Highlands Bankshare, Inc. is the holding company of Highlands Union Bank. It was formed in 1995 to take advantage of additional financial opportunities for the bank and its investors.

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• 2006 Annual Report*

• Message from the CEO

Dear Shareholders:

Who could have possibly predicted the destabilizing journey the year 2008 would become? It will likely be the year the financial crisis we have been in as a country began and peaked. In September 2008, the financial crisis took center stage. The Federal Housing Finance Agency placed Fannie Mae and Freddie Mac into conservatorship. Equity owners were required to take an other than temporary impairment (OTTI) charge to earnings on their investments in Fannie and Freddie preferred stock. Lehman Brothers announced it would file for chapter eleven bankruptcy. The same month, the Federal Reserve Board authorized a loan of up to $85,000,000,000 to rescue (AIG). The Federal Reserve announced several steps it was taking to provide liquidity to large financial firms. It was announced that SEC Chairman Cox, Treasury Secretary Paulson and Federal Reserve Chairman Ben Bernanke would together push for a comprehensive plan to purchase illiquid mortgage-backed securities. In October, the Emergency Economic Stabilization Bill was passed. In addition to Congress providing $700,000,000,000 in funding to support a financial industry in crisis, the FDIC also increased its coverage to $250,000 to give confidence to depositors. On October 14, 2008, the Federal Deposit Insurance Corporation also announced the development of a guarantee program under the systemic risk exception to the Federal Deposit Act (“FDA”) pursuant to which the FDIC would offer a guarantee of certain financial institution indebtedness in exchange for an insurance premium to be paid to the FDIC by issuing financial institutions (the “FDIC Temporary Liquidity Guarantee Program”).

The second aspect of the “TLGP” program is related to all non-interest bearing transaction accounts and all deposit transaction accounts with an interest rate up to .50% are fully insured. Beginning in December of 2008, the Bank began taking full advantage of this additional insurance on behalf of its customers.

There are many other things in the Emergency Economic Stabilization Bill intended to support the financial industry and to give confidence to the general public as to the safety of their deposits in the banking system. $250,000,000,000 of the $700,000,000,000 was set aside for “healthy banks” that might need to raise capital, as the traditional capital markets had ceased and capital for all banks was virtually unavailable. It was recognized it was critical that the eligible banks have access to capital in order to provide the financial stability to lead our country out of financial crisis. The role of community banks in our recovery is widely acknowledged. Highlands Bankshares, Inc. applied to participate under this original capitalization program and received approval to participate from the Treasury. Management and the Board of Directors continue to review the merits of the program.

As you are aware, as the year moved on, there were many more actions taken by our government and by the Federal Reserve Bank to try to stabilize the economy and financial markets. The year concluded with very little good economic news, but a lot of hope that the actions taken in 2008 and actions planned in 2009 would begin showing signs of improvement. No one knows when the economy will turn around, but most economists predict late 2009 or early 2010.

Data for the banking industry reveals that bank earnings nationally were down 83.9% over 2007. Net income declined $83,900,000,000 from the 100,000,000,000 in net income in 2007. The financial industry’s average Return on Average Assets for the year was .12%. This was the lowest annual total since 1990. This decline was due largely to loan losses, write-downs in investment portfolios, declining interest margins, and losses in securities income.

The results of operations for Highlands Bankshares, Inc. and Highlands Union Bank reflected mixed results. Net operating income remains sound for the bank in this struggling environment. Net operating income (excluding OTTI) for 2008 was $4,067,000, compared to $4,901,000 in 2007, a decline of 17.02%. Net interest income was $19,694,000 compared to $18,904,000 in 2007, an increase of 4.18%. Assets grew to $668,996,000, a 1.24% increase. Loans grew to $490,000,000 from $451,291,000 in 2007, an 8.67% increase. Deposits grew to $522,736,000 from $512,747,000 in 2007, an increase of 1.94%. Allowance for loan loss reserve was increased from 1.03% in 2007, to 1.05% of total loans in 2008. Nonperforming loans decreased from 1.80% of total loans in 2007, to 1.41% in 2008.

As previously reported to you, on September 7, 2008, the U.S. Treasury, the Federal Reserve Bank and the Federal Housing Finance Agency announced they were putting both Fannie Mae and Freddie Mac in conservatorship and eliminating for an unspecified amount of time, dividend payments on the preferred stock. They also were giving management control to their regulator (FHFA). Due to the actions of the U.S. government and the uncertainty surrounding the ongoing viability of these two government-sponsored enterprises, Highlands Bankshares, Inc. determined that it was necessary to take a one-time (other-than-temporary-impairment) charge. This one-time OTTI charge in the amount of $3,952,000 (net of applicable taxes) was recorded in the third quarter of 2008. These agency preferred stocks were widely held by banks, both large and small, and by insurance companies. After considering the impact of this one-time charge to earnings, both the company and the bank remain well capitalized under regulatory requirements. Being a one-time, non-cash impairment charge, it does not affect the company’s cash flows.

Even with this one-time charge to earnings, Highlands Bankshares, Inc. and Highlands Union Bank ended the year in the black. Consolidated net income including the OTTI charge to earnings was $115,000 for 2008.

These net results, while disappointing, are reflective of the banking industry at this time. We are encouraged, however, by the net operating results excluding the OTTI charge considering the environment we are operating in. Net operating profitability is what we take with us as we move into 2009.

We want our shareholders to know Highlands Union Bank did not participate in subprime lending, which is one of the causes of the current financial crisis. Highlands Union Bank has consistently maintained prudent and traditional standards in its lending philosophy.

There were many accomplishments in 2008 for your company. One of the highlights was the opening of a new branch bank on Veterans Boulevard in Sevierville, Tenn. This makes a footprint of three new banks for HUB in the Sevierville/Knoxville marketplace. During the year, in an effort to reward existing customers and attract new ones, we offered a new “Rewards Points” program. This program awards points for the signature-based use of checking account debit cards. The points may be redeemed for merchandise and gift cards.

During 2008, Highlands Union Bank invested in new technology to protect customer accounts and financial information. This technology provides real-time replication of our core banking system between two physically separate sites. This takes a giant step in assuring that should an interruption occur at one site, a failover will occur to the other site within a matter of minutes to provide continued access to financial information. Highlands Union Bank understands customers expect access to their financial assets and information at any time of the day and without interruption. To this end we continuously strive to provide an exceptional experience for each customer and to insure our customers’ financial assets are safe and secure.

In January of 2008, Highlands Bankshares, Inc. called 50% of its outstanding trust preferred stock, which the company had issued in 1998 at an interest rate of 9.25%. This was a partial culmination of our strategic plan to redeem the 9.25% capital at the call date in 2008. In January 2008, the capital markets were stable and HBI had been preapproved to issue new trust preferred stock if needed at a much cheaper interest rate. Since that time, as you know, most capital markets have disappeared. Also during the year we were able to buy back 138,874 shares of HBI stock. This removed these shares from the marketplace and increased the percentage of ownership represented by the remaining shares.

Subsequent to the end of the year, in January 2009, the HUB family and our community lost a dear friend of more than 20 years due to the untimely death of Mr. James T. (Tom) Riffe. Tom was a significant contributor to the success of the company since his arrival in 1985. Tom was a wonderful friend to me personally, as well as everyone who knew him. A tribute to Tom can be seen in this report.

As we enter 2009, we remain optimistic about the future of your company and the many opportunities that lie ahead. We also remain well aware of the many challenges that lie ahead for our country, our communities and our company. We assure you we remain diligent and focused on meeting these challenges. We continue to believe that during economically challenging times, well managed banks with a record of sound, traditional banking practices emerge much stronger than before.

The directors, officers and employees of Highlands Bankshares, Inc. and Highlands Union Bank greatly appreciate the continued support and confidence of our customers, shareholders and friends. We look forward to reporting to you on the future progress of your company.

Samuel L. Neese
Chief Executive Officer