Bank had 47 full time equivalent employees and Highlands had 4 full time equivalent employees. No person is employed by HBI Life on a full time basis.

Competition

The Banks' primary trade area is generally defined as Grant, Hardy, Mineral, Randolph, Pendleton and Tucker Counties in West Virginia, the western portion of Frederick County in Virginia and portions of Western Maryland. This area includes the towns of Petersburg, Wardensville, Moorefield and Keyser and several rural towns. The Banks' secondary trade area includes portions of Hampshire County in West Virginia. The Banks primarily compete with four state chartered banks, three national banks, and three credit unions. In addition, the Banks compete with money market mutual funds and investment brokerage firms for deposits in their service area.  No financial institution has been chartered in the area within the last five years although other state and nationally chartered banks have opened branches in this area within this time period.  Competition for new loans and deposits in the Banks' service area is quite intense.

Regulation and Supervision

The Company, as a registered bank holding company, and its subsidiary Banks, as insured depository institutions, operate in a highly regulated environment and are regularly examined by federal and state regulators.  The following description briefly discusses certain provisions of federal and state laws and regulations and the potential impact of such provisions to which the Company and subsidiary are subject.  These federal and state laws and regulations are designed to reduce potential loss exposure to the depositors of such depository institutions and to the Federal Deposit Insurance Corporation’s insurance fund and are not intended to protect the Company’s security holders.  Proposals to change the laws and regulations governing the banking industry are frequently raised in Congress, in state legislatures, and before the various bank regulatory agencies.  The likelihood and timing of any changes and the impact such changes might have on the Company are impossible to determine with any certainty.  A change in applicable laws or regulations, or a change in the way such laws or regulations are interpreted by regulatory agencies or courts, may have a material impact on the business, operations and earnings of the Company.  To the extent that the following information describes statutory or regulatory provisions, it is qualified entirely by reference to the particular statutory or regulatory provision.

 
3

 
As a bank holding company registered under the Bank Holding Company Act of 1956, as amended (the “BHCA”), the Company is subject to regulation by the Federal Reserve Board.  Federal banking laws require a bank holding company to serve as a source of financial strength to its subsidiary depository institutions and to commit resources to support such institutions in circumstances where it might not do so otherwise.  Additionally, the Federal Reserve Board has jurisdiction under the BHCA to approve any bank or non-bank acquisition, merger or consolidation proposed by a bank holding company.  The BHCA generally limits the activities of a bank holding company and its subsidiaries to that of banking, with the managing or controlling of banks as to be a proper incident thereto.  The BHCA also prohibits a bank holding company, with certain exceptions, from acquiring more than 5% of the voting shares of any company and from engaging in any business other than banking or managing or controlling banks.  The Federal Reserve Board has determined by regulation that certain activities are closely related to banking within the meaning of the BHCA.  These activities include:  operating a mortgage company, finance company, credit card company or factoring company; performing certain data processing operations; providing investment and financial advice; and acting as an insurance agent for certain types of credit-related insurance.

The Gramm-Leach-Bliley Act (“Gramm-Leach”) became law in November 1999.  Gramm-Leach established a comprehensive framework to permit affiliations among commercial banks, investment banks, insurance companies, securities firms, and other financial service providers.  Gramm-Leach permits qualifying bank holding companies to register with the Federal Reserve Board as “financial holding companies” and allows such companies to engage in a significantly broader range of financial activities than were historically permissible for bank holding companies.  Although the Federal Reserve Board provides the principal regulatory supervision of financial services permitted under Gramm-Leach, the Securities and Exchange Commission and state regulators also provide substantial supervisory oversight.  In addition to broadening the range of financial services a bank holding company may provide, Gramm-Leach also addressed customer privacy and information sharing issues and set forth certain customer disclosure requirements.  The Company has no current plans to petition the Federal Reserve Board for consideration as a financial holding company.

The Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 (“Riegle-Neal”) permits bank holding companies to acquire banks located in any state.  Riegle-Neal also allows national banks and state banks with different home states to merge across state lines and allows branch banking across state lines, unless specifically prohibited by state laws.

The International Money Laundering Abatement and Anti-Terrorist Financing Act of 2001 (“Patriot Act”) was adopted in response to the September 11, 2001 terrorist attacks.  The Patriot Act provides law enforcement with greater powers to investigate terrorism and prevent future terrorist acts.  Among the broad-reaching provisions contained in the Patriot Act are several designed to deter terrorists’ ability to launder money in the United States and provide law enforcement with additional powers to investigate how terrorists and terrorist organizations are financed.  The Patriot Act creates additional requirements for banks, which were already subject to similar regulations.  The Patriot Act authorizes the Secretary of Treasury to require financial institutions to take certain “special measures” when the Secretary suspects that certain transactions or accounts are related to money laundering.  These special measures may be ordered when the Secretary suspects that a jurisdiction outside of the United States, a financial institution operating outside of the United States, a class of transactions involving a jurisdiction outside of the United States or certain types of accounts are of “primary money laundering concern.”  The special measures include the following:  (a) require financial institutions to keep records and report on transactions or accounts at issue; (b) require financial institutions to obtain and retain information related to the beneficial ownership of any account opened or maintained by foreign persons; (c) require financial institutions to identify each customer who is permitted to use the account; and (d) prohibit or impose conditions on the opening or maintaining of correspondence or payable-through accounts.  Failure of a financial institution to maintain and implement adequate programs to combat money laundering and terrorist financing or to comply with all of the relevant laws or regulations could have serious legal and reputational consequences for an institution.

The operations of the insurance subsidiary are subject to the oversight and review by the State of Arizona Department of Insurance.

 
4

 
On July 30, 2002, the United States Congress enacted the Sarbanes-Oxley Act of 2002, a law that addresses corporate governance, auditing and accounting, executive compensation and enhanced timely disclosure of corporate information.  As Sarbanes-Oxley directs, the Company’s Chief Executive Officer and Chief Financial Officer are each required to certify that the Company’s quarterly and annual reports do not contain any untrue statement of a material fact.  Additionally, these individuals must certify the following:  they are responsible for establishing, maintaining and regularly evaluating the effectiveness of the Company’s internal controls; they have made certain disclosures to the Company’s auditors and the Audit Committee of the Board of Directors about the Company’s internal controls; and they have included information in the Company’s quarterly and annual reports about their evaluation and whether there have been significant changes in the Company’s internal controls or in other factors that could significantly affect internal controls subsequent to the evaluations.

Capital Adequacy

Federal banking regulations set forth capital adequacy guidelines, which are used by regulatory authorities to assess the adequacy of capital in examining and supervising a bank holding company and its insured depository institutions.  The capital adequacy guidelines generally require bank holding companies to maintain total capital equal to at least 8% of total risk-adjusted assets, with at least one-half of total capital consisting of core capital (i.e., Tier I capital) and the remaining amount consisting of “other” capital-eligible items (i.e., Tier II capital), such as perpetual preferred stock, certain subordinated debt, and, subject to limitations, the allowance for loan losses.  Tier I capital generally includes common stockholders’ equity plus, within certain limitations, perpetual preferred stock and trust preferred securities.  For purposes of computing risk-based capital ratios, bank holding companies must meet specific capital guidelines that involve quantitative measures of assets, liabilities and certain off-balance sheet items, calculated under regulatory accounting practices.  The Company’s and its subsidiaries’ capital accounts and classifications are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors.

In addition to total and Tier I capital requirements, regulatory authorities also require bank holding companies and insured depository institutions to maintain a minimum leverage capital ratio of 3%.  The leverage ratio is determined as the ratio of Tier I capital to total average assets, where average assets exclude goodwill, other intangibles, and other specifically excluded assets.  Regulatory authorities have stated that minimum capital ratios are adequate for those institutions that are operationally and financially sound, experiencing solid earnings, have high levels of asset quality and are not experiencing significant growth.  The guidelines also provide that banking organizations experiencing internal growth or making acquisitions will be expected to maintain strong capital positions substantially above the minimum supervisory levels.  In those instances where these criteria are not evident, regulatory authorities expect, and may require, bank holding companies and insured depository institutions to maintain higher than minimum capital levels.

Additionally, federal banking laws require regulatory authorities to take “prompt corrective action” with respect to depository institutions that do not satisfy minimum capital requirements.  The extent of these powers depends upon whether the institutions in question are “well capitalized,” “adequately capitalized,” “undercapitalized,” “significantly undercapitalized,” or “critically undercapitalized,” as such terms are defined under uniform regulations defining such capital levels issued by each of the federal banking agencies.  As an example, a depository institution that is not well capitalized is generally prohibited from accepting brokered deposits and offering interest rates on deposits higher than the prevailing rate in its market.  Additionally, a depository institution is generally prohibited from making any capital distribution (including payment of a dividend) or paying any management fee to its holding company, may be subject to asset growth limitations and may be required to submit capital restoration plans if the depository institution is considered undercapitalized.

 
5

 
The Company’s and its subsidiaries’ regulatory capital ratios are presented in the table below:

   
Actual Ratio
   
Actual Ratio
   
Regulatory
 
   
December 31, 2009
   
December 31, 2008
   
Minimum
 
Total Risk Based Capital
                 
Highlands Bankshares
    14.33 %     14.20 %      
The Grant County Bank
    14.12 %     13.99 %     8.00 %
Capon Valley Bank
    12.86 %     12.77 %     8.00 %
                         
Tier 1 Leverage Ratio
                       
Highlands Bankshares
    9.81 %     10.18 %        
The Grant County Bank
    9.91 %     10.00 %     4.00 %
Capon Valley Bank
    8.38 %     9.11 %     4.00 %
                         
Tier 1 Risk Based Capital Ratio
                       
Highlands Bankshares
    13.08 %     12.98 %        
The Grant County Bank
    12.89 %     12.79 %     4.00 %
Capon Valley Bank
    11.60 %     11.52 %     4.00 %

Dividends and Other Payments

The Company is a legal entity separate and distinct from its subsidiaries.  Dividends and management fees from Grant County Bank and Capon Valley Bank are essentially the sole source of cash for the Company, although HBI Life will periodically pay dividends to the Company. The right of the Company, and shareholders of the Company, to participate in any distribution of the assets or earnings of Grant County Bank and Capon Valley Bank through the payment of such dividends or otherwise is necessarily subject to the prior claims of creditors of Grant County Bank and Capon Valley Bank, except to the extent that claims of the Company in its capacity as a creditor may be recognized.  Moreover, there are various legal limitations applicable to the payment of dividends to the Company as well as the payment of dividends by the Company to its shareholders.  Under federal law, Grant County Bank and Capon Valley Bank may not, subject to certain limited exceptions, make loans or extensions of credit to, or invest in the securities of, or take securities of the Company as collateral for loans to any borrower.  Grant County Bank and Capon Valley Bank are also subject to collateral security requirements for any loans or extensions of credit permitted by such exceptions.

Grant County Bank and Capon Valley Bank are subject to various statutory restrictions on their ability to pay dividends to the Company.  Specifically, the approval of the appropriate regulatory authorities is required prior to the payment of dividends by Grant County Bank and Capon Valley Bank in excess of earnings retained in the current year plus retained net profits for the preceding two years.  The payment of dividends by the Company, Grant County Bank and Capon Valley Bank may also be limited by other factors, such as requirements to maintain adequate capital above regulatory guidelines.  The Federal Reserve Board and the Federal Deposit Insurance Corporation have the authority to prohibit any bank under their jurisdiction from engaging in an unsafe and unsound practice in conducting its business.  Depending upon the financial condition of Grant County Bank and Capon Valley Bank, the payment of dividends could be deemed to constitute such an unsafe or unsound practice.  The Federal Reserve Board and the FDIC have indicated their view that it’s generally unsafe and unsound practice to pay dividends except out of current operating earnings.  The Federal Reserve Board has stated that, as a matter of prudent banking, a bank or bank holding company should not maintain its existing rate of cash dividends on common stock unless (1) the organization’s net income available to common shareholders over the past year has been sufficient to fund fully the dividends and (2) the prospective rate or earnings retention appears consistent with the organization’s capital needs, asset quality, and overall financial condition.  Moreover, the Federal Reserve Board has indicated that bank holding companies should serve as a source of managerial and financial strength to their subsidiary banks.  Accordingly, the Federal Reserve Board has stated that a bank holding company should not maintain a level of cash dividends to its shareholders that places undue pressure on the capital of bank subsidiaries, or that can be funded only through additional borrowings or other arrangements that may undermine the bank holding company’s ability to serve as a source of strength.

 
6

 
Governmental Policies

The Federal Reserve Board regulates money and credit and interest rates in order to influence general economic conditions.  These policies have a significant influence on overall growth and distribution of bank loans, investments and deposits and affect interest rates charged on loans or paid for time and savings deposits.  Federal Reserve monetary policies have had a significant effect on the operating results of commercial banks in the past and are expected to continue to do so in the future.

Various other legislation, including proposals to overhaul the banking regulatory system and to limit the investments that a depository institution may make with insured funds, are from time to time introduced in Congress.  The Company cannot determine the ultimate effect that such potential legislation, if enacted, would have upon its financial condition or operations.

Beginning in late 2008, the economic environment caused higher levels of bank failures, which dramatically increased FDIC resolution costs and led to a significant reduction in the Deposit Insurance Fund. As a result, the FDIC has significantly increased the initial base assessment rates paid by financial institutions for deposit insurance. The base assessment rate was increased by seven basis points (7 cents for every $100 of deposits) for the first quarter of 2009. Effective April 1, 2009, initial base assessment rates were changed to range from 12 basis points to 45 basis points across all risk categories with possible adjustments to these rates based on certain debt-related components. These increases in the base assessment rate have increased our deposit insurance costs and negatively impacted our earnings. In addition, in May 2009, the FDIC imposed a special assessment on all insured institutions due to recent bank and savings association failures. The emergency assessment amounted to five basis points on each institution's assets minus tier one (core) capital as of June 30, 2009, subject to a maximum equal to 10 basis points times the institution's assessment base. The Company’s special assessment, which was reflected in earnings for the quarter ended June 30, 2009, was approximately $179,000. The FDIC may impose additional emergency special assessments if necessary to maintain public confidence in federal deposit insurance or as a result of deterioration in the deposit insurance fund reserve ratio due to institution failures. Any additional emergency special assessment imposed by the FDIC will negatively impact our earnings.

On November 12, 2009, the FDIC adopted a final rule requiring that all institutions prepay their assessments for the fourth quarter of 2009 and all of 2010, 2011 and 2012. This pre-payment was due on December 30, 2009. However, the FDIC may exempt certain institutions from the prepayment requirement if the FDIC determines that the prepayment would adversely affect the safety and soundness of the institution.

The Company is subject to extensive regulation, supervision and examination by federal and state banking authorities. Any change in applicable regulations or laws could have a substantial impact on the Company and the Company’s operations. Additional legislation and regulations that could significantly affect the Company’s powers, authority and operations may be enacted or adopted in the future, which could have a material adverse effect on the Company’s financial condition and results of operations. New legislation proposed by Congress may give bankruptcy courts the power to reduce the increasing number of home foreclosures by giving bankruptcy judges the authority to restructure mortgages and reduce a borrower's payments. Property owners would be allowed to keep their property while working out their debts. Other similar bills placing additional temporary moratoriums on foreclosure sales or otherwise modifying foreclosure procedures to the benefit of borrowers and the detriment of lenders may be enacted by either Congress or the States of West Virginia, Pennsylvania or Maryland in the future. These laws may further restrict the Company’s collection efforts on one-to-four single-family mortgage loans. Additional legislation proposed or under consideration in Congress would give current debit and credit card holders the chance to opt out of an overdraft protection program and limit overdraft fees, which could result in additional operational costs and a reduction in the Company’s non-interest income.

Further, the Company’s regulators have significant discretion and authority to prevent or remedy unsafe or unsound practices or violations of laws by financial institutions and holding companies in the performance of their supervisory and enforcement duties. In this regard, banking regulators are considering additional regulations governing compensation, which may adversely affect the Company’s ability to attract and retain employees. On

 
7

 
June 17, 2009, the Obama Administration published a comprehensive regulatory reform plan that is intended to modernize and protect the integrity of the United States financial system. The President's plan contains several elements that would have a direct effect on the Company. The reform plan proposes the creation of a new federal agency, the Consumer Financial Protection Agency, which would be dedicated to protecting consumers in the financial products and services market. The creation of this agency could result in new regulatory requirements and raise the cost of regulatory compliance. In addition, legislation stemming from the reform plan could require changes in regulatory capital requirements, and compensation practices. If implemented, the foregoing regulatory reforms may have a material impact on the Company’s operations. However, because the legislation needed to implement the President's reform plan has not been introduced, and because the final legislation may differ significantly from the legislation proposed by the Administration, the Company cannot determine the specific impact of regulatory reform at this time.

Available Information

The Company files annual, quarterly and current reports, proxy statements and other information with the SEC. The Company’s SEC filings are filed electronically and are available to the public via the Internet at the SEC’s website, www.sec.gov. In addition, any document filed by the Company with the SEC can be read and copies obtained at the SEC’s public reference facilities at 100 F Street, NE, Washington, DC 20549. Copies of documents can be obtained at prescribed rates by writing to the Public Reference Section of the SEC at 100 F Street NE, Washington, DC 20549. The public may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. Copies of documents can also be obtained free of charge by writing to Highlands Bankshares, Inc., P.O. Box 929, Petersburg, WV 26847.

Executive Officers

   
Age
 
Position with the Company
 
Principal Occupation (Past Five Years)
C.E. Porter
 
61
 
Chief Executive Officer
 
CEO of Highlands since 2004, President of The Grant County Bank since 1991
             
Alan L. Brill
 
55
 
Secretary and Treasurer; President of Capon Valley Bank
 
President of Capon Valley Bank since 2001
 
 
8

 
Item 1A.
Risk Factors

Not required for smaller reporting companies.

Item 1B.
Unresolved Staff Comments

None.

Item 2.
Properties

The table below lists the primary properties utilized in operations by the Company. All listed properties are owned by the Company.

Location
Description
3 N. Main Street, Petersburg, WV  26847
Primary Office, The Grant County Bank
Route 33, Riverton, WV  26814
Branch Office, The Grant County Bank
500 S. Main Street, Moorefield, WV  26836
Branch Office, The Grant County Bank
Route 220 & Josie Dr., Keyser, WV  26726
Branch Office, The Grant County Bank
Main Street, Harman, WV  26270
Branch Office, The Grant County Bank
William Avenue, Davis, WV  26260
Branch Office, The Grant County Bank
Route 32 & Cortland Rd., Davis, WV  26260
Branch Office, The Grant County Bank
2 W. Main Street, Wardensville, WV  26851
Primary Office, Capon Valley Bank
717 N. Main Street, Moorefield, WV  26836
Branch Office, Capon Valley Bank
17558 SR55, Baker, WV  26801
Branch Office, Capon Valley Bank
6701 Northwestern Pike, Gore, VA  22637
Branch Office, Capon Valley Bank
5511 Main Street, Stephens City, VA 22655
Future Branch Office, Capon Valley Bank


Item 3.
Legal Proceedings

Management is not aware of any material pending or threatened litigation in which Highlands or its subsidiaries may be involved as a defendant.  In the normal course of business, the Banks periodically must initiate suits against borrowers as a final course of action in collecting past due indebtedness.

Item 4.
(Removed and Reserved)


PART II

Item 5.
Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
 
The Company had approximately 845 shareholders as of December 31, 2009. This amount includes all shareholders, whether titled individually or held by a brokerage firm or custodian in street name. The Company's stock is not traded on any national or regional stock exchange although brokers may occasionally initiate or be a participant in a trade.  The Company’s stock is listed on the Over the Counter Bulletin Board under the symbol HBSI.OB.  The Company may not know terms of an exchange between individual parties.

The table on the following page outlines the dividends paid and market prices of the Company's stock based on prices disclosed to management.  Prices have been provided using a nationally recognized online stock quote system.  Such prices may not include retail mark-ups, mark-downs, or commissions. Dividends are subject to the restrictions described in Note Nine to the Financial Statements.

 
9

 
Highlands Bankshares, Inc. Common Stock
 
   
         
Estimated Market Range
 
   
Dividends Per Share
   
High
   
Low
 
      2009
                 
First Quarter
  $ .29     $ 35.00     $ 26.50  
Second Quarter
  $ .29     $ 27.65     $ 27.25  
Third Quarter
  $ .29     $ 27.50     $ 21.50  
Fourth Quarter
  $ .29     $ 22.50     $ 21.00  
                         
      2008
                       
First Quarter
  $ .27     $ 30.00     $ 27.00  
Second Quarter
  $ .27     $ 38.00     $ 27.75  
Third Quarter
  $ .27     $ 38.00     $ 31.00  
Fourth Quarter
  $ .27     $ 35.00     $ 29.00  

Item 6.
Selected Financial Data

The following table is not required for smaller reporting companies; however, the Company believes this information may be important to the reader.

   
Years Ending December 31,
 
   
(In thousands of dollars, except for per share amounts)
 
   
2009
   
2008
   
2007
   
2006
   
2005
 
Total Interest Income
  $ 24,274     $ 26,203     $ 27,664     $ 23,894     $ 19,813  
Total Interest Expense
    7,841       8,866       10,703       7,909       5,761  
Net Interest Income
    16,433       17,337       16,961       15,985       14,052  
                                         
Provision for Loan Losses
    1,864       909       837       682       875  
                                         
Net Interest Income After Provision for Loan Losses
    14,569       16,428       16,124       15,303       13,177  
                                         
Other Income
    2,532       2,699       2,080       1,997       1,669  
Other Expenses
    12,053       11,419       10,952       10,394       9,128  
                                         
Income Before Income Taxes
    5,048       7,708       7,252       6,906       5,718  
                                         
Income Tax Expense
    1,692       2,738       2,599       2,391       1,916  
                                         
Net Income
  $ 3,356     $ 4,970     $ 4,653     $ 4,515     $ 3,802  
                                         
Total Assets at Year End
  $ 407,810     $ 378,295     $ 380,936     $ 357,316     $ 337,573  
Long Term Debt at Year End
  $ 10,866     $ 11,317     $ 11,819     $ 14,992     $ 15,063  
                                         
Net Income Per Share of Common Stock
  $ 2.51     $ 3.59     $ 3.24     $ 3.14     $ 2.65  
Dividends Per Share of Common Stock
  $ 1.16     $ 1.08     $ 1.00     $ .94     $ .82  
                                         
Return on Average Assets
    0.84 %     1.32 %     1.24 %     1.29 %     1.21 %
Return on Average Equity
    8.33 %     12.38 %     12.03 %     12.67 %     11.53 %
Dividend Payout Ratio
    46.19 %     30.12 %     30.88 %     29.91 %     30.99 %
Year End Equity to Assets Ratio
    10.16 %     10.41 %     10.66 %     10.38 %     10.07 %

 
10

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

Forward Looking Statements

Certain statements in this report may constitute “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995.  Forward-looking statements are statements that include projections, predictions, expectations or beliefs about future events or results or otherwise are not statements of historical fact.  Such statements are often characterized by the use of qualified words (and their derivatives) such as “expect,” “believe,” “estimate,” “plan,” “project,” “anticipate” or other similar words.  Although the Company believes that its expectations with respect to certain forward-looking statements are based upon reasonable assumptions within the bounds of its existing knowledge of its business and operations, there can be no assurance that actual results, performance or achievements of the Company will not differ materially from any future results, performance or achievements expressed or implied by such forward-looking statements.  Actual future results and trends may differ materially from historical results or those anticipated depending on a variety of factors, including, but not limited to the effects of or changes in:  general economic conditions, the interest rate environment, legislative and regulatory requirements, competitive pressures, new products and delivery systems, inflation, changes in the stock and bond markets, technology, downturns in the trucking and timber industries, effects of mergers and/or downsizing in the poultry industry in Hardy County, and consumer spending and savings habits.  Additionally, actual future results and trends may differ from historical or anticipated results to the extent: (1) any significant downturn in certain industries, particularly the trucking and timber and coal extraction industries are experienced; (2) loan demand decreases from prior periods; (3) the Company may make additional loan loss provisions due to negative credit quality trends in the future that may lead to a deterioration of asset quality; (4) the Company does not continue to experience significant recoveries of previously charged-off loans or loans resulting in foreclosure; (5) increased liquidity needs may cause an increase in funding costs; (6) the quality of the Company’s securities portfolio may deteriorate: (7) the Company is unable to control costs and expenses as anticipated; (8) the FDIC further increases or requires prepayment of FDIC assessments; and (9) future legislation including the financial reform bill in Congress limits the Company’s activities and results in higher costs. The Company does not update any forward-looking statements that may be made from time to time by or on behalf of the Company.
 
Introduction

The following discussion focuses on significant results of the Company’s operations and significant changes in our financial condition or results of operations for the periods indicated in the discussion. This discussion should be read in conjunction with the financial statements and related notes included in this report. Current performance does not guarantee, and may not be indicative of, similar performance in the future.

Critical Accounting Policies

The Company’s financial statements are prepared in accordance with accounting principles generally accepted in the United States (“GAAP”). The financial statements contained within these statements are, to a significant extent, financial information that is based on measures of the financial effects of transactions and events that have already occurred. A variety of factors could affect the ultimate value that is obtained either when earning income, recognizing an expense, recovering an asset or relieving a liability. In addition, GAAP itself may change from one previously acceptable method to another method. Although the economics of these transactions would be the same, the timing of events that would impact these transactions could change.

Allowance for Loan Losses

The allowance for loan losses is an estimate of the losses that may be sustained in the loan portfolio. The allowance is based on two basic principles of accounting: (i) ASC 450, “Contingencies, which requires that losses be accrued when they are probable of occurring and estimable and (ii) ASC 310, “Receivables”, which requires that losses be accrued based on the differences between the value of collateral, present value of future cash flows or values that are observable in the secondary market and the loan balance.

 
11


The allowance for loan losses includes two basic components: estimated credit losses on individually evaluated loans that are determined to be impaired, and estimated credit losses inherent in the remainder of the loan portfolio. Under authoritative accounting guidance, an individual loan is impaired when, based on current information and events, it is probable that a Company will be unable to collect all amounts due according to the contractual terms of the loan agreement. An individually evaluated loan that is determined not to be impaired is evaluated under ASC 450 when specific characteristics of the loan indicate that it is probable there would be estimated credit losses in a group of loans with those characteristics.

Authoritative accounting guidance does not specify how an institution should identify loans that are to be evaluated for collectibility, nor does it specify how an institution should determine that a loan is impaired. Each subsidiary of the Company uses its standard loan review procedures in making those judgments so that allowance estimates are based on a comprehensive analysis of the loan portfolio. For loans that are individually evaluated and found to be impaired, the associated allowance is based upon the estimated fair value, less costs to sell, of any collateral securing the loan as compared to the existing balance of the loan as of the date of analysis.

All other loans, including individually evaluated loans determined not to be impaired under authoritative accounting guidance, are included in a group of loans that are measured under ASC 450 to provide for estimated credit losses that have been incurred on groups of loans with similar risk characteristics. The methodology for measuring estimated credit losses on groups of loans with similar risk characteristics in accordance with authoritative accounting guidance is based on each group’s historical net charge-off rate, adjusted for the effects of the qualitative or environmental factors that are likely to cause estimated credit losses as of the evaluation date to differ from the group’s historical loss experience.

Post Retirement Benefits and Life Insurance Investments

The Company has invested in and owns life insurance policies on key officers. The policies are designed so that the Company recovers the interest expenses associated with carrying the policies and the officer will, at the time of retirement, receive any earnings in excess of the amounts earned by the Company. The Company recognizes as an asset the net amount that could be realized under the insurance contract as of the balance sheet date. This amount represents the cash surrender value of the policies less applicable surrender charges. The portion of the benefits, which will be received by the executives at the time of their retirement, is considered, when taken collectively, to constitute a retirement plan. Therefore the Company accounts for these policies using guidance found in ASC 715, “Compensation – Retirement Benefits” which requires that an employer’s obligation under a deferred compensation agreement be accrued over the expected service life of the employee through their normal retirement date.

Assumptions are used in estimating the present value of amounts due officers after their normal retirement date.  These assumptions include the estimated income to be derived from the investments and an estimate of the Company’s cost of funds in these future periods.  In addition, the discount rate used in the present value calculation will change in future years based on market conditions.

Intangible Assets

The Company carries intangible assets related to the purchase of two banks. Amounts paid to purchase these banks were allocated as intangible assets. Generally accepted accounting principles were applied to allocate the intangible components of the purchases. The excess was allocated between identifiable intangibles (core deposit intangibles) and unidentified intangibles (goodwill). Goodwill is required to be evaluated for impairment on an annual basis, and the value of the goodwill adjusted accordingly, should impairment be found.  As of December 31, 2009, the Company did not identify an impairment of this intangible.

In addition to the intangible assets associated with the purchases of banks, the company also carries intangible assets relating to the purchase of naming rights to certain features of a performing arts center in Petersburg, WV.

A summary of the change in balances of intangible assets can be found in Note Twenty Two to the Financial Statements.

 
12


Recent Accounting Pronouncements

Refer to Note 2 of the Company’s consolidated financial statements for a discussion of recent accounting pronouncements.

Overview of 2009 Results

Net income for 2009 decreased by 32.47% as compared to 2008. The Company experienced a 5.21% decrease in net interest income due to a continuing decline in net interest margin.  The Company also experienced a significant increase in the provision for loan losses of 105.06% or $955,000 from 2008 to 2009 due to an increase in non-performing assets. Non-interest income decreased 6.19% primarily as a  result of decreases in non-recurring income as well as a reduction in life insurance investment income. Non-interest expense increased 5.55% due largely to an increase in salary and benefits expense and increases in FDIC insurance premiums.

The table below compares selected commonly used measures of bank performance for the twelve month periods ended December 31, 2009 and 2008:

   
2009
   
2008
 
Annualized return on average assets
    0.84 %     1.32 %
Annualized return on average equity
    8.33 %     12.38 %
Net interest margin (1)
    4.50 %     4.97 %
Efficiency Ratio (2)
    63.55 %     56.99 %
Earnings per share (3)
  $ 2.51     $ 3.59  

(1) On a fully taxable equivalent basis and including loan origination fees
(2) Non-interest expenses for the period indicated divided by the sum of net interest income and non-interest income for the period indicated.
(3) Per weighted average shares of common stock outstanding for the period indicated. Earnings per share for 2008 reflect share repurchase of 100,001 shares during the second and third quarters of 2008.

The change in non-interest income from 2008 to 2009 was impacted significantly by non-recurring items. The table below summarizes the impact of non-recurring items on both 2009 and 2008 non-interest income:

   
Impact of non- recurring item, year ended December 31,
       
   
2009
   
2008
   
Increase
(Decrease)
 
Description of non-recurring item
                 
Gains (losses) recorded on calls of securities available for sale
  $ (7 )   $ 110     $ (117 )
Gains (losses) recorded on sale of other real estate owned
    80       4       76  
Gain on life insurance settlement
    0       30       (30 )
Net gains recorded on sale of fixed assets
    2       32       (30 )
Total impact of non-recurring items on non-interest income
  $ 75     $ 176     $ (101 )

Net Interest Income

2009 Compared to 2008

Net interest income, on a fully taxable equivalent basis, decreased 5.11% from 2008 to 2009 as average balances of both earning assets and interest bearing liabilities increased from year to year.  The decrease in net interest income was most impacted by changes in average rates earned on assets and paid on interest bearing liabilities and by changes in the relative mix of earning assets and interest bearing liabilities.
 
For the year ended December 31, 2009, the Company’s average earning assets increased 4.83%; however, the percent of average loan balances, the highest earning of the Company’s earning assets, to total average earning assets remained relatively flat at 90.30% in 2009 compared to 90.04% in 2008.  The benefits of the Company’s increase in earning assets were offset by an increase in average interest bearing liabilities from 2008 to 2009 of 5.98%.  The average balances of time deposits and long-term debt, both comparatively more expensive interest

 
13

 
bearing liabilities, increased 8.39% from 2008 to 2009. These changes in the relative mix of earning assets and interest bearing liabilities and the change in the average yields negatively impacted the Company’s net interest income.

Rate cuts by the Federal Reserve (“the Fed”) for the target rate for federal funds sold continue to impact yields on earning assets and average rates paid on interest bearing liabilities. The Company experienced declining rates for 2009 as compared to 2008 on all components of earning assets and on the savings and time deposit components of interest bearing liabilities.

The Company believes that its deposits will be sufficient to fund the current and expected loan demand.  Should the loan demand increase beyond the Company’s current expectations, the Company may be required to fund these loans with borrowings which could result in a reduction of net interest margin.  However, management believes total net interest income would not be adversely affected.
.
Also, balances of non-performing loans and other real estate acquired through foreclosure have increased from December 31, 2008 to December 31, 2009. Increases in balances of non-accrual loans and other real estate acquired through foreclosure often have adverse effects on net interest income. Should balances of non-accrual loans and other real estate acquired through foreclosure continue to increase, net interest margin may decrease accordingly.  Further discussion relating to the Company’s loan portfolio and credit quality can be found as part of this Management’s Discussion and Analysis under the headings of “Loan Portfolio” and “Credit Quality.”
 
The table below illustrates the effects on net interest income of changes in average volumes of interest bearing liabilities and earning assets from 2008 to 2009 and changes in average rates on interest bearing liabilities and earning assets from 2008 to 2009 (in thousands of dollars):

EFFECT OF RATE-VOLUME CHANGES ON NET INTEREST
(On a fully taxable equivalent basis)
Increase (Decrease) 2009 Compared to 2008

   
Due to change in:
       
   
Average Volume
   
Average Rate
   
Total Change
 
Interest Income
                 
Loans
  $ 1,146     $ (2,587 )   $ (1,441 )
Taxable investment securities
    (19 )     (239 )     (258 )
Non-taxable investment securities
    39       (4 )     35  
Interest bearing deposits
    (3 )     (34 )     (37 )
Federal funds sold
    2       (216 )     (214 )
Total Interest Income
    1,165       (3,080 )     (1,915 )
                         
Interest Expense
                       
Demand deposits
    (3 )     (0 )     (3 )
Savings deposits
    2       (193 )     (191 )
Time deposits
    583       (1,431 )     (848 )
Borrowings
    (5 )     22       17  
Total Interest Expense
    577       (1,602 )     (1,025 )
                         
Net Interest Income
  $ 588     $ (1,478 )   $ ( 890 )
 
 
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The table below sets forth an analysis of net interest income for the years ended December 31, 2009 and 2008 (average balances and interest income/expense shown in thousands of dollars):

   
2009
   
2008
 
   
Average
Balance
   
Income
/Expense
   
Yield
/Rate
   
Average
Balance
   
Income
/Expense
   
Yield
/Rate
 
                                     
Earning Assets
                                   
Loans
  $ 331,740     $ 23,368       7.04 %   $ 315,473     $ 24,809       7.86 %
Taxable investment securities
    20,180       729       3.61 %     20,745       987       4.76 %
Non-taxable investment securities
    4,059       240       5.92 %     3,392       205       6.04 %
Interest bearing deposits
    1,028       7       .68 %     1,419       44       3.10 %
Federal funds sold
    10,288       20       .19 %     9,354       234       2.50 %
Total Earning Assets
    367,295       24,364       6.63 %     350,383       26,279       7.50 %
                                                 
Allowance for loan losses
    (3,755 )                     (3,637 )                
Other non-earning assets
    34,097                       30,276                  
                                                 
Total Assets
  $ 397,637                     $ 377,022                  
                                                 
Interest Bearing Liabilities
                                               
Demand deposits
  $ 22,430     $ 74       .33 %   $ 23,258     $ 77       .33 %
Savings deposits
    49,618       192       .39 %     49,363       383       .78 %
Time deposits
    213,483       7,049       3.30 %     195,963       7,897       4.03 %
Overnight and other short-term debt
    1,407       7       0.50 %     1,412       19       1.35 %
Long-term debt
    11,237       519       4.62 %     11,357       490       4.31 %
Total Interest Bearing Liabilities
    298,175       7,841       2.63 %     281,353       8,866       3.15 %
                                                 
Demand deposits
    50,650                       49,827                  
Other liabilities
    8,524                       5,711                  
Stockholders’ equity
    40,288                       40,131                  
                                                 
Total Liabilities and Stockholders’ Equity
  $ 397,637                     $ 377,022                  
                                                 
Net Interest Income
          $ 16,523                     $ 17,413          
Net Yield on Earning Assets
                    4.50 %                     4.97 %
                                                 
Notes:
                                               
(1) Yields are computed on a taxable equivalent basis using a 37% tax rate
(2) Average balances are based upon daily balances
(3) Includes loans in non-accrual status
(4) Income on loans includes fees

 
15

 
Loan Portfolio

The Company is an active residential mortgage and construction lender and extends commercial loans to small and medium sized businesses within its primary service area.  The Company’s commercial lending activity extends across its primary service areas of Grant, Hardy, Hampshire, Mineral, Randolph, Tucker and Pendleton counties in West Virginia and Frederick County, Virginia.  Consistent with the Company’s focus on providing community-based financial services, the Company does not attempt to diversify its loan portfolio geographically by making significant amounts of loans to borrowers outside of its primary service area.

The table below summarizes the Company’s loan portfolio at December 31, 2009, 2008, 2007, 2006 and 2005 (in thousands of dollars):

   
At December 31,
 
   
2009
   
2008
   
2007
   
2006
   
2005
 
Real estate mortgage
  $ 162,619     $ 156,877     $ 169,122     $ 164,243     $ 153,646  
Real estate construction
    30,759       27,210       15,560       14,828       12,201  
Commercial
    97,606       97,709       79,892       70,408       57,908  
Installment
    44,499       43,958       45,625       43,337       46,265  
Total Loans
    335,483       325,754       310,199       292,816       270,020  
                                         
Allowance for loan losses
    (4,021 )     (3,667 )     (3,577 )     (3,482 )     (3,129 )
                                         
Net Loans
  $ 331,462     $ 322,087     $ 306,622     $ 289,334     $ 266,891  

Commercial loan balances include certain loans secured by commercial real estate. As of December 31, 2009 the Company maintained balances of loans secured by real estate of $274,610,000 or 81.86% of total loans compared to $261,289,000 or 80.21% of total loans at December 31, 2008.  The increase in real estate secured loans of $13,321,000 during 2009 exceeds the increase in total loans of $9,729,000 during 2009.

There were no foreign loans outstanding during any of the above periods.

The following table illustrates the Company’s loan maturity distribution as of December 31, 2009 (in thousands of dollars):

   
Maturity Range
 
   
Less than 1 Year
   
1-5 Years
   
Over 5 Years
   
Total
 
Loan Type
 
 
                   
Commercial
  $ 34,241     $ 20,615     $ 42,750     $ 97,606  
Real estate mortgage and construction
    61,927       42,567       88,884       193,378  
Installment
    14,017       25,287       5,195       44,499  
Total Loans
  $ 110,185     $ 88,469     $ 136,829     $ 335,483  

Credit Quality

The principal economic risk associated with each of the categories of loans in the Company’s portfolio is the creditworthiness of its borrowers.  Within each category, such risk is increased or decreased depending on prevailing economic conditions.  The risk associated with the real estate mortgage loans and installment loans to individuals varies based upon employment levels, consumer confidence, fluctuations in value of residential real estate and other conditions that affect the ability of consumers to repay indebtedness.  The risk associated with commercial, financial and agricultural loans varies based upon the strength and activity of the local economies of the Company’s market areas.  The risks associated with real estate construction loans vary based upon the supply of and demand for the type of real estate under construction.

 
16

 
An inherent risk in the lending of money is that the borrower will not be able to repay the loan under the terms of the original agreement.  The allowance for loan losses (see subsequent section) provides for this risk and is reviewed at least quarterly for adequacy.  This review also considers concentrations of loans in terms of geography, business type or level of risk.  While lending is geographically diversified within the service area, the Company does have some concentration of loans in the area of agriculture (primarily poultry farming), and the timber and coal extraction industries. The Company recognizes these concentrations and considers them when structuring its loan portfolio.

Non-performing loans include non-accrual loans, loans 90 days or more past due and restructured loans. Non-accrual loans are loans on which interest accruals have been discontinued.  Loans are typically placed in non-accrual status when the collection of principal or interest is 90 days past due and collection is uncertain based on the net realizable value of the collateral and/or the financial strength of the borrower. Also, the existence of any guaranties by federal or state agencies is given consideration in this decision.  The policy is the same for all types of loans.  Restructured loans are loans for which a borrower has been granted a concession on the interest rate or the original repayment terms because of financial difficulties. Non-performing loans do not represent or result from trends or uncertainties which management reasonably expects will materially impact future operating results, liquidity, or capital resources. Non-performing loans are listed in the table below.

The following table summarizes the Company’s non-performing loans (in thousands of dollars):

   
At December 31,
 
   
2009
   
2008
   
2007
   
2006
   
2005
 
Loans accounted for on a non-accrual basis
                             
Consumer
  $ 269     $ 180     $ 71     $ 83     $ 124  
Commercial
    90       0       0       0       0  
Real estate
    2,208       1,166       845       161       619  
Total Non-accrual Loans
    2,567       1,346       916       244       743  
                                         
Restructured Loans
    1,836       705       198       0       0  
                                         
Loans delinquent 90 days or more
                                       
Consumer
    167       575       497       122       74  
Commercial
    90       65       3       0       966  
Real estate
    1,935       2,832       1,744       1,335       149  
Total delinquent loans
    2,192       3,472       2,244       1,457       1,189  
                                         
Total Non-performing loans
  $ 6,595     $ 5,523     $ 3,358     $ 1,701     $ 1,932  

The carrying value of real estate acquired through foreclosure was $3,223,000 at December 31, 2009 and $1,359,000 at December 31, 2008. The Company's practice is to value real estate acquired through foreclosure at the lower of (i) an independent current appraisal or market analysis less anticipated costs of disposal, or (ii) the existing loan balance.   The Company does not anticipate further losses from the disposal of other real estate owned.

Because of its large impact on the local economy, the Company continues to monitor the economic health of the poultry industry. The Company has direct loans to poultry growers and the industry is a large employer in the Company’s trade area. In recent periods, the Company’s loan portfolio has also begun to reflect a concentration in loans collateralized by heavy equipment, particularly in the trucking, mining and timber industries. Because of the impact of the slowing economic conditions on the housing market, the timber sector has experienced a recent downturn. However, the Company has experienced no material losses related to foreclosures of loans collateralized by assets typical to the timber harvest industry. While close monitoring of this sector is necessary, the Company expects no significant losses in the foreseeable future.

Allowance For Loan Losses

The allowance for loan losses is an estimate of the losses in the current loan portfolio. The allowance is based on two principles of accounting:  (i) ASC 450, “Contingencies” which requires that losses be accrued when they are probable of occurring and estimable and (ii) ASC 310, “Receivables”, which requires that loans be identified which have characteristics of impairment as individual risks, (e.g. the collateral, present value of cash flows or observable market values are less than the loan balance).

 
17


Each of the Company's banking subsidiaries, Capon Valley Bank and The Grant County Bank, determines the adequacy of its allowance for loan losses independently. Although the loan portfolios of the two Banks are similar to each other, some differences exist which result in divergent risk patterns and different charge-off rates amongst the functional areas of the Banks’ portfolios. Each Bank pays particular attention to individual loan performance, collateral values, borrower financial condition and economic conditions. The determination of an adequate allowance at each Bank is done in a three-step process. The first step is to identify impaired loans. Impaired loans are problem loans above a certain threshold, which have estimated losses, calculated based on the fair value of the collateral with which the loan is secured.

A summary of the loans which the Company has identified as impaired follows (in thousands of dollars):

December 31, 2009
 
         
Identified
 
Loan Type
 
Balance
   
Impairment
 
Consumer mortgage
  $ 2,124     $ 335  
Commercial
    276       66  
Commercial mortgage
    689       87  
Installment
    336       174  
    $ 3,425     $ 662  

The second step is to identify loans above a certain threshold, which are problem loans due to the borrowers' payment history or deteriorating financial condition.  Losses in this category are determined based on historical loss rates adjusted for current economic conditions.  The final step is to calculate a loss for the remainder of the portfolio using historical loss information for each type of loan classification which are also adjusted for current economic conditions. The determination of specific allowances and weighting is somewhat subjective and actual losses may be greater or less than the amount of the allowance.  However, the Company believes that the allowance represents a fair assessment of the losses that exist in the current loan portfolio.

The required level of the allowance for loan losses is computed quarterly and the allowance adjusted prior to the issuance of the quarterly financial statements.  All loan losses charged to the allowance are approved by the boards of directors of each Bank at their regular meetings.  In addition, the Company’s audit committee periodically reviews the allowance methodology for consistency and reasonableness.  Also, both banks have outsourced independent loan review performed at least annually the results of which are reviewed by both bank boards and the Company’s audit committee with changes factored into the allowance calculations.  Independent outsourced loan review considers the adequacy of loan underwriting, asset quality, the accuracy of the banks’ loan risk ratings and the appropriateness of specific reserves as well as the overall reasonableness of the allowance for loan losses.  The allowance is reviewed for adequacy after considering historical loss rates, current economic conditions (both locally and nationally) and any known credit problems that have not been considered under the above formula.

The Company has analyzed the potential risk of loss on the Company's loan portfolio given the loan balances and the value of the underlying collateral and has recognized losses where appropriate. Non-performing loans are closely monitored on an ongoing basis as part of the Company's loan review process.

During 2009, the Company’s experienced level of net charge-offs, as compared to gross loan balances, was significantly greater than that experienced in 2008.  As a result of the impact of increased net charge-offs, an increase in specific reserves as well as continued increases in loan balances, the Company’s provision for loan losses during 2009 was $955,000 greater than in 2008. The Company’s ratio of allowance for loan losses to gross loans increased from 1.13% at December 31, 2008 to 1.20% at December 31, 2009.  At December 31, 2009, the ratio of the allowance for loan losses to non-performing loans was 60.97% compared to 66.40% at December 31, 2008. No loss is expected for loans classified as troubled-debt restructurings in the table above. When considering the removal of restructured loans from the non-performing assets, the coverage ratio increases to 84.49% at Decmeber 31, 2009 from 76.11% at December 31, 2008.  These loans are performing in accordance with their restructured terms and were not on non-accrual at December 31, 2009.

 
18

 
Cumulative net loan losses, after recoveries, for the five-year period ending December 31, 2009 are as follows (in thousands of dollars):

   
Dollars
   
Percent of Total
 
Commercial
  $ 1,180       31 %
Real Estate
    631       16 %
Consumer
    2,031       53 %
Total
  $ 3,842          

An analysis of the changes in the allowance for loan losses is set forth in the following table (in thousands of dollars):

   
2009
   
2008
   
2007
   
2006
   
2005
 
Balance at beginning of period
  $ 3,667     $ 3,577     $ 3,482     $ 3,129     $ 2,530  
                                         
Charge-offs:
                                       
Commercial loans
    492       198       540       27       45  
Real estate loans
    445       228       47       1       8  
Consumer loans
    863       524       494       551       567  
Total Charge-offs:
    1,800       950       1,081       579       620  
                                         
Recoveries:
                                       
Commercial loans
    10       20       59       5       28  
Real estate loans
    72       2       4       20       0  
Consumer loans
    208       109       276       225       150  
Total Recoveries
    290       131       339       250       178  
                                         
Net Charge-offs
    1,510       819       742       329       442  
                                         
Provision for loan losses
    1,864       909       837       682       875  
Other additions
    0       0       0       0       166  
                                         
Balance at end of period
  $ 4,021     $ 3,667     $ 3,577     $ 3,482     $ 3,129  
                                         
Percent of net charge-offs to average net loans outstanding during the period
    .46 %     .26 %     .24 %     .11 %     .17 %

The table below shows the allocation of loans in the loan portfolio and the corresponding amounts of the allowance allocated by loan type (dollar amounts in thousands of dollars):

   
At December 31,
 
   
2009
   
2008
   
2007
   
2006
   
2005
 
   
Amount
   
Percent
of
Loans
   
Amount
   
Percent
of
Loans
   
Amount
   
Percent
of
Loans
   
Amount
   
Percent
of
Loans
   
Amount
   
Percent
of
Loans
 
Commercial
  $ 1,669       29 %   $ 1,349       30 %   $ 1,140       26 %   $ 1,492       24 %   $ 900       21 %
Mortgage
    1,034       58 %     994       57 %     1,200       59 %     996       61 %     1,139       62 %
Consumer
    1,220       13 %     1,285       13 %     1,172       15 %     967       15 %     1,082       17 %
Unallocated
    98               39               65               27               8          
Totals
  $ 4,021       100 %   $ 3,667       100 %   $ 3,577       100 %   $ 3,482       100 %   $ 3,129       100 %
 
 
19

 
As certain loans identified as impaired are paid current, collateral values increase or loans are removed from watch lists for other reasons, and as other loans become identified as impaired, the allocation of the allowance among the loan types may change.  The allocation also changes because delinquency levels within each of the respective portfolios change.  The Company feels that the allowance is a fair representation of the losses present in the portfolio given historical loss trends, economic conditions and any known credit problems as of any quarter's end. The Company believes that the allowance is to be taken as a whole, and allocation between loan types is an estimation of potential losses within each type given information known at the time.

The above figures act as the beginning for the allocation of overall allowances.  Additional changes have been made in the allocation of the allowance to address unknowns and contingent items. The unallocated portion is not computed using a specific formula and is the Company’s best estimate of what should be allocated for contingencies in the current portfolio.

Non-Interest Income

2009 Compared to 2008

Non-interest income decreased 6.19%, or $167,000 from 2009 to 2008.

Of this decrease, a large portion related to the recording of non-recurring income items in 2009 as compared to 2008. Further discussions of non-recurring income, net of non-recurring losses, for 2009 as compared to 2008, is found in the overview section above. In addition, the increases in non-recurring income items, slight decreases in service charges on deposit accounts and life insurance investment income comprise the largest portion of the decrease in non-interest income.

Service charges on deposit accounts decreased 1.60% from 2008 to 2009 as customers became more fee conscious of costs related to non-sufficient funds charges. During the latter part of 2007, The Grant County Bank implemented what is commonly referred to as a “courtesy overdraft” program which led to increases in service charges on deposit accounts in 2008 and 2007.  This income has now stabilized and is not expected to increase at the rate previously experienced.

Earnings on life insurance investment income decreased $48,000 from 2008 to 2009.  This income is tied to the Company’s investments in life insurance contracts as explained in Note Twenty of the consolidated financial statements.

Net insurance earnings and commissions decreased $59,000 from 2008 to 2009. Insurance earnings for the Company consist of commissions earned by the subsidiary banks on life and accident and health insurance sold in relation to the extension of credit and insurance revenues, net of benefits paid, expense allowances and policy and claim reserves earned by the life insurance subsidiary.  As the Company’s balances of installment loans and the new volume of installment loans, which are primary markets for credit life and accident and health insurance, have decreased over the past several years, gross revenues from insurance earnings have decreased. In relation to this decrease, required policy reserves have also declined.  The table below illustrates the components of insurance commissions and income for 2008 and 2009 (in thousands of dollars).

   
2009
   
2008
   
Increase
(Decrease)
 
Revenues
                 
Gross commissions and insurance revenues
  $ 195     $ 303     $ (108 )
                         
Expenses
                       
Benefits Paid
    44       23       21  
Changes in required policy and claim reserves
    (90 )     (38 )     (52 )
Expense allowance
    89       107       (18 )
Total Expenses
    43       92       (49 )
                         
Net insurance income
  $ 152     $ 211     $ 59  
 
 
20

 
Non-interest Expense

2009 compared to 2008

Non-interest expense increased 5.55% in 2009 as compared to 2008.

Changes in salary and benefits expense

The following table compares the components of salary and benefits expense for the twelve month periods ended December 31, 2009 and 2008 (in thousands of dollars):

Salary and Benefits Expense
 
   
2009
   
2008
   
Increase
(Decrease)
 
Employee salaries
  $ 4,443     $ 4,198     $ 245  
Employee benefit insurance
    976       878       98  
Payroll taxes
    352       346       6  
Post retirement plans
    803       866       (63 )
Total
  $ 6,574     $ 6,288     $ 286  

The table below illustrates the change in salary expense between 2009 compared to salary expense for 2008 occurring because of increases in average pay per employee and increases in the average number of full time employees (in thousands of dollars):

   
Amount
 
Changes due to increase in average cost per full time equivalent employee
  $ 443  
Changes due to decrease in the average full time equivalent employees for the periods
    (198 )
Total increase in salary expense
  $ 245  

Increases in average cost per full-time employee are primarily due to merit pay increases in non-executive compensation as well as an increase in benefit expense.

Changes in data processing expense

Data processing expense decreased 19.24%. The Company has moved toward increased electronic transfer of information between branch locations, converted to a different outsourced system and centralized data processing locations.  Data processing costs have been significantly reduced for 2009 as compared to 2008 as a result of a $10,000 data processing monthly credit from the vendor that expired at the end of November 2009.  Excluding this credit data processing expense decreased 6.18% from 2008 to 2009.

Changes in occupancy and equipment expense

The following table illustrates the components of occupancy and equipment expense for the twelve month periods ended December 31, 2009 and 2008 (in thousands of dollars):

   
2009
   
2008
   
Increase
(Decrease)
 
Depreciation of buildings and equipment
  $ 672     $ 702     $ (30 )
Maintenance expense on buildings and equipment
    401       439       (38 )
Utilities expense
    121       94       27  
Real estate and personal property tax
    101       88       13  
Other expense related to occupancy and equipment
    90       95       (5 )
Total occupancy and equipment expense
  $ 1,385     $ 1,418     $ (33 )

Changes in miscellaneous non-interest expense

Directors fees increased by 13.20% during 2009 due primarily to an increase in the overall rate paid per meeting attended.  Legal and professional fees decreased slightly by $8,000 or 1.72% from 2008 to 2009.  The table below illustrates components of other non interest expense for 2009 and 2008 (in thousands of dollars). The primary driver of the increase in miscellaneous non-interest expense is related to the $499,000 or 648.05% increase in FDIC premiums for 2009 compared to 2008.  Significant other non-interest expense are in the following table:

 
21

 
   
2009
   
2008
   
Increase
(Decrease)
 
Office supplies and postage & freight expense
    487       502       (15 )
ATM expense
    192       193       (1 )
Advertising and marketing expense
    159       189       (30 )
Amortization of intangible assets
    194       182       12  
Franchise taxes
    110       125       (15 )
FDIC assessment
    576       77       499  
Miscellaneous components of other non-interest expense
    836       782       54  
Total
  $ 2,554     $ 2,050     $ 504  

Securities Portfolio

The Company's securities portfolio serves several purposes.  Portions of the portfolio are used to secure certain public deposits.  The remaining portfolio is held as investments or used to assist the Company in liquidity and asset liability management.  Total securities, including restricted securities, represented 7.14% of total assets and 70.30% of total shareholders’ equity at December 31, 2009.
 
The securities portfolio typically will consist of three components: securities held to maturity, securities available for sale and restricted securities.  Securities are classified as held to maturity when the Company has the intent and the ability at the time of purchase to hold the securities to maturity. Held to maturity securities are carried at cost, adjusted for amortization of premiums and accretion of discounts. Securities to be held for indefinite periods of time are classified as available for sale and accounted for at market value. Securities available for sale include securities that may be sold in response to changes in market interest rates, changes in the security's prepayment risk, increases in loan demand, general liquidity needs and other similar factors. Restricted securities are those investments purchased as a requirement of membership in certain governmental lending institutions and cannot be transferred without the issuer’s permission.  The Company's purchases of securities have generally been limited to securities of high credit quality with short to medium term maturities.

The Company identifies at the time of acquisition those securities that are available for sale. These securities are valued at their market value with any difference in market value and amortized cost shown as an adjustment in stockholders' equity.  Changes within the year in market values are reflected as changes in other comprehensive income, net of the deferred tax effect.  As of December 31, 2009, the fair value of the securities available for sale exceed their cost basis by $513,000 ($323,000 after tax effect of $190,000).

The table below summarizes the carrying value of the Company’s securities at December 31, 2009, 2008 and 2007 (in thousands of dollars):

   
Available for Sale
Carrying Value
December 31,
 
   
2009
   
2008
   
2007
 
U.S. Treasuries and Agencies
  $ 12,426     $ 7,726     $ 15,245  
Mortgage backed securities
    5,836       10,342       7,784  
State and municipals
    3,946       3,609       3,039  
Certificates of deposit
    4,703       0       0  
Marketable equities
    25       15       22  
Total
  $ 26,936     $ 21,692     $ 26,090  
 
 
22


The carrying amount and estimated market value of debt securities (in thousands of dollars) at December 31, 2009 by contractual maturity are shown below.  Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.

   
Amortized Cost
   
Fair Value
   
Equivalent Average Yield
 
                   
Securities Available for Sale
                 
Due in 3 months through one year
  $ 4,329     $ 4,385       2.64 %
Due after one year through five
    16,124       16,365       2.20 %
Due five years through ten years
    325       326       4.47 %
Mortgage backed securities
    5,630       5,835       5.06 %
Equity securities with no maturity
    15       25          
Total Available For Sale
  $ 26,423     $ 26,936       2.91 %

Yields on tax exempt securities are stated at actual yields.

Any changes in market values of securities deemed by management to be attributable to reasons other than changes in market rates of interest would be recorded through results of operations.  It is the Company’s determination that all securities held at December 31, 2009 which have fair values less than the amortized cost, have these gross unrealized losses related to increases in the current interest rates for similar issues of securities, and that no material impairment for any securities in the portfolio exists because of downgrades of the securities or as a result of a change in the financial condition of any of the issuers. A summary of the length of time of unrealized losses for all securities held at December 31, 2009 can be found in the footnotes to the consolidated financial statements. The Company reviews all securities with unrealized losses, and all securities in the portfolio on a regular basis to determine whether the potential for other than temporary impairment exists. One of the criteria for making this determination is the rating given to each bond by the major ratings agencies Moodys and Standard & Poors.
 
A summary of the Company’s securities portfolio at December 31, 2009, based on the ratings of the securities in the portfolio given by these ratings agencies is shown below (in thousands of dollars):

     
Amortized
Cost
   
Gross Unrealized
Gains
   
Gross Unrealized
Losses
   
Market
Value
 
Ratings Provided by Ratings Agencies
                         
Moody’s
 
S&P
                         
                               
U.S. Treasuries and Agencies
                         
Aaa
 
AAA
    $ 12,250     $ 177     $ 1     $ 12,426  
                                       
Mortgage Backed Securities
                                 
Aaa
 
AAA
    $ 5,630     $ 206     $ 0     $ 5,836  
                                       
State and Municipals
                                 
Aaa
 
AA+
    $ 2,026     $ 41     $ 0     $ 2,067  
Aa3
 
AAA
      335       23       0       358  
Aa3
  A+       511       40       0       551  
Aa3
 
No Rating
      140       7       0       147  
A3
 
No Rating
      140       1       0       141  
Baa1
  A       130       0       0       130  
No Rating
 
No Rating
      550       2       0       552