HIGHLANDS BANKSHARES INC /WV/ – 10-K – Management’s Discussion and Analysis of Financial Condition and Results or Operations

Forward Looking Statements

    Certain statements in this report may constitute "forward-looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements are statements that include projections, predictions, expectations or beliefs about future events or results or otherwise are not statements of historical fact. Such statements are often characterized by the use of qualified words (and their derivatives) such as "expect," "believe," "estimate," "plan," "project," "anticipate" or other similar words. Although the Company believes that its expectations with respect to certain forward-looking statements are based upon reasonable assumptions within the bounds of its existing knowledge of its business and operations, there can be no assurance that actual results, performance or achievements of the Company will not differ materially from any future results, performance or achievements expressed or implied by such forward-looking statements. Actual future results and trends may differ materially from historical results or those anticipated depending on a variety of factors, including, but not limited to, the effects of 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, mining, and timber industries, downturns in the housing market affecting manufacturers of household cabinetry and thus, employment, effects of mergers and/or downsizing in the poultry industry in Hardy County, continued challenges in the current economic environment affecting our financial condition and results of operations, continued deterioration in the financial condition of the U.S. banking system impacting the valuations of investments the Company has made in the securities of other financial institutions, and consumer spending and savings habits, particularly in the current economic environment. 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; (5) the Company is unable to control costs and expenses as anticipated, (6) legislative and regulatory changes could increase expenses (including changes as a result of rules and regulations adopted under the Dodd-Frank Wall Street Reform and Consumer Protection Act); (7) the effects of the last year's down grade of U.S. Government Securities by one of the credit rating agencies could have a material adverse effect on the company's operations, earnings and financial condition; and (8) any additional assessments imposed by the FDIC. Additionally, consideration should be given to the cautionary language contained elsewhere in this Form 10-K. The Company does not update any forward-looking statements that may be made from time to time by

or on behalf of the Company.    Introduction    The following discussion focuses on significant results of the Company's operations and significant changes in our financial condition or results of operations for the periods indicated in the discussion. This discussion should be read in conjunction with the financial statements and related notes included in this report. Current performance does not guarantee, and may not be indicative of, similar performance in the future.    Critical Accounting Policies    The Company's financial statements are prepared in accordance with accounting principles generally accepted in the United States ("GAAP"). The financial statements contained within these statements are, to a significant extent, financial information that is based on measures of the financial effects of transactions and events that have already occurred. A variety of factors could affect the ultimate value that is obtained either when earning income, recognizing an expense, recovering an asset or relieving a liability. In addition, GAAP itself may change from one previously acceptable method to another method. Although the economics of these transactions would be the same, the timing of events that would impact these transactions could change.    Allowance for Loan Losses    The allowance for loan losses is an estimate of the losses that may be sustained in the loan portfolio. The allowance is based on two basic principles of accounting: (i) ASC 450, Contingencies, which requires that losses be accrued when they are probable of occurring and estimable and (ii) ASC 310, Loans and Debt Securities Acquired with Deteriorated Credit Quality which requires that losses be accrued based on the differences between the value of collateral, present value of future cash flows or values that are observable in the secondary market and the loan balance.    11 --     Table of Contents    

The allowance consists of specific, general and unallocated components. The specific component relates to loans that are determined to be impaired. The general component covers non-impaired loans and is based on management's internal risk ratings as well as historical loss experience adjusted for qualitative factors. An unallocated component is maintained to cover uncertainties that could affect management's estimate of probable losses.

GAAP does not specify how an institution should identify loans that are to be evaluated for collectability, nor does it specify how an institution should determine that a loan is impaired. Each subsidiary of Highlands uses its standard loan review procedures in making those judgments so that allowance estimates are based on a comprehensive analysis of the loan portfolio. For loans that are individually evaluated and found to be impaired, the associated allowance is based upon the estimated fair value, less costs to sell, of any collateral securing the loan as compared to the existing balance of the loan as of the date of analysis.    All other loans, including individually evaluated loans determined not to be impaired, are included in a group of loans that are measured under ASC 450 to provide for estimated credit losses that have been incurred on groups of loans with similar risk characteristics. The methodology for measuring estimated credit losses on groups of loans with similar risk characteristics in accordance with ASC 450 is based on each group's historical net charge-off rate, adjusted for the effects of the qualitative or environmental factors that are likely to cause estimated credit losses as of the evaluation date to differ from the group's historical loss experience.    

Post Retirement Benefits and Life Insurance Investments

    The Company has invested in and owns life insurance policies on key officers. The policies are designed so that the company recovers the interest expenses associated with carrying the policies and the officer will, at the time of retirement, receive any earnings in excess of the amounts earned by the Company. The Company recognizes as an asset the net amount that could be realized under the insurance contract as of the balance sheet date. This amount represents the cash surrender value of the policies less applicable surrender charges. The portion of the benefits, which will be received by the executives at the time of their retirement, is considered, when taken collectively, to constitute a retirement plan. Therefore the Company accounts for these policies using guidance found in ASC 715, Compensation -Retirement Benefits. ASC 715 requires that an employer's obligation under a deferred compensation agreement be accrued over the expected service life of the employee through their normal retirement date. Assumptions are used in estimating the present value of amounts due officers after their normal retirement date. These assumptions include the estimated income to be derived from the investments and an estimate of the Company's cost of funds in these future periods. In addition, the discount rate used in the present value calculation will change in future years based on

market conditions.    Intangible Assets   

The Company carries intangible assets related to the purchase of two banks. Amounts paid to purchase these banks were allocated as intangible assets. Generally accepted accounting principles were applied to allocate the intangible components of the purchases. The excess was allocated between identifiable intangibles (core deposit intangibles) and unidentified intangibles (goodwill). Goodwill is required to be evaluated for impairment on an annual basis, and the value of the goodwill adjusted accordingly, should impairment be found. As of December 31, 2011, the Company did not identify an impairment of this intangible. In addition to the intangible assets associated with the purchases of banks, the company also carries intangible assets relating to the purchase of naming rights to certain features of a performing arts center in Petersburg, WV. Intangible assets other than goodwill, which are determined to have finite lives, are amortized based upon the estimated economic benefits received.    

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

Recent Accounting Pronouncements

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

   12 --     Table of Contents       Overview of 2011 Results   

Net income for 2011 decreased by 12.56% as compared to 2010. The Company's net interest income decreased slightly as the reduction in interest expenses matched the decreases in interest income. The Company experienced an increase in the provision for loan losses of 3.93% or $137,000 from 2010 to 2011. Non-interest income increased 0.33%. The increase in non-interest income was the result of increase in life insurance investment income in excess of the decreases in overdraft fees, service charge fees, and non-recurring gains on the sale of securities during 2010. Non-interest expense increased 0.27% due largely to decreases in employee related costs and decreased FDIC insurance premium rates offset by impairment write-downs of other real estate owned.    

The table below compares selected commonly used measures of bank performance for the twelve month periods ended December 31, 2011 and 2010:

                                            2011        2010 Annualized return on average assets      0.34 %      0.38 % Annualized return on average equity      3.41 %      4.00 % Net interest margin (1)                  4.47 %      4.49 % Efficiency Ratio (2)                    70.30 %     69.87 % Earnings per share (3)                $  1.04     $  1.19    

(1) On a fully taxable equivalent basis and including loan origination fees (2) Non-interest expenses for the period indicated divided by the sum of net

interest income and non-interest income for the period indicated. (3) Per weighted average shares of common stock outstanding for the period

    indicated.     Net Interest Income    2011 Compared to 2010    Net interest income, on a fully taxable equivalent basis, decreased 0.97% from 2010 to 2011. The decrease in net interest income was driven by changes in average rates earned on assets and paid on interest bearing liabilities and by changes in the relative mix of earning assets and interest bearing liabilities.    For the year ended December 31, 2011, the Company's average earning assets decreased 0.53%; the percent of average loan balances, the highest earning of the Company's earning assets, to total average earning assets decreased slightly to 86.79% in 2011 compared to 89.26% in 2010. The decrease in earning assets was more than offset by the decrease in interest bearing liabilities of 2.28% from 2010 to 2011. These changes in the relative mix of earning assets and interest bearing liabilities and the change in the average yields offset resulting in the decrease of the Company's net interest income.    Federal Reserve target rate for federal funds sold continues to impact yields on earning assets and average rates paid on interest bearing liabilities. The Company experienced declining rates for 2011 as compared to 2010 on all components of earning assets and on the savings and time deposit components of interest bearing liabilities.    The Company believes that its deposits will be sufficient to fund the current and expected loan demand.  Should the loan demand increase beyond the Company's current expectations, the Company may be required to fund these loans with borrowings which could result in a reduction of net interest margin. However, management believes total net interest income would not be adversely affected.    Also, balances of non-performing loans and other real estate acquired through foreclosure have increased from December 31, 2010 to December 31, 2011. Increases in balances of non-accrual loans and other real estate acquired through foreclosure often have adverse effects on net interest income. Should balances of non-accrual loans and other real estate acquired through foreclosure continue to increase, net interest margin may decrease accordingly. Further discussion relating to the Company's loan portfolio and credit quality can be found as part of this Management's Discussion and Analysis under the headings of "Loan Portfolio" and "Credit Quality."    13 --     Table of Contents     The table below illustrates the effects on net interest income of changes in average volumes of interest bearing liabilities and earning assets from 2010 to 2011 and changes in average rates on interest bearing liabilities and earning assets from 2010 to 2011 (in thousands of dollars):                                EFFECT OF RATE-VOLUME CHANGES ON NET INTEREST                                 (On a fully taxable equivalent basis)                               Increase (Decrease) 2011 Compared to 2010                                                           Due to change in:                                                     Average                                                     Volume         Average Rate        Total Change Interest Income Loans                                             $    (695 )    $       (1,001 )    $       (1,696 ) Taxable investment securities                           131                (148 )               (17 ) Non-taxable investment securities                       (58 )               (25 )               (83 ) Interest bearing deposits                                 1                  (3 )                (2 ) Federal funds sold                                        5                  (1 )                 4 Total Interest Income                                  (616 )            (1,178 )            (1,794 )  Interest Expense Demand deposits                                           2                  (2 )                 0 Savings deposits                                          8                 (55 )               (47 ) Time deposits                                          (234 )            (1,313 )            (1,547 ) Borrowings                                               13                 (50 )               (37 ) Total Interest Expense                                 (211 )            (1,420 )            (1,631 )  Net Interest Income                               $    (405 )    $          242      $         (163 )     14 --     Table of Contents      

The table below sets forth an analysis of net interest income for the years ended December 31, 2011 and 2010 (average balances and interest income/expense shown in thousands of dollars):

                                                   2011                                          2010                                 Average         Income         Yield          Average         Income         Yield                                Balance(2)      /Expense       /Rate(1)       Balance(2)      /Expense       /Rate(1)  Earning Assets Loans(3)(4)                   $    321,908     $  20,448           6.35 %   $    332,846     $  22,144           6.65 % Taxable investment securities                          32,156           608           1.89 %         25,243           625           2.48 % Non-taxable investment securities                           1,826            69           3.78 %          3,357           152           4.53 % Interest bearing deposits            3,272             6            .18 %          2,928             8            .27 % Federal funds sold                  11,742            18            .15 %          8,502            14            .16 % Total Earning Assets               370,904        21,149           5.70 %        372,876        22,943           6.15 %  Allowance for loan losses           (5,635 )                                      (4,811 ) Other non-earning assets            40,239                                 

      40,705  Total Assets                  $    405,508                                  $    408,770  Interest Bearing Liabilities Demand deposits               $     24,740     $      29            .12 %   $     23,337     $      29            .12 % Savings deposits                    56,314           128            .23 %         52,857           176            .33 % Time deposits                      207,423         3,988           1.92 %        219,593         5,535           2.52 % Long-term debt                      10,742           438           4.07 %         10,412           474           4.55 % Total Interest Bearing Liabilities                        299,219         4,583           1.53 %        306,199         6,214           2.03 %  Demand deposits                     57,550                                        53,771 Other liabilities                    7,942                                         9,007 Stockholders' equity                40,797                                        39,793  Total Liabilities and Stockholders' Equity          $    405,508                                  $    408,770  Net Interest Income                            $  16,566                                     $  16,729 Net Yield on Earning Assets                                        4.47 %  

                                     4.49 %     Notes:

(1) Yields are computed on a taxable equivalent basis using a 30% tax rate (2) Average balances are based upon daily balances (3) Includes loans in non-accrual status (4) Income on loans includes fees

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

The table below summarizes the Company's loan portfolio at December 31, 2011, 2010, 2009, 2008 and 2007 (in thousands of dollars):

                                  2011          2010          2009          2008          2007 Real estate mortgage        $ 162,214     $ 168,226     $ 162,619     $ 156,877     $ 169,122 Real estate construction       23,711        33,746        30,759        27,210        15,560 Commercial                    101,517        97,089        97,606        97,709        79,892 Installment                    25,614        30,275        44,499        43,958        45,625 Total Loans                   313,056       329,336       335,483       325,754       310,199  Allowance for loan losses      (6,111 )      (5,407 )      (4,021 )      (3,667 )      (3,577 )  Net Loans                   $ 306,945     $ 323,929     $ 331,462     $ 322,087     $ 306,622    

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

The following table illustrates the Company's loan maturity distribution as of December 31, 2011 (in thousands of dollars):

                                                                    Maturity Range                                             Less                                            than 1                                             Year          1-5 Years        Over 5 Years         Total Loan Type Commercial                               $  34,889      $    19,231      $       47,397      $ 101,517

Real estate mortgage and construction       49,198           33,334        

    103,393        185,925 Installment                                  5,695           16,774               3,145         25,614 Total Loans                              $  89,782      $    69,339      $      153,935      $ 313,056     Credit Quality   

The principal economic risk associated with each of the categories of loans in the Company's portfolio is the creditworthiness of its borrowers. Within each category, such risk is increased or decreased depending on prevailing economic conditions. The risk associated with the real estate mortgage loans and installment loans to individuals varies based upon employment levels, consumer confidence, fluctuations in value of residential real estate and other conditions that affect the ability of consumers to repay indebtedness. The risk associated with commercial, financial and agricultural loans varies based upon the strength and activity of the local economies of the Company's market areas. The risks associated with real estate construction loans vary based upon the supply of and demand for the type of real estate under construction.    An inherent risk in the lending of money is that the borrower will not be able to repay the loan under the terms of the original agreement. The allowance for loan losses (see subsequent section) provides for this risk and is reviewed at least quarterly for adequacy. This review also considers concentrations of loans in terms of geography, business type or level of risk. While lending is geographically diversified within the service area, the Company does have some concentration of loans in the area of agriculture (primarily poultry farming), and the timber and coal extraction industries. The Company recognizes these concentrations and considers them when structuring its loan portfolio.    16 --     Table of Contents     Non-performing loans include non-accrual loans and loans 90 days or more past due (including non-performing restructured loans). Non-accrual loans are loans on which interest accruals have been discontinued. Loans are typically placed in non-accrual status when the collection of principal or interest is 90 days past due and collection is uncertain based on the net realizable value of the collateral and/or the financial strength of the borrower. Also, the existence of any guaranties by federal or state agencies is given consideration in this decision. The policy is the same for all types of loans. Non-performing loans do not represent or result from trends or uncertainties which management reasonably expects will materially impact future operating results, liquidity, or capital resources.    The following table summarizes the Company's non-performing loans, restructured loans accruing interest and other real estate owned at December 31, 2011 and December 31, 2010 (in thousands of dollars):                                                            December 31,       December 31,                                                             2011               2010 Loans on non-accrual status                             $       8,021      $       6,979

Loans delinquent 90 days or more still accruing         $         536      $         866 Total non-performing loans                              $       8,557     

$ 7,845

Restructured loans still accruing                       $      13,055      $       1,037 Other real estate owned (OREO)                          $       7,070     

$ 4,700

Total non-performing loans and other risk assets $ 28,682 $ 13,582

Restructured loans are loans on which the interest rate or repayment terms have been changed due to financial hardship of the borrower. Restructured loans that are performing in accordance with modified terms are $11,233,000 and $5,219,000 at December 31, 2011 and December 31, 2010, respectively. Restructured loans not performing in accordance with modified terms totaled $2,919,000 as of December 31, 2011. All restructured loans are included in impaired loans in Note Five. The increase in restructured loans is the result of including loan balloon renewal agreements for troubled borrowers in accordance with the new guidelines adopted with ASU 2011-02.    The carrying value of real estate acquired through foreclosure was $7,070,000 at December 31, 2011 and $4,700,000 at December 31, 2010. The Company's practice is to value real estate acquired through foreclosure at the lower of (i) an independent current appraisal or market analysis less anticipated costs of disposal, or (ii) the existing loan balance. The Company does not anticipate further losses from the disposal of other real estate owned.    Because of its large impact on the local economy, management continues to monitor the economic health of the poultry industry. The Company has direct loans to poultry growers and the industry is a large employer in the Company's trade area. In addition, multiple manufacturers of household cabinetry are large employers in the Company's primary trade area. Due to the downturn in the housing market nationally, there have been indications that the demand for cabinetry has decreased, impacting the performance of these manufacturers. Because of the impact on the local economy, management has begun to monitor the performance of this industry as it relates to local employment trends. Additionally, the Company's loan portfolio contains a segment of loans collateralized by heavy equipment, particularly in the trucking, mining and timber industries. Because of the impact of the slowing economic conditions on the housing market, the timber sector has experienced a recent downturn. While the Company has experienced some losses related to the downturn in this industry, no material losses related to foreclosures of loans collateralized by assets typical to the timber harvest industry have occurred. This industry has seen some improvement during the current year, resulting in reduced financial stresses on the Company's borrowers.    17 --     Table of Contents     Allowance For Loan Losses    The allowance for loan losses is an estimate of the losses in the current loan portfolio. The allowance is based on two principles of accounting: (i) ASC 450, "Contingencies" which requires that losses be accrued when they are probable of occurring and estimable and (ii) ASC 310, "Receivables", which requires that loans be identified which have characteristics of impairment as individual risks (e.g. the collateral, present value of cash flows or observable market values are less than the loan balance).    Each of the Company's banking subsidiaries determines the adequacy of its allowance for loan losses independently using the same allowance for loan loss methodology. The allowance is calculated quarterly and adjusted prior to the issuance of the quarterly financial statements. All loan losses charged to the allowance are approved by the boards of directors of each bank at their regular meetings. In addition the boards of directors of each bank review the allowance methodology for consistency and reasonableness. The allowance is reviewed for adequacy after considering historical loss rates, current economic conditions (both locally and nationally) delinquency trends and charge-off activity, status of past due and non-performing loans, growth within the portfolio, the amount and types of loans comprising the loan portfolio, adverse situations that may affect a borrower's ability to pay, the estimated value of underlying collateral, prevailing economic conditions and any known credit problems that have not been considered elsewhere in the calculation. Although the loan portfolios of the two banks are similar to each other, some differences exist which result in divergent risk patterns and different historical charge-off rates amongst the functional areas of the banks' loan portfolios. Each bank pays particular attention to the individual loan performance, collateral values, borrower financial condition and economic conditions. A committee, with representatives from both subsidiary banks, meets to discuss the overall economic conditions that impact both subsidiary banks in the same fashion.    The determination of an adequate allowance at each bank is done in a four step process. The first step is to identify impaired loans. Impaired loans are problem loans above a certain threshold which are not expected to perform in accordance with the original loan agreement. A loan is considered impaired when, based on current information and events, it is probable that the Banks will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. Factors considered by management in determining impairment include payment status, collateral value, and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower's prior payment record, and the amount of the shortfall in relation to the principal and interest owed. Impairment is measured on a loan by loan basis for commercial loans by either the present value of expected future cash flows discounted at the loan's effective interest rate, the loan's obtainable market price, or the fair value of the collateral if the loan is collateral dependent.    Large groups of smaller balance homogeneous loans are collectively evaluated for impairment. Accordingly, the Banks do not separately identify individual consumer and residential loans for impairment disclosures, unless the loans are the subject of a restructuring agreement.    Impaired loans and their resulting valuation allowance are disclosed in the table below.                              December 31, 2011              December 31, 2010                                       Identified                     Identified Loan Type               Balance       Impairment       Balance       Impairment Commercial mortgage   $  26,543     $      1,018     $  24,147     $        904 Commercial other            691              167           988               21 Consumer mortgage         1,966              328           253                0                       $  29,200     $      1,513     $  25,388     $        925     The second step is to allocate losses to non-impaired loans based on historical loss rates of loans, by category, and considering the potential impact of other qualitative factors on future loan performance.    18 --     Table of Contents    

Management has determined that the allowance for loan losses is adequate to absorb any losses inherent in the portfolio. Although management believes that it uses the best information available to make such determinations, future adjustments to the allowance for loan losses may be necessary, and the results of operations could be significantly and adversely affected if circumstances differ substantially from the assumptions used in making the determinations. Because future events affecting borrowers and collateral cannot be predicted with certainty, there can be no assurance that the existing allowance for loan losses is adequate or that material increases will not be necessary should the quality of the loans deteriorate as a result of factors previously discussed.    Both banks have outsourced independent loan review performed at least annually, the results of which are reviewed by both bank boards and the Company's audit committee, with changes factored into the allowance calculations. Independent outsourced loan review considers the adequacy of loan underwriting, asset quality, the accuracy of the banks' loan risk ratings and the appropriateness of specific reserves as well as the overall reasonableness of the allowance for loan losses.    Provisions for loan losses are charged to operations in order to maintain the allowance for loan losses at a level management considers adequate to absorb credit losses inherent in the loan portfolio. Credit exposures deemed uncollectible are charged against the allowance for loan losses. Recoveries of previously charged-off loans are credited to the allowance for loan losses. During 2011, the Company's net charge-offs, as compared to gross loan balances, was greater than that experienced in 2010. As a result of the impact of increased net charge-offs, the Company's provision for loan losses during 2011 was $137,000 greater than in 2010. The Company's ratio of allowance for loan losses to gross loans increased from 1.64% at December 31, 2010 to 1.95% at December 31, 2011. At December 31, 2011, the ratio of the allowance for loan losses to non-performing loans was 71.43% compared to 68.93% at December 31, 2010.   

Cumulative net loan losses, after recoveries, for the five-year period ending December 31, 2011 are as follows (in thousands of dollars):

                   Dollars       Percent of Total Commercial    $   4,066                     50 % Real Estate       2,255                     28 % Consumer          1,771                     22 % Total         $   8,092    

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

                                 2011           2010           2009           2008           2007 Balance at beginning of period                      $   5,407      $   4,021      $   3,667      $   3,577      $   3,482  Charge-offs: Commercial loans                2,485            849            492            198            540 Real estate loans                 565          1,230            445            228             47 Consumer loans                    372            668            863            524            494 Total Charge-offs:              3,422          2,747          1,800            950          1,081  Recoveries: Commercial loans                  266            144             10             20             59 Real estate loans                  15            167             72              2              4 Consumer loans                    221            335            208            109            276 Total Recoveries                  502            646            290            131            339  Net Charge-offs                 2,920          2,101          1,510            819            742  Provision for loan losses                          3,624          3,487          1,864            909            837  Balance at end of period    $   6,111      $   5,407      $   4,021      $   3,667      $   3,577  Percent of net charge-offs to average net loans outstanding during the period                 .92 %          .63 %          .46 %          .26 %          .24 %     19 --     Table of Contents    

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

                          2011                      2010                      2009                      2008                      2007                            Percent                   Percent                   Percent                   Percent                   Percent                              of                        of                        of                        of                        of               Amount        Loans       Amount        Loans       Amount        Loans       Amount        Loans       Amount        Loans Commercial    $ 3,363            32 %   $ 2,232            30 %   $ 1,669            29 %   $ 1,349            30 %   $ 1,140            26 % Real Estate     1,959            59 %     1,662            61 %     1,034            58 %       994            57 %     1,200            59 % Consumer          428             9 %       968             9 %     1,220            13 %     1,285            13 %     1,172            15 % Unallocated       361             0 %       545             0 %        98             0 %        39             0 %        65             0 % Totals        $ 6,111           100 %   $ 5,407           100 %   $ 4,021           100 %   $ 3,667           100 %   $ 3,577           100 %    

As certain loans identified as impaired are paid current, collateral values increase or loans are removed from watch lists for other reasons, and as other loans become identified as impaired, the allocation of the allowance among the loan types may change. The allocation also changes because delinquency levels within each of the respective portfolios change. The Company feels that the allowance is a fair representation of the losses present in the portfolio given historical loss trends, economic conditions and any known credit problems as of any quarter's end. The Company believes that the allowance is to be taken as a whole, and allocation between loan types is an estimation of potential losses within each loan type given information known at the time.    Non-Interest Income    2011 Compared to 2010   

Non-interest income increased 0.33%, or $7,000 from 2010 to 2011.

    The increase in non-interest income was the result of increase in life insurance investment income in excess of the decreases in overdraft fees, service charge fees, and non-recurring gains on the sale of securities during 2010.    Service charges on deposit accounts decreased 7.57%. The largest portion of these charges is non-sufficient funds fees on non-interest bearing transaction accounts. The subsidiary banks continued to see decreases in service charges associated with the program commonly referred to as the "courtesy overdraft" program. This is the result of customer's choice not to participate in the subsidiary bank's automatic overdraft protection coupled with better management, by customers, of their accounts.    Net insurance earnings and commissions decreased $37,000 from 2010 to 2011. Insurance earnings for the Company consist of commissions earned by the subsidiary banks on life and accident and health insurance sold in relation to the extension of credit and insurance revenues, net of benefits paid, expense allowances and policy and claim reserves earned by the life insurance subsidiary. As the Company's balances of installment loans and the volume of installment loans, which are primary markets for credit life and accident and health insurance, have decreased over the past several years, gross revenues from insurance earnings have decreased. In relation to this decrease, required policy reserves have also declined. The table below illustrates the components of insurance commissions and income for 2010 and 2011 (in thousands of dollars), which is reported as other operating income.                                                                                       Increase                                                      2011           2010          (Decrease) Revenues

Gross commissions and insurance revenues $ 123$ 158

    $        (35 )  Expenses Benefits Paid                                            17              8                 9

Changes in required policy and claim reserves           (43 )          (55

)              12 Expense allowance                                        49             68               (19 ) Total Expenses                                           23             21                (2 )  Net insurance income                              $     100      $     137      $        (37 )     20 --     Table of Contents     Non-interest Expense    2011 compared to 2010   

Non-interest expense increased 0.27% in 2011 as compared to 2010.

Changes in salary and benefits expense

    The following table compares the components of salary and benefits expense for the twelve month periods ended December 31, 2011 and 2010 (in thousands of dollars):                              Salary and Benefits Expense                                                 2011        2010        Increase (Decrease) Employee salaries                          $ 4,450     $ 4,493     $                 (43 ) Employee benefit insurance                   1,165       1,117                        48 Payroll taxes                                  359         351                         8

Deferred loan origination costs               (198 )         0                      (198 ) Non-recurring post retirement adjustment       (70 )         0             

         (70 ) Post retirement plans                          719         975                      (256 ) Total                                      $ 6,425     $ 6,936     $                (511 )    

The decrease of 7.37% in employee related cost during 2011 compared to 2010 is mainly the result of the implementation of the Financial Accounting Standard ASC 310-20 Nonrefundable Fees and Other Costs. The Company began deferral of costs associated with loan origination at the beginning of 2011 and is amortizing the cost over the life of the loan. Additionally, the Company did not contribute to the discretionary employee stock ownership plan or the profit sharing plan during 2011 as part of a cost cutting initiative for 2011 which also included a reduction in director fees paid.    

Changes in data processing expense

Data processing expense increased 5.09% or $56,000 during 2011 compared to 2010. The increase was driven by a credit received from the Company's core system vendor during 2010 for an error in billing during the system conversion in the fall of 2009 partially offset by additional costs attributed to increased costs at one of the subsidiary banks as a result of increase in the number of customer deposit accounts, internet banking costs, and a full year of costs during 2011 for a branch location which was not open the full year in 2010.    

Changes in occupancy and equipment expense

    The following table illustrates the components of occupancy and equipment expense for the twelve month periods ended December 31, 2011 and 2010 (in thousands of dollars):                                                                                         Increase                                                        2011           2010          (Decrease) Depreciation of buildings and equipment             $     783      $     787      $         (4 ) Maintenance expense on buildings and equipment            344            369               (25 ) Utilities expense                                         144            133                11 Real estate and personal property tax                     105            100                 5 Other expense related to occupancy and equipment          107             98                 9 Total occupancy and equipment expense               $   1,483      $   1,487      $         (4 )    

Occupancy and equipment expenses decreased 0.3% during 2011 compared to 2010. Increases in utilities and taxes were offset by decreases in maintenance expenses.

Other changes in non-interest expense

    Director fees decreased by 14.43% during 2011 driven by the number of meetings held during 2011 compared to 2010 and a reduction in fees paid to directors

per meeting.    Legal and professional fees decreased by $95,000 or 15.73% from 2010 to 2011 driven by non-recurring legal expenses incurred during 2010 and a reduction in third party internal audit fees compared to 2010.    21 --     Table of Contents    

Office supplies and postage and freight expenses decreased 14.99% or $61,000 during 2011 compared to 2010, largely driven by the reduction of courier services between branches.

FDIC premium expense decreased 21.45% or $142,000 during 2011 compared to 2010 driven by the decreased premiums rates adjusted by the FDIC during 2011.

    Loan and foreclosed asset expenses increased 153.35% or $871,000 during 2011 compared to 2010 due to the increased number of foreclosures during 2011, valuation adjustments on foreclosed properties, and increased costs associated with obtaining updated appraisals on impaired relationships.    

The table below illustrates components of other non-interest expense for 2011 and 2010 (in thousands of dollars).

Significant other non-interest expense are in the following table:

                                                                                      Increase                                                      2011           2010          (Decrease) ATM expense                                       $    (109 )    $     (72 )    $        (37 )

Advertising and marketing expense                       150            158                (8 ) Amortization of intangible assets                       187            190                (3 ) Franchise taxes                                         116             96                20 Miscellaneous components of other non-interest expense                                                 590            584                 6 Total                                             $     934      $     956      $        (22 )     Securities Portfolio   

The Company's securities portfolio serves several purposes. Portions of the portfolio are used to secure certain public deposits. The remaining portfolio is held as investments or used to assist the Company in liquidity and asset liability management. Total securities, including restricted securities, represented 10.22% of total assets and 99.10% of total shareholders' equity

at December 31, 2011.    The securities portfolio typically will consist of three components: securities held to maturity, securities available for sale and restricted securities. Securities are classified as held to maturity when management has the intent and the Company has the ability at the time of purchase to hold the securities to maturity. Held to maturity securities are carried at cost, adjusted for amortization of premiums and accretion of discounts. Securities to be held for indefinite periods of time are classified as available for sale and accounted for at market value. Securities available for sale include securities that may be sold in response to changes in market interest rates, changes in the security's prepayment risk, increases in loan demand, general liquidity needs and other similar factors. Restricted securities are those investments purchased as a requirement of membership in certain governmental lending institutions and cannot be transferred without the issuer's permission. The Company's purchases of securities have generally been limited to securities of high credit quality with short to medium term maturities.    The Company identifies at the time of acquisition those securities that are available for sale. These securities are valued at their market value with any difference in market value and amortized cost shown as an adjustment in stockholders' equity. Changes within the year in market values are reflected as changes in other comprehensive income, net of the deferred tax effect. As of December 31, 2011, the fair value of the securities available for sale exceeds their cost basis by $430,000 ($271,000 after tax effect of $159,000).    

The table below summarizes the carrying value of the Company's securities at December 31, 2011, 2010 and 2009 (in thousands of dollars):

                                                 Available for Sale                                                 Carrying Value                                                  December 31,                                         2011         2010         2009 U.S. Treasuries and Agencies          $ 21,932     $  9,258     $ 12,426 Mortgage backed securities               5,604        5,651        5,836 Collateralized mortgage obligations      3,413        1,764            0 State and municipals                     2,698        2,157        3,946 Certificates of deposit                  5,910        6,465        4,703 Marketable equities                          0           29           25 Total                                 $ 39,557     $ 25,324     $ 26,936     22 --     Table of Contents    

The carrying amount and estimated market value of securities (in thousands of dollars) at December 31, 2011 by contractual maturity are shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment

penalties.                                                                                               Equivalent                                                   Amortized Cost        Fair Value       Average Yield  Securities Available for Sale Due in next twelve months                         $         9,495      $      9,572                1.80 % Due after one year through five                            20,788            20,968                1.39 % Due beyond five years                                       3,388             3,413                2.14 % Mortgage backed securities                                  5,456             5,604                2.48 % Total Available For Sale                          $        39,127      $   

 39,557                1.71 %               Yields on tax exempt securities are stated at actual yields.    Any changes in market values of securities deemed by management to be attributable to reasons other than changes in market rates of interest would be recorded through results of operations. It is the Company's determination that all securities held at December 31, 2011 which have fair values less than the amortized cost, have these gross unrealized losses related to increases in the current interest rates for similar issues of securities, and that no material impairment for any securities in the portfolio exists because of downgrades of the securities or as a result of a change in the financial condition of any of the issuers. A summary of the length of time of unrealized losses for all securities held at December 31, 2011 can be found in the footnotes to the consolidated financial statements. The Company reviews all securities with unrealized losses, and all securities in the portfolio on a regular basis to determine whether the potential for other than temporary impairment exists. One of the criteria for making this determination is the rating given to each bond by the major ratings agencies, Moody's and Standard & Poors.    A summary of the Company's securities portfolio at December 31, 2011, based on the ratings of the securities in the portfolio given by these ratings agencies, is shown below (in thousands of dollars):                                                                   Gross             Gross                                                              Unrealized        Unrealized                                        Amortized Cost          Gains             Losses          Market Value    Ratings Provided by Ratings             Agencies      Moody's            S&P  U.S. Treasuries and Agencies         Aaa              AA+         $         17,655      $        158      $          4      $       17,809      No Rating        No Rating                 4,086                37                 0               4,123 

Mortgage Backed Securities</p>

     MBS Agency       MBS Agency                 5,456               151      $          3               5,604  

Commercial Mortgage Obligations

     MBS Agency       MBS Agency                 3,387                37                11               3,413  State and Municipals         Aa3              AA-                      951                43                 0                 994         Aa2              AA                     1,094                 9                 0               1,103      No Rating           AA-                      402                 4                 0                 406      No Rating        No Rating                   195                 0                 0                 195     23 --     Table of Contents     Deposits   

The Company's primary source of funds is local deposits. The Company's deposit base is comprised of demand deposits, savings and money market accounts and other time deposits. The majority of the Company's deposits are provided by individuals and businesses located within the communities served.

Total balances of deposits increased 0.4% from December 31, 2010 to December 31, 2011.

A summary of the maturity range of time deposits over $100,000 is as follows (in thousands of dollars):

                                        At December 31,                              2011         2010         2009 

Three months or less $ 10,472$ 11,725$ 11,133 Four to twelve months 32,040 36,431 36,512 One year to three years 22,066 22,419 23,447 Four years to five years 9,534 4,428 4,504 Total

                      $ 74,112     $ 75,003     $ 75,596     Debt Instruments    Long-Term Borrowings    The Company borrows funds from the Federal Home Loan Bank ("FHLB") to reduce market rate risks or to provide operating liquidity. The Company typically will initiate these borrowings in response to a specific need for managing market risks or for a specific liquidity need and will attempt to match features of these borrowings to best suit the specific need. Therefore, the borrowings on the Company's balance sheet as of December 31, 2011 and throughout the twelve month period ended December 31, 2011 have varying features of amortization or single payment with periodic, regular interest payment and also have interest rates which vary based on the terms and on the features of the specific borrowing. More information regarding the Company's FHLB advances can be found in Note Thirteen of the consolidated financial statements.    Short-Term Borrowings   

As it becomes necessary for short-term liquidity needs and when beneficial for assisting in managing profitability the Company will periodically utilize either the FHLB or other available credit facilities for overnight or other short term borrowings. The use of short-term debt instruments is not a frequently utilized borrowing mechanism of the Company; however, during the third quarter of 2010, circumstances prescribed use of these borrowing facilities. At December 31, 2011, the Company had no balance in overnight and other short-term borrowings.    Capital Resources    The assessment of capital adequacy depends on a number of factors such as asset quality, liquidity, earnings performance and changing competitive conditions and economic forces. The Company seeks to maintain a strong capital base to support growth and expansion activities, to provide stability to current operations, and to promote public confidence.    The Company's capital position continues to exceed regulatory minimums. The primary indicators relied on by the Federal Reserve Board and other bank regulators in measuring strength of capital position are the Tier 1 Capital, Total Capital and Leverage ratios. Tier 1 Capital consists of common stockholders' equity adjusted for unrealized gains and losses on securities. Total Capital consists of Tier 1 Capital and a portion of the allowance for loan losses. Risk-based capital ratios are calculated with reference to risk-weighted assets, which consist of both on and off-balance sheet risks.    The capital management function is an ongoing process. The Company looks first and foremost to maintain capital levels adequate to satisfy regulatory requirements through earnings retention. The maintenance of capital adequacy is weighed against the management of capital for satisfactory return on equity, typically via use of dividends and/or share repurchases. During 2011, the Company's capital position increased $306,000 versus the decrease of $54,000 during 2010. The return on average equity was 3.41% in 2011 compared to 4.00% for 2010. Total cash dividends declared represented 43.25% of net income for 2011 compared to 87.39% for 2010. Book value per share was $31.17 at December 31, 2011 compared to $30.94 at December 31, 2010.    24 --     Table of Contents     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 balances of borrowed funds and decreases in secondary liquidity sources such as balances of federal funds sold and balances of securities. The Company maintains credit facilities which are typically sufficient to adequately fulfill any short-term liquidity needs, and management of deposit balances and long term borrowings are utilized for longer term liquidity management. Increases in liquidity requirements may cause the Company to offer above market rates on deposit products to attract new depositors, which would impact the Company's net interest income.    The 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 two subsidiary Banks, Capon Valley Bank and The Grant County Bank. 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 December 31, 2011, the subsidiary Banks could pay dividends to the Company of approximately $3,307,000 without permission of

the regulatory authorities.    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. The Company 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.    

Item7A. Quantitative and Qualitative Disclosures About Market Risk

Not required for smaller reporting companies.

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