UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C.  20549

FORM 10-Q

[X] Quarterly Report Pursuant to Section 13 or 15(d)

of the Securities Exchange Act of 1934

For the quarterly period ended September 30, 2018

[   ] Transition Report Pursuant to Section 13 or 15(d)

of the Securities Exchange Act of 1934

For the transition period from ____________ to _____________

Commission File Number:  0-27622

HIGHLANDS BANKSHARES, INC.

(Exact name of registrant as specified in its charter)

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

276-628-9181

(Registrant's telephone number, including area code)

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

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

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, smaller reporting company, or an emerging growth company.  See the definitions of "large accelerated filer," "accelerated filer," "smaller reporting company," and "emerging growth company" in Rule 12b-2 of the Exchange Act.

Large accelerated filer  ☐	Accelerated filer  ☐	Non-accelerated filer  þ  (Do not check if a smaller reporting company)
Smaller reporting company  þ	Emerging growth company  ☐

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act.  ☐

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes [  ] No [X ]

Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date: 8,250,728 shares of common stock, par value $0.625 per share, outstanding as of November 13, 2018.

Highlands Bankshares, Inc.

Form 10-Q

For the Quarter Ended September 30, 2018

INDEX

PART I. FINANCIAL INFORMATION	PAGE
Item 1.  Financial Statements
Consolidated Balance Sheets at September 30, 2018 (Unaudited) and December 31, 2017	3
Consolidated Statements of Income (Unaudited) for the three- and nine-month periods ended September 30, 2018 and 2017	4
Consolidated Statements of Comprehensive Income (Unaudited) for the three- and nine-month periods ended September 30, 2018 and 2017	5
Consolidated Statements of Cash Flows (Unaudited) for the nine month periods ended September 30, 2018 and 2017	6
Consolidated Statements of Changes in  Stockholders' Equity (Unaudited) for the nine-month periods ended September 30, 2018 and 2017	7
Notes to Consolidated Financial Statements (Unaudited)	8
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations	29
Item 3. Quantitative and Qualitative Disclosures About Market Risk	34
Item 4.  Controls and Procedures	34
PART II.  OTHER INFORMATION
Item 1.  Legal Proceedings	35
Item 1A. Risk Factors	35
Item 2.  Unregistered Sales of Equity Securities and Use of Proceeds	35
Item 3.  Defaults Upon Senior Securities	35
Item 4.  Mine Safety Disclosures	35
Item 5.  Other Information	35
Item 6.  Exhibits	35
SIGNATURES AND CERTIFICATIONS	36

2

PART I.

FINANCIAL INFORMATION

ITEM 1.  Financial Statements

Consolidated Balance Sheets

(Amounts in thousands) 

	(Unaudited) September 30, 2018			December 31, 2017
ASSETS
Cash and due from banks	$	23,258		$	15,179
Federal funds sold	791			15,618
Total cash and cash equivalents	24,049			30,797
Investment securities available for sale (amortized cost $73,822 at September 30, 2018, $79,990 at December 31, 2017)	70,149			78,527
Other investments, at cost	3,199			3,116
Loans held for sale	1,614			4,808
Loans	452,566			431,574
Allowance for loan losses	(4,226		)	(3,954		)
Net loans	448,340			427,620
Premises and equipment, net	17,687			18,332
Real estate held for sale	817			1,430
Deferred tax assets	6,984			7,161
Interest receivable	1,904			1,987
Bank-owned life insurance	14,940			14,679
Other real estate owned	2,242			2,350
Other assets	1,684			3,290
Total assets	$	593,609		$	594,097
LIABILITIES AND STOCKHOLDERS' EQUITY
LIABILITIES
Deposits:
Non-interest bearing	$	154,196		$	148,633
Interest bearing	340,410			350,150
Total deposits	494,606			498,783
Interest, taxes and other liabilities	1,937			1,364
Short-term borrowings	42,120			10,000
Long-term debt	107			30,146
Total liabilities	538,770			540,293
STOCKHOLDERS' EQUITY
Common stock (8,249 shares and 8,199 shares issued and outstanding at September 30, 2018 and December 31, 2017)	5,156			5,124
Preferred stock (2,092 shares issued and outstanding for each period presented)	4,184			4,184
Additional paid-in capital	19,246			19,113
Retained earnings	29,163			26,539
Accumulated other comprehensive loss	(2,910		)	(1,156		)
Total stockholders' equity	54,839			53,804
Total liabilities and stockholders' equity	$	593,609		$	594,097

See accompanying Notes to Consolidated Financial Statements

3

Consolidated Statements of Income

(Amounts in thousands, except per share data)

(Unaudited)

	Three Months Ended September 30,				Nine Months Ended September 30,
	2018		2017		2018		2017
INTEREST INCOME
Loans receivable and fees on loans	$	5,558	$	5,207	$	16,149	$	15,258
Investment securities	434		521		1,350		1,675
Federal funds sold	17		33		144		157
Total interest income	6,009		5,761		17,643		17,090
INTEREST EXPENSE
Deposits	497		478		1,423		1,389
Other borrowed funds	294		469		981		1,655
Total interest expense	791		947		2,404		3,044
Net interest income	5,218		4,814		15,239		14,046
Provision for loan losses	198		19		542		71
Net interest income after provision for loan losses	5,020		4,795		14,697		13,975
NONINTEREST INCOME
Mortgage banking income	116		655		268		1,607
Securities gains, net	—		19		—		19
Service charges on deposit accounts	396		392		1,075		1,184
Other service charges, commissions and fees	404		479		1,251		1,440
Other operating income	152		155		545		410
Total noninterest income	1,068		1,700		3,139		4,660
NONINTEREST EXPENSE
Salaries and employee benefits	2,347		2,623		7,130		8,044
Occupancy and equipment expense	607		641		2,088		2,033
Foreclosed assets – write-down and operating expenses	89		69		366		263
Other operating expense	1,665		1,588		4,922		4,294
Total noninterest expense	4,708		4,921		14,506		14,634
Income before income taxes	1,380		1,574		3,330		4,001
Income tax expense (Note 5)	289		554		706		1,313
Net income	$	1,091	$	1,020	$	2,624	$	2,688
Net income per common share (Note 7)
Basic	0.13		0.12		0.32		0.33
Fully diluted	0.11		0.10		0.25		0.26

See accompanying Notes to Consolidated Financial Statements

4

Consolidated Statements of Comprehensive Income

(Amounts in thousands)

(Unaudited) 

	Three Months Ended September 30,						Nine Months Ended September 30,
	2018			2017			2018			2017
Net income	$	1,091		$	1,020		$	2,624		$	2,688
Other comprehensive (loss) income
Unrealized (losses) gains on securities during the period	(913		)	141			(2,210		)	767
Less: reclassification adjustment	—			(19		)	—			(19		)
Other comprehensive (loss) income before tax	(913		)	122			(2,210		)	748
Income tax benefit (expense) related to other comprehensive (loss) income	185			(34		)	456			(244		)
Other comprehensive (loss) income	(728		)	88			(1,754		)	504
Comprehensive income	$	363		$	1,108		$	870		$	3,192

See accompanying Notes to Consolidated Financial Statements

5

Consolidated Statements of Cash Flows

(Amounts in thousands)

(Unaudited) 

	Nine Months Ended September 30,
	2018			2017
CASH FLOWS FROM OPERATING  ACTIVITIES:
Net income	$	2,624		$	2,688
Adjustments to reconcile net income to net cash provided by operating activities:
Provision for loan losses	542			71
Depreciation and amortization	1,161			764
Provision for deferred tax assets	633			1,317
Net realized gains on available for sale securities	—			(19		)
Restricted stock expense	165			166
Loss on sale of premises and equipment	—			34
Originations of loans held for sale	(10,661		)	(42,104		)
Proceeds from loans held for sale	13,855			39,074
Decrease in interest receivable	83			(63		)
Valuation adjustment of real estate held for sale	250			187
Valuation adjustment of other real estate owned	215			—
(Increase) decrease in other assets	1,345			(1,289		)
Increase in interest, taxes and other liabilities	573			386
Net cash provided by operating activities	10,785			1,212
CASH FLOWS FROM INVESTING ACTIVITIES:
Securities available for sale:
Proceeds from sale of securities	—			6,624
Proceeds from maturities of securities	8,405			14,172
Purchase of debt and equity securities	(2,706		)	(6,938		)
Redemptions of other investments	19			2,918
Net increase in loans	(21,728		)	(23,492		)
Proceeds from sales of other real estate owned	359			712
Proceeds from sale of real estate held for sale	378			250
Premises and equipment expenditures	(164		)	(1,680		)
Disposition of premises and equipment	—			174
Net cash used in investing activities	(15,437		)	(7,260		)
CASH FLOWS FROM FINANCING ACTIVITIES:
Net decrease in time deposits	(4,687		)	(5,180		)
Net increase in demand, savings and other deposits	510			15,402
Net change in short-term borrowings	2,120			(27,543		)
Decrease in long-term debt	(39		)	—
Net cash used in financing activities	(2,096		)	(17,321		)
Net change in cash and cash equivalents	(6,748		)	(23,369		)
Cash and cash equivalents at beginning of period	30,797			50,385
Cash and cash equivalents at end of period	$	24,049		$	27,016
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION
Cash payments during the period for interest	$	2,376		$	2,981
Cash payments during the period for income taxes	65			—
SUPPLEMENTAL DISCLOSURE OF NONCASH TRANSACTIONS
Transfer of loans to other real estate owned	466			481
Reclassification of long-term debt to short-term borrowings	30,000			—

See accompanying Notes to Consolidated Financial Statements

6

Consolidated Statements of Changes in Stockholders' Equity

(Amounts in thousands)

(Unaudited)

	Common stock shares	Common stock par value		Preferred stock shares	Preferred stock par value		Additional paid-in-capital			Retained earnings		Accumulated other comprehensive income (loss)			Stockholders' equity
Balance December 31, 2016	8,199	$	5,124	2,092	$	4,184	$	18,891		$	26,785	$	(1,226	)	$	53,758
Net income	—	—		—	—		—			2,688		—			2,688
Other comprehensive income	—	—		—	—		—			—		491			491
Stock-based compensation	—	—		—	—		166			—		—			166
Balance September 30, 2017	8,199	$	5,124	2,092	$	4,184	$	19,057		$	29,473	$	(735	)	$	57,103
Balance December 31, 2017	8,199	$	5,124	2,092	$	4,184	$	19,113		$	26,539	$	(1,156	)	$	53,804
Net income	—	—		—	—		—			2,624		—			2,624
Other comprehensive loss	—	—		—	—		—			—		(1,754		)	(1,754		)
Restricted stock award	50	32		—	—		(32		)	—		—			—
Stock-based compensation	—	—		—	—		165			—		—			165
Balance September 30, 2018	8,249	$	5,156	2,092	$	4,184	$	19,246		$	29,163	$	(2,910	)	$	54,839

See accompanying Notes to Consolidated Financial Statements

7

Notes to Consolidated Financial Statements

(Unaudited)

(in thousands, except share, per share and percentage data)

Note 1  -  General

The consolidated financial statements of Highlands Bankshares, Inc. (the "Company") conform to United States generally accepted accounting principles and to banking industry practices. The accompanying consolidated interim financial statements are unaudited. In the opinion of management, all adjustments necessary for a fair presentation of the consolidated financial statements have been included. All such adjustments are of a normal and recurring nature. The consolidated balance sheet as of December 31, 2017 has been extracted from the audited financial statements included in the Company's Annual Report on Form 10-K for the year ended December 31, 2017 (the "2017 Form 10-K"). The notes included herein should be read in conjunction with the notes to consolidated financial statements included in the 2017 Form 10-K. The results of operations for the nine-month period ended September 30, 2018, are not necessarily indicative of the results to be expected for the full year.

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

Note 2 – Summary of Significant Accounting Policy Update For Certain Required Disclosures

In May 2014, the FASB issued ASU No. 2014-09, Revenue from Contracts with Customers. ASU 2014-09 is a comprehensive revenue recognition model that requires a company to recognize revenue to depict the transfer of goods or services to a customer at an amount that reflects the consideration it expects to receive in exchange for those goods or services. ASU 2014-09, as subsequently amended by ASU No. 2015-14 issued in August 2015, required adoption in annual reporting periods beginning after December 15, 2017, including interim reporting periods within that reporting period. Earlier application was permitted only as of annual reporting periods beginning after December 15, 2016, including interim reporting periods within that reporting period. The Company adopted ASU 2014-09 effective January 1, 2018.

Application of ASU 2014-09 requires identification of customer contracts, identification of the performance obligations within those contracts, identification of the transaction price, allocation of the transaction price to the performance obligations, and recognition of revenue once the performance obligation is satisfied. ASU 2014-09 requires disclosure regarding the nature, amount, timing and uncertainty of revenue and cash flows arising from customer contracts, including significant judgments and changes in judgments and assets recognized from costs incurred to obtain or fulfill a contract.

The Company’s primary source of revenue is interest income, which is excluded from the scope of this guidance; however, the Company evaluated the impact on noninterest income, which includes fees for services, commissions on sales, and various deposit service charges. The Company concluded that no cumulative-effect adjustment to retained earnings was necessary. The adoption of the standard did not have a material effect on the Company’s financial position or results of operations.

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

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

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

8

Note 3 - Investment Securities Available For Sale

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

	September 30, 2018
	Amortized cost		Gross unrealized gains		Gross unrealized losses		Fair value
State and political subdivisions	$	13,596	$	8	$	904	$	12,700
Mortgage backed securities	54,502		6		2,559		51,949
SBA pools	5,724		—		224		5,500
	$	73,822	$	14	$	3,687	$	70,149

	December 31, 2017
	Amortized cost		Gross unrealized gains		Gross unrealized losses		Fair value
State and political subdivisions	$	12,766	$	44	$	299	$	12,511
Mortgage backed securities	60,383		12		1,088		59,307
SBA pools	6,841		1		133		6,709
	$	79,990	$	57	$	1,520	$	78,527

Investment securities available for sale with a fair value of $36,168 and $26,856 at September 30, 2018 and December 31, 2017, respectively, were pledged as collateral on public deposits, FHLB advances and for other purposes as required or permitted by law.

The following table presents the age of gross unrealized losses and fair value by investment category:

	September 30, 2018
	Less than 12 months				12 months or more				Total
	Fair value		Unrealized losses		Fair value		Unrealized losses		Fair value		Unrealized losses
State and political subdivisions	$	3,696	$	138	$	8,421	$	767	$	12,117	$	904
Mortgage-backed securities	3,403		32		39,944		2,049		43,347		2,559
SBA pools	1,528		43		11,127		658		12,655		224
Total	$	8,627	$	213	$	59,492	$	3,474	$	68,119	$	3,687

	December 31, 2017
	Less than 12 months				12 months or more				Total
	Fair value		Unrealized losses		Fair value		Unrealized losses		Fair value		Unrealized losses
State and political subdivisions	$	1,744	$	18	$	7,158	$	281	$	8,902	$	299
Mortgage-backed securities	14,540		177		42,415		911		56,955		1,088
SBA pools	176		1		6,206		132		6,382		133
Total	$	16,460	$	196	$	55,779	$	1,324	$	72,239	$	1,520

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

The amortized cost and estimated fair value of securities available for sale at September 30, 2018 by contractual maturity are shown below. Expected maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.

9

	Amortized cost		Fair value
Investment securities with scheduled maturities:
Due in one year or less	$	98	$	101
Due after one year through five years	367		365
Due after five years through ten years	2,842		2,659
Due after ten years	16,013		15,075
Total investment securities with scheduled maturities	19,320		18,200
Mortgage-backed securities	54,502		51,949
Total investment securities available for sale	$	73,822	$	70,149

There were no gains or losses on the sales of investment securities during the first nine months of 2018. The following table summarizes the securities gains (losses) recognized for the period presented:

	Three months ended September 30,					Nine months ended September 30,
	2018		2017			2018		2017
Gross gains	$	—	$	32		$	—	$	32
Gross losses	—		(13		)	—		(13		)
Securities gains, net	$	—	$	19		$	—	$	19

Note 4  -  Loans and Allowance for Loan Losses

The composition of net loans is as follows:

	September 30, 2018		December 31, 2017
Real estate secured:
Residential 1-4 family	$	177,614	$	174,889
Multifamily	17,311		19,469
Construction and land loans	22,474		15,907
Commercial, owner occupied	90,852		82,121
Commercial, non-owner occupied	36,511		33,748
Second mortgages	4,332		4,684
Equity lines of credit	31,492		34,378
Farmland	12,535		13,188
Total real estate secured	393,121		378,384
Non-real estate secured
Personal	13,470		14,192
Commercial	43,903		36,785
Agricultural	2,756		2,950
Total non-real estate secured	60,129		53,927
Gross loans	453,250		432,311
Less:
Allowance for loan losses	4,226		3,954
Net deferred fees	684		737
Loans, net	$	448,340	$	427,620

10

The following table is an analysis of past due loans as of September 30, 2018:

	Past Due
	30-89 days		90 days and over		Total		Current		Total		> 90 Days and Accruing
Real estate secured
Residential 1-4 family	$	1,133	$	1,779	$	2,912	$	174,702	$	177,614	$	54
Equity lines of credit	75		—		75		31,417		31,492		—
Multifamily	—		—		—		17,311		17,311		—
Farmland	344		—		344		12,191		12,535		—
Construction, land development, other land loans	114		—		114		22,360		22,474		—
Commercial real estate:
Owner-occupied	—		756		756		90,096		90,852		—
Non-owner-occupied	1,862		—		1,862		34,649		36,511		—
Second mortgages	—		—		—		4,332		4,332		—
Non-real estate secured
Personal	116		28		144		13,326		13,470		—
Commercial	124		107		231		43,672		43,903		99
Agricultural	—		—		—		2,756		2,756		—
Total	$	3,768	$	2,670	$	6,438	$	446,812	$	453,250	$	153

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

	Past Due
	30-89 days		90 days and over		Total		Current		Total		> 90 Days and Accruing
Real estate secured
Residential 1-4 family	$	1,092	$	566	$	1,658	$	173,231	$	174,889	$	—
Equity lines of credit	—		—		—		34,378		34,378		—
Multifamily	—		—		—		19,469		19,469		—
Farmland	234		50		284		12,904		13,188		—
Construction, land development, other land loans	—		—		—		15,907		15,907		—
Commercial real estate:
Owner-occupied	11		708		719		81,402		82,121		—
Non-owner-occupied	—		—		—		33,748		33,748		—
Second mortgages	—		—		—		4,684		4,684		—
Non-real estate secured
Personal	211		23		234		13,958		14,192		—
Commercial	502		279		781		36,004		36,785		26
Agricultural	49		—		49		2,901		2,950		—
Total	$	2,099	$	1,626	$	3,725	$	428,586	$	432,311	$	26

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

11

The following is a summary of non-accrual loans at September 30, 2018 and December 31, 2017: 

	September 30, 2018		December 31, 2017
Real estate secured
Residential 1-4 family	$	1,726	$	887
Construction and land loans	9		—
Commercial real estate:
Owner-occupied	756		708
Non-owner-occupied	1,861		—
Farmland	142		193
Non-real estate secured
Personal	29		23
Commercial and agricultural	7		254
Total	$	4,530	$	2,065

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

	Number	Balance
Residential real estate in the process of foreclosure	4	$	786
Foreclosed residential real estate	5	480

The following tables represent a summary of credit quality indicators of the Company's loan portfolio at September 30, 2018 and December 31, 2017. The grades are assigned and/or modified by the Company's credit review and credit analysis departments based on the creditworthiness of the borrower and the overall strength of the loan.

The following tables provide the credit risk profile by internally assigned grade as of September 30, 2018 and December 31, 2017: 

September 30, 2018	Residential 1-4 Family		Multifamily		Farmland		Construction, Land Loans		Commercial Real Estate- Owner Occupied		Commercial Real Estate Non-Owner Occupied
Quality	$	40,297	$	—	$	—	$	2,451	$	3,317	$	817
Satisfactory	87,693		7,764		3,134		6,104		36,029		12,543
Acceptable	40,782		9,145		3,567		12,275		44,509		17,496
Special Mention	1,705		402		3,142		1,565		2,745		3,647
Substandard	7,137		—		2,692		79		4,252		2,008
Doubtful	—		—		—		—		—		—
Total	$	177,614	$	17,311	$	12,535	$	22,474	$	90,852	$	36,511

December 31, 2017	Residential 1-4 Family		Multifamily		Farmland		Construction, Land Loans		Commercial Real Estate- Owner Occupied		Commercial Real Estate Non-Owner Occupied
Quality	$	33,107	$	—	$	13	$	2,870	$	3,535	$	295
Satisfactory	95,659		10,653		4,419		5,445		45,906		13,602
Acceptable	40,487		8,816		3,333		5,906		28,344		15,609
Special Mention	388		—		3,206		1,565		2,542		2,226
Substandard	5,248		—		2,217		121		1,661		2,016
Doubtful	—		—		—		—		133		—
Total	$	174,889	$	19,469	$	13,188	$	15,907	$	82,121	$	33,748

12

Explanation of credit grades:

Quality--This grade is reserved for the Bank's top quality loans. These loans have excellent sources of repayment, with no significant identifiable risk of collection.  Generally, loans assigned this rating will demonstrate the following characteristics:

• Conformity in all respects with Bank policy, guidelines, underwriting standards, and Federal and State regulations (no exceptions of any kind).

• Documented historical cash flow that meets or exceeds required minimum Bank guidelines, or that can be supplemented with verifiable cash flow from other sources.

• Adequate secondary sources to liquidate the debt, including combinations of liquidity, liquidation of collateral, or liquidation value to the net worth of the borrower or guarantor.

For existing loans, all of the requirements above apply plus all payments have been made as agreed, current financial information on all borrowers and guarantors has been obtained and analyzed, and overall business operating trends are either stable or improving.

Satisfactory-This grade is given to performing loans. These loans have adequate sources of repayment, with little identifiable risk of collection. Loans assigned this rating will demonstrate the following characteristics:

• General conformity to the Bank's policy requirements, product guidelines and underwriting standards.  Any exceptions that are identified during the underwriting and approval process have been adequately mitigated by other factors.

• Documented historical cash flow that meets or exceeds required minimum Bank guidelines, or that can be supplemented with verifiable cash flow from other sources.  

• Adequate secondary sources to liquidate the debt, including combinations of liquidity, liquidation of collateral, or liquidation value to the net worth of the borrower or guarantor.

For existing loans, all of the requirements outlined above will apply, plus all payments have been made as agreed, current financial information on all borrowers and guarantors has been obtained and analyzed, and overall business operating trends are stable with any declines considered minor and temporary.

Acceptable-This grade is given to loans that show signs of weakness in either adequate sources of repayment or collateral, but have demonstrated mitigating factors that minimize the risk of delinquency or loss.  Loans assigned this rating may demonstrate some or all of the following characteristics:

• Additional exceptions to the Bank's policy requirements, product guidelines or underwriting standards that present a higher degree of risk to the Bank.  Although the combination and/or severity of identified exceptions is greater, all exceptions have been properly mitigated by other factors.

• Unproved, insufficient or marginal primary sources of repayment that appear sufficient to service the debt at this time.  Repayment weaknesses may be due to minor operational issues, financial trends, or reliance on projected (not historic) performance.

• Marginal or unproven secondary sources to liquidate the debt, including combinations of liquidation of collateral and liquidation value to the net worth of the borrower or guarantor.

For existing loans, payments have generally been made as agreed with only minor and isolated delinquencies.

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

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

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

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

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

The weaknesses may include, but are not limited to:

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

• Declining or inadequate liquidity

13

• Improper loan structure  or questionable repayment sources

• Lack of well-defined secondary repayment source, and

• Unfavorable competitive comparisons.

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

Doubtful -Loans classified Doubtful have all the weaknesses inherent in loans classified Substandard, plus the added characteristic that the weaknesses make collection or liquidation in full on the basis of currently existing facts, conditions, and values highly questionable and improbable. The ability of the borrower to service the debt is extremely weak, overdue status is constant, the debt has been placed on non-accrual status, and no definite repayment schedule exists.

However, these loans are not yet rated as loss because certain events may occur which would salvage the debt. Among these events are:

• Injection of capital

• Alternative financing

• Liquidation of assets or the pledging of additional collateral.

Credit Risk Profile based on payment activity as of September 30, 2018:

	Consumer - Non Real Estate		Equity Line of Credit /Second Mortgages		Commercial - Non Real Estate		Agricultural - Non Real Estate
Performing	$	13,442	$	35,824	$	43,796	$	2,756
Nonperforming (>90 days past due)	28		—		107		—
Total	$	13,470	$	35,824	$	43,903	$	2,756

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

	Consumer - Non Real Estate		Equity Line of Credit /Second Mortgages		Commercial - Non Real Estate		Agricultural - Non Real Estate
Performing	$	14,169	$	39,062	$	36,506	$	2,950
Nonperforming (>90 days past due)	23		—		279		—
Total	$	14,192	$	39,062	$	36,785	$	2,950

14

The following tables reflect the Bank's impaired loans at September 30, 2018:

September 30, 2018	Recorded Investment		Unpaid Principal Balance		Related Allowance		Average Recorded Investment		Interest Income Recognized
With no related allowance
Real estate secured
Residential 1-4 family	$	5,188	$	5,188	$	—	$	5,943	$	525
Equity lines of credit	33		33		—		38		—
Multifamily	—		—		—		—		—
Farmland	2,577		2,577		—		1,198		—
Construction, land development, other land loans	1,635		1,635		—		1,678		—
Commercial real estate- owner occupied	4,404		4,404		—		2,375		—
Commercial real estate- non owner occupied	—		—		—		16		36
Second mortgages	—		—		—		83		—
Non-real estate secured
Personal	—		—		—		24		4
Commercial and agricultural	1,324		1,324		—		996		2
Total	$	15,161	$	15,161	$	—	$	12,351	$	567

September 30, 2018	Recorded Investment		Unpaid Principal Balance		Related Allowance		Average Recorded Investment		Interest Income Recognized
With an allowance recorded
Real estate secured
Residential 1-4 family	$	1,719	$	1,719	$	202	$	891	$	—
Equity lines of credit	77		77		165		19		—
Multifamily	—		—		—		—		—
Farmland	166		166		4		1,233		—
Construction, land development, other land loans	31		31		—		8		—
Commercial real estate- owner occupied	1,745		1,745		354		1,686		—
Commercial real estate- non owner occupied	3,540		3,540		847		3,292		—
Second mortgages	—		—		—		—		—
Non-real estate secured
Personal	1		1		1		6		—
Commercial and agricultural	397		397		264		973		—
Total	$	7,676	$	7,676	$	1,837	$	8,108	$	—

15

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

December 31, 2017	Recorded Investment		Unpaid Principal Balance		Related Allowance		Average Recorded Investment		Interest Income Recognized
With no related allowance
Real estate secured
Residential 1-4 family	$	7,398	$	7,398	$	—	$	6,123	$	279
Equity lines of credit	49		49		—		37		—
Multifamily	—		—		—		495		56
Farmland	486		486		—		586		42
Construction, land development, other land loans	1,765		1,765		—		1,753		67
Commercial real estate- owner occupied	1,552		1,552		—		3,677		22
Commercial real estate- non owner occupied	63		63		—		973		19
Second mortgages	209		209		—		198		3
Non real estate secured
Personal	95		95		—		55		—
Commercial and agricultural	504		504		—		274		—
Total	$	12,121	$	12,121	$	—	$	14,171	$	488

December 31, 2017	Recorded Investment		Unpaid Principal Balance		Related Allowance		Average Recorded Investment		Interest Income Recognized
With an allowance recorded
Real estate secured
Residential 1-4 family	$	74	$	74	$	11	$	267	$	24
Equity lines of credit	—		—		—		—		—
Multifamily	—		—		—		—		—
Farmland	1,731		1,731		257		962		13
Construction, land development, other land loans	—		—		—		183		24
Commercial real estate- owner occupied	1,873		1,873		465		1,506		196
Commercial real estate- non owner occupied	3,892		3,892		955		2,951		141
Second mortgages	—		—		—		9		—
Non real estate secured
Personal	2		2		2		27		—
Commercial and agricultural	502		502		418		568		4
Total	$	8,074	$	8,074	$	2,108	$	6,473	$	402

16

The following tables present the balance in the allowance for loan losses and the recorded investment in loans by loan category and is segregated by impairment evaluation method as of and for the three- and nine- month periods ended September 30, 2018 and September 30, 2017.

Nine months ended September 30, 2018	Residential 1-4 Family			Multifamily		Construction and Land Loans			Commercial Owner Occupied			Commercial Non-Owner Occupied			Second Mortgages			Equity Line of Credit			Farmland			Personal and  Overdrafts			Commercial and Agricultural			Unallocated		Total
Allowance for loan losses:
Balance at December 31,  2017	$	133		$	—	$	1		$	1,636		$	955		$	12		$	—		$	54		$	265		$	383		$	515	$	3,954
Provision expense (credit) for credit losses	254			—		(5		)	(86		)	(108		)	(11		)	490			(51		)	18			(68		)	109		542
Charge-offs	80			—		—			123			—			5			—			1			224			231			—		664
Recoveries	(38		)	—		(5		)	(18		)	—			(5		)	(1		)	(2		)	(127		)	(198		)	—		(394		)
Net charge-offs (recoveries)	42			—		(5		)	105			—			—			(1		)	(1		)	97			33			—		270
Balance at September 30, 2018	$	345		$	—	$	1		$	1,445		$	847		$	1		$	491		$	4		$	186		$	282		$	624	$	4,226
Allowance allocated by impairment method:
Individually evaluated	$	202		$	—	$	—		$	354		$	847		$	—		$	165		$	4		$	1		$	264		$	—	$	1,837
Collectively evaluated	143			—		1			1,091			—			1			326			—			185			18			624		2,389
Loan balances by impairment method used:
Individually evaluated	$	6,907		$	—	$	1,667		$	6,149		$	3,539		$	—		$	110		$	2,744		$	1		$	1,720		$	—	$	22,837
Collectively evaluated	170,707			17,311		20,807			84,703			32,972			4,332			31,382			9,791			13,469			44,939			—		430,413
Balance at September 30, 2018	$	177,614		$	17,311	$	22,474		$	90,852		$	36,511		$	4,332		$	31,492		$	12,535		$	13,470		$	46,659		—		$	453,250

Three months ended September 30, 2018	Residential 1-4 Family			Multifamily		Construction and Land Loans			Commercial Owner Occupied			Commercial Non-Owner Occupied		Second Mortgages			Equity Line of Credit		Farmland			Personal and  Overdrafts			Commercial and Agricultural			Unallocated			Total
Allowance for loan losses:
Balance at June 30, 2018	$	230		$	—	$	58		$	993		$	397	$	1		$	357	$	296		$	216		$	643		$	947		$	4,138
Provision for credit losses	166			—		(60		)	478			450		(1		)	134		(292		)	20			(374		)	(323		)	198
Charge-offs	55			—		—			27			—		—			—		—			91			4			—			177
Recoveries	(4		)	—		(3		)	(1		)	—		(1		)	—		—			(41		)	(17		)	—			(67		)
Net charge-offs (recoveries)	51			—		(3		)	26			—		(1		)	—		—			50			(13		)	—			110
Balance at  September 30, 2018	$	345		$	—	$	1		$	1,445		$	847	$	1		$	491	$	4		$	186		$	282		$	624		$	4,226

17

Nine months ended September 30, 2017	Residential 1-4 Family			Multifamily		Construction and Land Loans			Commercial Owner Occupied		Commercial Non-Owner Occupied			Second Mortgages			Equity Line of Credit			Farmland			Personal and  Overdrafts			Commercial and Agricultural			Unallocated			Total
Allowance for loan losses:
Balance at December 31, 2016	$	371		$	—	$	21		$	1,339	$	445		$	15		$	27		$	16		$	802		$	535		$	1,258		$	4,829
Provision for credit losses	(92		)	—		(24		)	1,139		568			(14		)	(27		)	39			(195		)	(204		)	(1,119		)	71
Charge-offs	40			—		—			100		—			—			—			—			255			331			—			726
Recoveries	(27		)	—		(3		)	—		(1		)	(1		)	—			(2		)	(158		)	(424		)	—			(616		)
Net charge-offs (recoveries)	13			—		(3		)	100		(1		)	(1		)	—			(2		)	97			(93		)	—			110
Reclassification of reserve for unfunded commitments	—			—		—			—		—			—			—			—			—			—			(97		)	(97		)
Balance at September 30, 2017	$	266		$	—	$	—		$	2,378	$	1,014		$	2		$	—		$	57		$	510		$	424		$	42		$	4,693
Allowance allocated by impairment method:
Individually evaluated	$	28		$	—	$	—		$	1,698	$	1,014		$	—		$	—		$	57		$	—		$	409		$	—		$	3,206
Collectively evaluated	238			—		—			680		—			2			—			—			510			15			42			1,487
Loan balances by impairment method used:
Individually evaluated	$	5,260		$	1,101	$	142		$	5,939	$	3,510		$	190		$	—		$	835		$	80		$	479		$	—		$	17,536
Collectively evaluated	175,209			25,082		14,497			68,294		29,958			5,108			31,307			12,586			15,693			37,926			—			415,660
Balance at September 30, 2017	$	180,469		$	26,183	$	14,639		$	74,233	$	33,468		$	5,298		$	31,307		$	13,421		$	15,773		$	38,405		—			$	433,196

18

Three months ended September 30, 2017	Residential 1-4 Family			Multifamily		Construction and Land Loans			Commercial Owner Occupied		Commercial Non-Owner Occupied			Second Mortgages			Equity Line of Credit			Farmland		Personal and  Overdrafts			Commercial and Agricultural			Unallocated			Total
Allowance for loan losses:
Balance at June 30, 2017	$	295		$	—	$	—		$	1,979	$	1,116		$	2		$	32		$	19	$	522		$	541		$	165		$	4,671
Provision for credit losses	(29		)	—		(1		)	499		(101		)	(1		)	(32		)	37		22			(349		)	(26		)	19
Charge-offs	4			—		—			100		1			—			—			—		129			138			—			371
Recoveries	(4		)	—		(1		)	—		—			(1		)	—			—		(95		)	(370		)	—			(471		)
Net charge-offs (recoveries)	—			—		(1		)	100		1			(1		)	—			—		34			(232		)	—			(100		)
Reclassification of reserve for unfunded commitments	—			—		—			—		—			—			—			—		—			—			(97		)	(97		)
Balance at  September 30, 2017	$	266		$	—	$	—		$	2,378	$	1,014		$	2		$	—		$	57	$	510		$	424		$	42		$	4,693

19

The Company's credit administration personnel and senior financial officers are responsible for tracking, coding, and monitoring loans that become Troubled Debt Restructurings ("TDRs"). Concessions are made to existing borrowers in the form of modified interest rates and / or payment terms. The loans are segregated for regulatory and external reporting. Each specific TDR is reviewed to determine if the accrual of interest should be discontinued and also reviewed for impairment. The Company's senior credit officer performs this analysis on a quarterly basis in addition to determining any other loans that are impaired within the loan portfolio. The Company had a total of $11,937 and $8,005 of loans categorized as troubled debt restructurings as of September 30, 2018 and December 31, 2017, respectively. Interest is accrued on TDRs if the loan is otherwise not impaired and the full collection of principal and interest under the modified terms is still deemed probable.

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

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

Number Pre-Modification Recorded Investment Post-Modification Recorded Investment

Below Market Rate
Residential 1-4 family	3	$	549	$	549
Farmland	1	115		115
Commercial real estate-owner occupied	2	1,023		1,023
Commercial real estate-non-owner occupied	4	2,524		2,524
Total below market rate	10	4,211		4,211

Total restructurings 10 $ 4,211 $ 4,211

There were no new TDRs in the nine-month period ended September 30, 2017. There were no defaults in the three- or nine- month periods ending September 30, 2018 and September 30, 2017 of TDRs modified in the previous 12 months.

The Bank has engaged an external third party to perform its loan review function in order to identify weaknesses within the loan portfolio. The review, which seeks to cover 50 percent of loan balances each year, considers collateral, repayment history, guarantor strength, debt service coverage, and other relevant information on an individual and global level. These reviews consider borrower cash flow capacity, using financial statements, income tax returns and internally prepared interim statements for borrowers and guarantors. Debt service coverage (DSC) is calculated on each individual customer, or guarantor, as well as the aggregate or global DSC. The DSC is discounted to determine a stressed DSC. Collateral evaluation includes an inspection of the collateral file to determine if the Bank is properly secured. Collateral is discounted, when appropriate, to determine a stressed loan to value (LTV) ratio. 

The Company also seeks to identify potential problem relationships through a monthly watch list review, which includes a review of past due loans, as well as any other information that might be presented by loan officers, regarding a particular loan relationship that is exhibiting stress. Watch list relationships display distinct characteristics including, but not limited to, late payments greater than 60 days, a low DSC calculation, bankruptcy filings, casualty losses, or other issues that would cause a perceived increase in the risk of loss to the Bank.

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

20

are generally made to developers or investors for the purpose of acquiring, developing and constructing residential or commercial structures. Construction lending is generally considered to involve a higher degree of credit risk than long-term permanent financing.

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

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

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

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

(1) Present value of expected future cash flows discounted at the loan's effective interest rate;

(2) Loan's observable market price; or

(3) Fair value of the collateral.

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

ASC 450 Loan Loss:

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

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

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

National GDP growth rate

Local unemployment rates

Prime interest rate

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

21

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

Past-due loans

Non-accrual loans

Commercial real estate concentrations

Loan volume, including significant loan growth among specific classes of loans

Level and trend of classified loans

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

Once the quarterly ALLL is computed, the calculations are reviewed by the Company's management. The ALLL is then reviewed by the Board of Directors.

Loans Held for Sale

The Company's mortgage division originates certain single family, residential first mortgage loans for sale to a third party broker. Loan sale activity is summarized below. Loans are typically sold to investors within 20 days of closing. Management feels the carrying amounts approximate the fair values of loans held for sale.

	Nine months ended September 30
	2018		2017
Loans held for sale at end of period	$	1,614	$	4,285
Proceeds from sales of mortgage loans originated for sale	13,855		39,074
Gain on sales of mortgage loans originated for sale	268		1,607

Note 5  -  Income Taxes

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

	Three months ended September 30,						Nine months ended September 30,
	2018			2017			2018			2017
Tax expense (benefit) at statutory rate	$	290		$	535		$	699		$	1,360
Increase (decrease) in tax expense resulting from:
Tax-exempt interest	(27		)	(29		)	(85		)	(58		)
Other, net	26			48			92			11
Income tax expense	$	289		$	554		$	706		$	1,313
Statutory corporate federal income tax rate	21		%	34		%	21		%	34		%

Note 6  - Capital Requirements

Regulators of the Company and its subsidiary, Highlands Union Bank (the "Bank"), have implemented risk-based capital guidelines which require compliance with certain minimum capital ratios as a percent of assets and other certain off-balance sheet items that are adjusted for predefined credit risk factors. On July 7, 2013 the Federal Reserve Board approved Basel III final rules to improve the banking sector's ability to absorb shocks arising from financial and economic stress. The final rules include a new common equity tier 1 minimum ratio and raise the tier 1 risk-weighted assets ratio to 6 percent from 4 percent. In addition, beginning in 2016, the new rules required banks to maintain a capital conservation buffer between 2 and 2 ½ %. Additionally, the new rules increased the risk weighting of various assets. The new rules are being phased in between 2015 and 2019. Generally, the Basel III final rules require banks to maintain higher levels of common equity and regulatory capital.

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On February 5, 2015 the Company received notification from the Federal Reserve Bank that it would no longer be required to report holding company consolidated capital ratios.

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

	September 30, 2018		December 31, 2017
Tier 1 leverage	9.14	%	8.36	%
Tier 1 risk-based	12.30	%	12.15	%
Total risk-based	13.28	%	13.11	%
Common equity tier 1	12.30	%	12.15	%

Note 7 – Stock and Earnings Per Share

Earnings per common share is computed using the weighted average outstanding shares for the three- and nine month periods ended September 30, 2018 and 2017. The following is a reconciliation of the numerators and the denominators of the basic and diluted earnings per common share computation:

	Three months ended September 30,				Nine months ended September 30,
(thousands, except per share information)	2018		2017		2018		2017
Net income available to common stockholders	$	1,091	$	1,020	$	2,624	$	2,688
Weighted average common shares outstanding	8,211		8,199		8,224		8,199
Total shares outstanding including assumed conversion of preferred securities	10,303		10,292		10,326		10,292
Basic earnings per common share	$	0.13	$	0.12	$	0.32	$	0.33
Fully diluted earnings per share (including convertible preferred shares outstanding and restricted stock)	0.11		0.10		0.25		0.26

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

Note 8 – Commitments and Contingencies

The Bank is a party to various financial instruments with off-balance sheet risk arising in the normal course of business to meet the financing needs of its customers. Those financial instruments include commitments to extend credit and standby letters of credit.

At September 30, 2018, unused commitments totaled $59,548, compared to $55,038 at December 31, 2017. Standby letters of credit totaled $973 at September 30, 2018 and December 31, 2017.

Note 9 – Fair Value

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

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Fair Value Hierarchy

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

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

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

Recurring - Investment Securities Available for Sale

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

The following tables summarize the Company's available for sale securities portfolio measured at fair value on a recurring basis as of September 30, 2018 and December 31, 2017, segregated by the level of the valuation inputs within the fair value hierarchy.

September 30, 2018
	Level 1		Level 2		Level 3		Total Fair Value
State and political subdivisions	$	—	$	12,700	$	—	$	12,700
Mortgage backed securities	—		51,949		—		51,949
SBA pools	—		5,500		—		5,500
Total available for sale securities	$	—	$	70,149	$	—	$	70,149

December 31, 2017
	Level 1		Level 2		Level 3		Total Fair Value
State and political subdivisions	$	—	$	12,511	$	—	$	12,511
Mortgage backed securities	—		59,307		—		59,307
SBA pools	—		6,709		—		6,709
Total available for sale securities	$	—	$	78,527	$	—	$	78,527

Recurring - Derivatives

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

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Non Recurring - Loans

The Company does not record loans at fair value on a recurring basis. However, from time to time, a loan is considered impaired and an allowance for loan loss is established. Loans for which it is probable that payment of interest and principal will not be made in accordance with the contractual terms of the loan agreement are considered impaired. Once a loan is identified as individually impaired, management measures impairment using one of several methods, including recently appraised collateral value and /or tax assessed value, liquidation value and discounted cash flows. Those impaired loans not requiring an allowance represent loans for which the fair value of the expected repayments or collateral exceed the recorded investments in such loans. At September 30, 2018 and December 31, 2017, all of the total impaired loans were evaluated based on the fair value of the collateral or the present value of the future cash flows. The Company frequently obtains appraisals prepared by external professional appraisers and applies discounts ranging from 8% to 40% depending on type of property, condition, location, etc. The Company also, in certain instances, prepares internally generated valuations from on-site inspections, third-party valuation models or other information.

Non Recurring – Loans Held for Sale

Loans held for sale are carried at the lower of cost or market value. The fair value of loans held for sale is based on inputs derived from secondary markets for loans with similar characteristics. The Company considers loans held for sale as non-recurring level 2.

Non Recurring –Other Real Estate Owned  / Repossessions / Real Estate Held for Sale

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

Real estate held for sale is adjusted to fair value upon transfer from fixed assets or when no longer being used for banking purposes.

The following table summarizes the Company's assets at fair value on a non-recurring basis as of September 30, 2018 and December 31, 2017, segregated by the level of the valuation inputs within the fair value hierarchy. The tables disclose the recorded investment of impaired loans requiring a specific allowance.

September 30, 2018	Level 1		Level 2		Level 3		Fair Value
Impaired loans	$	—	$	—	$	5,839	$	5,839
OREO	—		—		2,242		2,242
Real estate held for sale	—		—		817		817

December 31, 2017	Level 1		Level 2		Level 3		Fair Value
Impaired loans	$	—	$	—	$	5,967	$	5,967
OREO	—		—		2,350		2,350
Real estate held for sale	—		—		1,430		1,430

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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 (dollars in thousands):

			Quantitative Information about Level 3 Fair Value Measurements
	12/31/17		9/30/2018		Valuation Techniques	Unobservable Input (2)	Range (Weighted Average)
OREO, net	$	2,350	$	2,242	Appraisal of collateral (1)	Appraisal adjustments	0% to 45% (13%)
						Liquidation expenses	0% to 10% (9%)
Real estate held for sale	$	1,430	$	817	Appraisal of collateral (1)	Appraisal adjustments	0% to 50% (40%)
						Liquidation expenses	0% to 10% (8%)
Impaired loans	$	5,967	$	5,839	Fair value of collateral –real estate  (1), (3)	Appraisal adjustments	0% to 10% (9%)
					Fair value of collateral –equipment, inventory, other  (1), (3)	Appraisal adjustments	25% to 50% (33%)
						Liquidation expenses	0% to 20% (12%)

Valuation adjustments and liquidation cost adjustments represent unobservable inputs for OREO and impaired loans.  The ranges of discounts applied are based on age of independent appraisals, type and condition of collateral, current market conditions, and experience with the local market.

(1)  Fair value is generally determined through independent appraisals of the underlying collateral, which generally include various level 3 inputs which are not identifiable.

(2)  Appraisals may be adjusted by management for qualitative factors such as economic conditions and estimated liquidation expenses.  The range and weighted average of liquidation expenses and other appraisal adjustments are presented as a percent of the appraisal.

(3)  Includes qualitative adjustments by management.

Fair Value of Financial Instruments

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

Cash and Cash Equivalents

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

Securities Available for Sale

Fair values are determined in the manner as described above.

Other Investments

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

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Loans

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

Deposits

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

Other Short-Term Borrowings

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

Long-term Debt and Capital Securities

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

Off-Balance Sheet Instruments

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

The carrying amounts and fair values of the Company's financial instruments at September 30, 2018 and December 31, 2017 were as follows:

	September 30, 2018				December 31, 2017
	Carrying Amount		Fair Value		Carrying Amount		Fair Value
Cash and cash equivalents	$	24,049	$	24,049	$	30,797	$	30,797
Securities available for sale	70,149		70,149		78,527		78,527
Other investments	3,199		3,199		3,116		3,116
Loans, net	448,340		441,706		427,620		429,467
Interest rate swaps	216		216		45		45
Deposits	494,606		405,899		498,783		424,664
Other short-term borrowings	42,120		42,120		10,000		10,000
Long-term debt	107		81		30,243		30,780

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Note 10–Formal Written Agreement

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

• strengthen board oversight of the management and operations of the Bank;

• strengthen credit risk management and administration;

• provide for the effective grading of the Bank's loan portfolio;

• summarize the findings of its review of the adequacy of the staffing of its loan review function;

• improve the Bank's position with respect to loans, relationships, or other assets in excess of $500 that currently are, or in the future become past due more than 90 days, on the Bank's problem loan list, or adversely classified in any report of examination of the Bank;

• review and revise the Bank's methodology for determining the allowance for loan and lease losses ("ALLL") and maintain an adequate ALLL;

• maintain sufficient capital at the Company and the Bank;

• establish a revised written contingency funding plan;

• establish a revised written strategic and capital plan;

• establish a revised investment policy;

• improve the Bank's earnings and overall condition;

• revise the Bank's information technology program;

• establish a disaster recovery and business continuity program; and,

• establish a committee to monitor compliance with all aspects of the written agreement.

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

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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, 2017.

Results of Operations

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

The following table provides summarized income statements for the three- and nine-month periods ended September 30, 2018 and September 30, 2017.

	Three months ended September 30,				Nine months ended September 30,
	2018		2017		2018		2017
Net interest income	$	5,218	$	4,814	$	15,239	$	14,046
Provision expense	198		19		542		71
Noninterest income	1,068		1,700		3,139		4,660
Noninterest expense	4,708		4,921		14,506		14,634
Income before income taxes	1,380		1,574		3,330		4,001
Income tax expense	289		554		706		1,313
Net income	$	1,091	$	1,020	$	2,624	$	2,688

Comparison of Third Quarter 2018 to Third Quarter 2017

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

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

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

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

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

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

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

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

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

Comparison of Year-to-Date 2018 to Year-to-Date 2017

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

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

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

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

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

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

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

Financial Position

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

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

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

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

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

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

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

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

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	September 30, 2018			December 31, 2017
Balance in thousands	Number	Balance		Number	Balance
Land development/vacant land	8	$	308	10	$	663
1-4 family residential mortgage	5	481		2	142
Commercial real estate	3	1,453		3	1,545
Total	16	$	2,242	15	$	2,350

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

	September 30, 2018			December 31, 2017
Balance in thousands	Number	Balance		Number	Balance
Sevierville and Knoxville TN Area	1	$	71	1	$	71
Southwest VA and Tri-city TN Area	13	2,119		12	2,209
Boone and Banner Elk NC Area	2	52		2	70
Total	16	$	2,242	15	$	2,350

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

The allowance for loan losses is calculated based on management's judgment and analysis of current and historical loss experience, risk characteristics of the loan portfolio, concentrations of credit and asset quality, as well as other internal and external factors, including general economic conditions. The calculation of the allowance for loan losses is reviewed by the senior credit officers, the chief risk officer, senior financial officers and the board of directors.

The Company continually monitors the loan portfolio for signs of credit weaknesses or developing collection problems. Loan loss provisions for each period are determined after evaluating the loan portfolio and determining the level necessary to absorb current charge-offs and maintain the reserve at adequate levels. The Company's allowance for loan losses at September 30, 2018 was 0.93 percent of total loans compared to 0.92 percent at December 31, 2017 and 1.09 percent at September 30, 2017. The reduction in the allowance for loan losses since September 30, 2017 reflects the impact of charge-offs of previously impaired loans recorded during late 2017. At September 30, 2018, management concluded that the Company's allowance for loan losses is adequate based on the requirements of accounting principles generally accepted in the United States of America.

Liquidity and Capital Resources

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

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

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

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

Risk Management

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

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

Caution About Forward-Looking Statements

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

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

• adverse economic conditions in the market area and the impact on credit quality and risks inherent in the loan portfolio such as repayment risk and fluctuating collateral values;

• our inability to manage, dispose of and properly value non-performing assets and other real estate owned;

• further deterioration in the housing market and collateral values;

• our inability to assess the creditworthiness of our loan portfolio and maintain a sufficient allowance for loan losses;

• our inability to maintain adequate sources of funding and liquidity, including secondary sources such as Federal Home Loan Bank advances;

• our ability to attract and maintain capital levels adequate to support our asset levels and risk profile;

• our inability to comply with the written agreement, dated October 13, 2010, with the Federal Reserve Bank of Richmond;

• our successful management of interest rate risk and changes in interest rates and interest rate policies;

• reliance on our management team, including our ability to attract and retain key personnel;

• our ability to successfully manage our strategic plan;

• difficult market conditions in our industry;

• problems with technology utilized by us;

• our ability to successfully manage third-party vendors upon whom we are dependent;

• competition with other banks and financial institutions, and companies outside of the banking industry, including those companies that have substantially greater access to capital and other resources;

• potential impact on us of recently enacted legislation and future regulation;

• changes in accounting policies or standards;

• demand, development and acceptance of new products and services; and,

• changing trends in customer profiles and behavior.

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ITEM 3.Quantitative and Qualitative Disclosures About Market RiskNot Applicable

ITEM 4. Controls and Procedures

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

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

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PART II. OTHER INFORMATION

Item 1.  Legal Proceedings

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

Item 1A. Risk Factors

Not applicable

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

None

Item 3.  Defaults Upon Senior Securities

None

Item 4.  Mine Safety Disclosures

Not Applicable

Item 5.  Other Information

None

Item 6.  Exhibits

Exhibit Index
31.1	Rule 13a-14(a) Certification of President and Chief Executive Officer
312	Rule 13a-14(a) Certification of Chief Financial Officer
32.1	Certification Statement of President and Chief Executive Officer pursuant to 18 U.S.C. Section 1350.
32.2	Certification Statement of Chief Financial Officer pursuant to 18 U.S.C. Section 1350.
101	The following materials from the Registrant's Quarterly Report on Form 10-Q for the quarter ended September 30, 2018, formatted in Extensible Business Reporting Language (XBRL), include: (i) the Consolidated Balance Sheets, (ii) the Consolidated Statements of Income, (iii) the Consolidated Statements of Comprehensive Income, (iv) Consolidated Statements of Cash Flows; (v) Consolidated Statements of Changes in Stockholders' Equity and (vi) related notes (furnished herewith).

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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 13, 2018	By:	/s/ Timothy K. Schools
		Timothy K. Schools
		President and Chief Executive Officer
Date: November 13, 2018		/s/ John H. Gray
		John H. Gray
		Chief Financial Officer

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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, 2018, formatted in Extensible Business Reporting Language (XBRL), include: (i) the Consolidated Balance Sheets, (ii) the Consolidated Statements of Income, (iii) the Consolidated Statements of Comprehensive Income, (iv) Consolidated Statements of Cash Flows; (v) Consolidated Statements of Changes in Stockholders' Equity and (vi) related notes (furnished herewith).

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