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, 2019

[   ] 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	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 14, 2019.

Highlands Bankshares, Inc.

Form 10-Q

For the Quarter Ended September 30, 2019

INDEX

PART I. FINANCIAL INFORMATION	PAGE
Item 1.  Financial Statements
Consolidated Balance Sheets at September 30, 2019 (Unaudited) and December 31, 2018	3
Consolidated Statements of Income (Unaudited) for the three- and nine-month periods ended September 30, 2019 and 2018	4
Consolidated Statements of Comprehensive Income (Unaudited) for the three- and nine-month periods ended September 30, 2019 and 2018	5
Consolidated Statements of Cash Flows (Unaudited) for the nine-month periods ended September 30, 2019 and 2018	6
Consolidated Statements of Changes in Stockholders' Equity (Unaudited) for the three- and nine-month periods ended Septemer 30, 2019 and 2018	7
Notes to Consolidated Financial Statements (Unaudited)	8
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations	27
Item 3. Quantitative and Qualitative Disclosures About Market Risk	32
Item 4.  Controls and Procedures	32
PART II.  OTHER INFORMATION
Item 1.  Legal Proceedings	33
Item 1A. Risk Factors	33
Item 2.  Unregistered Sales of Equity Securities and Use of Proceeds	33
Item 3.  Defaults Upon Senior Securities	33
Item 4.  Mine Safety Disclosures	33
Item 5.  Other Information	33
Item 6.  Exhibits	33
SIGNATURES AND CERTIFICATIONS	33

2

PART I.

FINANCIAL INFORMATION

ITEM 1.  Financial Statements

Consolidated Balance Sheets

(Amounts in thousands) 

	(Unaudited) September 30, 2019			December 31, 2018
ASSETS
Cash and due from banks	$	20,248		$	19,965
Federal funds sold	2,627			10,101
Total cash and cash equivalents	22,875			30,066
Investment securities available for sale (amortized cost $56,337 at September 30, 2019, $71,260 at December 31, 2018)	56,472			68,631
Other investments, at cost	1,493			2,774
Loans held for sale	233			265
Loans	453,239			448,121
Allowance for loan losses	(4,168		)	(4,373		)
Net loans	449,071			443,748
Premises and equipment, net	16,969			17,447
Real estate held for sale	590			817
Deferred tax assets	5,358			6,526
Interest receivable	1,962			1,617
Bank-owned life insurance	15,307			15,022
Other real estate owned	2,484			2,212
Other assets	2,460			2,816
Total assets	$	575,274		$	591,941
LIABILITIES AND STOCKHOLDERS' EQUITY
LIABILITIES
Deposits:
Non-interest bearing	$	154,279		$	156,408
Interest bearing	355,826			346,408
Total deposits	510,105			502,816
Interest, taxes and other liabilities	3,747			2,391
Short-term borrowings	—			30,000
Long-term debt	54			93
Total liabilities	513,906			535,300
STOCKHOLDERS' EQUITY
Common stock (8,251 shares issued and outstanding at September 30, 2019 and December 31, 2018)	5,156			5,156
Preferred stock (2,092 shares issued and outstanding at September 30, 2019 and December 31, 2018)	4,184			4,184
Additional paid-in capital	19,312			19,277
Retained earnings	32,608			30,131
Accumulated other comprehensive loss	108			(2,107		)
Total stockholders' equity	61,368			56,641
Total liabilities and stockholders' equity	$	575,274		$	591,941

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,
	2019		2018		2019		2018
INTEREST INCOME
Loans receivable and fees on loans	$	5,912	$	5,558	$	17,217	$	16,149
Investment securities	388		434		1,233		1,350
Federal funds sold	85		17		453		144
Total interest income	6,385		6,009		18,903		17,643
INTEREST EXPENSE
Deposits	967		497		2,746		1,423
Other borrowed funds	116		294		664		981
Total interest expense	1,083		791		3,410		2,404
Net interest income	5,302		5,218		15,493		15,239
Provision for loan losses	548		198		1,487		542
Net interest income after provision for loan losses	4,754		5,020		14,006		14,697
NONINTEREST INCOME
Service charges on deposit accounts	348		396		1,028		1,075
Other service charges, commissions and fees	393		404		1,110		1,251
Mortgage banking income	54		116		150		268
Securities gains, net	28		—		21		—
Other operating income	152		152		489		545
Total noninterest income	975		1,068		2,798		3,139
NONINTEREST EXPENSE
Salaries and employee benefits	2,262		2,347		6,959		7,130
Occupancy and equipment expense	575		607		1,770		2,088
OREO expenses, net	40		89		182		366
Other operating expense	1,775		1,665		4,828		4,922
Total noninterest expense	4,652		4,708		13,739		14,506
Income before income taxes	1,077		1,380		3,065		3,330
Income tax expense (Note 6)	231		289		588		706
Net income	$	846	$	1,091	$	2,477	$	2,624
Net income per common share (Note 8)
Basic	$	0.10	$	0.13	0.30		0.32
Fully diluted	0.08		0.11		0.24		0.25

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,
	2019			2018			2019			2018
Net income	$	846		$	1,091		$	2,477		$	2,624
Other comprehensive income (loss)
Unrealized gains (losses) on securities during the period	555			(913		)	2,764			(2,210		)
Less: reclassification adjustment	(28		)	—			(21		)	—
Other comprehensive income (loss) before tax	527			(913		)	2,743			(2,210		)
Income tax (expense) benefit related to other comprehensive income (loss)	(56		)	185			(528		)	456
Other comprehensive income (loss)	471			(728		)	2,215			(1,754		)
Comprehensive income	$	1,317		$	363		$	4,692		$	870

See accompanying Notes to Consolidated Financial Statements

5

Consolidated Statements of Cash Flows

(Amounts in thousands)

(Unaudited) 

	Nine Months Ended September 30,
	2019			2018
CASH FLOWS FROM OPERATING  ACTIVITIES:
Net income	$	2,477		$	2,624
Adjustments to reconcile net income to net cash provided by operating activities:
Provision for loan losses	1,487			542
Depreciation and amortization	1,015			1,161
Provision for deferred tax assets	487			633
Net realized gains on available for sale securities	(21		)	—
Restricted stock expense	35			165
Originations of loans held for sale	(5,453		)	(10,661		)
Proceeds from loans held for sale	5,485			13,855
Increase (decrease) in interest receivable	(345		)	83
Valuation adjustment of real estate held for sale	—			250
Valuation adjustment of other real estate owned	—			215
Decrease in other assets	191			1,345
Increase in interest, taxes and other liabilities	1,236			573
Net cash provided by operating activities	6,594			10,785
CASH FLOWS FROM INVESTING ACTIVITIES:
Securities available for sale:
Proceeds from sale of securities	9,402			—
Proceeds from maturities of securities	7,395			8,405
Purchase of debt and equity securities	(2,170		)	(2,706		)
Redemptions of other investments	1,281			19
Net increase in loans	(8,926		)	(21,728		)
Proceeds from sales of other real estate owned	1,844			359
Proceeds from sale of real estate held for sale	227			378
Premises and equipment expenditures	(88		)	(164		)
Net cash provided (used) by investing activities	8,965			(15,437		)
CASH FLOWS FROM FINANCING ACTIVITIES:
Net increase (decrease) in time deposits	11,634			(4,687		)
Net (decrease) increase in demand, savings and other deposits	(4,345		)	510
Net change in short-term borrowings	(30,000		)	2,120
Decrease in long-term debt	(39		)	(39		)
Net cash used by financing activities	(22,750		)	(2,096		)
Net change in cash and cash equivalents	(7,191		)	(6,748		)
Cash and cash equivalents at beginning of period	30,066			30,797
Cash and cash equivalents at end of period	$	22,875		$	24,049
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION
Cash payments during the period for interest	$	2,936		$	2,376
Cash payments during the period for income taxes	—			65
SUPPLEMENTAL DISCLOSURE OF NONCASH TRANSACTIONS
Transfer of loans to other real estate owned	2,116			466
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
Three-month period
Balance June 30, 2018	8,199	$	5,124	2,092	$	4,184	$	19,224		$	28,072	$	(2,443	)	$	54,161
Net income	—	—		—	—		—			1,091		—			1,091
Other comprehensive loss	—	—		—	—		—			—		(467		)	(467		)
Restricted stock award	50	32		—	—		(32		)	—		—			—
Stock-based compensation	—	—		—	—		54			—		—			54
Balance September 30, 2018	8,249	$	5,156	2,092	$	4,184	$	19,246		$	29,163	$	(2,910	)	$	54,839
Balance June 30, 2019	8,251	$	5,156	2,092	$	4,184	$	19,292		$	31,762	$	(363	)	$	60,031
Net income	—	—		—	—		—			846		—			846
Other comprehensive income	—	—		—	—		—			—		471			471
Stock-based compensation	—	—		—	—		20			—		—			20
Balance September 30, 2019	8,251	$	5,156	2,092	$	4,184	$	19,312		$	32,608	$	108		$	61,368
Nine-month period
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		)
Stock-based compensation	—	—		—	—		165			—		—			165
Restricted stock award	50	32					(32		)						—
Balance September 30, 2018	8,249	$	5,156	2,092	$	4,184	$	19,246		$	29,163	$	(2,910	)	$	54,839
Balance December 31, 2018	8,251	$	5,156	2,092	$	4,184	$	19,277		$	30,131	$	(2,107	)	$	56,641
Net income	—	—		—	—		—			2,477		—			2,477
Other comprehensive income	—	—		—	—		—			—		2,215			2,215
Stock-based compensation	—	—		—	—		35			—		—			35
Balance September 30, 2019	8,251	$	5,156	2,092	$	4,184	$	19,312		$	32,608	$	108		$	61,368

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, 2018 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, 2018 (the "2018 Form 10-K"). The notes included herein should be read in conjunction with the notes to the consolidated financial statements included in the 2018 Form 10-K. The results of operations for the nine-month period ended September 30, 2019, 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 - Proposed Merger with First Community Bankshares, Inc.

On September 11, 2019, the Company entered into an Agreement and Plan of Merger (the “Merger Agreement”) with First Community Bankshares, Inc., a Virginia corporation (“First Community”). The Merger Agreement provides that, upon the terms and conditions set forth therein, the Company will merge with and into First Community (the “Merger”), with First Community continuing as the surviving corporation. At the effective time of the Merger, the Company’s wholly-owned subsidiary, Highlands Union Bank, will merge with and into First Community's wholly-owned subsidiary, First Community Bank with First Community Bank continuing as the surviving entity.

Subject to the terms and conditions of the Merger Agreement, at the effective time of the Merger, the Company’s shareholders will have the right to receive 0.2703 shares of First Community common stock, par value $1.00, for each share of the Company’s common stock. Based on First Community's 20-day average price prior to announcement of the Merger, the estimated aggregate purchase price was $91,000,000.

The transaction is expected to close on December 31, 2019 or in the first quarter of 2020, subject to shareholder and regulatory approval and other customary closing conditions.

Note 3 – Summary of Significant Accounting Policy Update For Certain Required Disclosures

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. As initially adopted, 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). During July 2019, the FASB voted to propose a deferral of the effective date for several of its recent standards, including ASU 2016-13. Based on the proposed extended adoption date, the provisions of ASU 2016-13 would be effective for the Company beginning January 1, 2023. 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.

In February 2016, the FASB issued ASU 2016-02, Leases, which revised certain aspects of recognition, measurement, presentation, and disclosure of leasing transactions. ASU 2016-02 was effective for the Company on January 1, 2019. The standard provides for a modified retrospective transition approach requiring lessees to recognize and measure leases on the balance sheet at the beginning of either the earliest period presented or as of the beginning of the period of adoption with the option to elect certain practical expedients. The Company has elected to apply the standard as of the beginning of the period of adoption (January 1, 2019) and did not restate comparative periods. The Company has adopted all the optional practical expedients available under ASU 2016-02.

8

The operating leases of the Company relate to office space and bank branches. As a result of implementing ASU 2016-02, the Company recognized an operating lease right-of-use (“ROU”) asset and an operating lease liability of $120,000 on January 1, 2019, with no impact on net income or stockholders’ equity. The ROU asset and operating lease liability are recorded in premises and equipment and other liabilities, respectively, in the consolidated balance sheet as of September 30, 2019.

Operating lease ROU assets represent our right to use an underlying asset during the lease term and operating lease liabilities represent our obligation to make lease payments arising from the lease. ROU assets and operating lease liabilities are recognized at lease commencement based on the present value of the remaining lease payments using a discount rate that represents our incremental borrowing rate at the lease commencement date. Operating lease expense, which is comprised of amortization of the ROU asset and the implicit interest accreted on the operating lease liability, is recognized over the lease term, and is recorded in occupancy expense in the consolidated statements of operations.

Note 4 - Investment Securities Available For Sale

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

	September 30, 2019
	Amortized cost		Gross unrealized gains		Gross unrealized losses		Fair value
State and political subdivisions	$	9,877	$	221	$	9	$	10,089
Mortgage backed securities	41,920		103		201		41,822
SBA pools	4,540		29		8		4,561
	$	56,337	$	353	$	218	$	56,472

	December 31, 2018
	Amortized cost		Gross unrealized gains		Gross unrealized losses		Fair value
State and political subdivisions	$	13,590	$	9	$	763	$	12,836
Mortgage backed securities	52,344		8		1,798		50,554
SBA pools	5,326		—		85		5,241
	$	71,260	$	17	$	2,646	$	68,631

Investment securities available for sale with a fair value of $35,767 and $37,448 at September 30, 2019 and December 31, 2018, respectively, were pledged as collateral on public deposits, FHLB advances and for other purposes as required or permitted by law.

9

The following tables present the age of gross unrealized losses and fair value by investment category:

	September 30, 2019
	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	$	1,352	$	3	$	469	$	6	$	1,821	$	9
Mortgage-backed securities	4,215		15		26,352		186		30,567		201
SBA pools	1,607		8		—		—		1,607		8
Total	$	7,174	$	26	$	26,821	$	192	$	33,995	$	218

	December 31, 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	$	3,608	$	73	$	7,791	$	690	$	11,399	$	763
Mortgage-backed securities	2,319		8		46,661		1,790		48,980		1,798
SBA pools	—		—		5,218		85		5,218		85
Total	$	5,927	$	81	$	59,670	$	2,565	$	65,597	$	2,646

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, 2019 and December 31, 2018, 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, 2019 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.

	September 30, 2019				December 31, 2018
	Amortized cost		Fair value		Amortized cost		Fair value
Investment securities with scheduled maturities:
Due in one year or less	$	—	$	—	$	98	$	100
Due after one year through five years	—		—		367		366
Due after five years through ten years	2,109		2,163		2,782		2,638
Due after ten years	12,308		12,487		15,669		14,973
Total investment securities with scheduled maturities	14,417		14,650		18,916		18,077
Mortgage-backed securities	41,920		41,822		52,344		50,554
Total investment securities available for sale	$	56,337	$	56,472	$	71,260	$	68,631

The following table summarizes the securities gains (losses) recognized for the periods presented:

	Three months ended September 30,					Nine months ended September 30,
	2019			2018		2019			2018
Gross gains	$	62		$	—	$	62		$	—
Gross losses	(34		)	—		(41		)	—
Securities gains, net	$	28		$	—	$	21		$	—

10

Note 5  -  Loans and Allowance for Loan Losses

The composition of net loans is as follows:

	September 30, 2019		December 31, 2018
Real estate secured:
Residential 1-4 family	$	161,939	$	165,109
Multifamily	23,758		18,378
Construction and land loans	24,587		21,029
Commercial, owner occupied	96,224		96,224
Commercial, non-owner occupied	38,166		39,869
Second mortgages	3,151		4,054
Equity lines of credit	28,528		30,221
Farmland	9,523		12,149
Total real estate secured	385,876		387,033
Non-real estate secured
Personal	11,627		12,754
Commercial	53,401		46,202
Agricultural	2,967		2,830
Total non-real estate secured	67,995		61,786
Gross loans	453,871		448,819
Less:
Allowance for loan losses	4,168		4,373
Net deferred fees	632		698
Loans, net	$	449,071	$	443,748

11

The following table is an analysis of past due loans as of September 30, 2019:

	Past Due
	30-89 days		90 days and over		Total		Current		Total		> 90 Days and Accruing
Real estate secured
Residential 1-4 family	$	1,368	$	780	$	2,148	$	159,791	$	161,939	$	—
Equity lines of credit	105		18		123		28,405		28,528		—
Multifamily	—		—		—		23,758		23,758		—
Farmland	—		—		—		9,523		9,523		—
Construction, land development, other land loans	50		69		119		24,468		24,587		—
Commercial real estate:
Owner-occupied	690		1,244		1,934		94,290		96,224		—
Non-owner-occupied	84		—		84		38,082		38,166		—
Second mortgages	—		—		—		3,151		3,151		—
Non-real estate secured
Personal	91		23		114		11,513		11,627		—
Commercial	657		32		689		52,712		53,401		168
Agricultural	10		—		10		2,957		2,967		—
Total	$	3,055	$	2,166	$	5,221	$	448,650	$	453,871	$	168

The following table is an analysis of past due loans as of December 31, 2018:

	Past Due
	30-89 days		90 days and over		Total		Current		Total		> 90 Days and Accruing
Real estate secured
Residential 1-4 family	$	1,481	$	819	$	2,300	$	162,809	$	165,109	$	105
Equity lines of credit	218		75		293		29,928		30,221		—
Multifamily	402		—		402		17,976		18,378		—
Farmland	754		—		754		11,395		12,149		—
Construction, land development, other land loans	16		—		16		21,013		21,029		—
Commercial real estate:
Owner-occupied	9		756		765		95,459		96,224		—
Non-owner-occupied	—		1,859		1,859		38,010		39,869		—
Second mortgages	—		—		—		4,054		4,054		—
Non-real estate secured
Personal	186		4		190		12,564		12,754		—
Commercial	82		114		196		46,006		46,202		2
Agricultural	—		—		—		2,830		2,830		—
Total	$	3,148	$	3,627	$	6,775	$	442,044	$	448,819	$	107

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.

12

The following is a summary of non-accrual loans at September 30, 2019 and December 31, 2018: 

	September 30, 2019		December 31, 2018
Real estate secured
Residential 1-4 family	$	873	$	1,196
Multifamily	—		—
Construction and land loans	352		8
Commercial real estate:
Owner-occupied	2,493		2,038
Non-owner-occupied	—		2,004
Equity lines of credit	18		75
Farmland	940		142
Non-real estate secured
Personal	28		26
Commercial and agricultural	651		431
Total	$	5,355	$	5,920

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, 2019.

	Number	Balance
Real estate in the process of foreclosure	5	$	736
Foreclosed residential real estate	6	753

The following tables represent a summary of credit quality indicators of the Company's loan portfolio at September 30, 2019 and December 31, 2018. 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, 2019 and December 31, 2018: 

September 30, 2019	Residential 1-4 Family		Multifamily		Farmland		Construction, Land Loans		Commercial Real Estate- Owner Occupied		Commercial Real Estate Non-Owner Occupied
Quality	$	11,542	$	—	$	—	$	561	$	1,292	$	336
Satisfactory	93,155		8,348		2,077		4,855		31,743		11,404
Acceptable	51,432		13,390		2,714		15,763		51,094		21,253
Special Mention	674		2,020		395		2,954		4,818		3,663
Substandard	5,136		—		4,337		454		7,277		1,510
Doubtful	—		—		—		—		—		—
Total	$	161,939	$	23,758	$	9,523	$	24,587	$	96,224	$	38,166

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December 31, 2018	Residential 1-4 Family		Multifamily		Farmland		Construction, Land Loans		Commercial Real Estate- Owner Occupied		Commercial Real Estate Non-Owner Occupied
Quality	$	12,991	$	—	$	—	$	724	$	1,632	$	131
Satisfactory	107,925		4,276		2,736		5,314		39,679		13,046
Acceptable	37,036		13,700		3,617		13,349		47,963		21,073
Special Mention	1,696		402		—		1,565		2,720		3,615
Substandard	5,461		—		5,796		77		4,230		2,004
Doubtful	—		—		—		—		—		—
Total	$	165,109	$	18,378	$	12,149	$	21,029	$	96,224	$	39,869

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.

14

Special Mention-This grade is given to Watch List loans that include the following characteristics:

• Loans with underwriting guideline tolerances and/or exceptions with no identifiable mitigating factors.

• Extending loans that are currently performing satisfactorily but with potential weaknesses that may, if not corrected, weaken the asset or inadequately protect the Bank's position at some future date. Potential weaknesses are the result of deviations from prudent lending practices.

• Loans where adverse economic conditions that develop subsequent to the loan origination do not jeopardize liquidation of the debt, but do substantially increase the level of risk may also warrant this rating.

Substandard-Loans in this category are characterized by deterioration in quality exhibited by any number of well-defined weaknesses requiring corrective action. A substandard loan is inadequately protected by the current sound net worth and paying capacity of the obligor or of the collateral pledged, if any. Loans classified as substandard must have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt; they are characterized by the distinct possibility that the institution will sustain some loss if the deficiencies are not corrected.

The weaknesses may include, but are not limited to:

• High debt to worth ratios and or declining or negative earnings trends

• Declining or inadequate liquidity

• Improper loan structure  or questionable repayment sources

• Lack of well-defined secondary repayment source, and

• Unfavorable competitive comparisons.

Such loans are no longer considered to be adequately protected due to the borrower's declining net worth, lack of earnings capacity, declining collateral margins and/or unperfected collateral positions. A possibility of loss of a portion of the loan balance cannot be ruled out. The repayment ability of the borrower is marginal or weak and the loan may have exhibited excessive overdue status or extensions and/or renewals.

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, 2019:

	Consumer - Non Real Estate		Equity Line of Credit /Second Mortgages		Commercial - Non Real Estate		Agricultural - Non Real Estate
Performing	$	11,604	$	31,661	$	53,369	$	2,967
Nonperforming (>90 days past due)	23		18		32		—
Total	$	11,627	$	31,679	$	53,401	$	2,967

Credit Risk Profile based on payment activity as of December 31, 2018:

	Consumer - Non Real Estate		Equity Line of Credit /Second Mortgages		Commercial - Non Real Estate		Agricultural - Non Real Estate
Performing	$	12,750	$	34,200	$	46,088	$	2,830
Nonperforming (>90 days past due)	4		75		114		—
Total	$	12,754	$	34,275	$	46,202	$	2,830

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The following tables reflect the Bank's impaired loans at September 30, 2019:

September 30, 2019	Recorded Investment		Unpaid Principal Balance		Related Allowance		Average Recorded Investment		Interest Income Recognized
With no related allowance
Real estate secured
Residential 1-4 family	$	4,081	$	4,081	$	—	$	4,409	$	144
Equity lines of credit	—		—		—		2		—
Multifamily	—		—		—		101		—
Farmland	4,228		4,228		—		4,998		76
Construction, land development, other land loans	1,968		1,968		—		1,801		92
Commercial real estate- owner occupied	4,818		4,818		—		4,397		214
Commercial real estate- non owner occupied	62		62		—		16		—
Second mortgages	429		429		—		204		—
Non-real estate secured
Personal	42		42		—		22		98
Commercial and agricultural	283		283		—		530		29
Total	$	15,911	$	15,911	$	—	$	16,480	$	653

September 30, 2019	Recorded Investment		Unpaid Principal Balance		Related Allowance		Average Recorded Investment		Interest Income Recognized
With an allowance recorded
Real estate secured
Residential 1-4 family	$	588	$	588	$	96	$	481	$	—
Equity lines of credit	—		—		—		33		—
Multifamily	—		—		—		206		—
Farmland	116		116		2		462		—
Construction, land development, other land loans	—		—		—		15		—
Commercial real estate- owner occupied	3,822		3,822		856		2,571		—
Commercial real estate- non owner occupied	1,527		1,527		302		2,520		—
Second mortgages	34		34		4		17		—
Non-real estate secured
Personal	4		4		3		16		—
Commercial and agricultural	1,041		1,041		784		988		13
Total	$	7,132	$	7,132	$	2,047	$	7,309	$	13

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The following tables reflect the Bank's impaired loans at December 31, 2018:

December 31, 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	$	4,325	$	4,325	$	—	$	5,862	$	134
Equity lines of credit	7		7		—		28		—
Multifamily	402		402		—		201		—
Farmland	5,681		5,681		—		3,084		10
Construction, land development, other land loans	1,635		1,635		—		1,700		2
Commercial real estate- owner occupied	5,332		5,332		—		3,442		9
Commercial real estate- non owner occupied	—		—		—		32		—
Second mortgages	100		100		—		155		—
Non real estate secured
Personal	—		—		—		48		9
Commercial and agricultural	317		317		—		411		20
Total	$	17,799	$	17,799	$	—	$	14,963	$	184

December 31, 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	$	631	$	631	$	191	$	353	$	307
Equity lines of credit	105		105		80		53		6
Multifamily	—		—		—		—		—
Farmland	122		122		2		927		—
Construction, land development, other land loans	—		—		—		—		—
Commercial real estate- owner occupied	1,704		1,704		351		1,789		—
Commercial real estate- non owner occupied	3,686		3,686		844		3,789		45
Second mortgages	35		35		7		18		—
Non real estate secured
Personal	18		18		7		10		—
Commercial and agricultural	1,161		1,161		880		832		—
Total	$	7,462	$	7,462	$	2,362	$	7,771	$	358

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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, 2019 and September 30, 2018.

Nine months ended September 30, 2019	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, 2018	$	492		$	25	$	27		$	1,022	$	895		$	13		$	127	$	11		$	114		$	957		$	690		$	4,373
Provision expense (credit) for credit losses	221			349		14			225		497			122			51		2			172			524			(690		)	1,487
Charge-offs	170			202		—			—		657			89			75		—			262			501			—			1,956
Recoveries	(23		)	—		(6		)	—		(2		)	(3		)	—		(2		)	(78		)	(150		)	—			(264		)
Net charge-offs (recoveries)	147			202		(6		)	—		655			86			75		(2		)	184			351			—			1,692
Balance at September 30, 2019	$	566		$	172	$	47		$	1,247	$	737		$	49		$	103	$	15		$	102		$	1,130		$	—		$	4,168
Allowance allocated by impairment method:
Individually evaluated	$	96		$	—	$	—		$	856	$	302		$	4		$	—	$	2		$	3		$	784		$	—		$	2,047
Collectively evaluated	470			172		47			391		435			45			103		13			99			346			—			2,121
Loan balances by impairment method used:
Individually evaluated	$	4,670		$	—	$	1,968		$	8,640	$	1,590		$	464		$	—	$	4,343		$	45		$	1,324		$	—		$	23,044
Collectively evaluated	157,269			23,758		22,619			87,584		36,576			2,687			28,528		5,180			11,582			55,044			—			430,827
Balance at September 30, 2019	$	161,939		$	23,758	$	24,587		$	96,224	$	38,166		$	3,151		$	28,528	$	9,523		$	11,627		$	56,368		—			$	453,871

Three months ended September 30, 2019	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, 2019	$	663		$	173	$	55		$	1,073	$	757		$	14		$	148		$	13		$	112		$	971		$	264		$	4,243
Provision for credit losses	(106		)	201		(10		)	174		(20		)	123			(45		)	—			131			364			(264		)	548
Charge-offs	—			202		—			—		1			89			—			—			172			227			—			691
Recoveries	(9		)	—		(2		)	—		(1		)	(1		)	—			(2		)	(31		)	(22		)	—			(68		)
Net charge-offs (recoveries)	(9		)	202		(2		)	—		—			88			—			(2		)	141			205			—			623
Balance at September 30, 2019	$	566		$	172	$	47		$	1,247	$	737		$	49		$	103		$	15		$	102		$	1,130		$	—		$	4,168

18

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 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
Reclassification of reserve for unfunded commitments	—			—		—			—			—		—			—		—			—			—			—			—
Balance at September 30, 2018	$	345		$	—	$	1		$	1,445		$	847	$	1		$	491	$	4		$	186		$	282		$	624		$	4,226

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 $8,516 and $11,546 of loans categorized as troubled debt restructurings as of September 30, 2019 and December 31, 2018, 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, 2019 that represent new TDRs.

Number Pre-Modification Recorded Investment Post-Modification Recorded Investment

Below Market Rate
Farmland	1	$	754	$	754
Commercial real estate-owner occupied	2	1,258		1,258
Commercial	4	449		449
Total	7	$	2,461	$	2,461

The following table identifies restructurings completed during the nine-month period ended September 30, 2018 that represented new TDRs.

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	10	$	4,211	$	4,211

There were no defaults in the nine-month periods ending September 30, 2019 and September 30, 2018 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 25 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. 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 watch list reviews, which include reviews of past due data and other information that might be helpful in evaluating 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

20

estate ("CRE") loan segment is further disaggregated into two classes. Non-owner occupied CRE loans, which include loans secured by non-owner occupied nonfarm nonresidential properties, generally have a greater risk profile than all other CRE loans, which include multifamily structures and owner-occupied commercial structures. The construction loan segment is further disaggregated into two classes. One-to-four family residential construction loans are generally made to individuals for the acquisition of and/or construction on a lot or lots on which a residential dwelling is to be built. Commercial construction loans are generally made to developers or investors for the purpose of acquiring, developing and constructing residential or commercial structures. Construction lending is generally considered to involve a higher degree of credit risk than long-term permanent financing.

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

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

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 a recent appraisal, 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, 2019 and December 31, 2018, all impaired loans were evaluated based on either the fair value of the collateral or the discounted cash flows.

For impaired loans valued based on collateral value, the collateral value is adjusted for age and condition of the security, 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.

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:

a. National GDP growth rate

b. Local unemployment rates

c. Prime interest rate

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

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

a. Past-due loans

b. Non-accrual loans

c. Commercial real estate concentrations

d. Loan volume

e. Level and trend of classified loans

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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 and approved 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 has concluded that the carrying amounts approximate the fair values of loans held for sale.

	Nine months ended September 30,
	2019		2018
Loans held for sale at end of period	$	233	$	1,614
Proceeds from sales of mortgage loans originated for sale	5,485		13,855
Gain on sales of mortgage loans originated for sale	150		268

Note 6  -  Income Taxes

Income tax expense at statutory rates for the three- and nine-month periods ended September 30, is shown below, with adjustments needed to determine income tax expense recorded in the consolidated statements of income.

	Three months ended September 30,						Nine months ended September 30,
	2019			2018			2019			2018
Tax expense at statutory rate	$	226		$	290		$	644		$	699
Increase (decrease) in tax expense resulting from:
Tax-exempt interest	(27		)	(27		)	(85		)	(85		)
Other, net	32			26			29			92
Income tax expense	$	231		$	289		$	588		$	706
Statutory corporate federal income tax rate	21		%	21		%	21		%	21		%

Note 7  - 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.

The following table presents the capital ratios for the Bank only.

	September 30, 2019		December 31, 2018
Tier 1 leverage	9.81	%	9.14	%
Tier 1 risk-based	13.12	%	12.31	%
Total risk-based	14.08	%	13.30	%
Common equity tier 1	13.12	%	12.31	%

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Note 8 – 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, 2019 and 2018. The following provides information for the calculation of basic and diluted earnings per common share:

	Three months ended September 30,				Nine months ended September 30,
(thousands, except per share information)	2019		2018		2019		2018
Net income available to common stockholders	$	846	$	1,091	$	2,477	$	2,624
Weighted average common shares outstanding	8,199		8,199		8,199		8,199
Total shares outstanding including assumed conversion of preferred securities	10,343		10,303		10,343		10,326
Basic earnings per common share	$	0.10	$	0.13	$	0.30	$	0.32
Fully diluted earnings per share (including convertible preferred shares outstanding and restricted stock)	0.08		0.11		0.24		0.25

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 52,000 shares have been issued under the 2018 Restricted Stock Plan as of September 30, 2019.

Note 9 – 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, 2019, unused commitments totaled $52,737, compared to $56,726 at December 31, 2018. Standby letters of credit totaled $1,656 at September 30, 2019 and $3,477 at December 31, 2018.

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Note 10 – 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.

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, 2019 and December 31, 2018, segregated by the level of the valuation inputs within the fair value hierarchy.

September 30, 2019
	Level 1		Level 2		Level 3		Total Fair Value
State and political subdivisions	$	—	$	10,089	$	—	$	10,089
Mortgage backed securities	—		41,822		—		41,822
SBA pools	—		4,561		—		4,561
Total available for sale securities	$	—	$	56,472	$	—	$	56,472

December 31, 2018
	Level 1		Level 2		Level 3		Total Fair Value
State and political subdivisions	$	—	$	12,836	$	—	$	12,836
Mortgage backed securities	—		50,554		—		50,554
SBA pools	—		5,241		—		5,241
Total available for sale securities	$	—	$	68,631	$	—	$	68,631

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Recurring - Derivatives

The Company has entered into interest rate swaps related to customer loan transactions to manage its interest rate risk. Interest rate swaps, which had a notional value of $12,890 as of September 30, 2019 and December 31, 2018, 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, 2019 totaled $413, compared to $38 at December 31, 2018.

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, 2019 and December 31, 2018, 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, 2019 and December 31, 2018, 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, 2019	Level 1		Level 2		Level 3		Fair Value
Impaired loans	$	—	$	—	$	5,085	$	5,085
OREO	—		—		2,484		2,484
Real estate held for sale	—		—		590		590

December 31, 2018	Level 1		Level 2		Level 3		Fair Value
Impaired loans	$	—	$	—	$	5,100	$	5,100
OREO	—		—		2,212		2,212
Real estate held for sale	—		—		817		817

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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: 

			Quantitative Information about Level 3 Fair Value Measurements
	12/31/18		9/30/2019		Valuation Techniques	Unobservable Input (2)	Range
OREO, net	$	2,212	$	2,484	Appraisal of collateral (1)	Appraisal adjustments	0% to 20%
						Liquidation expenses	0% to 10%
Real estate held for sale	$	817	$	590	Appraisal of collateral (1)	Appraisal adjustments	0% to 20%
						Liquidation expenses	0% to 10%
Impaired loans	$	5,100	$	5,085	Fair value of collateral –real estate  (1), (3)	Appraisal adjustments	0% to 100%
					Fair value of collateral –equipment, inventory, other  (1), (3)	Appraisal adjustments	25% to 80%
						Liquidation expenses	0% to 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

The carrying amounts and fair values of the Company's financial instruments at September 30, 2019 and December 31, 2018 were as follows:

		September 30, 2019				December 31, 2018
	Fair Value Inputs	Carrying Amount		Fair Value		Carrying Amount		Fair Value
Cash and cash equivalents	(1)	$	22,875	$	22,875	$	30,066	$	30,066
Securities available for sale	Level 2	56,472		56,472		68,631		68,631
Other investments	(2)	1,493		1,493		2,774		2,774
Loans, net	Level 2	449,071		447,818		443,748		429,289
Interest rate swaps	Level 2	413		413		38		38
Deposits	Level 2	510,105		463,409		502,816		422,570
Other short-term borrowings	Level 2	—		—		30,000		30,142
Long-term debt	Level 2	54		53		93		89

(1) - management believes the carrying value of cash and cash equivalents is a reasonable estimate of fair value

(2) - other investments include Federal Home Loan Bank stock, Federal Reserve Bank stock, and equity investments in Community Bankers Bank and Pacific Coast Bankers Bank; the carrying value of those securities approximates fair value based on the redemption provisions of those counterparties

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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, 2018.

Results of Operations

Consolidated net income totaled $846,000 for the three-month period ended September 30, 2019, compared to $1,091,000 for the three-month period ended September 30, 2018. The large reduction resulted from a significant increase in provision expense.

Consolidated net income for the nine-month period ended September 30, 2019 totaled $2.5 million compared to $2.6 million for the comparable period of 2018. The increase in provision expense during 2019 was partially offset by lower noninterest expense.

The following table provides summarized income statements for the three and nine-month periods ended September 30, 2019.

	Three months ended September 30,				Nine months ended September 30,
	2019		2018		2019		2018
Net interest income	$	5,302	$	5,218	$	15,493	$	15,239
Provision expense	548		198		1,487		542
Noninterest income	975		1,068		2,798		3,139
Noninterest expense	4,652		4,708		13,739		14,506
Income before income taxes	1,077		1,380		3,065		3,330
Income tax expense	231		289		588		706
Net income	$	846	$	1,091	$	2,477	$	2,624

Comparison of Third Quarter 2019 to Third Quarter 2018

Net interest income for the three-month period ended September 30, 2019 increased $84,000 or 1.6 percent compared to the three months ended September 30, 2018 primarily due to improved loan interest income and lower FHLB interest expense, which more than offset the increase in deposit interest expense. 

Average loan balances for the three months ended September 30, 2019 increased $4.9 million or 1.1 percent compared to the three month period ended September 30, 2018. Average securities balances declined $10.5 million or 14.2 percent during the same period. The yield on average interest-earning assets was 4.68 percent for the three-month period ended September 30, 2019 compared to 4.57 percent in the same period of 2018. 

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Average interest-bearing liabilities decreased $5.1 million in the three months ended September 30, 2019, when compared to the same period of 2018, as the impact of the FHLB advance repayment more than offset the $18.4 million growth in interest-bearing deposits. The average rate on interest-bearing liabilities increased from 0.83 percent in the three month period ended September 30, 2018, to 1.16 percent for the three months ended September 30, 2019 due to growth in time deposits and upward pressure on deposit rates.

The net interest margin declined from 3.97 percent in the three-month period ended September 30, 2018, to 3.84 percent for the three months ended September 30, 2019. The net interest margin continues to experience gradual tightening as demand for time deposit products continues and existing time deposits reprice at current rates. The reduction in the net interest margin was softened somewhat by the repayment of $30.0 million in FHLB advances during the third quarter of 2019.

The provision for loan losses for the three-month period ended September 30, 2019 totaled $548,000, compared to $198,000 during the corresponding period of 2018. Net charge-offs for the three-month period ended September 30, 2019 totaled $623,000 compared to net charge-offs of $110,000 recorded during the same period of 2018. Net charge-offs during the third quarter of 2019 represent 0.56 percent of loans outstanding. The large increase in net charge-offs in the three-month period ended September 30, 2019 includes $373,000 of charge-offs on various loans within two specific relationships.

During the third quarter of 2019, noninterest income decreased $93,000 compared to the corresponding period for 2018. Most of the reduction related to service charge income and mortgage income, primarily due to lower bad check income and lower secondary marketing income. Smaller reductions were noted in other service charges, commissions and fees.

Total noninterest expense for the three-month period ended September 30, 2019 decreased $56,000 from the comparable period in 2018. Salaries and employee benefits decreased $85,000 for the three months ended September 30, 2019 as compared to the prior year period. Occupancy expense was down due to lower rental expense associated with the mortgage origination offices. OREO-related expenses decreased during the three-month period ended September 30, 2019, when compared to the comparable period in 2018 due to lower net losses recorded on properties sold during the quarter.

Other noninterest expense increased $110,000 during the three-month period ended September 30, 2019. For the current quarter, other noninterest expense includes $426,000 of merger-related expenses, primarily legal expenses and professional services resulting from the proposed merger.

The annualized return on average equity was 5.63 percent for the three-month period ended September 30, 2019, compared to 7.94 percent for the corresponding period of 2018. Annualized return on average assets for the three months ended September 30, 2019 was 0.58 percent compared to 0.74 percent for the three months ended September 30, 2018.

Comparison of Year-to-Date 2019 to Year-to-Date 2018

Net interest income increased $254,000 during the first nine months of 2019 when compared to the same period of 2018, the result of higher loan interest income, higher fed funds interest income and lower FHLB interest expense, partially offset by higher deposit interest expense.

The provision for loan losses was $1.5 million during the first nine months of 2019, compared to $542,000 during the same period of 2018. Higher provision expense during 2019 results from increased net charge-offs and recent loan growth, particularly among construction and commercial loans. Net charge-offs for the first nine months of 2019 totaled $1.7 million or 0.50 percent of loans held for investment, compared to $270,000 during the same period of 2018. The net charge-offs for 2019 include $1.1 million of charge-offs related to four specific exposures.

Noninterest income declined $341,000 during the first nine months of 2019. Other service charges and fees declined $141,000 primarily due to lower financial services income. Mortgage banking income declined $118,000 resulting from the reorganization and shrinkage of the mortgage division. Other operating income declined $56,000 due to a non-recurring swap-related fee recognized during 2018.

Noninterest expense decreased $767,000 during the first nine months of 2019, when compared to the same period of 2018. Salaries and employee benefits declined $171,000 during the first nine months of 2019, the result of the reorganization within the mortgage division, net of higher health care costs. Occupancy expense decreased $318,000 due to lower lease, depreciation, insurance and equipment maintenance expense. OREO-related expenses decreased $184,000 during 2019 due to lower writedowns resulting from updated appraisals and losses recorded upon liquidation of foreclosed properties. Other noninterest expense decreased $94,000 during the first nine months of 2019. During 2019, other noninterest expense included $558,000 of merger-related expenses,

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primarily legal and professional services. During 2018, other noninterest expense included $235,000 in writedowns of real estate held for sale.

Income tax expense declined $118,000 during the first nine months of 2019 due to lower pre-tax income.

The annualized return on average equity was 6.33 percent for the nine-month period ended September 30, 2019, compared to 6.48 percent for the corresponding period of 2018. Annualized return on average assets for the nine months ended September 30, 2019 was 0.62 percent compared to 0.60 percent for the nine months ended September 30, 2018.

Financial Position

Investment securities available for sale totaled $56.5 million at September 30, 2019, compared to $68.6 million at December 31, 2018. Investment securities available for sale at September 30, 2019 included mortgage-backed securities/CMOs (74.1 percent of the total securities portfolio), municipal securities (17.9 percent), and SBA loan pools (8.1 percent).  There were no investment securities held to maturity at September 30, 2019 or December 31, 2018. The reduction since December 31, 2018 results from scheduled maturities, calls and sales undertaken to generate liquidity to fund repayment of the FHLB advances during the third quarter.

Other investments include investments in the Federal Reserve Bank of Richmond, Federal Home Loan Bank of Atlanta (FHLB), Pacific Coast Bankers Bank, and Community Bankers Bank. These investments had a carrying value of $1.5 million at September 30, 2019, compared to $2.8 million at December 31, 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. The reduction since December 31, 2018 resulted from the repurchase of FHLB stock following repayment of the advances that matured during the third quarter.

Loans, net of deferred fees, totaled $453.2 million at September 30, 2019, compared to $448.1 million at December 31, 2018. Loan demand was relatively weak during the first quarter of 2019, but more robust growth during the second and third quarters resulted in a modest increase in loans as of September 30, 2019.

Deposits at September 30, 2019 totaled $510.1 million, a $7.3 million increase since December 31, 2018. Despite the increase in total deposits during 2019, the Company has experienced reductions among non-interest bearing deposits, which have declined $2.1 millionsince December 31, 2018. Interest bearing deposits have increased $9.4 million since December 31, 2018.

The Company's loan to deposit ratio was 88.9 percent at September 30, 2019 compared to 89.1 percent at December 31, 2018, reflecting the combined impact of weak loan growth and more robust deposit growth during the nine-month period ended September 30, 2019.

During the quarter ended September 30, 2019, the Company repaid 30.0 million in FHLB advances that matured in August 2019. The Company continues to maintain security agreements with the FHLB that allow it to borrow when needed, using 1-4 family residential mortgage, commercial real estate, equity lines of credit and multi-family loans as collateral.

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 $8.0 million or 1.76 percent of loans held for investment and OREO at September 30, 2019, compared to $8.2 million or 1.83 percent of loans held for investment and OREO at December 31, 2018.  The Company continues its efforts to manage non-accrual exposures and liquidate other real estate owned.

At September 30, 2019, other real estate owned (OREO) totaled $2.5 million and consisted of 19 relationships. At December 31, 2018 OREO balances were $2.2 million and consisted of 20 relationships. The $272,000 increase in OREO since December 31, 2018 resulted from foreclosures of collateral securing loans previously classified as nonaccrual, net of writedowns and proceeds received.

As of September 30, 2019, the Company had loans with a total balance of $736,000 that were in process of foreclosure. While the Company believes the related loans are generally well-secured, 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.

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The following chart details each category type, number of relationships, and balance.

	September 30, 2019			December 31, 2018
Balance in thousands	Number	Balance		Number	Balance
Land development/vacant land	9	$	657	8	$	308
1-4 family residential mortgage	6	753		9	785
Commercial real estate	4	1,074		3	1,119
Total	19	$	2,484	20	$	2,212

Marketability of OREO properties differs considerably between the Company's various market areas. The following table provides information about properties owned in each geographic area, the number of individual properties and book value.

	September 30, 2019			December 31, 2018
Balance in thousands	Number	Balance		Number	Balance
Sevierville and Knoxville TN	1	$	71	1	$	71
Southwest VA and Tri-City TN	15	2,114		17	2,089
Boone and Banner Elk NC	3	299		2	52
Total	19	$	2,484	20	$	2,212

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, 2019 was 0.92 percent of total loans compared to 0.98 percent at December 31, 2018. The reduction in the allowance for loan losses since December 31, 2018 reflects the impact of charge-offs of previously impaired loans recorded during the first three quarters of 2019. At September 30, 2019, 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 $61.4 million at September 30, 2019, compared to $56.6 million at December 31, 2018. The change in stockholders' equity during 2019 reflects current retained earnings and a reduction in accumulated other comprehensive loss related to 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, 2019, each of the Bank's capital ratios exceeded the required level to be classified as well-capitalized. See Note 7 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 ($22.9 million as of September 30, 2019) and unrestricted investment securities available for sale ($20.7 million as of September 30, 2019). Cash and cash equivalents are immediately available for satisfaction of deposit withdrawals, customer credit needs, and operations of the Bank. The Bank also maintains access to credit with both the Federal Home Loan Bank and other correspondent financial institutions. 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.

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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. The Company continues to dedicate significant attention to risk management, with a goal of preventing cybersecurity attacks and, if they occur, to quickly detect and correct any weakness to prevent future attacks.

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;

• risks related to the proposed merger with First Community Bankshares, including the risk the proposed transaction is not approved by the regulatory authorities or the shareholders, and the risks related to the conversion of the Company's systems to those of First Community Bankshares;

• 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 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 Interim 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 2019 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

The Company, the Bank and other subsidiaries are occasionally named as defendants in various legal actions arising from our normal business activities in which damages in various amounts are claimed. Although the amount of any ultimate liability with respect to those matters cannot be determined, in the opinion of management, no legal actions currently exist that are expected to have a material effect on the Company's consolidated financial statements.

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. On October 24, 2019, the complaint was stricken from the court docket due to inactivity.

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
31.2	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, 2019, 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).

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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 14, 2019	By:	/s/ Bryan T. Booher
		Bryan T. Booher
		Interim Chief Executive Officer
Date: November 14, 2019		/s/ John H. Gray
		John H. Gray
		Chief Financial Officer

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Exhibit Index
31.1	Rule 13a-14(a) Certification of President and Chief Executive Officer
31.2	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, 2019, 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).

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