UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

x	QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
	EXCHANGE ACT OF 1934

For the quarterly period ended

September 30, 2011

o	TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
	EXCHANGE ACT OF 1934

For the transition period from

Commission file number: 000-54110

Highlands Bancorp, Inc.
(Exact name of registrant as specified in its charter)

New Jersey		27-1954096
(State or other jurisdiction of		(I.R.S. Employer
incorporation or organization)		Identification No.)

310 Route 94, Vernon, New Jersey 07462
(Address of principal executive offices) (Zip Code)

Registrant’s telephone number, including area code		973-764-3200

N/A
(Former name, former address and former fiscal year, if changed since last report)

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

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

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

Large accelerated filer o	Accelerated filer o

Non-accelerated filer o	Smaller reporting company þ

Indicate by check mark whether the registrant is a shell company (as defined in rule 12b-2 of the Exchange Act). Yes o No x

As of November 8, 2011 there were 1,788,262 shares of the registrant’s common stock, no par value outstanding.

Highlands Bancorp, Inc.

INDEX

		Page
Part I – CONSOLIDATED FINANCIAL INFORMATION		Number

Item 1:	Consolidated Financial Statements

	Consolidated Balance Sheets as of September 30, 2011 and December 31, 2010 (Unaudited)	3

	Consolidated Statements of Operations for the Three and Nine Months Ended September 30, 2011 and 2010 (Unaudited)	4

	Consolidated Statements of Comprehensive Income for the Three and Nine Months Ended September 30, 2011 and 2010 (Unaudited)	5

	Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 2011 and 2010 (Unaudited)	6

	Notes to Consolidated Financial Statements (Unaudited)	7

Item 2:	Management’s Discussion and Analysis of Financial Condition and Results of Operations	20

Item 3:	Quantitative and Qualitative Disclosures about Market Risk	29

Item 4:	Controls and Procedures	30


Part II - OTHER INFORMATION

Item 1:	Legal Proceedings	30

Item 1.A.	Risk Factors	30

Item 2:	Unregistered Sales of Equity Securities and Use of Proceeds	30

Item 3:	Defaults Upon Senior Securities	30

Item 4:	(Removed and Reserved)	30

Item 5:	Other Information	30

Item 6:	Exhibits	30


SIGNATURES		32

Part 1. CONSOLIDATED FINANCIAL INFORMATION

Item 1. Consolidated Financial Statements

HIGHLANDS BANCORP, INC.
Consolidated Balance Sheets (Unaudited)

	September 30,			December 31,
	2011			2010
	(In Thousands, except share and per share data)
ASSETS
Cash and due from banks	$	1,567		$	1,225
Interest bearing deposits in other banks		40			30
Federal funds sold		-			192

Cash and Cash Equivalents		1,607			1,447

Time deposits in other banks		8,296			19,596
Securities available for sale		16,480			17,462
Restricted investment in bank stock		533			790
Loans receivable, net of allowance for loan losses of $2,049 and $1,693, respectively		130,936			121,030
Premises and equipment, net		946			899
Goodwill		804			804
Accrued interest receivable		677			631
Foreclosed assets		658			799
Other assets		615			775

Total Assets	$	161,552		$	164,233

LIABILITIES AND STOCKHOLDERS' EQUITY
Liabilities
Deposits:
Non-interest bearing	$	25,290		$	26,293
Interest-bearing		112,395			110,106
Total Deposits		137,685			136,399

Borrowings		5,161			11,000
Accrued interest payable		67			70
Other liabilities		800			657

Total Liabilities		143,713			148,126

Stockholders' Equity
Preferred stock, Series C, liquidation preference of $1,000 per share,		6,853			5,501
6,853 outstanding at September 30, 2011; none outstanding at
December 31, 2010. Series A, liquidation preference of $1,000 per
share, none outstanding at September 30, 2011; 5,450 outstanding at
December 31, 2010. Warrant preferred stock Series B, liquidation
preference of $1,000 per share, none outstanding at September 30, 2011;
155 outstanding at December 31, 2010.
Common stock, no par value; authorized 10,000,000 shares; issued and
outstanding 1,788,262 shares		15,972			15,972
Accumulated deficit		(5,202	)		(5,624	)
Accumulated other comprehensive income		216			258

Total Stockholders' Equity		17,839			16,107

Total Liabilities and Stockholders' Equity	$	161,552		$	164,233

See Notes to Unaudited Consolidated Financial Statements.

HIGHLANDS BANCORP, INC.
Consolidated Statements of Operations (Unaudited)
	Three Months Ended						Nine Months Ended
	September 30,						September 30,
	2011			2010			2011			2010
	(In Thousands)
	except share and per share data)
Interest income:
Loans	$	1,828		$	1,587		$	5,304		$	4,784
Securities		71			138			243			497
Federal funds sold		1			2			2			4
Other interest-earning assets		17			92			93			300
Total interest income		1,917			1,819			5,642			5,585

Interest expense:
Deposits		272			334			814			1,123
Borrowings		34			35			103			116
Total interest expense		306			369			917			1,239

Net Interest Income		1,611			1,450			4,725			4,346
Provision for loan losses		235			121			362			558

Net interest income after provision for loan losses		1,376			1,329			4,363			3,788

Non-interest income
Fees and service charges		101			98			278			282
Gain on sale of investment securities		-			-			45			87
Loss on sale of foreclosed assets		-			-			(11	)		-
Other income		24			9			53			29
Total non-interest income		125			107			365			398

Non-interest expenses
Salaries and employee benefits		587			541			1,766			1,657
Occupancy and equipment		249			243			695			721
Professional fees		(1	)		170			335			412
Advertising and promotion		25			16			67			67
Data processing		138			130			423			383
Other		228			206			706			614
Total non-interest expense		1,226			1,306			3,992			3,854

Net income	$	275		$	130		$	736		$	332
Preferred stock dividends and accretion		(155	)		(79	)		(314	)		(238	)
Net income available to common stockholders	$	120		$	51		$	422		$	94

Net income per common share
Basic and diluted	$	0.07		$	0.03		$	0.24		$	0.05

Weighted average common shares outstanding
Basic and diluted		1,788,262			1,788,262			1,788,262			1,788,262

See Notes to Unaudited Consolidated Financial Statements.

HIGHLANDS BANCORP, INC.
Consolidated Statements of Comprehensive Income
(Unaudited)

	Three Months Ended					Nine Months Ended
	September 30,					September 30,
	2011			2010		2011			2010
	(in Thousands)

Net income	$	275		$	130	$	736		$	332
Comprehensive income:
Net change in unrealized gain on
securities available for sale		(6	)		85		3			425
Reclassification adjustment for net
gains included in net income		-			-		(45	)		(87	)
		(6	)		85		(42	)		338
Total comprehensive income	$	269		$	215	$	694		$	670

See Notes to Unaudited Consolidated Financial Statements.

HIGHLANDS BANCORP, INC.
Consolidated Statements of Cash Flows
(Unaudited)
	Nine Months September 30,
	2011			2010
	(In Thousands)
Cash flows from operating activities:
Net income	$	736		$	332
Adjustments to reconcile net income to net cash
provided by operating activities:
Depreciation of premises and equipment		183			263
Amortization and accretion, net		135			45
Gain on sale of available for sale securities		(45	)		(87	)
Provision for loan losses		362			558
Loss on sale of foreclosed assets		11			-
(Increase) decrease in interest receivable		(46	)		32
Decrease in other assets		160			184
Decrease in accrued interest payable		(3	)		(38	)
Increase in other liabilities		143			32
Net cash provided by operating activities		1,636			1,321

Cash flows from investing activities:
Purchases of time deposits		(9,543	)		(25,119	)
Principal repayments on time deposits		20,843			23,830
Purchases of securities available for sale		(7,805	)		(6,111	)
Proceeds from sales of securities available for sale		1,117			1,330
Proceeds from maturities, calls and prepayments of securities available for sale		7,534			6,418
Net increase in loans receivable		(10,552	)		(3,502	)
Purchases of restricted stock		(193	)		(677	)
Redemption of restricted stock		450			611
Purchases of premises and equipment		(224	)		(33	)
Proceeds from the sale of foreclosed assets		412			-
Net cash provided by (used in) investing activities		2,039			(3,253	)

Cash flows from financing activities:
Net increase (decrease) in deposits		1,286			(1,703	)
(Decrease) increase in short term borrowings		(5,839	)		1,906
Increase (decrease) in long term borrowings		-			500
Proceeds from the issuance of preferred stock		6,853			-
Redemption of preferred stock		(5,605	)		-
Cash dividends paid on preferred stock		(210	)		(215	)
Net cash provided by (used in) financing activities		(3,515	)		488

Net increase (decrease) in cash and cash equivalents		160			(1,444	)
Cash and cash equivalents-beginning		1,447			3,298
Cash and cash equivalents-ending	$	1,607		$	1,854

Supplemental information:
Cash paid during the period for interest	$	920		$	1,277

Supplemental schedule of Non-cash Investing Activities:
Foreclosed real estate acquired in settlement of loan	$	282		$	415


See Notes to Unaudited Consolidated Financial Statements

HIGHLANDS BANCORP, INC.

Notes to Consolidated Financial Statements

Note 1 – Basis of Presentation

The consolidated financial statements include the accounts of Highlands Bancorp, Inc. (the “Company”) and its wholly owned subsidiary, Highlands State Bank (the “Bank” or “Highlands”) and the Bank’s wholly-owned subsidiary, HSB Mountain Lakes, LLC. On April 30, 2010 the stockholders of the Bank approved the formation of a bank holding company, Highlands Bancorp, Inc., under a Plan of Acquisition (the "Plan") whereby each outstanding share of the Bank’s common stock, $5 par value per share, was transferred and contributed to the holding company in exchange for one share of the holding company’s common stock, no par value per share. This exchange of shares was completed on August 31, 2010.

The only activity of Highlands Bancorp, Inc. is the ownership of Highlands State Bank. The Company is subject to the supervision and regulation of the Board of Governors of the Federal Reserve System (the “FRB”) and New Jersey Department of Banking and Insurance (“NJDOBI”). The Bank is subject to supervision and regulation by the NJDOBI and the Federal Deposit Insurance Corporation (“FDIC”).

All significant intercompany accounts and transactions have been eliminated in the consolidated financial statements.

Highlands State Bank is a New Jersey state chartered bank which commenced operations on October 31, 2005 and is a full service bank providing personal and business lending and deposit services. The Bank’s trade area includes Sussex County and a portion of Passaic County in New Jersey. HSB Mountain Lakes, LLC was formed in 2010 to hold certain real estate acquired in settlement of loans.

The accompanying unaudited consolidated financial statements have been prepared in accordance with United States of America generally accepted accounting principles (US GAAP) for interim financial information and in accordance with instructions for Form 10-Q and Rule 10-01 of the Securities and Exchange Commission Regulation S-X. Accordingly, they do not include all of the information and footnotes required by US GAAP for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. Operating results for the three and nine months ended September 30, 2011, are not necessarily indicative of the results that may be expected for the year ended December 31, 2011.

These unaudited consolidated financial statements presented in this report should be read in conjunction with the audited financial statements and the accompanying notes for the year ended December 31, 2010, included in the Annual Report on Form 10-K of Highlands Bancorp, Inc. filed with the Securities Exchange Commission (“SEC”).

The significant accounting policies of the Company as applied in the interim financial statements presented, are substantially the same as those followed on an annual basis as presented in the Company’s Annual Report on Form 10-K for the year ended December 31, 2010.

The Company has evaluated subsequent events for potential recognition and/or disclosure in this Quarterly Report on Form 10-Q through the date these financial statements were issued.

Note 2 - Securities Available for Sale

The amortized cost, gross unrealized gains and losses, estimated fair value, and maturities of securities available for sale at September 30, 2011 and December 31, 2010 are as follows:

			Gross		Gross
	Amortized		Unrealized		Unrealized		Fair
	Cost		Gains		Losses		Value
	(In Thousands)
September 30, 2011
U.S Government agencies and sponsored agencies
Due within one year	$	999	$	14	$	-	$	1,013
Due after one but within five years		5,051		49		-		5,100
Due after five but within ten years		1,009		1		-		1,010
Due after ten years		5,616		54		-		5,670
U.S Government sponsored enterprises (GSEs)-mortgage-backed securities		3,281		108		14		3,375
Other
Due after five but within ten years		192		4		-		196
Due after ten years		117		7		8		116

	$	16,265	$	237	$	22	$	16,480

December 31, 2010
U.S Government agencies and sponsored agencies
Due within one year	$	1,002	$	5	$	-	$	1,007
Due after one but within five years		6,548		82		-		6,630
Due after five but within ten years		1,022		-		7		1,015
Due after ten years		3,108		39		-		3,147
U.S Government sponsored enterprises (GSEs)-mortgage-backed securities		4,340		119		16		4,443
Other
Due after five but within ten years		244		7				251
Due after ten years		940		34		5		969

	$	17,204	$	286	$	28	$	17,462

The table below shows the Company’s securities, their gross unrealized losses and fair value, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position at September 30, 2011 and December 31, 2010:

	Less than 12 Months				12 Months or More				Total
			Gross				Gross				Gross
	Fair		Unrealized		Fair		Unrealized		Fair		Unrealized
	Value		Losses		Value		Losses		Value		Losses
	(In thousands)
September 30, 2011
U.S Government sponsored
enterprises (GSEs) -
mortgage-backed securities	$	1,538	$	1	$	774	$	13	$	2,312	$	14
Other		104		8		-		-		104		8
	$	1,642	$	9	$	774	$	13	$	2,416	$	22

December 31, 2010
U.S Government agencies
and sponsored agencies	$	1,015	$	7	$	-	$	-	$	1,015	$	7
U.S Government sponsored
enterprises (GSEs) -
mortgage-backed securities		1,252		16		-		-		1,252		16
Other		102		5		-		-		102		5
	$	2,369	$	28	$	-	$	-	$	2,369	$	28

At September 30, 2011, the Company had 4 securities in an unrealized loss position. Three of these securities relate to U.S. Government sponsored enterprise mortgage-backed securities. Unrealized losses on these securities relate to interest rate fluctuations. Unrealized losses in the other category consists of a private label mortgage-backed security which has a B- rating but the issuer has not defaulted on principal or interest payments. Management concluded that these securities were not other-than-temporarily impaired at September 30, 2011. The Bank does not intend to sell these securities and it is not more likely than not that it will be required to sell these securities before recovery of the cost basis. Future deterioration in the credit quality of these large financial institutions could result in impairment charges in the future.

Note 3 – Loans Receivable and Credit Quality Disclosures

The composition of loans receivable at September 30, 2011 and December 31, 2010 is as follows:

	September 30,			December 31,
(In Thousands)	2011			2010
Commercial	$	17,014		$	17,481
Commercial real estate		74,631			61,223
Commercial construction		7,110			5,020
Residential real estate		10,486			11,846
Home equity		23,475			26,909
Consumer-other		288			231
Total Loans		133,004			122,710

Allowance for loan losses		(2,049	)		(1,693	)
Net deferred loan (fees) costs		(19	)		13
		(2,068	)		(1,680	)
	$	130,936		$	121,030

The following table summarizes information in regards to the allowance for loan losses and the recorded investment in loans receivable as of September 30, 2011 and the activity in the allowance for loan losses for the three and nine months ended September 30, 2011:

(In Thousands)	Commercial			Commercial Real Estate		Commercial Construction		Residental		Home Equity			Consumer - Other			Unallocated			Total
Allowance for credit
losses:
Beginning Balance, 6/30/11	$	462		$	856	$	236	$	52	$	195		$	10		$	2		$	1,813
Charge-offs		-			-		-		-		-			-			-			-
Recoverables		-			-		-		-		-			-			-			-
Provisions		65			67		62		35		15			(6	)		(2	)		236
Ending balance 9/30/11	$	527		$	923	$	298	$	87	$	210		$	4		$	-		$	2,049

Beginning Balance 1/1/11	$	483		$	717	$	207	$	49	$	231		$	6		$	-		$	1,693
Charge-offs		-			-		-		-		(73	)		-			-			(73	)
Recoverables		60			-		-		-		5			2			-			67
Provisions		(16	)		206		91		38		47			(4	)		-			362
Ending balance 9/30/11	$	527		$	923	$	298	$	87	$	210		$	4		$	-		$	2,049
Ending balance: individually evaluated for impairment	$	18		$	121	$	194	$	35	$	-		$	-		$	-		$	368
Ending balance: collectively evaluted for impairment	$	509		$	802	$	104	$	52	$	210		$	4		$	-		$	1,681
Ending balance: loans aquired with deteriorated credit quality	$	-		$	-	$	-	$	-	$	-		$	-		$	-		$	-

Financing receivables:
Ending balance	$	17,014		$	74,631	$	7,110	$	10,486	$	23,475		$	288					$	133,004
Ending balance: individually evaluted for impairment	$	466		$	2,370	$	2,066	$	575	$	-		$	-					$	5,477
Ending balance: collectively evaluated for impairment	$	16,548		$	72,261	$	5,044	$	9,911	$	23,475		$	288					$	127,527
Ending balance: loans acquired with deteriorated credit quality	$	-		$	-	$	-	$	-	$	-		$	-					$	-

The following table presents the classes of the commercial loan portfolio summarized by the aggregate pass rating and the classified ratings of special mention, substandard and doubtful within the Company’s internal risk rating system as of September 30, 2011 and December 31, 2010:

(In Thousands)	Commercial		Commercial		Commercial Real Estate		Commercial Real Estate		Commercial Construction		Commercial Construction
	9/30/2011		12/31/2010		9/30/2011		12/31/2010		9/30/2011		12/31/2010
Pass	$	16,221	$	16,815	$	72,261	$	57,492	$	5,044	$	3,247
Special Mention		127		209		-		1,571		-		-
Substandard		666		457		2,370		2,160		2,066		1,773
Doubtful		-		-		-		-		-		-
Total	$	17,014	$	17,481	$	74,631	$	61,223	$	7,110	$	5,020

Consumer Credit Exposure
Credit Risk Profile Based on Payment Activity

(In Thousands)	Residential Mortgage Loans		Residential Mortgage Loans		Home Equity Loans		Home Equity Loans		Consumer - Other		Consumer - Other
	9/30/2011		12/31/2010		9/30/2011		12/31/2010		9/30/2011		12/31/2010
Performing	$	10,136	$	11,496	$	23,319	$	26,679	$	284	$	231
Nonperforming		350		350		156		230		4		-
Total	$	10,486	$	11,846	$	23,475	$	26,909	$	288	$	231

The following table summarizes information in regards to impaired loans by loan portfolio class as of September 30, 2011 and December 31, 2010:

	Recorded Investment		Unpaid Principal Balance		Related Allowance		Average Recorded Investment		Interest Income Recognized
September 30, 2011	(In Thousands)
With no related allowance recorded:
Commercial	$	-	$	-	$	-	$	-	$	-
Commercial real estate		-		-		-		-		-
Commercial construction		-		-		-		-		-

With an allowance recorded:
Commercial	$	466	$	472	$	18	$	474	$	-
Commercial real estate		2,370		2,375		121		2,093		18
Commercial construction		2,066		2,862		194		1,916		-
Residential mortgage		575		575		35		64		-

Total:
Commercial	$	466	$	472	$	18	$	474	$	-
Commercial real estate		2,370		2,375		121		2,093		18
Commercial construction		2,066		2,862		194		1,916		-
Residential mortgage		575		575		35		64		-


	Recorded Investment		Unpaid Principal Balance		Related Allowance		Average Recorded Investment		Interest Income Recognized
December 31, 2010	(In Thousands)
With no related allowance recorded:
Commercial	$	-	$	-	$	-	$	-	$	-
Commercial real estate		-		-		-		-		-
Commercial construction		-		-		-		-		-

With an allowance recorded:
Commercial	$	457	$	459	$	13	$	427	$	2
Commercial real estate		2,160		2,166		45		1,745		26
Commercial construction		1,773		2,569		118		2,478		-

Total:
Commercial	$	457	$	459	$	13	$	427	$	2
Commercial real estate		2,160		2,166		45		1,745		26
Commercial construction		1,773		2,569		118		2,478		-

The following table presents non-accrual loans by classes of the loan portfolio as of September 30, 2011 and December 31, 2010:

	09/30/11		12/31/10
	(In Thousands)
Commercial	$	208	$	457
Commercial real estate		1,320		1,334
Commercial construction		2,066		1,773
Residential mortgage		350		350
Home equity		156		230
Consumer, other		4		-
	$	4,104	$	4,144

The performance and credit quality of the loan portfolio is also monitored by analyzing the age of the loans receivable as determined by the length of time a recorded payment is past due. The following table presents the classes of the loan portfolio summarized by the past due status as of September 30, 2011 and December 31, 2010:

September 30, 2011	30-59 Days Past Due		60-89 Days Past Due		Greater than 90 Days		Total Past Due		Current		Total Financing Receivables		Recorded Investment > 90 Days and Accruing
	(In Thousands)
Commercial	$	8	$	200	$	437	$	645	$	16,369	$	17,014	$	-
Commercial real estate		245		247		1,887		2,379		72,252		74,631		827
Commercial construction		-		293		1,773		2,066		5,044		7,110		-
Residential real estate		-		-		350		350		10,136		10,486		-
Home Equity		316		200		156		672		22,803		23,475		-
Consumer other		8		-		4		12		276		288		-

Total	$	577	$	940	$	4,607	$	6,124	$	126,880	$	133,004	$	827



December 31, 2010	30-59 Days Past Due		60-89 Days Past Due		Greater than 90 Days		Total Past Due		Current		Total Financing Receivables		Recorded Investment > 90 Days and Accruing
	(In Thousands)
Commercial	$	22	$	43	$	437	$	502	$	16,979	$	17,481	$	-
Commercial real estate		1,101		-		1,334		2,435		58,788		61,223		-
Commercial construction		-		-		1,773		1,773		3,247		5,020		-
Residential real estate		-		210		141		351		11,495		11,846		-
Home Equity		-		-		230		230		26,679		26,909		-
Consumer other		2		-		-		2		229		231		-

Total	$	1,125	$	253	$	3,915	$	5,293	$	117,417	$	122,710	$	-

The Company may grant a concession or modification for economic or legal reasons related to a borrower’s financial condition that it would not otherwise consider resulting in a modified loan which is then identified as a troubled debt restructuring (TDR). The Company may modify loans through rate reductions, extensions of maturity, interest only payments, or payment modifications to better match the timing of cash flows due under the modified terms with the cash flows from the borrowers’ operations. Loan modifications are intended to minimize the economic loss and to avoid foreclosure or repossession of the collateral. TDRs are considered impaired loans for purposes of calculating the Company’s allowance for loan losses.

The Company identifies loans for potential restructure primarily through direct communication with the borrower and evaluation of the borrower’s financial statements, revenue projections, tax returns, and credit reports. Even if the borrower is not presently in default, management will consider the likelihood that cash flow shortages, adverse economic conditions, and negative trends may result in a payment default in the near future.

At September 30, 2011 the company had three loans classified as TDR’s with combined balances of $1.9 million. The following table reflects information regarding the Company’s troubled debt restructurings for the nine month period ending September 30, 2011, and troubled debt restructuring loans which have subsequently defaulted in the last twelve months:

Pre-Modification

Post-Modification

Outstanding

Troubled Debt Restructurings for the

Number of

Recorded

nine months ended September 30, 2011:

Contracts

Investments

(in Thousands)

Commercial real estate

463

482

Residential real estate

511

575

Troubled Debt Restructurings that

Number of

Recorded

subsequently defaulted in the last

Contracts

Investment

twelve months:

(in Thousands)

Commercial real estate

827

The residential real estate TDR was a 25-year interest only home equity that was modified to a 30 amortizing loan with a 3 year balloon by taking out a first mortgage with another institution of $64 thousand. The rate was reduced to 2.875% from 5.00%. The new structure moved the bank into first position. This loan has a loss reserve of $35 thousand.

The commercial real estate mortgage was modified from a 20-year amortizing loan with a 5-year balloon and a rate of 6.50% to a 5-year balloon with the first 2 years being interest only payments at 4.00% and then converting to 3 years principal and interest with a floor of 6.00% based on a 30 year payment schedule. At restructure the principal balance was $463 thousand. Owed interest, late fees and arrears escrow of $19 thousand were added to the principal balance. This property has a loss reserve of $22 thousand.

As of September 30, 2011, no available commitments were outstanding on TDRs. All TDRs are on accrual status as the loans were performing at the date of modification and management believes that payments are probable under the modified terms.

Note 4 - Foreclosed Assets

Assets acquired through, or in lieu of, loan foreclosure are held for sale and are initially recorded at fair value less cost to sell at the date of foreclosure, establishing a new cost basis. Subsequent to foreclosure, valuations are periodically performed by management and the assets are carried at the lower of carrying amount or fair value less cost to sell. Revenue and expenses from operations and changes in the valuation allowance are included in net expense from other non-interest expense.

Note 5 – Preferred Stock

In October 2008, the United States Treasury Department (the “Treasury”) announced a voluntary Capital Purchase Program, a part of the Troubled Asset Relief Program (TARP), to encourage U.S. financial institutions to build capital to increase the flow of financing to U.S. businesses and consumers and to support the U.S. economy. Highlands applied to participate in this program prior to December 31, 2008 and received approval in January 2009.

On May 8, 2009, the Bank issued to the Treasury 3,091 shares of Series 2009A Preferred Stock and a warrant to purchase 155 shares of the Bank’s Series 2009B Preferred Stock for an aggregate purchase price of $3,091,000 in cash (“TARP funds”). The warrant was exercised as a cashless exercise on May 8, 2009 and 155 shares of Series 2009B Preferred Stock were issued. Both series of preferred stock qualified as a Tier 1 capital. On December 22, 2009, the Bank consummated a second financing with the Treasury under the Capital Purchase Program for Small Banks pursuant to which the Bank issued to the Treasury an additional 2,359 shares of Series 2009A Preferred Stock for total proceeds of $2,359,000. The Series 2009A Preferred Stock paid non-cumulative dividends of 5% per annum for the first five years and 9% per annum thereafter. Series 2009B Preferred Stock paid non-cumulative dividends of 9% per annum.

Upon consummation of the holding company reorganization on August 31, 2010, the Company assumed all of the Bank’s obligations under the preferred stock, and issued to the Treasury shares of the Company’s preferred stock in exchange for the outstanding shares of Bank preferred stock.

On September 22, 2011, the Company entered into a Securities Purchase Agreement (the “Purchase Agreement”) with the Secretary of the Treasury (the “Treasury”), pursuant to which the Company issued and sold to the Treasury 6,853 shares of its Senior Non-Cumulative Perpetual Preferred Stock, Series C (the “Series C Preferred Stock”), having a liquidation preference of $1,000 per share (the “Liquidation Amount”), for proceeds of $6,853,000. The Purchase Agreement was entered into, and the Series C Preferred Stock was issued, pursuant to the Treasury’s SBLF program, a $30 billion fund established under the Small Business Jobs Act of 2010 that encourages lending to small businesses by providing capital to qualified community banks with assets of less than $10 billion. The proceeds were used to redeem the Series 2009A and 2009B preferred stock previously issued to the U.S. Treasury under the Capital Purchase Program, and to further enhance the Bank’s business lending efforts.

The Series C Preferred Stock qualifies as Tier 1 capital for the Company. Non-cumulative dividends are payable quarterly on the Series C Preferred Stock, beginning January 1, 2012. The dividend rate is calculated as a percentage of the aggregate Liquidation Amount of the outstanding Series C Preferred Stock and is based on changes in the level of “Qualified Small Business Lending” or “QSBL” (as defined in the Purchase Agreement) by the Bank. Based upon the increase in the Bank’s level of QSBL over the baseline level calculated under the terms of the Purchase Agreement, the dividend rate for the initial dividend period, which is from the date of issuance through December 31, 2011, has been set at 1.6513936%. For the 2nd through 10th calendar quarters, the annual dividend rate may be adjusted to between 1% and 5%, to reflect the amount of change in the Banks’ level of QSBL. For the 11th calendar quarter through 4.5 years after issuance, the dividend rate will be fixed at between 1% and 7% based upon the increase in QSBL as compared to the baseline. After 4.5 years from issuance, the dividend rate will increase to 9%.

The Series C preferred shares are non-voting, other than class voting rights on matters that could adversely affect the shares. The preferred shares are redeemable at any time, with Treasury, Federal Reserve and FDIC approval. Apart from the Series C shares, not other shares of the Company’s preferred stock are currently outstanding.

Note 6 – Basic and Diluted Income Per Common Share

Basic income per common share represents income available to common stockholders divided by the weighted-average number of common shares outstanding during the period, as adjusted for stock dividends and splits. Diluted income per common share reflects additional common shares that would have been outstanding if dilutive potential common shares had been issued, as well as any adjustments to income that would result from the assumed issuance. Potential common shares that may be issued by the Company relate solely to outstanding stock options, and are determined using the treasury stock method.


	Three Months Ended September 30,				Nine Months Ended September 30,
	2011		2010		2011		2010
	(In Thousands, except				(In Thousands, except
	per share data)				per share data)

Net income available to common stockholders	$	120	$	51	$	422	$	94

Weighted average shares outstanding		1,788,262		1,788,262		1,788,262		1,788,262
Dilutive effect of potential common shares, stock options		-		-		-		-

Diluted weighted average common shares outstanding		1,788,262		1,788,262		1,788,262		1,788,262
Basic net income per common share	$	0.07	$	0.03	$	0.24	$	0.05
Diluted net income per common share	$	0.07	$	0.03	$	0.24	$	0.05


Stock options for 124,000 shares of common stock were not considered in computing diluted earnings per common share for the three and nine months ended September 30, 2011 and 2010, respectively because they were not dilutive.

Note 7 – Guarantees

The Company does not issue any guarantees that would require liability recognition or disclosure, other than its standby letters of credit. Standby letters of credit are conditional commitments issued by the Company to guarantee the performance of a customer to a third party. Generally, all letters of credit, when issued, have expiration dates within one year. The credit risk involved in issuing letters of credit is essentially the same as those that are involved in extending loan facilities to customers. The Company generally holds collateral and/or personal guarantees supporting these commitments. The Company had $275 thousand of standby letters of credit outstanding as of September 30, 2011, of which $187 thousand were secured by collateral. The current amount of the liability as of September 30, 2011 for guarantees under standby letters of credit issued is not material.

Note 8 – Short-term and Long-term Borrowings

The Company has a $5,000,000 line of credit with Atlantic Central Bankers Bank (ACBB) for federal funds purchased. $2,500,000 of the line of credit is unsecured and $2,500,000 of the line of credit is secured by securities held by ACBB in safekeeping. There was a balance of $161,000 outstanding under this line at September 30, 2011 compared to no balance or December 31, 2010. The line of credit expires June 30, 2012.

As of September 30, 2011 and December 31, 2010, the Company had $5.0 million and $11.0 million in long-term borrowings with the Federal Home Loan Bank of New York (FHLB) with a weighted average interest rate of 2.61% and 1.38%, respectively.

The FHLB borrowings at September 30, 2011 mature as follows:


	(In Thousands)
2012	$	2,000
2013		3,000
	$	5,000

A $2,000,000 advance maturing in 2013 contains a convertible option which allows the FHLB at quarterly intervals commencing after each conversion date to convert the fixed convertible advance into replacement funding for the same or lesser principal based on any advance then offered by the FHLB at its then current market rate. The Company has the option to repay this advance, if converted, without penalty.

The FHLB borrowings are secured under terms of a blanket collateral agreement by a pledge of qualifying collateral.

Note 9 – Fair Value Measurements and Fair Value of Financial Instruments

Management uses its best judgment in estimating the fair value of the Company’s financial instruments; however, there are inherent weaknesses in any estimation technique. Therefore, for substantially all financial instruments, the fair value estimates herein are not necessarily indicative of the amounts the Company could have realized in a sale transaction on the date indicated. The estimated fair value amounts have been measured as of the respective period-end and have not been re-evaluated or updated for purposes of these financial statements subsequent to period-end. As such, the estimated fair values of these financial instruments subsequent to the period-end reporting dates may be different than the amounts reported at period-end.

The Company follows the provisions and guidance of FASB ASC 820 “Fair Value Measurements and Disclosures”. This guidance, which defines fair value, establishes a framework for measuring fair value under U.S. GAAP, expands disclosures about fair value measurements and applies to other accounting pronouncements that require or permit fair value measurements. Fair value is defined as the price that would be received to sell the asset or transfer the liability in an orderly transaction (that is not a forced liquidation or distressed sale) between market participants at the measurement date under current market conditions.

The fair value guidance establishes a fair value hierarchy that prioritizes the inputs to valuation methods used to measure fair value. The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1 measurements) and the lowest priority to unobservable inputs (Level 3 measurements). The three levels of the fair value hierarchy are as follows:

Level 1: Unadjusted quoted prices in active markets that are accessible at the measurement date for identical, unrestricted assets or liabilities.

Level 2: Quoted prices in markets that are not active, or inputs that are observable either directly or indirectly, for substantially the full term of the asset or liability.

Level 3: Prices or valuation techniques that require inputs that are both significant to the fair value measurement and unobservable (i.e., supported with little or no market activity).

An asset’s or liability’s level within the fair value hierarchy is based on the lowest level of input that is significant to the fair value measurement.

For financial assets measured at fair value on a recurring basis, the fair value measurements by level within the fair value hierarchy used at September 30, 2011 and December 31, 2010 are as follows:

			(Level 1)				(Level 3)
			Quoted Prices in		(Level 2)		Significant
			Active Markets for		Significant Other		Unobservable
	Total		Identical Assets		Observable Inputs		Inputs
Securities Available for Sale:	(In Thousands)
September 30, 2011:
U.S Government agencies
and sponsored agencies	$	12,793	$	-	$	12,793	$	-
U.S Government sponsored
enterprises (GSEs) -
mortgage-backed securities		3,375				3,375
Other		312				312
	$	16,480	$	-	$	16,480	$	-

Securities Available for Sale:
December 31, 2010:
U.S Government agencies
and sponsored agencies	$	11,799	$	-	$	11,799	$	-
U.S Government sponsored
enterprises (GSEs) -
mortgage-backed securities		4,443				4,443
Other		1,220				1,220
	$	17,462	$	-	$	17,462	$	-

There were no transfers in or out of Level 1 and Level 2 fair value measurements during the nine months ended September 30, 2011.

For financial assets measured at fair value on a nonrecurring basis, the fair value measurements by level within the fair value hierarchy used at September 30, 2011 and December 31, 2010 are as follows:


			(Level 1)				(Level 3)
			Quoted Prices in		(Level 2)		Significant
	September 30,		Active Markets for		Significant Other		Unobservable
(In thousands)	2011		Identical Assets		Observable Inputs		Inputs

Impaired Loans	$	5,109	$	-	$	-	$	5,109

Foreclosed Assets	$	658	$	-	$	-	$	658


	December 31,
		2010

Impaired Loans	$	4,214	$	-	$	-	$	4,214

Foreclosed Assets	$	799	$	-	$	-	$	799

Real estate properties acquired through, or in lieu of, foreclosure are to be sold and are carried at fair value less estimated cost to sell. Fair value is based upon independent market prices or appraised value of the property. These assets are included in Level 3 fair value based upon the lowest level of input that is significant to the fair value measurement.

Below is management’s estimate of the fair value of all financial instruments, whether carried at cost or fair value on the Company’s balance sheet. The following information should not be interpreted as an estimate of the fair value of the entire Company since a fair value calculation is only provided for a limited portion of the Company’s assets and liabilities. Due to a wide range of valuation techniques and the degree of subjectivity used in making the estimates, comparisons between the Company’s disclosures and those of other companies may not be meaningful. The following methods and assumptions were used to estimate the fair values of the Company’s financial instruments at September 30, 2011 and December 31, 2010:

Cash and Cash Equivalents (Carried at Cost)

The carrying amounts reported in the balance sheet for cash and short-term instruments approximate those assets’ fair values.

Time Deposits in Other Banks (Carried at Cost)

Fair values for fixed-rate time certificates of deposit are estimated using a discounted cash flow calculation that applies interest rates currently being offered in the market on certificates to a schedule of aggregated expected monthly maturities on time deposits. The Company generally purchases amounts below the insured limit, limiting the amount of credit risk on these time deposits.

Securities Available for Sale (Carried at Fair Value)

The fair value of securities available for sale is determined by matrix pricing (Level 2), which is a mathematical technique used widely in the industry to value debt securities without relying exclusively on quoted market prices for the specific securities but rather by relying on the securities’ relationship to other benchmark quoted prices.

Loans Receivable (Carried at Cost)

The fair values of loans are estimated using discounted cash flow analyses, using market rates at the balance sheet date that reflect the credit and interest rate-risk inherent in the loans. Projected future cash flows are calculated based upon contractual maturity or call dates and projected repayments and prepayments of principal. Generally, for variable rate loans that reprice frequently and with no significant change in credit risk, fair values are based on carrying values.

Impaired Loans (Generally Carried at Fair Value)

Impaired loans are those loans on which the Company has measured impairment generally based on the fair value of the loan’s collateral. Fair value is generally determined based upon independent third-party appraisals of the properties, or discounted cash flows based upon the expected proceeds. These assets are included as Level 3 fair values, based upon the lowest level of input that is significant to the fair value measurements.

Restricted Investment in Bank Stock (Carried at Cost)

The carrying amount of restricted investment in bank stock approximates fair value, and considers the limited marketability of such securities.

Accrued Interest Receivable and Payable (Carried at Cost)

The carrying amount of accrued interest receivable and accrued interest payable approximates its fair value.

Deposit Liabilities (Carried at Cost)

The fair values disclosed for demand deposits (e.g., interest and noninterest checking, passbook savings and money market accounts) are, by definition, equal to the amount payable on demand at the reporting date (i.e., their carrying amounts). Fair values for fixed-rate certificates of deposit are estimated using a discounted cash flow calculation that applies interest rates currently being offered in the market on certificates to a schedule of aggregated expected monthly maturities on time deposits.

Borrowings (Carried at Cost)

Fair values of FHLB advances are estimated using discounted cash flow analysis, based on quoted prices for new FHLB advances with similar credit risk characteristics, terms and remaining maturity. These prices obtained from this active market represent a market value that is deemed to represent the transfer price if the liability were assumed by a third party.

Off-Balance Sheet Financial Instruments (Disclosed at Cost)

Fair values for the Company’s off-balance sheet financial instruments (lending commitments and letters of credit) are based on fees currently charged in the market to enter into similar agreements, taking into account the remaining terms of the agreements and the counterparties’ credit standing.

The following table summarizes the carrying amount and fair value estimates of the Company’s financial instruments at September 30, 2011 and December 31, 2010:


	September 30, 2011				December 31, 2010
	Carrying or				Carrying or
	Notional		Fair		Notional		Fair
	Amount		Value		Amount		Value
	(In Thousands)
Financial Assets:
Cash and cash equivalents	$	1,607	$	1,607	$	1,447	$	1,447
Time deposits in other banks		8,296		8,296		19,596		19,596
Securities available for sale		16,480		16,480		17,462		17,462
Loans receivable, net		130,936		132,264		121,030		121,407
Restricted investment in bank stock		533		533		790		790
Accrued interest receivable		677		677		631		631

Financial Liabilities:
Demand and savings deposits		101,481		101,481		110,161		110,161
Time deposits		36,204		35,985		26,238		26,094
Borrowings		5,161		5,242		11,000		11,036
Accrued interest payable		67		67		70		70

Off-Balance Financial Instruments:
Commitments to extend credit		-		-		-		-
Letters of credit		-		-		-		-

Note 10 - Contingencies

In the normal course of business, the Company is subject to various lawsuits involving matters generally incidental to its business. Other than as described below, Management is of the opinion that the ultimate liability, if any, resulting from any pending actions or proceedings will not have a material effect on the financial position or results of operations of the Company.

On December 14, 2009, Union Center National Bank ("UCNB") initiated an action in New Jersey Superior Court against the Bank seeking to require the Bank to repurchase UCNB's participation interest in a loan with a total principal amount of $6.9 million. UCNB held 85.5072% of the loan. UCNB also asserted a claim for negligent handling and administration of the loan. The Bank filed an answer contesting liability and asserted counterclaims against UCNB. UCNB filed a motion for summary judgment, which was denied without prejudice. The parties filed cross-motions for partial summary judgment. In response, the court referred the case to mediation, and through the mediation process, the parties have reached an agreement in principal to settle this dispute, subject to satisfaction of certain conditions. Under the agreement in principal, the Company will acquire UCNB’s interest in the loan and underlying collateral for a price of $2.225 million and the parties will each dismiss their claims in the underlying lawsuit with prejudice and exchange limited releases. Consummation of the agreement in principal is to occur on or before November 21, 2011. The Company estimates no significant loss on the settlement as management believes the net realizable value of the collateral on this impaired loan is adequate to cover the carrying value of the loan after the repurchase. The loan is in the process of foreclosure.

Note 11 – New Accounting Standards

ASU 2010-20, Receivables (Topic 310): Disclosures about the Credit Quality of Financing Receivables and the Allowance for Credit Losses, will help investors assess the credit risk of a company’s receivables portfolio and the adequacy of its allowance for credit losses held against the portfolio by expanding credit risk disclosures. This ASU requires more information about the credit quality of financing receivables in the disclosures to financial statements, such as aging information and credit quality indicators. Both new and existing disclosures must be disaggregated by portfolio segment or class. The disaggregation of information is based on how a company develops its allowance for credit losses and how it manages its credit exposure.

The amendments in this Update apply to all public and nonpublic entities with financing receivables. Financing receivables include loans and trade accounts receivable. However, short-term trade accounts receivable, receivables measured at fair value or lower of cost or fair value, and debt securities are exempt from these disclosure amendments.

For public companies, the amendments that require disclosures as of the end of a reporting period are effective for periods ending on or after December 15, 2010. The amendments that require disclosures about activity that occurs during a reporting period are effective for periods beginning on or after December 15, 2010. The Company has adopted ASU 2010-20 and has included the required disclosures.

In April 2011, the FASB issued ASU 2011-02, A Creditor’s Determination of Whether a Restructuring Is a Troubled Debt Restructuring, which updates ASC 310. This updated clarifies which loan modifications constitute troubled debt restructurings. In evaluating whether a restructuring constitutes a troubled debt restructuring, a creditor must separately conclude that both of the following exist: 1) the restructuring constitutes a concession; and 2) the debtor is experiencing financial difficulty. The update clarifies the guidance on a creditor’s evaluation of whether it has granted a concession to note that if a debtor does not otherwise have access to funds at a market rate for debt with similar characteristics as the restructured debt, the restructuring would be considered to be at a below-market rate, which may indicate that the creditor has granted a concession. Additionally, a temporary or permanent increase in the contractual interest rate as a result of a restructuring does not preclude the restructuring from being considered a concession because the new contractual interest rate on the restructured debt could still be below the market interest rate for new debt with similar characteristics. Furthermore, a restructuring that results in a delay in payment that is insignificant is not a concession. The update also clarifies the guidance on a creditor’s evaluation of whether a debtor is experiencing financial difficulty to note that a creditor may conclude that a debtor is experiencing financial difficulties, even though the debtor is not currently in payment default. The amendments in this ASU are effective for the first interim or annual period beginning on or after June 15, 2011. The adoption did not have a significant impact on our financial position or results of operations, as we had already implemented these principles in our evaluations of TDRs during 2011.

In April 2011, the FASB issued ASU 2011-03, Reconsideration of Effective Control for Repurchase Agreements, which updates ASC 860, Transfers and Servicing. The ASU removes from the assessment of effective control the criterion requiring the transferor to have the ability to repurchase or redeem the financial assets on substantially the agreed terms, even in the event of default by the transferee. Accordingly, upon the adoption of the ASU’s guidance, a transferor in a repurchase transaction is deemed to have effective control if the following three conditions in ASC 860-10-40-24 are met: 1) The financial assets to be repurchased or redeemed are the same or substantially the same as those transferred, 2) The agreement is to repurchase or redeem them before maturity, at a fixed or determinable price, and 3) The agreement is entered into contemporaneously with, or in contemplation of, the transfer. The guidance in the ASU is effective prospectively for transactions or modifications of existing transactions that occur on or after the first interim or annual period beginning on or after December 15, 2011. Early adoption is not permitted. The Company is continuing to evaluate this guidance, but does not expect the adoption to have a significant impact on our financial position or results of operations.

In May 2011, the FASB issued ASU No. 2011-04, Fair Value Measurement (Topic 820): Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs. This update amends FASB ASC Topic 820, Fair Value Measurements, to bring U.S. GAAP for fair value measurements in line with International Accounting Standards. The Update clarifies existing guidance for items such as: the application of the highest and best use concept to non-financial assets and liabilities; the application of fair value measurement to financial instruments classified in a reporting entity’s stockholder’s equity; and disclosure requirements regarding quantitative information about unobservable inputs used in the fair value measurements of level 3 assets. The Update also creates an exception to Topic 820 for entities which carry financial instruments within a portfolio or group, under which the entity is now permitted to base the price used for fair valuation upon a price that would be received to sell the net asset position or transfer a net liability position in an orderly transaction. The Update also allows for the application of premiums and discounts in a fair value measurement if the financial instrument is categorized in level 2 or 3 of the fair value hierarchy. Lastly, the ASU contains new disclosure requirements regarding fair value amounts categorized as level 3 in the fair value hierarchy such as: disclosure of the valuation process used; effects of and relationships between unobservable inputs; usage of nonfinancial assets for purposes other than their highest and best use when that is the basis of the disclosed fair value; and categorization by level of items disclosed at fair value, but not measured at fair value for financial statement purposes. For public entities, this Update is effective for interim and annual periods beginning after December 15, 2011. Early adoption is not permitted. The Company does not anticipate the adoption of this update will impact its financial condition or results of operations.

In June 2011, the FASB issued ASU No. 2011-05, Comprehensive Income (Topic 220): Presentation of Comprehensive Income. The provisions of this update amend FASB ASC Topic 220, Comprehensive Income, to facilitate the continued alignment of U.S. GAAP with International Accounting Standards. The Update prohibits the presentation of the components of comprehensive income in the statement of stockholder’s equity. Reporting entities are allowed to present either: a statement of comprehensive income, which reports both net income and other comprehensive income; or separate statements of net income and other comprehensive income. Under previous GAAP, all 3 presentations were acceptable. Regardless of the presentation selected, the Reporting Entity is required to present all reclassifications between other comprehensive and net income on the face of the new statement or statements. The provisions of this Update are effective for fiscal years and interim periods beginning after December 31, 2011 for public entities. As the two remaining options for presentation existed prior to the issuance of this Update, early adoption is permitted.

In September, 2011, the FASB issued Accounting Standards Update (ASU) 2011-08, Testing Goodwill for Impairment. The purpose of this ASU is to simplify how entities test goodwill for impairment by adding a new first step to the preexisting goodwill impairment test under ASC Topic 350, Intangibles – Goodwill and other. This amendment gives the entity the option to first assess a variety of qualitative factors such as economic conditions, cash flows, and competition to determine whether it was more likely than not that the fair value of goodwill has fallen below its carrying value. If the entity determines that it is not likely that the fair value has fallen below its carrying value, then the entity will not have to complete the original two-step test under Topic 350. The amendments in this ASU are effective for impairment tests performed for fiscal years beginning after December 15, 2011. Early adoption is permitted. The Company is evaluating the impact of this ASU on its consolidated financial statements.

Item 2 – Management’s Discussion and Analysis of Financial Condition and Results of Operations

This discussion and analysis provides an overview of the financial condition and results of operations of Highlands Bancorp, Inc. (the “Company”) and its consolidated subsidiary, Highlands State Bank (the “Bank”), as of September 30, 2011 and for the three and nine month periods ended September 30, 2011 and 2010. This discussion should be read in conjunction with the preceding financial statements and related footnotes, as well as with the audited financial statements and the accompanying notes for the year ended December 31, 2010, included in the Company’s Annual Report on Form 10-K filed with the SEC. Current performance does not guarantee and may not be indicative of similar performance in the future.

Critical Accounting Policies

Disclosure of the Company’s significant accounting policies is included in Note 1 to the financial statements included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2010. Some of these policies are particularly sensitive, requiring significant judgments, estimates and assumptions to be made by management, most particularly in connection with determining the provision for loan losses and the appropriate level of the allowance for loan losses, the determination of other-than-temporary impairment on securities, and the valuation of deferred tax assets.

Forward-looking Statements

This Quarterly Report on Form 10-Q, including this discussion and analysis, contains forward-looking statements within the meaning of the Securities Exchange Act of 1934, as amended, including statements of goals, intentions, and expectations as to future trends, plans, events or results of the Company’s operations and policies and regarding general economic conditions. These statements are based upon current and anticipated economic conditions, nationally and in the Company’s market, interest rates and interest rate policy, competitive factors and other conditions that, by their nature, are not susceptible to accurate forecast, and are subject to significant uncertainty.

Such forward-looking statements can be identified by the use of forward-looking terminology such as “believes”, “expects”, “may”, “intends”, “will”, “should”, “anticipates”, or the negative of any of the foregoing or other variations thereon or comparable terminology, or by discussion of strategy.

No assurance can be given that the future results covered by forward-looking statements will be achieved. Such statements are subject to risks, uncertainties, and other factors that could cause actual results to differ materially from future results expressed or implied by such forward-looking statements. Important factors that could impact the Company’s operating results include, but are not limited to, those disclosed under the heading Risk Factors in the Company’s Annual Report on Form 10-K previously filed with the SEC and, in addition, (i) the effects of changing economic conditions in the Company's market areas and nationally, (ii) credit risks of commercial, real estate, consumer and other lending activities, (iii) significant changes in interest rates, (iv) changes in federal and state banking laws and regulations which could impact the Company’s operations, and (v) other external developments which could materially affect the Company’s business and operations.

OVERVIEW

Highlands Bancorp, Inc. is a New Jersey business corporation and bank holding company registered under the Bank Holding Company Act of 1956. Highlands Bancorp Inc. was incorporated on February 2, 2010 for the purpose of acquiring Highlands State Bank (referred to in this report as the Bank), thereby enabling the Bank to operate within a holding company structure. On August 31, 2010, Highlands Bancorp, Inc. acquired 100% of the outstanding shares of the Bank.

The principal activities of Highlands Bancorp, Inc. are owning and supervising the Bank. The Bank is a community-oriented, full-service commercial bank providing commercial and consumer financial services to businesses and individuals in Sussex and Passaic Counties in New Jersey and surrounding areas. The Bank is a New Jersey state chartered commercial bank that commenced operations on October 31, 2005. The Bank’s principal office is located in Vernon, New Jersey and it operates two additional branches, one each in Sparta, New Jersey and Totowa, New Jersey.

The Company’s assets declined $2.7 million from $164.2 million at December 31, 2010 to $161.6 million at September 30, 2011 due to net maturities of time deposits in other banks of $11.3 million, and calls, maturities and sales of investment securities. These funds were used during the period to fund loan portfolio growth and to pay down FHLB borrowings. As a result, we experienced a decline in the investment portfolio of $982 thousand. Net loans increased $9.9 million to $130.9 million at September 30, 2011, reflecting growth in commercial real estate and construction loans, partially offset by home equity, residential and commercial loan paydowns and payoffs. Total deposits increased $1.3 million from $136.4 million at December 31, 2010 to $137.7 million at September 30, 2011. Increases in time deposits, money market account, and interest-bearing demand balances of $10.0 million, $515 thousand, and $463 thousand, respectively were partially offset by declines in savings and checking balances of $8.7 million and $1.0 thousand, respectively. Borrowings decreased $6.0 million from $11.0 million at December 31, 2010 to $5.0 million at September 30, 2011 as excess liquidity was also used to pay down FHLB borrowings.

The Company had net income of $275 thousand for the third quarter of 2011 compared to net income $130 thousand for the third quarter of 2010. Net income available to common stockholders, reflecting the impact of dividends paid on the Company’s preferred stock issued to the Treasury, for the three months ended September 30, 2011 was $120 thousand compared to net income available to common stockholders for the three months ended September 30, 2010 of $51 thousand. Net income for the nine months ended September 30, 2011 was $736 thousand compared to $332 thousand in the prior year, and net income available to common stockholders for the first nine months of 2011 was $422 thousand compared to $94 thousand for the prior year period. Net income available to common stockholders and the related net income per diluted common share for the third quarter of 2011 and year-to-date 2011 includes a charge to retained earnings of $83,000 for the remaining unaccreted discount on preferred stock issued to the United States Treasury (“Treasury”) in 2009 under the Treasury’s Capital Purchase Program (“CPP”). The one-time write-off was the result of the Company redeeming the Treasury’s CPP preferred in order to participate in the Treasury’s Small Business Lending Fund (“SBLF”). As a result of the Company’s participation in the SBLF and its redemption of the CPP preferred stock, the Company expects to pay preferred stock dividends at a lower rate in future periods.

The cost of interest-bearing liabilities for the third quarter of 2011 decreased 14 basis points to 1.01% compared to 1.15% for the third quarter of 2010, reflecting a general decline in rates paid on deposits. The largest declines were evident in the yields paid on time deposits, savings, and money market account balances as a result of management’s on-going monitoring and response to the continued low interest rate environment. Yields earned on interest-earning assets increased for the third quarter of 2011 to 4.78%, from 4.40% for the same period of 2010. Loan portfolio yields increased 2 basis points to 5.55% for 2011, when compared to 5.53% for the third quarter of 2010. When compared to the third quarter of 2010, yields on investment securities for the third quarter of 2011 declined 130 basis points from 3.15% to 1.85% due to calls, maturities and sales of higher yielding securities, and the yield on short-term investments decreased 50 basis points from 1.23% to 0.73% due to declines in the rates paid on deposits with other banks. As a result, the net interest rate spread increased 51 basis points for the three months ended September 30, 2011 to 3.76%. The net interest margin also improved 50 basis points to 4.01% for the third quarter of 2011 from 3.51% for the third quarter period of 2010. For the nine months ended September 30, 2011, the yield on earning assets increased 12 basis points to 4.70% when compared to 4.58% for the nine months ended September 30, 2010, while the cost of funds declined 28 basis points for the first nine months of 2011 when compared to the same period in 2010. This resulted in a 41 basis point improvement in the net interest spread to 3.70%. The net interest margin improved to 3.94% for the nine months ended September 30, 2001, from 3.56% for the comparable period of 2010.

Comparison of Results of Operation for the Three Months Ended September 30, 2011 and 2010

Net Interest Income

Total interest income for the three months ended September 30, 2011 increased $98 thousand as compared to the three months ended September 30, 2010 as increased loan interest income from growth in the loan portfolio was partially offset by decreases in interest income from other asset classes as a result of calls, maturities, and sales of investment securities and lower time deposit balances in other banks. Average earning assets were $160.6 million for the three months ended September 30, 2011 compared to $165.3 million for the three months ended September 30, 2010. The average balance of loans receivable increased to $131.8 million during the current quarter from $114.7 million in the year ago period. The yield on average earning assets was 4.78% for the third quarter of 2011 compared to 4.40% for the third quarter of 2010, reflecting the increase in higher yielding loans. The yield on the loan portfolio increased 2 basis points to 5.55% in the current quarter from 5.53% in the year ago period. Yields on other interest earning assets reflected declines, with the largest decrease in the investment securities portfolio, on which the yield declined to 1.85% in the three months ended September 30, 2011 from 3.15% in the prior year period, due to sales, calls and maturities of higher yielding securities, and continued low interest rate reinvestment opportunities.

Total interest expense for the three months ended September 30, 2011 decreased $33 thousand to $306 thousand as compared with $369 thousand for the three months ended September 30, 2010 as a result of savings balance declines and reductions to rates paid on interest-bearing deposit account balances across the portfolio. Average interest bearing liabilities were $121.0 million for the three months ended September 30, 2011 compared to $128.6 million for the three months ended September 30, 2010, and reflected increases in time deposits, money market and interest-bearing checking accounts, offset by decreases in savings account balances and borrowed funds. The yield on average interest bearing liabilities was 1.01% for the third quarter of 2011 compared to 1.15% for the third quarter of 2010. This decrease was the result of market conditions, deposit mix, competition, and management’s resulting adjustments to the interest rates provided to depositors.

Net interest income for the three months ended September 30, 2011 was $1.6 million compared to net interest income of $1.5 million for the three months ended September 30, 2010. The improvement in net interest income for 2011 is a result of growth in the loan portfolio and the reduced cost of funds associated with interest-bearing deposit balance declines and reductions in interest rates paid on deposits. The Company’s net interest margin for the three months ended September 30, 2011 increased 50 basis points to 4.01% from 3.51% for the three months ended September 30, 2010.

The table below sets forth average balances and corresponding yields for the three month periods ended September 30, 2011 and September 30, 2010:

	2011							2010
	Average		Income/		Yield/			Average		Income/		Yield/
(Dollars in thousands)	Balance		Expense		Rate			Balance		Expense		Rate

Interest-earning assets:
Loans receivable	$	131,808	$	1,828		5.55	%	$	114,732	$	1,587		5.53	%
Securities available for sale		15,388		71		1.85	%		17,520		138		3.15	%
Federal funds sold		4,060		1		0.10	%		3,205		2		0.25	%
Deposits with other banks		9,325		17		0.73	%		29,814		92		1.23	%
Total interest-earning assets		160,581		1,917		4.78	%		165,271		1,819		4.40	%

Non-interest earning assets		4,827							4,395

TOTAL ASSETS	$	165,408						$	169,666


Interest-bearing liabilities:
Demand, interest-bearing	$	7,359	$	8		0.43	%	$	6,865	$	12		0.70	%
Money market and savings		71,867		125		0.70	%		85,512		172		0.80	%
Time deposits		36,777		139		1.51	%		29,623		150		2.03	%
Borrowed funds		5,041		34		2.70	%		6,564		35		2.13	%
Total interest-bearing liabilities		121,044		306		1.01	%		128,564		369		1.15	%

Non-interest bearing liabilities:
Demand, non-interest bearing deposits		26,936							24,383
Other liabilities		501							428

Stockholders' equity		16,927							16,291

TOTAL LIABILITIES AND
STOCKHOLDERS' EQUITY	$	165,408						$	169,666

Net interest income/rate spread			$	1,611		3.76	%			$	1,450		3.25	%

Net interest margin						4.01	%						3.51	%

Provision for Loan Losses

For the three months ended September 30, 2011, we recognized a provision for loan losses of $235 thousand, compared to $121 thousand for the three months ended September 30, 2010. The higher provision was due to increases in both the total loan portfolio and in the level of non-performing assets, and reflects management’s view of the risks inherent in the portfolio in the current economic environment. At September 30, 2011, the allowance for loan losses of $2.0 million represented 1.54% of total outstanding loans, compared to 1.38% of total outstanding loans at December 31, 2010. Based principally on economic conditions, asset quality, and loan-loss experience, including that of comparable institutions in the Company’s market area, the allowance is believed to be adequate. The Company has not participated in any sub-prime lending activity. There were no charged off loans or recoveries during the third quarter of 2011, while the third quarter of 2010 reflected $168 thousand in charged off loans and no recoveries.

Non-interest Income

Total non-interest income was $125 thousand for the three month period ended September 30, 2011 compared to $107 thousand for the same period in 2010. The increase for 2011 when compared to the same period of last year is primarily due to higher debit card interchange and other loan fees for a combined total of $6 thousand, and from rental income collected on a foreclosed property during the third quarter of 2010.

Non-interest Expense

Non-interest expenses decreased $80 thousand or 6.1% from $1.3 million for the three months ended September 30, 2010 to $1.2 million for the three month period ended September 30, 2011 due to a decrease in professional fees of $171 thousand. The decrease is primarily due to the receipt of an insurance claim reimbursement of $133 thousand relating to legal fees incurred for a loan-related litigation expense incurred in prior periods. There were increased salary and benefits charges of $46 thousand due to increases in staff and medical costs, higher rent expense of $30 thousand as a result of the Totowa branch relocation and contracted annual rent increases for the bank’s other two locations, and increased audit costs of $17 thousand, higher data processing charges of $8 thousand, increased foreclosed asset costs of $12 thousand, higher shareholder expense of $7 thousand, and increased loan-related expenses of $7 thousand.

Income Taxes

Income tax expense on pre-tax income of $275 thousand and $130 thousand for the three months ended September 30, 2011 and 2010, respectively, was offset by the utilization of net operating loss carryforwards and the resultant reversal of the valuation allowance on deferred tax assets of approximately $110 thousand and $52 thousand, respectively. The remaining deferred tax benefit related to net operating loss carryforwards has not been recognized due to uncertainty of realization. The Company has net operating loss carryforwards available for federal and state income tax purposes of approximately $7.0 million and $4.0 million, respectively at September 30, 2011 which start to expire in 2025 for federal purposes and 2012 for state purposes.

Comparison of Results of Operation for the Nine Months Ended September 30, 2011 and 2010

Net Interest Income

Total interest income for the nine months ended September 30, 2011 remained stable at $5.6 million as compared to the prior year period. Interest income was impacted by lower balances in investment securities and time deposits with other banks due to calls, maturities and sales, offset by higher interest income from loan portfolio growth. Average earning assets were $160.0 million for the nine months ended September 30, 2011 compared to $162.6 million for the nine months ended September 30, 2010. The yield on average earning assets for the first nine months of 2011 was 4.70% compared to 4.58% for the same period of last year.

Total interest expense for the nine months ended September 30, 2011 decreased $322 thousand to $917 thousand as compared with $1.2 million for the nine months ended September 30, 2010, primarily due to lower savings account balances and borrowings, and from reductions made to rates paid on deposits. Average interest bearing liabilities were $122.1 million for the nine months ended September 30, 2011 compared to $128.3 million for the nine months ended September 30, 2010. The yield on average interest bearing liabilities was 1.00% for the first three quarters of 2011 compared to 1.29% for the first three quarters of 2010. This decrease was the result of market conditions, deposit mix, competition, and management’s resulting adjustments to the interest rates paid to depositors.

Net interest income for the nine months ended September 30, 2011 was $4.7 million compared to net interest income of $4.3 million for the nine months ended September 30, 2010. The improvement in net interest income for the first three quarters of 2011 is a result of a lower cost of funds and loan growth. Our net interest margin for the nine months ended September 30, 2011 increased 38 basis points to 3.94% from 3.56% for the nine months ended September 30, 2010, due to the continued low interest rate environment.

The following table sets forth average balances and corresponding yields for the nine month periods ended September 30, 2011 and September 30, 2010:


Average Balances, Interest Income and Interest Expense, and Rates
	2011							2010
	Average		Income/		Yield/			Average		Income/		Yield/
(Dollars in thousands)	Balance		Expense		Rate			Balance		Expense		Rate

Interest-earning assets:
Loans receivable	$	127,717	$	5,304		5.54	%	$	115,864	$	4,784		5.51	%
Securities available for sale		15,679		243		2.07	%		18,679		497		3.55	%
Federal funds sold		2,813		2		0.09	%		2,307		4		0.23	%
Deposits with other banks		13,750		93		0.90	%		25,724		300		1.55	%
Total interest-earning assets		159,959		5,642		4.70	%		162,574		5,585		4.58	%

Non-interest earning assets		4,799							4,437

TOTAL ASSETS	$	164,758						$	167,011

HIGHLANDS BANCORP, INC. 10-Q