|
Item
2.
|
Manageme
n
t’s
Discussion and Analysis of Financial Condition and
Results of Operations
|
Forward
Looking Statements
Certain
statements in this report may constitute “forward-looking statements” within the
meaning of the Private Securities Litigation Reform Act of
1995. Forward-looking statements are statements that include
projections, predictions, expectations or beliefs about future events or results
or otherwise are not statements of historical fact. Such statements
are often characterized by the use of qualified words (and their derivatives)
such as “expect,” “believe,” “estimate,” “plan,” “project,” “anticipate” or
other similar words. Although the Company believes that its
expectations with respect to certain forward-looking statements are based upon
reasonable assumptions within the bounds of its existing knowledge of its
business and operations, there can be no assurance that actual results,
performance or achievements of the Company will not differ materially from
any
future results, performance or achievements expressed or implied by such
forward-looking statements. Actual future results and trends may
differ materially from historical results or those anticipated depending on
a
variety of factors, including, but not limited to, the effects of and changes
in: general economic conditions, the interest rate environment,
legislative and regulatory requirements, competitive pressures, new products
and
delivery systems, inflation, changes in the stock and bond markets, technology,
downturns in the trucking and timber industries, effects of mergers and/or
downsizing in the poultry industry in the Company’s geographic operating
footprint, and consumer spending and savings habits. Additionally,
actual future results and trends may differ from historical or anticipated
results to the extent: (1) any significant downturn in certain industries,
particularly the trucking and timber industries are experienced; (2) loan demand
decreases from prior periods; (3) the Company may make additional loan loss
provisions due to negative credit quality trends in the future that may lead
to
a deterioration of asset quality; (4) the Company may not continue to experience
significant recoveries of previously charged-off loans or loans resulting in
foreclosure; and (5) the Company is unable to control costs and expenses as
anticipated. The Company does not update any forward-looking statements that
may
be made from time to time by or on behalf of the Company. Additionally,
consideration should be given to the cautionary language found elsewhere in
this
Form 10-Q and in the section on “Risk Factors” Item 1A in the Company’s Annual
Report of Form 10-K for the year ended December 31, 2006.
Introduction
The
following discussion focuses on significant results of the Company’s operations
and significant changes in our financial condition or results of operations
for
the periods indicated in the discussion. This discussion should be read in
conjunction with the preceding financial statements and related notes, as well
as the Company’s Annual Report on Form 10-K for the period ended December 31,
2006.
Current
performance does not guarantee, and may not be indicative of, similar
performance in the future.
Critical
Accounting Policies
The
Company’s financial statements are prepared in accordance with accounting
principles generally accepted in the United States (“GAAP”). The financial
statements contained within these statements are, to a significant extent,
financial information that is based on measures of the financial effects of
transactions and events that have already occurred. A variety of factors could
affect the ultimate value that is obtained either when earning income,
recognizing an expense, recovering an asset or relieving a liability. In
addition, GAAP itself may change from one previously acceptable method to
another method. Although the economics of these transactions would be the same,
the timing of events that would impact these transactions could
change.
Disclosure
of the Company’s significant accounting policies is included in Note Two to the
Consolidated Financial Statements of the Company’s Annual Report on Form 10-K
for the period ended December 31, 2006. Some of the policies are particularly
sensitive, requiring significant judgments, estimates and assumptions by
management.
The
allowance for loan losses is an estimate of the losses that may be sustained
in
the loan portfolio. The allowance is based on two basic principles of
accounting: (i) SFAS No. 5, Accounting for Contingencies, which requires that
losses be accrued when they are probable of occurring and estimable and (ii)
SFAS No. 114, Accounting by Creditors for Impairment of a Loan, which requires
that losses be accrued based on the differences between the value of collateral,
present value of future cash flows or values that are observable in the
secondary market and the loan balance. Additional information pertaining to
the
allowance for loan losses and provision for loan losses is contained on pages
16-18 of this report.
The
Company has invested in and owns life insurance policies on certain officers.
The policies are designed so that the company recovers the interest expenses
associated with carrying the policies and the officer will, at the time of
retirement, receive any earnings in excess of the amounts earned by the Company.
The Company recognizes as an asset the net amount that could be realized under
the insurance contract as of the balance sheet date. This amount represents
the
cash surrender value of the policies less applicable surrender charges. The
portion of the benefits, which will be received by the executives at the time
of
their retirement, is considered, when taken collectively, to constitute a
retirement plan. Therefore the Company accounts for these policies using
guidance found in Statement of Financial Accounting Standards No. 106,
"Employers' Accounting for Post Retirement Benefits Other Than Pensions.” SFAS
No. 106 requires that an employers' obligation under a deferred compensation
agreement be accrued over the expected service life of the employee through
their normal retirement date. Assumptions are used in estimating the present
value of amounts due officers after their normal retirement
date. These assumptions include the estimated income to be derived
from the investments and an estimate of the Company’s cost of funds in these
future periods. In addition, the discount rate used in the present
value calculation will change in future years based on market
conditions.
During
2005, the Company purchased all
the outstanding shares of the National Bank of Davis. The net assets of this
purchase were recorded at fair value, including goodwill. Goodwill represents
the cost in excess of the fair value of net assets acquired (including
identifiable intangibles) in transactions accounted for as
purchases. In accordance with provisions of SFAS No. 142,
"
Goodwill and Other
Intangible Assets
",
goodwill is not amortized over an estimated useful life, but rather will be
tested at least annually for impairment. Core deposit and other intangible
assets include premiums paid for acquisitions of core deposits (core deposit
intangibles) and other identifiable intangible assets. Intangible
assets other than goodwill, which are determined to have finite lives, are
amortized based upon the estimated economic benefits
received
.
Recent
Accounting Pronouncements
In
September 2006, the FASB issued Statement of Financial Accounting Standards
No.
158, “Employers Accounting for Defined Benefit Pension and Other Postretirement
Plans—an amendment of FASB Statements No. 87, 88, 106 and 132R” (SFAS 158). SFAS
158 requires an employer to recognize the over-funded or under-funded status
of
a defined benefit postretirement plan as an asset or liability in its statement
of financial position and to recognize changes in that funded status, through
comprehensive income, in the year in which the changes occur. The funded status
of a benefit plan will be measured as the difference between plan assets at
fair
value and benefit obligation. For any other postretirement plan, the benefit
obligation is the accumulated postretirement benefit obligation. SFAS 158 also
requires an employer to measure the funded status of a plan as of the date
of
its year-end statement of financial position. The Statement also requires
additional disclosures in the notes to financial statements about certain
effects on net periodic benefit cost for the next fiscal year that arise from
delayed recognition of the gains or losses, prior service costs or credits,
and
transition asset or obligation. Under SFAS 158 a company is required to
initially recognize the funded status of a defined benefit postretirement plan
to provide the required disclosures as of the end of the fiscal year ending
after December 15, 2006. The requirement to measure plan assets and benefit
obligations as of the date of the employer’s fiscal year end statement of
financial position is effective for fiscal years ending after December 15,
2008.
The Grant County Bank is a member of the West Virginia Bankers' Association
Retirement Plan, a defined benefit plan under SFAS 158.
In
September of 2006, the Emerging Issues Task Force of the FASB (EITF) issued
EITF
06-04. This pronouncement affects the recording of post retirement costs of
insurance of bank owned life insurance policies in instances where the Company
has promised a continuation of life insurance coverage to persons post
retirement. EITF 06-04 requires that a liability equal to the present value
of
the cost of post retirement insurance be recorded during the insured employees’
term of service. The terms of this pronouncement require the initial recording
of this liability with a corresponding adjustment to retained earnings to
reflect the implementation of the pronouncement. This EITF becomes
effective for fiscal years ending after December 15, 2007, and as such Highlands
Bankshares’ financial statements for the periods shown in this Quarterly Report
on Form 10-Q do not reflect the recording of this liability. On January 1,
2008,
Highlands Bankshares will record the appropriate liability and corresponding
effect on retained earnings, and for periods after January 1, 2008 will record
an appropriate liability and corresponding effects on current income for the
applicable periods. At present, the exact effect of this pronouncement on
Highlands retained earnings or current income for future periods has not been
calculated.
No
other
recent accounting pronouncements had a material impact on the Company’s
consolidated financial statements, and it is believed that none will have a
material impact on the Company’s operations in future years.
Overview
of Results
Net
income for the first nine months of 2007 was .48% higher than the same period
in
2006. A 6.86% increase in net interest income was offset by a slight decline
in
non-interest income and a 7.26% increase in non-interest expense.
Net
interest income grew largely as the result of continued growth in average
balances of earning assets compared to growth in interest bearing liabilities,
although the effects of this relative growth were offset to some degree by
increases in average rates on interest bearing liabilities being greater than
the increases experienced in the average rates earned on earning
assets.
During
2006, the Company recorded a one-time gain of $155,000 related to an insurance
settlement (See Note Twenty of the Financial Statements included in the
Company’s Annual Report on Form 10-K for the Year Ended December 31, 2006) This
gain recorded in 2006 was the largest factor in contributing to the Company’s
$29,000 decrease in other interest income for the first nine months of 2007
as
compared to 2006. Service charge income continued to increase largely as a
result of the growth of Company’s deposit base.
The
increase in non-interest expense was largely the result of increases in the
cost
of employee salaries and benefits, increases in legal and professional fees,
and
the impact of continued operational growth on both occupancy and equipment
expense and data processing expense.
Highlands'
results of operations are discussed in greater detail following this overview.
Unless otherwise specifically noted, the underlying causes for changes in the
results for the quarter ended September 30, 2007 as compared to the same quarter
in 2006 are substantially the same as the causes discussed for the nine months
ended September 30, 2007 as compared to the nine months ended September 30,
2006.
Net
Interest Income
Net
interest income, on a fully taxable equivalent basis, increased 6.83% for the
first nine months of 2007 as compared to the same period in 2006. This increase
came primarily as the result of the relative size of increases in earning assets
compared to increases in interest bearing liabilities, which was offset in
part
by the increase in the average rates paid on interest bearing liabilities
compared to the increase average rate earned on earning assets.
The
table
on the following page illustrates the effects on net interest income, on a
fully
taxable equivalent basis, and for the first nine months of each year, of changes
in average volumes of interest bearing liabilities and earning assets from
2006
to 2007 and changes in average rates on interest bearing liabilities and earning
assets from 2006 to 2007 (in thousands of dollars):
|
EFFECT
OF RATE-VOLUME CHANGES ON NET INTEREST INCOME
|
|
|
(On
a fully taxable equivalent basis)
|
|
|
(In
thousands of dollars)
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Increase
(Decrease) Nine Months Ended September 30, 2007 Compared to Nine
Months Ended September 30, 2006
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Due
to change in:
|
|
|
|
|
|
|
|
Average
Volume
|
|
|
Average
Rate
|
|
|
Total
Change
|
|
|
Interest
Income
|
|
|
|
|
|
|
|
|
|
|
Loans
|
|
$
|
1,570
|
|
|
$
|
1,111
|
|
|
$
|
2,681
|
|
|
Federal
funds sold
|
|
|
210
|
|
|
|
52
|
|
|
|
262
|
|
|
Interest
bearing deposits
|
|
|
41
|
|
|
|
20
|
|
|
|
61
|
|
|
Taxable
investment securities
|
|
|
(56
|
)
|
|
|
197
|
|
|
|
141
|
|
|
Nontaxable
investment securities
|
|
|
(6
|
)
|
|
|
6
|
|
|
|
0
|
|
|
Total
Interest Income
|
|
|
1,759
|
|
|
|
1,386
|
|
|
|
3,145
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Interest
Expense
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Demand
deposits
|
|
|
(1
|
)
|
|
|
2
|
|
|
|
1
|
|
|
Savings
deposits
|
|
|
(28
|
)
|
|
|
133
|
|
|
|
105
|
|
|
Time
deposits
|
|
|
978
|
|
|
|
1,331
|
|
|
|
2,309
|
|
|
Borrowed
money
|
|
|
(98
|
)
|
|
|
16
|
|
|
|
(82
|
)
|
|
Total
Interest Expense
|
|
|
851
|
|
|
|
1,482
|
|
|
|
2,333
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Net
Interest Income
|
|
$
|
908
|
|
|
$
|
(96
|
)
|
|
$
|
812
|
|
Increases
by the Federal Reserve Board (“The Fed”) throughout 2005 and continuing into
2006 for the target rate for federal funds sold has caused both rates earned
on
assets and rates paid on liabilities to increase. Although the
increases by The Fed slowed in late 2006 and the Fed has cut rates during 2007,
the Company’s balance sheet continues to be impacted by the increases enacted
during 2005 and early 2006. As older earning assets and interest bearing
liabilities mature and are replaced by newer earning assets and interest bearing
liabilities, which bear higher rates of interest, the Company has experienced
increases in both the average rates earned on assets and the average rates
paid
on liabilities
Due
mainly to both the shorter maturities on deposits versus those on loans or
securities investments, and the relative ratio of time deposits, typically
a
higher cost interest bearing liability, to other interest bearing liabilities,
the average rates paid on interest bearing liabilities increased 81 basis points
compared to a 52 basis point increase in average rates earned on
assets.
Historically,
the Company, in an effort to attract deposits with which to fund loan growth,
has often paid rates on deposits higher than national averages. During the
later
portions of 2004 and during 2005, the Company chose to fund loan growth through
reductions in deposit balances and also reductions of comparatively lower
earning assets like federal funds sold and securities rather than compete for
deposits based upon rate. As The Fed has continued to increase the target rate
for federal funds sold, the average rates earned by securities, federal funds
sold and deposits in other banks have increased more than the rates on loans.
As
such, Management has somewhat eased its strategy for funding loans through
reductions in these lower earning assets because, in some instances, the rates
paid on these assets are greater than the cost of interest on new deposits.
In
addition, strong loan demand throughout the later parts of 2006 and continuing
into 2007 created a need for the offering of higher rates on deposits to attract
new deposits with which to fund this loan growth. As such, the Company’s average
rates paid on time deposits and average balances of time deposits have
increased.
As
of
September 30, 2007, the Company had balances of liquid funds, mostly in the
form
of federal funds sold, greater than seen during previous recent years. Because
of the larger balances of liquid funds, Management anticipates that, in the
immediately upcoming quarters, the need for offering above market rates to
attract new deposits will continue to lessen as compared to recent years,
allowing net interest margins to continue at or near recent levels.
Although
rate increases by the Fed in 2005 and 2006 have ceased, and during the third
quarter of 2007 the Fed implemented decreases in the target rate for Federal
Fund Sold, the Company anticipates that during the immediately upcoming
quarters, its ability to manage its balance sheet of earning assets and interest
bearing liabilities will have a greater impact on the Company’s net interest
margin during these quarters than the effects of the rate decreases. Although
the Company anticipates that the recently enacted rate decreases by the Fed
will
cause both the average rates paid on earning assets and interest bearing
liabilities to decline, the current balances of liquid funds, in the form of
federal funds sold and interest bearing deposits, will allow the Company enough
funding flexibility such that no significant decreases in net interest margin
are anticipated in the immediately upcoming quarters should loan demand remain
strong.
The
table
below sets forth an analysis of net interest income for the nine-month periods
ended September 30, 2007 and 2006 (Average balances and interest/expense shown
in thousands of dollars):
|
|
|
2007
|
|
|
2006
|
|
|
|
|
Average
|
|
|
Income/
|
|
|
|
|
|
Average
|
|
|
Income/
|
|
|
|
|
|
|
|
Balance
|
|
|
Expense
|
|
|
Rate
|
|
|
Balance
|
|
|
Expense
|
|
|
Rate
|
|
|
Interest
Income
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Loans
1,2
|
|
$
|
300,905
|
|
|
$
|
18,830
|
|
|
|
8.34
|
%
|
|
$
|
274,230
|
|
|
$
|
16,149
|
|
|
|
7.85
|
%
|
|
Federal
funds sold
|
|
|
15,715
|
|
|
|
600
|
|
|
|
5.09
|
%
|
|
|
9,695
|
|
|
|
338
|
|
|
|
4.65
|
%
|
|
Interest
bearing deposits
|
|
|
2,490
|
|
|
|
100
|
|
|
|
5.35
|
%
|
|
|
1,216
|
|
|
|
39
|
|
|
|
4.28
|
%
|
|
Taxable
investment securities
|
|
|
23,581
|
|
|
|
948
|
|
|
|
5.36
|
%
|
|
|
25,339
|
|
|
|
807
|
|
|
|
4.25
|
%
|
|
Nontaxable
investment securities
3
|
|
|
2,927
|
|
|
|
134
|
|
|
|
6.10
|
%
|
|
|
3,076
|
|
|
|
134
|
|
|
|
5.81
|
%
|
|
Total
Earning Assets
|
|
|
345,618
|
|
|
|
20,612
|
|
|
|
7.95
|
%
|
|
|
313,556
|
|
|
|
17,467
|
|
|
|
7.43
|
%
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Cash
and cash equivalents
|
|
|
8,006
|
|
|
|
|
|
|
|
|
|
|
|
7,957
|
|
|
|
|
|
|
|
|
|
|
Allowance
for loan losses
|
|
|
(3,626
|
)
|
|
|
|
|
|
|
|
|
|
|
(3,232
|
)
|
|
|
|
|
|
|
|
|
|
Insurance
contracts
|
|
|
6,151
|
|
|
|
|
|
|
|
|
|
|
|
6,256
|
|
|
|
|
|
|
|
|
|
|
Non-earning
assets
|
|
|
15,535
|
|
|
|
|
|
|
|
|
|
|
|
14,615
|
|
|
|
|
|
|
|
|
|
|
Total
Assets
|
|
$
|
371,684
|
|
|
|
|
|
|
|
|
|
|
$
|
339,152
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Interest
Expense
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Interest
bearing demand deposits
|
|
$
|
25,528
|
|
|
$
|
168
|
|
|
|
.88
|
%
|
|
$
|
25,677
|
|
|
$
|
167
|
|
|
|
.87
|
%
|
|
Savings
and money markets
|
|
|
47,744
|
|
|
|
507
|
|
|
|
1.42
|
%
|
|
|
51,288
|
|
|
|
402
|
|
|
|
1.05
|
%
|
|
Time
deposits
|
|
|
194,156
|
|
|
|
6,783
|
|
|
|
4.66
|
%
|
|
|
159,320
|
|
|
|
4,474
|
|
|
|
3.74
|
%
|
|
Long
term debt
|
|
|
12,841
|
|
|
|
447
|
|
|
|
4.64
|
%
|
|
|
15,779
|
|
|
|
529
|
|
|
|
4.47
|
%
|
|
Total
Interest Bearing Liabilities
|
|
|
280,269
|
|
|
|
7,905
|
|
|
|
3.76
|
%
|
|
|
252,064
|
|
|
|
5,572
|
|
|
|
2.95
|
%
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Demand
deposits
|
|
|
48,249
|
|
|
|
|
|
|
|
|
|
|
|
47,968
|
|
|
|
|
|
|
|
|
|
|
Other
liabilities
|
|
|
4,923
|
|
|
|
|
|
|
|
|
|
|
|
3,893
|
|
|
|
|
|
|
|
|
|
|
Stockholders’
equity
|
|
|
38,243
|
|
|
|
|
|
|
|
|
|
|
|
35,227
|
|
|
|
|
|
|
|
|
|
|
Total
liabilities and stockholders’ equity
|
|
$
|
371,684
|
|
|
|
|
|
|
|
|
|
|
$
|
339,152
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Net
Interest Income
|
|
|
|
|
|
$
|
12,707
|
|
|
|
|
|
|
|
|
|
|
$
|
11,895
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Net
Yield on Earning Assets
3
|
|
|
|
|
|
|
|
|
|
|
4.90
|
%
|
|
|
|
|
|
|
|
|
|
|
5.06
|
%
|
1
Balances
of loans
include loans in non-accrual status
2
Interest
income on
loans includes fees
3
Yields
are on a
fully taxable equivalent basis
The
table
below sets forth an analysis of net interest income for the three-month periods
ended September 30, 2007 and 2006 (Average balances and interest/expense shown
in thousands of dollars):
|
|
|
2007
|
|
|
2006
|
|
|
|
|
Average
|
|
|
Income/
|
|
|
|
|
|
Average
|
|
|
Income/
|
|
|
|
|
|
|
|
Balance
|
|
|
Expense
|
|
|
Rate
|
|
|
Balance
|
|
|
Expense
|
|
|
Rate
|
|
|
Interest
Income
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Loans
1,2
|
|
$
|
305,542
|
|
|
$
|
6,471
|
|
|
|
8.47
|
%
|
|
$
|
278,888
|
|
|
$
|
5,698
|
|
|
|
8.17
|
%
|
|
Federal
funds sold
|
|
|
15,449
|
|
|
|
195
|
|
|
|
5.05
|
%
|
|
|
9,636
|
|
|
|
124
|
|
|
|
5.15
|
%
|
|
Interest
bearing deposits
|
|
|
2,660
|
|
|
|
30
|
|
|
|
4.51
|
%
|
|
|
1,497
|
|
|
|
16
|
|
|
|
4.28
|
%
|
|
Taxable
investment securities
|
|
|
25,792
|
|
|
|
354
|
|
|
|
5.49
|
%
|
|
|
23,620
|
|
|
|
276
|
|
|
|
4.67
|
%
|
|
Nontaxable
investment securities
3
|
|
|
2,860
|
|
|
|
46
|
|
|
|
6.43
|
%
|
|
|
2,858
|
|
|
|
42
|
|
|
|
5.88
|
%
|
|
Total
Earning Assets
|
|
|
352,303
|
|
|
|
7,096
|
|
|
|
8.06
|
%
|
|
|
316,499
|
|
|
|
6,156
|
|
|
|
7.78
|
%
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Cash
and cash equivalents
|
|
|
7,950
|
|
|
|
|
|
|
|
|
|
|
|
8,015
|
|
|
|
|
|
|
|
|
|
|
Allowance
for loan losses
|
|
|
(3,693
|
)
|
|
|
|
|
|
|
|
|
|
|
(3,330
|
)
|
|
|
|
|
|
|
|
|
|
Insurance
contracts
|
|
|
6,205
|
|
|
|
|
|
|
|
|
|
|
|
5,976
|
|
|
|
|
|
|
|
|
|
|
Nonearning
assets
|
|
|
16,518
|
|
|
|
|
|
|
|
|
|
|
|
15,010
|
|
|
|
|
|
|
|
|
|
|
Total
Assets
|
|
$
|
379,283
|
|
|
|
|
|
|
|
|
|
|
$
|
342,170
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Interest
Expense
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Interest
bearing demand deposits
|
|
$
|
24,358
|
|
|
$
|
55
|
|
|
|
.90
|
%
|
|
$
|
25,218
|
|
|
$
|
55
|
|
|
|
.87
|
%
|
|
Savings
and money markets
|
|
|
49,278
|
|
|
|
191
|
|
|
|
1.55
|
%
|
|
|
48,696
|
|
|
|
139
|
|
|
|
1.14
|
%
|
|
Time
deposits
|
|
|
201,223
|
|
|
|
2,406
|
|
|
|
4.78
|
%
|
|
|
164,822
|
|
|
|
1,679
|
|
|
|
4.04
|
%
|
|
Long
term debt
|
|
|
12,416
|
|
|
|
144
|
|
|
|
4.61
|
%
|
|
|
15,781
|
|
|
|
174
|
|
|
|
4.41
|
%
|
|
Total
Interest Bearing Liabilities
|
|
|
287,275
|
|
|
|
2,796
|
|
|
|
3.89
|
%
|
|
|
254,517
|
|
|
|
2,047
|
|
|
|
3.22
|
%
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Demand
deposits
|
|
|
47,435
|
|
|
|
|
|
|
|
|
|
|
|
47,930
|
|
|
|
|
|
|
|
|
|
|
Other
liabilities
|
|
|
5,550
|
|
|
|
|
|
|
|
|
|
|
|
3,477
|
|
|
|
|
|
|
|
|
|
|
Stockholders’
equity
|
|
|
39,023
|
|
|
|
|
|
|
|
|
|
|
|
36,246
|
|
|
|
|
|
|
|
|
|
|
Total
liabilities and stockholders’ equity
|
|
$
|
379,283
|
|
|
|
|
|
|
|
|
|
|
$
|
342,170
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Net
Interest Income
|
|
|
|
|
|
$
|
4,300
|
|
|
|
|
|
|
|
|
|
|
$
|
4,109
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Net
Yield on Earning Assets
3
|
|
|
|
|
|
|
|
|
|
|
4.88
|
%
|
|
|
|
|
|
|
|
|
|
|
5.19
|
%
|
|
|
|
|
1
Balances
of
loans include loans in nonaccrual status
|
|
|
2
Interest
income on loans includes fees
|
|
|
3
Yields
are on
a fully taxable equivalent basis
|
|
Loan
Portfolio
The
Company is an active residential mortgage and construction lender and generally
extends commercial loans to small and medium sized businesses within its primary
service area. The Company's commercial lending activity extends
across its primary service areas of Grant, Hardy, Hampshire, Mineral, Randolph,
Tucker, and northern Pendleton counties in West Virginia, Frederick County,
Virginia and Garrett County, Maryland. Consistent with its focus on
providing community-based financial services, the Company does not attempt
to
diversify its loan portfolio geographically by making significant amounts of
loans to borrowers outside of its primary service area.
Credit
Quality and Allowance for Loan Losses
Non-performing
loans increased 41.45% from December 31, 2006 to September 30, 2007.
Non-performing loans represented .78% of gross loans at September 30, 2007
and
.58% of gross loans at December 31, 2006. The increase in non-performing loans
was the result of the decline in quality of a few larger loans. As potential
impairments on these loans have been considered by Management in the Company’s
allowance for loan loss, no further loss not already allowed for is anticipated.
In addition, because this increase is the result of a few larger loans,
management believes that the increase in non-performing loans is not indicative
of a growing trend of deterioration of quality in its loan
portfolio.
The
following table summarizes the Company’s non-performing loans at September 30,
2007 and December 31, 2006 (in thousands of dollars):
|
|
|
September
30,
|
|
|
December
31,
|
|
|
|
|
2007
|
|
|
2006
|
|
|
Non-accrual
loans
|
|
$
|
1,371
|
|
|
$
|
244
|
|
|
Loans
past due 90 days and still accruing interest
|
|
|
1,035
|
|
|
|
1,457
|
|
|
Total
non-performing loans
|
|
$
|
2,406
|
|
|
$
|
1,701
|
|
Non-performing
loans include non-accrual loans, loans 90 days or more past due and restructured
loans. Non-accrual loans are loans on which interest accruals have been
suspended or discontinued permanently. Restructured loans are loans
on which the original interest rate or repayment terms have been changed due
to
financial hardship of the borrower.
Loans
are
typically placed on non-accrual status once they have reached certain levels
of
delinquency, depending on loan type, and it is no longer reasonable to expect
collection of principal and interest because collateral is insufficient to
cover
both the principal and interest due. After loans are placed on non-accrual
status, they are returned to accrual status if the obligation is brought current
by the borrower, or they are charged off if payment is not made and Management
believes that collection of the amounts due is doubtful. Charged-off loans
are
charged against the allowance for loan losses. Any subsequent collection or
sale
of repossessed collateral is typically added to the allowance as a
recovery.
Because
of its large impact on the local economy, Management continuously monitors
the
economic health of the poultry industry. The Company has direct loans
to poultry growers and the industry is a large employer in the Company’s trade
area. The Company’s loan portfolio also reflects a concentration in
loans collateralized by heavy equipment, particularly in the trucking and timber
and coal extraction industries. In part because of rising fuel costs, and
because of continued slow economic growth, the trucking sector experienced
a
recent downturn, and profitability growth within this sector still appears
to be
sluggish. While close monitoring of this sector is necessary, management expects
no significant losses in the foreseeable future.
An
inherent risk in the lending of money is that the borrower will not be able
to
repay the loan under the terms of the original agreement. The
allowance for loan losses provides for this risk and is reviewed periodically
for adequacy. This review also considers concentrations of loans in
terms of geography, business type or level of risk. While lending is
geographically diversified within the service area, the Company does have some
concentration of loans in the area of agriculture (primarily poultry farming),
timber and related industries. Management recognizes these concentrations and
considers them when structuring its loan portfolio.
Each
of
the Company's banking subsidiaries, Capon Valley Bank and The Grant County
Bank,
determines the adequacy of its allowance for loan losses independently. Although
the loan portfolios of the two banks are similar to each other, some differences
exist which result in divergent risk patterns and different charge-off rates
amongst the functional areas of the banks’ portfolios. Each bank pays
particular attention to individual loan performance, collateral values, borrower
financial condition and economic conditions. The determination of an
adequate allowance at each bank is done in a three-step process. The
first step is to identify impaired loans. Impaired loans are problem loans
above
a certain threshold, which have estimated losses calculated based on collateral
values and projected cash flows. The second step is to identify loans
above a certain threshold, which are problem loans due to the borrower’s payment
history or deteriorating financial condition. Losses in this category
are determined
based
on
historical loss rates adjusted for current economic conditions. The
final step is to calculate a loss for the remainder of the portfolio using
historical loss information for each type of loan classification. The
determination of specific allowances and weighting is somewhat subjective and
actual losses may be greater or less than the amount of the
allowance. However, Management believes that the allowance represents
a fair assessment of the losses that exist in the current loan
portfolio.
The
required level of the allowance for loan losses is computed quarterly and the
allowance adjusted prior to the issuance of the quarterly financial
statements. All loan losses charged to the allowance are approved by
the boards of directors of each bank at their regular meetings. The
allowance is reviewed for adequacy after considering historical loss rates,
current economic conditions (both locally and nationally) and any known credit
problems that have not been considered under the above formula.
Management
has analyzed the potential risk of loss on the Company's loan portfolio given
the loan balances and the value of the underlying collateral and has recognized
losses where appropriate. Non-performing loans are closely monitored on an
ongoing basis as part of the Company's loan review process.
The
following table shows the allocation for loans in the loan portfolio and the
corresponding amounts of the allowance allocated by loan type as of September
30, 2007 and December 31, 2006 (in thousands of dollars):
|
|
|
September
30, 2007
|
|
|
December
31, 2006
|
|
|
|
|
|
|
|
Percent
of
|
|
|
|
|
|
Percent
of
|
|
|
|
|
Amount
|
|
|
Loans
|
|
|
Amount
|
|
|
Loans
|
|
|
Loan
Type
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Commercial
|
|
$
|
1,467
|
|
|
|
26
|
%
|
|
$
|
1,492
|
|
|
|
24
|
%
|
|
Mortgage
and construction
|
|
|
1,010
|
|
|
|
59
|
%
|
|
|
996
|
|
|
|
61
|
%
|
|
Consumer
|
|
|
1,135
|
|
|
|
15
|
%
|
|
|
967
|
|
|
|
15
|
%
|
|
Unallocated
|
|
|
99
|
|
|
|
|
|
|
|
27
|
|
|
|
|
|
|
Totals
|
|
$
|
3,711
|
|
|
|
|
|
|
$
|
3,482
|
|
|
|
|
|
As
certain loans identified as impaired are paid current, collateral values
increase or loans are removed from watch lists for other reasons, and as other
loans become identified as impaired, and because delinquency levels within
each
of the portfolios change, the allocation of the allowance among the loan types
may change. Management feels that the allowance is a fair representation of
the
losses present in the portfolio given historical loss trends, economic
conditions and any known credit problems as of a given date. Management believes
that the allowance is to be taken as a whole, and allocation between loan types
is an estimation of potential losses within each type given information known
at
the time.
The
following table summarizes the Company’s net charge-offs by loan type for the
nine-month periods ended September 30, 2007 and 2006 (in thousands of
dollars):
|
|
|
2007
|
|
|
2006
|
|
|
Charge-offs
|
|
|
|
|
|
|
|
Commercial
|
|
$
|
(141
|
)
|
|
$
|
(27
|
)
|
|
Mortgage
and construction
|
|
|
(38
|
)
|
|
|
(1
|
)
|
|
Consumer
|
|
|
(361
|
)
|
|
|
(402
|
)
|
|
Total
Charge-offs
|
|
|
(540
|
)
|
|
|
(430
|
)
|
|
|
|
|
|
|
|
|
|
|
|
Recoveries
|
|
|
|
|
|
|
|
|
|
Commercial
|
|
|
50
|
|
|
|
4
|
|
|
Mortgage
|
|
|
4
|
|
|
|
0
|
|
|
Consumer
|
|
|
229
|
|
|
|
169
|
|
|
Total
Recoveries
|
|
|
283
|
|
|
|
173
|
|
|
|
|
|
|
|
|
|
|
|
|
Total
Net Charge-offs
|
|
$
|
(257
|
)
|
|
$
|
(257
|
)
|
The
provision for loan losses taken during the first nine months of 2007 was $22,000
less than that taken during the same period in 2006. In spite of the decrease
in
the provision, the ratio of the allowance for loan losses to gross loans
increased from 1.19% at December 31, 2006 to 1.20% at September 30,
2007. At September 30, 2006, the ratio of the allowance for
loan losses to gross loans was 1.19%. The ratio of allowance for loan
losses to non-performing loans was 1.54 at September 30, 2007 compared to 2.05
at December 31, 2006.
Non-interest
Expense
Non-interest
expense increased 7.26% for the first nine months of 2007 as compared to the
same period in 2006.
As
the
relative size of the Company’s operations continued to increase, the Company’s
cost of equipment and also data processing expense also increased. Legal and
professional fees increased $65,000 as compared to 2006 largely as a result
of
increased on-site engagements of consultants assisting the Company with Sarbanes
Oxley Rule 404 compliance.
The
cost
of employee salaries and related benefits increased 5.75% as normal annual
increases in pay and increases in the number of full time equivalent employees
employed by the Company and its subsidiaries were coupled with a slight increase
in the cost of postretirement benefit plans. The table below
summarizes the effects of increases in average pay per employee, increases
in
the number of full time equivalent employees and changes in the cost of post
retirement benefits for employees on changes in the cost of salaries and
employee benefits from 2006 to 2007 (in thousands of dollars):
|
|
|
Amount
|
|
|
Increase
in cost due to increases in average rate of employee salaries and
benefits
|
|
$
|
82
|
|
|
Increase
in cost of employee salaries and benefits due to increases in full
time
equivalent employees
|
|
|
129
|
|
|
Increase
in costs related to post retirement benefits
|
|
|
32
|
|
|
Total
Increase in cost of employee salaries and benefits
|
|
$
|
243
|
|
Borrowed
Funds
The
Company borrows funds from the Federal Home Loan Bank (“FHLB”) to reduce market
rate risks, provide liquidity, and to fund capital additions. These
borrowings may have fixed or variable interest rates and are amortized over
a
period of one to twenty years, or may be comprised of single payment borrowings
with periodic interest payments and principal amounts due at maturity. In an
attempt to manage interest expense and interest rate risk and as competition
for
deposits have increased, the Company has, during recent periods, used these
available debt vehicles to fund loan growth more frequently than was utilized
in
the past.
Liquidity
Operating
liquidity is the ability to meet present and future financial obligations.
Short-term liquidity is provided primarily through cash balances, deposits
with
other financial institutions, federal funds sold, non-pledged securities and
loans maturing within one year. Additional sources of liquidity available to
the
Company include, but are not limited to, loan repayments, the ability to obtain
deposits through the adjustment of interest rates and the purchasing of federal
funds. To further meet its liquidity needs, the Company also
maintains lines of credit with correspondent financial institutions, the Federal
Reserve Bank of Richmond and the Federal Home Loan Bank of
Pittsburgh.
Historically,
the Company’s primary need for additional levels of operational liquidity has
been to fund increases in loan balances. The Company has normally funded
increases in loans by increasing deposits and decreases in secondary liquidity
sources such as balances of federal funds sold and balances of securities.
In
recent periods, the Company has substantially maintained or increased levels
of
these secondary liquidity resources and does not anticipate that an unexpectedly
high level of loan demand in coming periods would impact liquidity to the extent
that the Company would be required to pay above market rates to obtain
deposits.
The
parent Company’s operating funds, funds with which to pay shareholder dividends
and funds for the exploration of new business ventures, have been supplied
primarily through dividends paid by the Company’s subsidiary banks Capon Valley
Bank (CVB) and The Grant County Bank (GCB). The various regulatory
authorities impose restrictions on dividends paid by a state bank. A
state bank cannot pay dividends without the consent of the relevant banking
authorities in excess of the total net profits of the current year and the
combined retained profits of the previous two years. As of October 1,
2007, the subsidiary banks could pay dividends to Highlands Bankshares, Inc.
of
approximately $8,032,000 without permission of the regulatory
authorities.
Capital
The
Company seeks to maintain a strong capital base to expand facilities, promote
public confidence, support current operations and grow at a manageable
level. As of September 30, 2007, the Company was above the regulatory
minimum levels of capital. The table below summarizes the capital ratios for
the
Company and its subsidiary banks as of September 30, 2007 and December 31,
2006:
|
|
|
September
30, 2007
|
|
|
December
31, 2006
|
|
|
|
|
Actual
|
|
|
Regulatory
|
|
|
Actual
|
|
|
Regulatory
|
|
|
|
|
Ratio
|
|
|
Minimum
|
|
|
Ratio
|
|
|
Minimum
|
|
|
Total
Risk Based Capital Ratio
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Highlands
Bankshares
|
|
|
14.32
|
%
|
|
|
8.00
|
%
|
|
|
13.45
|
%
|
|
|
8.00
|
%
|
|
Capon
Valley Bank
|
|
|
14.51
|
%
|
|
|
8.00
|
%
|
|
|
14.56
|
%
|
|
|
8.00
|
%
|
|
The
Grant County Bank
|
|
|
13.15
|
%
|
|
|
8.00
|
%
|
|
|
12.63
|
%
|
|
|
8.00
|
%
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Tier
1 Leverage Ratio
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Highlands
Bankshares
|
|
|
9.85
|
%
|
|
|
4.00
|
%
|
|
|
9.26
|
%
|
|
|
4.00
|
%
|
|
Capon
Valley Bank
|
|
|
9.87
|
%
|
|
|
4.00
|
%
|
|
|
9.53
|
%
|
|
|
4.00
|
%
|
|
The
Grant County Bank
|
|
|
9.06
|
%
|
|
|
4.00
|
%
|
|
|
8.85
|
%
|
|
|
4.00
|
%
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Tier
1 Risk Based Capital Ratio
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Highlands
Bankshares
|
|
|
13.09
|
%
|
|
|
4.00
|
%
|
|
|
12.21
|
%
|
|
|
4.00
|
%
|
|
Capon
Valley Bank
|
|
|
13.26
|
%
|
|
|
4.00
|
%
|
|
|
13.30
|
%
|
|
|
4.00
|
%
|
|
The
Grant County Bank
|
|
|
11.92
|
%
|
|
|
4.00
|
%
|
|
|
11.39
|
%
|
|
|
4.00
|
%
|
Effects
of Inflation
Inflation
primarily affects industries having high levels of property, plant and equipment
or inventories. Although the Company is not significantly affected in these
areas, inflation does have an impact on the growth of assets. As
assets grow rapidly, it becomes necessary to increase equity capital at
proportionate levels to maintain the appropriate equity to asset
ratios. Traditionally, the Company's earnings and high capital
retention levels have enabled the Company to meet these needs. The Company's
reported earnings results have been minimally affected by
inflation. The different types of income and expense are affected in
various ways. Interest rates are affected by inflation, but the
timing and magnitude of the changes may not coincide with changes in the
consumer price index. Management actively monitors interest rate
sensitivity in order to minimize the effects of inflationary trends on interest
rates. Other areas of non-interest expenses may be more directly affected by
inflation.