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EX-32 - SMARTFINANCIAL INC.v222467_ex32.htm
EX-31 - SMARTFINANCIAL INC.v222467_ex31.htm

United States Securities and Exchange Commission
Washington, D.C. 20549

FORM 10-Q

(Mark One)

x
QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended March 31, 2011

¨
TRANSITION REPORT PURSUANT SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the transition period from __________to ___________.

Commission File Number: 000-30497

(Exact name of small business issuer as specified in its charter)

Tennessee
 
62-1173944
(State or other jurisdiction of incorporation or organization)
 
(I.R.S. Employer Identification No.)
     
835 Georgia Avenue Chattanooga, Tennessee
 
37402
(Address of principal executive offices)
 
(Zip Code)
     
423-385-3000
 
Not Applicable
(Registrant’s telephone number, including area code)
 
(Former name, former address and former fiscal
   
year, if changes 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  ¨

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 during the preceding 12 months (or for such period that the registrant was required to submit and post such files).
Yes  ¨    No  ¨

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.  (Check one):
Large accelerated filer  ¨     Accelerated filer  ¨       Non-accelerated filer  ¨    Smaller reporting company  x

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

As of May 5, 2011 there were 6,500,396 shares of common stock, $1.00 par value per share, issued and outstanding.

 
 

 

TABLE OF CONTENTS

PART I –FINANCIAL INFORMATION
   
Item 1.  Financial Statements (Unaudited)
4
   
Item 2.  Management’s Discussion and Analysis of Financial Condition and Results of Operations
24
   
Item 3.  Quantitative and Qualitative Disclosures about Market Risk
31
   
Item 4T.Controls and Procedures
31
   
PART II – OTHER INFORMATION
   
Item 1. Legal Proceedings
32
   
Item 1A. Risk Factors
32
   
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
32
   
Item 3. Defaults Upon Senior Securities
32
   
Item 4. [Removed and Reserved]
32
   
Item 5. Other Information
32
   
Item 6. Exhibits
32

 
2

 

FORWARD-LOOKING STATEMENTS

Cornerstone Bancshares, Inc. (“Cornerstone”) may from time to time make written or oral statements, including statements contained in this report (including, without limitation, certain statements in “Management Discussion and Analysis of Financial Condition and Results of Operations” in Item 2), that constitute forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934 (the “Exchange Act”). The words “expect,” “anticipate,” “intend,” “consider,” “plan,” “believe,” “seek,” “should,” “estimate,” and similar expressions are intended to identify such forward-looking statements, but other statements may constitute forward-looking statements. These statements should be considered subject to various risks and uncertainties. Such forward-looking statements are made based upon management’s belief as well as assumptions made by, and information currently available to, management pursuant to “safe harbor” provisions of the Private Securities Litigation Reform Act of 1995. Cornerstone’s actual results may differ materially from the results anticipated in forward-looking statements due to a variety of factors. Such factors include, without limitation, those specifically described in Item 1A of Part I of Cornerstone’s Annual Report on Form 10-K for the year ended December 31, 2010, as well as the following:  (i) the ability of Cornerstone Community Bank (the “Bank”) to comply with the requirements of the consent order issued by the Federal Deposit Insurance Corporation on April 2, 2010 or the written agreement entered with the Tennessee Department of Financial Institutions on April 8, 2010 (collectively, the “Action Plans”); (ii) the ability of Cornerstone to raise additional capital necessary to retire certain holding company loans and enable the Bank to achieve and maintain the elevated capital levels required under the Action Plans; (iii) unanticipated deterioration in the financial condition of borrowers resulting in significant increases in loan losses and provisions for those losses; (iv) increased competition with other financial institutions; (v) changes in economic conditions in Cornerstone’s market area; (vi) rapid fluctuations or unanticipated changes in interest rates; (vii) the effect on Cornerstone and the financial institutions and banking industry from difficult market conditions, unprecedented volatility and the soundness of other financial institutions; (viii) the -ability of Cornerstone to restructure its loan portfolio to regulatory acceptable levels and composition; (ix) the effect of recent legislative regulatory initiatives; and (x) changes in the legislative and regulatory environment. Many of such factors are beyond Cornerstone’s ability to control or predict, and readers are cautioned not to put undue reliance on such forward-looking statements. Cornerstone does not intend to update or reissue any forward-looking statements contained in this report as a result of new information or other circumstances that may become known to Cornerstone.

 
3

 

Cornerstone Bancshares, Inc. and Subsidiary
Consolidated Balance Sheets

   
Unaudited
       
   
March 31,
   
December 31,
 
   
2011
   
2010
 
ASSETS
           
             
Cash and due from banks
  $ 1,508,964     $ 1,490,030  
Interest-bearing deposits at other financial institutions
    39,921,667       21,491,922  
Total cash and cash equivalents
    41,430,631       22,981,952  
                 
Securities available for sale
    100,788,157       108,250,434  
Securities held to maturity (fair value approximates of $94,528 and $98,388 at March 31, 2011 and December 31, 2010, respectively)
    92,064       95,702  
Federal Home Loan Bank stock, at cost
    2,322,900       2,322,900  
Loans, net of allowance for loan losses of $7,913,933 at March 31, 2011 and $9,132,171 at December 31, 2010
    265,835,680       276,114,617  
Bank premises and equipment, net
    5,961,127       8,047,370  
Accrued interest receivable
    1,430,772       1,326,480  
Foreclosed assets
    20,463,835       12,808,838  
Other assets
    9,214,836       9,551,121  
Total Assets
  $ 447,540,002     $ 441,499,414  
                 
LIABILITIES AND STOCKHOLDERS' EQUITY
               
                 
Deposits:
               
Noninterest-bearing demand deposits
  $ 33,529,178     $ 28,980,043  
Interest-bearing demand deposits
    27,945,913       24,834,214  
Savings deposits and money market accounts
    34,775,755       34,041,672  
Time deposits
    241,235,748       247,591,161  
Total deposits
    337,486,594       335,447,090  
Federal funds purchased and securities sold under agreements to repurchase
    27,789,544       24,325,372  
Federal Home Loan Bank advances and other borrowings
    53,480,000       54,715,000  
Accrued interest payable
    211,452       176,761  
Other liabilities
    1,282,836       1,016,038  
Total Liabilities
    420,250,426       415,680,261  
                 
Stockholders' Equity:
               
Preferred stock - no par value; 2,000,000 shares authorized; 148,920 shares issued and outstanding in 2011 and 114,540 shares issued and outstanding in 2010
    3,579,085       2,727,424  
Common stock - $l.00 par value; 20,000,000 shares authorized; 6,709,199 issued in 2011 and 2010; 6,500,396 outstanding in 2011 and 2010
    6,500,396       6,500,396  
Additional paid-in capital
    21,257,083       21,237,298  
Retained (deficit)
    (4,064,855 )     (4,317,130 )
Accumulated other comprehensive income
    17,867       (328,835 )
Total Stockholders' Equity
    27,289,576       25,819,153  
Total Liabilities and Stockholders' Equity
  $ 447,540,002     $ 441,499,414  

The Notes to Consolidated Financial Statements are an intergral part of these statements.

 
4

 

Cornerstone Bancshares, Inc. and Subsidiary
Consolidated Statements of Operations

   
Unaudited
 
   
Three months ended
 
   
March 31,
 
   
2011
   
2010
 
INTEREST INCOME
           
Loans, including fees
  $ 4,638,805     $ 5,948,246  
Investment securities
    568,672       1,129,279  
Federal funds sold & other earning assets
    11,003       23,661  
Total interest income
    5,218,480       7,101,186  
                 
INTEREST EXPENSE
               
Time deposits
    1,052,449       1,684,027  
Other deposits
    92,612       97,723  
Federal funds purchased and securities sold under agreements to repurchase
    31,003       35,415  
FHLB advances and other borrowings
    579,658       779,197  
Total interest expense
    1,755,722       2,596,362  
                 
Net interest income before provision for loan losses
    3,462,758       4,504,824  
Provision for loan losses
    15,000       1,015,000  
Net interest income after the provision for loan losses
    3,447,758       3,489,824  
                 
NONINTEREST INCOME
               
Customer service fee
    215,451       341,914  
Other noninterest income
    20,279       20,611  
Net gains from sale of loans and other assets
    34,027       41,137  
Total noninterest income
    269,757       403,662  
                 
NONINTEREST EXPENSE
               
Salaries and employee benefits
    1,542,702       1,633,344  
Net occupancy and equipment expense
    406,334       355,183  
Depository insurance
    322,655       269,740  
Foreclosed assets, net
    361,570       196,173  
Other operating expense
    783,354       945,558  
Total noninterest expense
    3,416,615       3,399,998  
                 
Income before provision for income taxes
    300,900       493,488  
Provision for income taxes
    48,625       149,701  
                 
Net income
    252,275       343,787  
                 
Preferred stock dividend requirements
    71,588       -  
                 
Net income available to common shareholders
  $ 180,687     $ 343,787  
                 
EARNINGS PER COMMON SHARE
               
Basic net income per common share
  $ 0.03     $ 0.05  
Diluted net income per common share
  $ 0.03     $ 0.05  
                 
DIVIDENDS DECLARED PER COMMON SHARE
  $ -     $ -  

The Notes to Consolidated Financial Statements are an intergral part of these statements.

 
5

 

Cornerstone Bancshares, Inc. and Subsidiary
Consolidated Statement of Changes in Stockholders' Equity - Unaudited
For the three months ended March 31, 2011

                     
Additional
   
 
   
Other
   
Total
 
   
Comprehensive
   
Preferred
   
Common
   
Paid-in
   
Retained
   
Comprehensive
   
Stockholders'
 
   
Income
   
Stock
   
Stock
   
Capital
   
(Deficit)
   
Income
   
Equity
 
                                           
BALANCE, December 31, 2010
        $ 2,727,424     $ 6,500,396     $ 21,237,298     $ (4,317,130 )   $ (328,835 )   $ 25,819,153  
                                                       
Employee compensation stock option expense
          -       -       19,785       -       -       19,785  
                                                       
Issuance of Series A Convertible Preferred Stock
          851,661       -       -       -       -       851,661  
                                                       
Comprehensive income:
                                                     
Net income
  $ 252,275       -       -       -       252,275       -       252,275  
                                                         
Other comprehensive income, net of tax:
                                                       
Unrealized holding gains on securities available for sale, net of reclassification adjusment
    346,702       -       -       -       -       346,702       346,702  
                                                         
Total comprehensive income
  $ 598,977                                                  
                                                         
BALANCE, March 31, 2011
          $ 3,579,085     $ 6,500,396     $ 21,257,083     $ (4,064,855 )   $ 17,867     $ 27,289,576  

The Notes to Consolidated Financial Statements are an intergral part of these statements.

 
6

 

Cornerstone Bancshares, Inc. and Subsidiary
Consolidated Statements of Cash Flows

   
Unaudited
 
   
Three months ended March 31,
 
   
2011
   
2010
 
             
CASH FLOWS FROM OPERATING ACTIVITIES
           
Net income
  $ 252,275     $ 343,787  
Adjustments to reconcile net income to net cash provided by operating activities:
               
Depreciation and amortization
    62,414       127,676  
Provision for loan losses
    15,000       1,015,000  
Stock compensation expense
    19,785       18,653  
Net gains on sales of loans and other assets
    (34,027 )     (41,137 )
Changes in other operating assets and liabilities:
               
Net change in loans held for sale
    (654,500 )     359,000  
Accrued interest receivable
    (104,292 )     (460,424 )
Accrued interest payable
    34,691       36,627  
Other assets and liabilities
    458,737       765,491  
Net cash provided by operating activities
    50,083       2,164,673  
                 
                 
CASH FLOWS FROM INVESTING ACTIVITIES
               
Proceeds from security transactions:
               
Securities available for sale
    8,014,091       14,324,849  
Securities held to maturity
    3,581       5,590  
Purchase of securities available for sale
    -       (39,859,220 )
Purchase of Federal Home Loan Bank stock
    -       (93,700 )
Loan originations and principal collections, net
    5,159,587       9,785,667  
Purchase of bank premises and equipment
    (6,392 )     (24,612 )
Proceeds from sale of bank premises and equipment
    45,082       46,107  
Proceeds from sale of other real estate and other assets
    62,310       2,476,687  
Net cash provided by (used in) investing activities
    13,278,259       (13,338,632 )
                 
                 
CASH FLOWS FROM FINANCING ACTIVITIES
               
Net increase in deposits
    2,039,504       24,455,672  
Net increase in federal funds purchased and securities sold under agreements to repurchase
    3,464,172       3,664,399  
Net payments on Federal Home Loan Bank advances and other borrowings
    (1,235,000 )     (50,000 )
Issuance of preferred stock
    851,661       -  
Net cash provided by financing activities
    5,120,337       28,070,071  
                 
NET INCREASE IN CASH AND CASH EQUIVALENTS
    18,448,679       16,896,112  
                 
CASH AND CASH EQUIVALENTS,  beginning of period
    22,981,952       38,202,205  
                 
CASH AND CASH EQUIVALENTS, end of period
  $ 41,430,631     $ 55,068,317  
                 
                 
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION
               
Cash paid during the period for interest
  $ 1,721,031     $ 2,559,735  
Cash paid during the period for taxes
    -       -  
                 
NONCASH INVESTING AND FINANCING ACTIVITIES
               
Acquisition of real estate through foreclosure
  $ 7,774,928     $ 460,000  

The Notes to Consolidated Financial Statements are an integral part of these statements.

 
7

 

CORNERSTONE BANCSHARES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

Note 1. Presentation of Financial Information

Nature of Business-Cornerstone is a bank holding company whose primary business is performed by its wholly-owned subsidiary, Cornerstone Community Bank (the “Bank”).  The Bank provides a full range of banking services to the Chattanooga, Tennessee market.  The Bank has also established a loan production office (“LPO”) in Dalton, Georgia to further enhance the Bank’s lending markets.  The Bank specializes in asset based lending, commercial lending and payment processing.  The Bank has a wholly-owned subsidiary, Eagle Financial, Inc. (“Eagle”), which specializes in finance and accounts receivable factoring.

Interim Financial Information (Unaudited)-The financial information in this report for March 31, 2011 and March 31, 2010 has not been audited. The information included herein should be read in conjunction with the annual consolidated financial statements and footnotes thereto included in the 2010 Annual Report to Shareholders which was furnished to each shareholder of Cornerstone in April of 2011. The consolidated financial statements presented herein conform to U.S. generally accepted accounting principles and to general industry practices.  In the opinion of Cornerstone’s management, the accompanying interim financial statements contain all material adjustments, consisting only of normal recurring adjustments, necessary to present fairly the financial condition, the results of operations, and cash flows for the interim period. Results for interim periods are not necessarily indicative of the results to be expected for a full year.

Use of Estimates-The preparation of financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities as of the balance sheet date and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Material estimates that are particularly susceptible to significant change in the near term include the determination of the allowance for loan losses.

Consolidation-The accompanying consolidated financial statements include the accounts of Cornerstone, the Bank  and Eagle.   Substantially all intercompany transactions, profits and balances have been eliminated.

Reclassification-Certain amounts in the prior consolidated financial statements have been reclassified to conform to the current period presentation.  The reclassifications had no effect on net income or stockholders’ equity as previously reported.

Accounting Policies-During interim periods, Cornerstone follows the accounting policies set forth in its Annual Report on Form 10-K for the year ended December 31, 2010 as filed with the Securities and Exchange Commission.  Since December 31, 2010, there have been no significant changes in any accounting principles or practices, or in the method of applying any such principles or practices, except for the following:

In January 2011, the FASB issued Accounting Standards Update 2011-01, Deferral of the Effective Date of Disclosures about Troubled Debt Restructurings in ASU 2010-20.  This update defers the effective date of reporting  troubled debt restructuring (“TDR”) credit quality disclosures until the additional guidance is issued that clarifies what constitutes a TDR.

In April 2011, the FASB issued Accounting Standards Update 2011-02, The Creditor’s Determination of Whether a Restructuring Is a Troubled Debt Restructuring.  This update provides additional guidance in determining what is considered a TDR.  The update clarifies the two additional criteria that are required in determining a TDR.  The update  is effective for interim or annual periods beginning after June 15, 2011.  Cornerstone is currently evaluating the impact of this update to our consolidated financial statements.

 
8

 

CORNERSTONE BANCSHARES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

Earnings per Common Share- Basic earnings per share (“EPS”) is computed by dividing income available to common shareholders (numerator) by the weighted average number of common shares outstanding during the period (denominator). Diluted EPS is computed by dividing income available to common shareholders (numerator) by the adjusted weighted average number of shares outstanding (denominator). The adjusted weighted average number of shares outstanding reflects the potential dilution occurring if securities or other contracts to issue common stock were exercised or converted into common stock resulting in the issuance of common stock that share in the earnings of the entity.

The following is a summary of the basic and diluted earnings per share for the three month periods ended March 31, 2011 and March 31, 2010.

   
Three Months Ended March 31,
 
 
 
2011
   
2010
 
Basic earnings per common share calculation:             
Numerator: Net income available to common shareholders
  $ 180,687     $ 343,787  
Denominator: Weighted avg. common shares outstanding
    6,500,396       6,500,396  
Effect of dilutive stock options
    -       -  
Diluted shares
    6,500,396       6,500,396  
                 
Basic earnings per common share
  $ 0.03     $ 0.05  
Diluted earnings per common share
  $ 0.03     $ 0.05  

Note 2. Stock Based Compensation

Accounting Policies- Cornerstone, as required by FASB, applies the fair value recognition provisions of ASC 718, Compensation –Stock Compensation.  As a result, for the three month period ended March 31, 2011, the compensation cost charged to earnings related to the vested incentive stock options was approximately $20,000, which had no material impact on earnings per share.

Officer and Employee Plans-Cornerstone has two stock option plans under which officers and employees can be granted incentive stock options or non-qualified stock options to purchase a total of up to 1,420,000 shares of Cornerstone’s common stock.  The exercise price for incentive stock options must be not less than 100 percent of the fair market value of the common stock on the date of the grant.  The exercise price of the non-qualified stock options may be equal to or more or less than the fair market value of the common stock on the date of the grant.  The incentive stock options vest 30% on the second anniversary of the grant date, 60% on the third anniversary of the grant date and 100% on the fourth anniversary of the grant date, and the non-qualified stock options vest 50% on the first anniversary of the grant date and 100% on the second anniversary of the grant date.  The options expire ten years from the grant date.  At March 31, 2011, the total remaining compensation cost to be recognized on non-vested options is approximately $362,000.  A summary of the status of these stock option plans is presented in the following table:

 
9

 

CORNERSTONE BANCSHARES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

             
Weighted-
     
             
Average
     
         
Weighted
 
Contractual
     
         
Average
 
Remaining
 
Aggregate
 
         
Exercisable
 
Term
 
Intrinsic
 
   
Number
   
Price
 
(in years)
 
Value
 
Outstanding at December 31, 2010
    520,900     $ 5.79  
4.0 Years
  $ -  
Granted
    208,000       1.70  
9.9 Years
    -  
Exercised
    -       -            
Forfeited
    149,300       4.59            
Outstanding at March 31, 2011
    579,600     $ 4.63  
6.5 Years
  $ -  
Options exercisable at March 31, 2011
    296,915     $ 6.66         -  

The weighted average grant date fair value of stock options granted during the three months ended March 31, 2011 was $0.83 per share.  This was determined using the Black-Scholes option pricing model with the following weighted-average assumptions:

Dividend yield
    0.0 %
Expected life
 
7.0 Years
 
Expected volatility
    43.11 %
Risk-free interest rate
    2.81 %

Board of Directors Plan-Cornerstone has a stock option plan under which members of the Board of Directors, at the formation of the Bank, were granted options to purchase a total of up to 600,000 shares of the Bank's common stock.  On October 15, 1997, the Bank stock options were converted to Cornerstone stock options.  Only non-qualified stock options may be granted under the plan.  The exercise price of each option equals the market price of Cornerstone’s stock on the date of grant and the maximum term is ten years.  Vesting is 50% on the first anniversary of the grant date and 100% on the second anniversary of the grant date.  At March 31, 2011, there was no remaining compensation cost to be recognized on non-vested options.  A summary of the status of this stock option plan is presented in the following table:

             
Weighted-
     
             
Average
     
         
Weighted
 
Contractual
     
         
Average
 
Remaining
 
Aggregate
 
         
Exercisable
 
Term
 
Intrinsic
 
   
Number
   
Price
 
(in years)
 
Value
 
Outstanding at December 31, 2010
    100,250     $ 9.42  
5.7 Years
  $ -  
Granted
    -       -            
Exercised
    -       -            
Forfeited
    -       -            
Outstanding at March 31, 2011
    100,250     $ 9.42  
5.4 Years
  $ -  
Options exercisable at March 31, 2011
    100,250     $ 9.42            

 
10

 

CORNERSTONE BANCSHARES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

Note 3. Securities

The amortized cost and fair value of securities available-for-sale and held-to-maturity at March 31, 2011 and December 31, 2010 are summarized as follows:

   
March 31, 2011
 
         
Gross
   
Gross
       
   
Amortized
   
Unrealized
   
Unrealized
   
Fair
 
 
 
Cost
   
Gains
   
Losses
   
Value
 
Debt securities available-for-sale:                         
U.S. Government agencies
  $ 4,331,601     $ 15,263     $ -     $ 4,346,864  
                                 
State and municipal securities
    20,857,684       231,403       (211,651 )     20,877,436  
                                 
Mortgage-backed securities:
                               
Residential mortgage guaranteed by GNMA
    17,566,405       186,760       -       17,753,165  
                                 
Collateralized mortgage obligations issued or guaranteed by U.S. Government agencies or sponsored agencies
    57,985,415       86,279       (261,002 )     57,810,692  
                                 
    $ 100,741,105     $ 519,705     $ (472,653 )   $ 100,788,157  
                                 
Debt securities held to maturity:
                               
Mortgage-backed securities:
                               
Residential mortgage guaranteed by GNMA
  $ 92,064     $ 2,464     $ -     $ 94,528  

 
11

 

CORNERSTONE BANCSHARES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

   
December 31, 2010
 
         
Gross
   
Gross
       
   
Amortized
   
Unrealized
   
Unrealized
   
Fair
 
 
 
Cost
   
Gains
   
Losses
   
Value
 
Debt securities available-for-sale:                         
U.S. Government agencies
  $ 4,571,444     $ 15,635     $ -     $ 4,587,079  
                                 
State and municipal securities
    20,868,771       191,429       (323,988 )     20,736,212  
                                 
Mortgage-backed securities:
                               
Residential mortgage guaranteed by GNMA
    18,747,272       130,609       (24,856 )     18,853,025  
                                 
Collateralized mortgage obligations issued or guaranteed by U.S. Government agencies or sponsored agencies
    64,575,092       135,479       (636,453 )     64,074,118  
                                 
    $ 108,762,579     $ 473,152     $ (985,297 )   $ 108,250,434  
                                 
Debt securities held to maturity:
                               
Mortgage-backed securities:
                               
Residential mortgage guaranteed by GNMA
  $ 95,702     $ 2,686     $ -     $ 98,388  

At March 31, 2011, securities with a fair value totaling approximately $98 million were pledged to secure public funds, securities sold under agreements to repurchase, the Federal Home Loan Bank (sometimes referred to herein as “FHLB”) as collateral for the Bank’s borrowings, as collateral for federal funds purchased from other financial institutions and serve as collateral for borrowings at the Federal Reserve Discount Window.

The amortized cost and estimated market value of securities at March 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.

   
Securities Available-for-Sale
   
Securities Held to Maturity
 
   
Amortized
   
Fair
   
Amortized
   
Fair
 
   
Cost
   
Value
   
Cost
   
Value
 
Due in one year or less
  $ -     $ -     $ -     $ -  
Due from one year to five years
    599,502       605,613       -       -  
Due from five years to ten years
    4,778,275       4,905,454       -       -  
Due after ten years
    19,811,508       19,713,233       -       -  
      25,189,285       25,224,300       -       -  
                                 
Mortgage-backed securities
    75,551,820       75,563,857       92,064       94,528  
                                 
    $ 100,741,105     $ 100,788,157     $ 92,064     $ 94,528  

 
12

 

CORNERSTONE BANCSHARES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

The following tables present the gross unrealized losses and fair value, aggregated by investment category and length of time that individual securities available for sale have been in a continuous unrealized loss position, as of March 31, 2011 and as of December 31, 2010:

   
As of March 31, 2011
 
   
Less than 12 Months
   
12 Months or Greater
   
Total
 
         
Gross
         
Gross
         
Gross
 
   
Fair
   
Unrealized
   
Fair
   
Unrealized
   
Fair
   
Unrealized
 
   
Value
   
Losses
   
Value
   
Losses
   
Value
   
Losses
 
Debt securities available for sale:
                                   
State and municipal securities
  $ 5,062,238     $ (135,886 )   $ 4,874,121     $ (75,765 )   $ 9,936,359     $ (211,651 )
                                                 
Mortgage-backed securities:
                                               
Collateralized mortgage obligations issued or guaranteed by U.S. Government agencies or sponsored agencies
    31,103,403       (261,002 )     -       -       31,103,403       (261,002 )
    $ 36,165,641     $ (396,888 )   $ 4,874,121     $ (75,765 )   $ 41,039,762     $ (472,653 )

   
As of December 31, 2010
 
   
Less than 12 Months
   
12 Months or Greater
   
Total
 
         
Gross
         
Gross
         
Gross
 
   
Fair
   
Unrealized
   
Fair
   
Unrealized
   
Fair
   
Unrealized
 
   
Value
   
Losses
   
Value
   
Losses
   
Value
   
Losses
 
Debt securities available for sale:
                                   
State and municipal securities
  $ 6,110,458     $ (154,802 )   $ 6,440,892     $ (169,186 )   $ 12,551,350     $ (323,988 )
                                                 
Mortgage-backed securities:
                                               
Residential mortgage guaranteed by GNMA
    5,647,347       (24,856 )     -       -       5,647,347       (24,856 )
                                                 
Collateralized mortgage obligations issued or guaranteed by U.S. Government agencies or sponsored agencies
    34,694,782       (636,453 )     -       -       34,694,782       (636,453 )
    $ 46,452,587     $ (816,111 )   $ 6,440,892     $ (169,186 )   $ 52,893,479     $ (985,297 )

Upon acquisition of a security, the Bank determines the appropriate impairment model that is applicable.  If the security is a beneficial interest in securitized financial assets, the Bank uses the beneficial interests in securitized financial assets impairment model.  If the security is not a beneficial interest in securitized financial assets, the Bank uses the debt and equity securities impairment model.  The Bank conducts periodic reviews to evaluate each security to determine whether an other-than-temporary impairment has occurred.  The Bank does not have any securities that have been classified as other-than-temporarily-impaired at March 31, 2011 or December 31, 2010.

At March 31, 2011 and December 31, 2010, the significant categories of temporarily impaired securities, and management’s evaluation of those securities are as follows:

 
13

 

CORNERSTONE BANCSHARES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

State and municipal securities:  At March 31, 2011, 21 investments in obligations of state and municipal securities had unrealized losses.  The Bank believes the unrealized losses on those investments were caused by the interest rate environment and does not relate to the underlying credit quality of the issuers.  Because the Bank has the intent and ability to hold those investments for a time necessary to recover their amortized cost bases, which may be maturity, the Bank does not consider those investments to be other-than-temporarily impaired at March 31, 2011.

Mortgage-backed securities:  At March 31, 2011, 8 investments in residential mortgage-backed securities had unrealized losses.  This impairment is believed to be caused by the current interest rate environment.  The contractual cash flows of those investments are guaranteed or issued by an agency of the U.S. Government.  Because the decline in market value is attributable to the current interest rate environment and not credit quality, and because the Bank does not intend to sell the investments and it is not more likely than not that the Bank will be required to sell the investments before recovery of their amortized cost bases, which may be maturity, the Bank does not deem those investments to be other-than-temporarily impaired at March 31, 2011.

Note 4. Loans and Allowance for Loan Losses

At March 31, 2011 and December 31, 2010, loans are summarized as follows (in thousands):

   
March 31,
   
December 31,
 
   
2011
   
2010
 
Commercial real estate-mortgage:
           
Owner-occupied
  $ 64,492     $ 64,971  
All other
    59,303       64,060  
Consumer real estate-mortgage
    70,260       71,878  
Construction and land development
    30,599       29,848  
Commercial and industrial
    45,980       51,160  
Consumer and other
    3,116       3,330  
Total loans
    273,750       285,247  
Less: Allowance for loan losses
    (7,914 )     (9,132 )
                 
Loans, net
  $ 265,836     $ 276,115  

The composition of loans by primary loan classification as well as impaired and performing loan status at March 31, 2011 and December 31, 2010 is summarized in the tables below (dollar amounts in thousands):

March 31, 2011
 
Commercial
   
Consumer
   
Construction
   
Commercial
             
   
Real Estate-
   
Real Estate-
   
and Land
   
and
   
Consumer
       
   
Mortgage
   
Mortgage
   
Development
   
Industrial
   
and Other
   
Total
 
Performing loans
  $ 116,351     $ 57,015     $ 29,786     $ 43,742     $ 3,116     $ 250,010  
Impaired loans
    7,444       13,245       813       2,238       -       23,740  
Total
  $ 123,795     $ 70,260     $ 30,599     $ 45,980     $ 3,116     $ 273,750  
                                                 
December 31, 2010
 
Commercial
   
Consumer
   
Construction
   
Commercial
                 
   
Real Estate-
   
Real Estate-
   
and Land
   
and
   
Consumer
         
   
Mortgage
   
Mortgage
   
Development
   
Industrial
   
and Other
   
Total
 
Performing loans
  $ 119,084     $ 61,455     $ 27,774     $ 50,492     $ 3,279     $ 262,084  
Impaired loans
    9,947       10,423       2,074       668       51       23,163  
Total
  $ 129,031     $ 71,878     $ 29,848     $ 51,160     $ 3,330     $ 285,247  

 
14

 

CORNERSTONE BANCSHARES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

The following tables show the allowance allocation by loan classification for impaired and performing loans as of March 31, 2011 and December 31, 2010 (dollar amounts in thousands):

March 31, 2011
 
Commercial
   
Consumer
   
Construction
   
Commercial
             
   
Real Estate-
   
Real Estate-
   
and Land
   
and
   
Consumer
       
 
 
Mortgage
   
Mortgage
   
Development
   
Industrial
   
and Other
   
Total
 
Allowance related to:                                     
Performing loans
  $ 2,234     $ 1,218     $ 1,153     $ 270     $ 19     $ 4,894  
Impaired loans
    905       1,642       -       473       -       3,020  
Total
  $ 3,139     $ 2,860     $ 1,153     $ 743     $ 19     $ 7,914  
 
December 31, 2010
 
Commercial
   
Consumer
   
Construction
   
Commercial
             
   
Real Estate-
   
Real Estate-
   
and Land
   
and
   
Consumer
       
 
 
Mortgage
   
Mortgage
   
Development
   
Industrial
   
and Other
   
Total
 
Allowance related to:                                    
Performing loans
  $ 887     $ 691     $ 3,178     $ 588     $ 48     $ 5,392  
Impaired loans
    906       2,420       60       337       17       3,740  
Total
  $ 1,793     $ 3,111     $ 3,238     $ 925     $ 65     $ 9,132  
 
The following tables detail the changes in the allowance for loan losses for the three month period ending March 31, 2011 and year ending December 31, 2010 by loan classification (dollars in thousands):

March 31, 2011
 
Commercial
   
Consumer
   
Construction
   
Commercial
             
   
Real Estate-
   
Real Estate-
   
and Land
   
and
   
Consumer
       
   
Mortgage
   
Mortgage
   
Development
   
Industrial
   
and Other
   
Total
 
Beginning balance
  $ 1,793     $ 3,111     $ 3,238     $ 925     $ 65     $ 9,132  
Charged-off loans
    (967 )     (353 )     (12 )     (15 )     (3 )     (1,350 )
Recovery of charge-offs
    53       6       3       48       7       117  
Provision for loan losses
    2,260       96       (2,076 )     (215 )     (50 )     15  
Ending balance
  $ 3,139     $ 2,860     $ 1,153     $ 743     $ 19     $ 7,914  
 
December 31, 2010
 
Commercial
   
Consumer
   
Construction
   
Commercial
             
   
Real Estate-
   
Real Estate-
   
and Land
   
and
   
Consumer
       
   
Mortgage
   
Mortgage
   
Development
   
Industrial
   
and Other
   
Total
 
Beginning balance
  $ 1,189     $ 719     $ 3,179     $ 786     $ 32     $ 5,905  
Charged-off loans
    (2,309 )     (562 )     (1,260 )     (443 )     (114 )     (4,688 )
Recovery of charge-offs
    213       54       19       282       56       624  
Provision for loan losses
    2,700       2,900       1,300       300       91       7,291  
Ending balance
  $ 1,793     $ 3,111     $ 3,238     $ 925     $ 65     $ 9,132  

Credit quality indicators:

Federal regulations require us to review and classify our assets on a regular basis. There are three classifications for problem assets: substandard, doubtful, and loss. “Substandard assets” must have one or more defined weaknesses and are characterized by the distinct possibility that we will sustain some loss if the deficiencies are not corrected. “Doubtful assets” have the weaknesses of substandard assets with the additional characteristic that the weaknesses make collection or liquidation in full on the basis of currently existing facts, conditions and values questionable, and there is a high possibility of loss. An asset classified “loss” is considered uncollectible and of such little value that continuance as an asset of the institution is not warranted. The regulations also provide for a “special mention” category, described as assets which do not currently expose an institution to a sufficient degree of risk to warrant classification but do possess credit deficiencies or potential weaknesses deserving close attention. When we classify an asset as substandard or doubtful, we may establish a specific allowance for loan losses.

 
15

 

CORNERSTONE BANCSHARES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

The following table outlines the amount of each loan classification  and the amount categorized into each risk rating as of March 31, 2011 and December 31, 2010 (amounts in thousands):

March 31, 2011
 
Commercial
   
Consumer
   
Construction
   
Commercial
             
   
Real estate-
   
Real Estate-
   
and Land
   
and
   
Consumer
       
   
Mortgage
   
Mortgage
   
Development
   
Industrial
   
and Other
   
Total
 
Pass
  $ 99,732     $ 49,594     $ 26,710     $ 36,685     $ 3,017     $ 215,738  
Special mention
    15,259       2,886       1,945       6,856       47       26,993  
Substandard
    1,360       4,535       1,131       201       52       7,279  
Substandard-impaired
    7,444       13,245       813       2,238       -       23,740  
    $ 123,795     $ 70,260     $ 30,599     $ 45,980     $ 3,116     $ 273,750  

December 31, 2010
 
Commercial
   
Consumer
   
Construction
   
Commercial
             
   
Real Estate-
   
Real Estate-
   
and Land
   
and
   
Consumer
       
   
Mortgage
   
Mortgage
   
Development
   
Industrial
   
and Other
   
Total
 
Pass
  $ 97,692     $ 49,974     $ 24,401     $ 41,963     $ 3,215     $ 217,245  
Special mention
    19,289       3,786       2,121       7,405       54       32,655  
Substandard
    2,103       7,695       1,252       1,124       10       12,184  
Substandard-impaired
    9,947       10,423       2,074       668       51       23,163  
    $ 129,031     $ 71,878     $ 29,848     $ 51,160     $ 3,330     $ 285,247  

After the Bank’s independent loan review department completes the loan grade assignment, a loan impairment analysis is performed on loans graded substandard or worse. The following tables present summary information pertaining to impaired loans by loan classification as of March 31, 2011 and December 31, 2010 (in thousands):

March 31, 2011
 
Unpaid
         
Average
 
   
Principal
   
Related
   
Recorded
 
   
Balance
   
Allowance
   
Investment
 
Impaired loans with no recorded allowance
                 
Commercial real estate – mortgage
  $ 3,745     $ -     $ 2,682  
Consumer real estate – mortgage
    5,790       -       4,227  
Construction and land development
    813       -       896  
Commercial and industrial
    674       -       817  
Consumer and other
    -       -       -  
Total
  $ 11,022     $ -     $ 8,622  

Impaired loans with a recorded allowance
                 
Commercial real estate – mortgage
  $ 3,699     $ 905     $ 6,014  
Consumer real estate – mortgage
    7,455       1,642       7,608  
Construction and land development
    -       -       547  
Commercial and industrial
    1,564       473       636  
Consumer and other
    -       -       233  
Total
  $ 12,718     $ 3,020     $ 15,038  
                         
Total impaired loans
  $ 23,740     $ 3,020     $ 23,660  

 
16

 

CORNERSTONE BANCSHARES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

December 31, 2010
 
Unpaid
         
Average
 
   
Principal
   
Related
   
Recorded
 
   
Balance
   
Allowance
   
Investment
 
Impaired loans with no recorded allowance
                 
Commercial real estate – mortgage
  $ 1,663     $ -     $ 2,747  
Consumer real estate – mortgage
    998       -       776  
Construction and land development
    1,793       -       1,526  
Commercial and industrial
    70       -       782  
Consumer and other
    2       -       1  
Total
  $ 4,526     $ -     $ 5,832  

Impaired loans with a recorded allowance
                 
Commercial real estate – mortgage
  $ 8,284     $ 906     $ 8,494  
Consumer real estate – mortgage
    9,425       2,420       8,968  
Construction and land development
    281       60       2,674  
Commercial and industrial
    598       337       1,060  
Consumer and other
    49       17       178  
Total
  $ 18,637     $ 3,740     $ 21,374  
                         
Total impaired loans
  $ 23,163     $ 3,740     $ 27,206  

Interest income recognized on impaired loans was approximately $333,000 and $943,000 for the three month ending March 31, 2011 and the year ending December 31, 2010, respectively.  There was no interest income recognized on a cash basis on impaired loans during these periods.

Impaired loans also include loans that the Bank may elect to formally restructure due to the weakening credit status of a borrower such that the restructuring may facilitate a repayment plan that minimizes the potential losses, if any, that the Bank may have to otherwise incur.   These loans are classified as impaired loans.  At March 31, 2011 and December 31, 2010, there were approximately $1.7 million and $948 thousand, respectively, of accruing restructured loans that remain in a performing status.

The following tables present an aged analysis of past due loans as of March 31, 2011 and December 31, 2010 (dollars in thousands):

March 31, 2011
 
30-89 Days
   
Past Due 90
                         
   
Past Due and
   
Days or More
         
Total
   
Current
   
Total
 
   
Accruing
   
and Accruing
   
Nonaccrual
   
Past Due
   
Loans
   
Loans
 
Commercial real estate:
 
 
                               
Owner-occupied
  $ 4,067     $ -     $ -     $ 4,067     $ 60,425     $ 64,492  
All other
    -       -       996       996       58,307       59,303  
Consumer real estate-mortgage
    3,430       -       4,826       8,256       62,004       70,260  
Construction and land development
    679       -       362       1,041       29,558       30,599  
Commercial and industrial
    227       -       49       276       45,704       45,980  
Consumer and other
    35       -       38       73       3,043       3,116  
Total
  $ 8,438     $ -     $ 6,271     $ 14,709     $ 259,041     $ 273,750  

December 31, 2010
 
30-89 Days
   
Past Due 90
                         
   
Past Due and
   
Days or More
         
Total
   
Current
   
Total
 
   
Accruing
   
and Accruing
   
Nonaccrual
   
Past Due
   
Loans
   
Loans
 
Commercial real estate:
 
 
                               
Owner-occupied
  $ 985     $ -     $ 618     $ 1,603     $ 63,368     $ 64,971  
All other
    203       -       7,808       8,011       56,049       64,060  
Consumer real estate-mortgage
    631       -       5,114       5,745       66,133       71,878  
Construction and land development
    317       -       -       317       29,531       29,848  
Commercial and industrial
    116       -       75       191       50,969       51,160  
Consumer and other
    54       -       18       72       3,258       3,330  
Total
  $ 2,306     $ -     $ 13,633     $ 15,939     $ 269,308     $ 285,247  

 
17

 

CORNERSTONE BANCSHARES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

Note 5. Commitments and Contingent Liabilities

Off Balance Sheet Arrangements - In the normal course of business, the Bank has entered into off-balance sheet financial instruments which include commitments to extend credit (i.e., including unfunded lines of credit) and standby letters of credit. Commitments to extend credit are usually the result of lines of credit granted to existing borrowers under agreements that the total outstanding indebtedness will not exceed a specific amount during the term of the indebtedness. Typical borrowers are commercial concerns that use lines of credit to supplement their treasury management functions; thus their total outstanding indebtedness may fluctuate during any time period based on the seasonality of their business and the resultant timing of their cash flows. Other typical lines of credit are related to home equity loans granted to consumers. Commitments to extend credit generally have fixed expiration dates or other termination clauses and may require payment of a fee.

Standby letters of credit are generally issued on behalf of an applicant (our customer) to a specifically named beneficiary and are the result of a particular business arrangement that exists between the applicant and the beneficiary. Standby letters of credit have fixed expiration dates and are usually for terms of two years or less unless terminated beforehand due to criteria specified in the standby letter of credit. A typical arrangement involves the applicant routinely being indebted to the beneficiary for such items as inventory purchases, insurance, utilities, lease guarantees or other third party commercial transactions. The standby letter of credit would permit the beneficiary to obtain payment from the  Bank under certain prescribed circumstances. Subsequently, the Bank would then seek reimbursement from the applicant pursuant to the terms of the standby letter of credit.
     
The Bank follows the same credit policies and underwriting practices when making these commitments as it does for on-balance sheet instruments. Each customer’s creditworthiness is evaluated on a case-by-case basis, and the amount of collateral obtained, if any, is based on management’s credit evaluation of the customer. Collateral held varies but may include cash, real estate and improvements, marketable securities, accounts receivable, inventory, equipment and personal property.

The contractual amounts of these commitments are not reflected in the consolidated financial statements and would only be reflected if drawn upon. Since many of the commitments are expected to expire without being drawn upon, the contractual amounts do not necessarily represent future cash requirements. However, should the commitments be drawn upon and should customers default on their resulting obligation to, the Bank’s maximum exposure to credit loss, without consideration of collateral, is represented by the contractual amount of those instruments.

A summary of the Bank’s total contractual amount for all off-balance sheet commitments at March 31, 2011 is as follows:
 
Commitments to extend credit
  $ 31.6 million  
Standby letters of credit
  $ 3.3 million  

Various legal claims also arise from time to time in the normal course of business. In the opinion of management, the resolution of claims outstanding at March 31, 2011 will not have a material effect on Cornerstone’s consolidated financial statements.

Note 6. Fair Value Disclosures

Fair Value Measurements:

Cornerstone uses fair value measurements to record fair value adjustments to certain assets and liabilities and to determine fair value disclosures.  In accordance with the “Fair Value Measurements and Disclosures” ASC Topic 820, the fair value of a financial instrument is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.  Fair value is best determined based upon quoted market prices.  In cases where quoted market prices are not available, fair values are based on estimates using present value or other valuation techniques.  Those techniques are significantly affected by the assumptions used, including the discount rate and estimates of future cash flows.  Accordingly, the fair value estimates may not be realized in an immediate settlement of the instrument.

 
18

 

CORNERSTONE BANCSHARES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

ASC Topic 820 provides a consistent definition of fair value, which focuses on exit price in an orderly transaction between market participants at the measurement date under current market conditions.  If there has been a significant decrease in the volume and level of activity for the asset or liability, a change in valuation technique or the use of multiple valuation techniques may be appropriate.  In such instances, determining the price at which willing market participants would transact at the measurement date under current market conditions depends on the facts and circumstances and requires the use of significant judgment.  The fair value is a reasonable point within the range that is most representative of fair value under current market conditions.

ASC Topic 820 also establishes a three-tier fair value hierarchy which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value, as follows:

Level 1 - Quoted prices (unadjusted) in active markets for identical assets or liabilities that Cornerstone has the ability to access.

Level 2 - Significant other observable inputs other than Level 1 prices, such as quoted prices for similar assets or liabilities in active markets, quoted prices in markets that are not active and other inputs that are observable or can be corroborated by observable market data.

Level 3 - Significant unobservable inputs that reflect a company’s own assumptions about the assumptions that market participants would use in pricing an asset or liability.

A financial instrument’s categorization within the valuation hierarchy is based upon the lowest level of input that is significant to the fair value measurement.

The following methods and assumptions were used by Cornerstone in estimating fair value disclosures for financial instruments.  There have been no changes in the methodologies used at March 31, 2011 and December 31, 2010.

Cash and cash equivalents:

The carrying amounts of cash and cash equivalents approximate fair values based on the short-term nature of the assets.

Securities:

Fair values are estimated using pricing models and discounted cash flows that consider standard input factors such as observable market data, benchmark yields, interest rate volatilities, broker/dealer quotes, and credit spreads.  Securities classified as available for sale are reported at fair value utilizing Level 2 inputs.

The carrying value of Federal Home Loan Bank stock approximates fair value based on the redemption provisions of the Federal Home Loan Bank.

Loans:

For variable-rate loans that reprice frequently and with no significant change in credit risk, fair values are based on carrying values.  Fair values for fixed-rate loans are estimated using discounted cash flow analysis, using market interest rates for comparable loans.  Loans for which it is probable that payment of interest and principal will not be made in accordance with the contractual terms of the loan agreement are considered impaired.  Once a loan is identified as individually impaired, management measures impairment in accordance with ASC Topic 310, “Accounting by Creditors for Impairment of a Loan.”  The fair value of impaired loans is estimated using several methods including collateral value, liquidation value and discounted cash flows.

Those impaired loans not requiring an allowance represent loans for which the fair value of the expected repayments or collateral exceed the recorded investments in such loans.  At March 31, 2011, substantially all of the total impaired loans were evaluated based on the fair value of collateral.  In accordance with ASC Topic 820, impaired loans where an allowance is established based on the fair value of collateral require classification in the fair value hierarchy.  When the fair value of the collateral is based on an observable market price or a current appraised value, Cornerstone records the impaired loan as nonrecurring Level 2.  When an appraised value is not available or management determines the fair value of the collateral is further impaired below the appraised value and there is no observable market price, Cornerstone records the impaired loan as nonrecurring Level 3.

 
19

 

CORNERSTONE BANCSHARES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

Cash surrender value of life insurance:

The carrying amounts of cash surrender value of life insurance approximate their fair value.  The carrying amount is based on information received from the insurance carriers indicating the financial performance of the policies and the amount Cornerstone would receive should the policies be surrendered.  Cornerstone reflects these assets within Level 2 of the valuation hierarchy.

Foreclosed assets:

Foreclosed assets, consisting of properties obtained through foreclosure or in satisfaction of loans, is initially recorded at fair value, determined on the basis of current appraisals, comparable sales, and other estimates of value obtained principally from independent sources, adjusted for estimated selling costs.  At the time of foreclosure, any excess of the loan balance over the fair value of the real estate held as collateral is treated as a charge against the allowance for loan losses.  Gains or losses on sale and any subsequent adjustment to the fair value are recorded as a component of foreclosed real estate expense.  Foreclosed assets are included in Level 2 of the valuation hierarchy.

Deposits:

The fair value of deposits with no stated maturity, such as noninterest-bearing and interest-bearing demand deposits, savings deposits, and money market accounts, is equal to the amount payable on demand at the reporting date.  The carrying amounts of variable-rate, fixed-term certificates of deposit approximate their fair values at the reporting date.  Fair values for fixed-rate certificates of deposit are estimated using a discounted cash flow calculation that applies market interest rates on comparable instruments to a schedule of aggregated expected monthly maturities on time deposits.

Securities sold under agreements to repurchase:

The estimated fair value of these liabilities approximates their carrying value.

Federal Home Loan Bank advances and other borrowings:

The carrying amounts of FHLB advances and other borrowings approximate their fair value.

Accrued interest:

The carrying amounts of accrued interest approximate fair value.

Commitments to extend credit, letters of credit and lines of credit:

The fair value of commitments is estimated using the fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the present creditworthiness of the counterparties.  For fixed-rate loan commitments, fair value also considers the difference between current levels of interest rates and the committed rates.

 
20

 

CORNERSTONE BANCSHARES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

Assets and liabilities recorded at fair value on a recurring basis are as follows.

         
Quoted Prices in
   
Significant
   
Significant
 
         
Active Markets
   
Other
   
Other
 
   
Balance as of
   
for Identical
   
Observable
   
Unobservable
 
   
March 31,
   
Assets
   
Inputs
   
Inputs
 
   
2011
   
(Level 1)
   
(Level 2)
   
(Level 3)
 
Debt securities available for sale:
                       
                         
U.S. Government agencies
  $ 4,346,864     $ -     $ 4,346,864     $ -  
State and municipal securities
    20,877,436       -       20,877,436       -  
Mortgage-backed securities:
                               
Residential mortgage guaranteed by GNMA
    17,753,165       -       17,753,165       -  
Collateralized mortgage obligations issued or guaranteed by U.S. Government agencies or sponsored agencies
    57,810,692       -       57,810,692       -  
                                 
Total securities available for sale
  $ 100,788,157     $ -     $ 100,788,157     $ -  
                                 
Cash surrender value of life insurance
  $ 1,142,062     $ -     $ 1,142,062     $ -  

Cornerstone has no assets or liabilities whose fair values are measured on a recurring basis using Level 3 inputs.

Certain assets and liabilities are measured at fair value on a nonrecurring basis, which means the assets and liabilities are not measured at fair value on an ongoing basis but are subject to fair value adjustments in certain circumstances (for example, when there is evidence of impairment).  The tables below present information about assets and liabilities on the balance sheet at March 31, 2011 for which a nonrecurring change in fair value was recorded.

         
Quoted Prices in
   
Significant
   
Significant
 
         
Active Markets
   
Other
   
Other
 
   
Balance as of
   
for Identical
   
Observable
   
Unobservable
 
   
March 31,
   
Assets
   
Inputs
   
Inputs
 
   
2011
   
(Level 1)
   
(Level 2)
   
(Level 3)
 
                         
Impaired loans
  $ 9,698     $ -     $ 9,698     $ -  
Foreclosed assets (OREO & Repossessions)
    20,464       -       20,464       -  

Loans include impaired loans held for investment for which an allowance for loan losses has been calculated based upon the fair value of the loans at March 31, 2011.  Losses derived from Level 2 inputs were calculated by models incorporating significant observable market data. 

 
21

 

CORNERSTONE BANCSHARES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

The carrying amount and estimated fair value of Cornerstone's financial instruments at March 31, 2011 and December 31, 2010 are as follows (in thousands):

   
March 31, 2011
   
December 31, 2010
 
   
Carrying
   
Estimated
   
Carrying
   
Estimated
 
   
Amount
   
Fair Value
   
Amount
   
Fair Value
 
Assets:
                       
Cash and cash equivalents
  $ 41,431     $ 41,431     $ 22,982     $ 22,982  
Securities
    100,880       100,883       108,346       108,349  
Federal Home Loan Bank stock
    2,323       2,323       2,323       2,323  
Loans, net
    265,836       267,013       276,115       277,796  
Cash surrender value of life insurance
    1,142       1,142       1,114       1,114  
Accrued interest receivable
    1,431       1,431       1,326       1,326  
                                 
Liabilities:
                               
Noninterest-bearing demand deposits
    33,529       33,529       28,980       28,980  
Interest-bearing demand deposits
    27,946       27,946       24,834       24,834  
Savings deposits and money market accounts
    34,776       34,776       34,042       34,042  
Time deposits
    241,236       243,093       247,591       249,990  
Federal funds purchased and securities sold under agreements to repurchase
    27,790       27,790       24,325       24,325  
Federal Home Loan Bank advances and other borrowings
    53,480       53,480       54,715       54,715  
Accrued interest payable
    211       211       177       177  
                                 
Unrecognized financial instruments
(net of contract amount):
                               
Commitments to extend credit
    -       -       -       -  
Letters of credit
    -       -       -       -  
Lines of credit
    -       -       -       -  

Note 7.  Other Comprehensive Income

Other comprehensive income consists of unrealized holding gains and losses on securities available for sale.  The following is a summary of other comprehensive income for the three months ended March 31, 2011 and 2010.

   
Three Months Ended
 
   
March 31,
 
   
2011
   
2010
 
Net income
  $ 252,275     $ 343,787  
Unrealized holding gains (losses) on securities available for sale, net of reclassification
    346,702       382,978  
                 
Comprehensive income
  $ 598,977     $ 726,765  

 
22

 

Cornerstone Bancshares Inc. and Subsidiary
Net Interest Margin Analysis
Taxable Equivalent Basis

(Amounts in thousands)
  Three months ended
March 31
 
Assets
  2011     2010  
   
Average
   
Income/
   
Yield/
   
Average
   
Income/
   
Yield/
 
 
 
Balance
   
Expense
   
Rate
   
Balance
   
Expense
   
Rate
 
Earning assets:                                                 
Loans, net of unearned income
  $ 284,297     $ 4,639       6.62 %   $ 330,024     $ 5,948       7.31 %
Investment securities
    109,844       568       2.41 %     134,834       1,129       3.62 %
Other earning assets
    24,122       11       0.18 %     45,528       24       0.21 %
Total earning assets
    418,263     $ 5,218       5.14 %     510,386     $ 7,101       5.70 %
Allowance for loan losses
    (9,071 )                     (5,993 )                
Cash and other assets
    28,629                       29,919                  
TOTAL ASSETS
  $ 437,821                     $ 534,312                  
                                                 
Liabilities and Shareholders' Equity
                                               
                                                 
Interest bearing liabilities:
                                               
Interest bearing demand deposits
  $ 27,590     $ 21       0.31 %   $ 27,908     $ 30       0.44 %
Savings deposits
    9,499       12       0.51 %     8,727       11       0.51 %
MMDA's
    24,437       60       1.00 %     23,718       57       0.97 %
Time deposits
    244,021       1,052       1.75 %     307,034       1,684       2.22 %
Federal funds purchased and securities sold under agreements to repurchase
    22,625       31       0.56 %     23,637       35       0.61 %
Other borrowings
    54,356       580       4.33 %     72,306       779       4.37 %
Total interest bearing liabilities
    382,528       1,756       1.86 %     463,330       2,596       2.27 %
Net interest spread
          $ 3,462       3.28 %           $ 4,505       3.43 %
Noninterest bearing demand deposits
    28,964                       48,211                  
Accrued expenses and other liabilities
    (354 )                     (5,897 )                
Shareholders' equity
    26,683                       28,668                  
TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY
  $ 437,821                     $ 534,312                  
Net yield on earning assets
                    3.44 %                     3.64 %
                                                 
Taxable equivalent adjustment:
                                               
Loans
            -                       -          
Investment securities
            85                       74          
Total adjustment
            85                       74          

 
23

 

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Cornerstone is a bank holding company and the parent company of the Bank, a Tennessee banking corporation which operates primarily in and around Chattanooga, Tennessee.  The Bank has one wholly owned subsidiary, Eagle, which is an accounts receivable financing company.  The Bank has five full-service banking offices located in Hamilton County, Tennessee, and one loan production office located in Dalton, Georgia.  The Bank’s business consists primarily of attracting deposits from the general public and, with these and other funds, originating real estate loans, consumer loans, business loans, and residential and commercial construction loans. The principal sources of income for the Bank are interest and fees collected on loans, fees collected on deposit accounts, and interest and dividends collected on other investments.  The principal expenses of the Bank are interest paid on deposits, employee compensation and benefits, office expenses, and other overhead expenses. Eagle’s principal source of income is revenue received from the purchase of receivables. Expenses are related to employee compensation and benefits and office and overhead expenses.

The following is a discussion of our financial condition at March 31, 2011 and December 31, 2010 and our results of operations for the three months ended March 31, 2011 and 2010. The purpose of this discussion is to focus on information about our financial condition and results of operations which is not otherwise apparent from the consolidated financial statements. The following discussion and analysis should be read along with our consolidated financial statements and the related notes included elsewhere herein.

Review of Financial Performance

As of March 31, 2011, Cornerstone had total consolidated assets of $447.5 million, total loans of $273.7 million, total securities of $100.9 million, total deposits of $337.5 million and stockholders’ equity of $27.3 million. Net income for the three month period ended March 31, 2011 totaled $252,275.

Results of Operations

Net income for the three months ended March 31, 2011 was $252,275 or $0.03 basic earnings per common share, compared to a net income of $343,787 or $0.05 basic earnings per common share, for the same period in 2010.

The following table presents our results for the three months ended March 31, 2011 compared to the three  months ended March 31, 2010 (amounts in thousands).

         
2011-2010
       
   
Three months
   
Percent
   
Dollar
 
   
ended March 31,
   
Increase
   
Amount
 
   
2011
   
2010
   
(Decrease)
   
Change
 
Interest income
  $ 5,218     $ 7,101       (26.52 )%   $ (1,883 )
Interest expense
    1,755       2,596       (32.40 )%     (841 )
Net interest income
                               
before provision for loan loss
    3,463       4,505       (23.13 )%     (1,042 )
                                 
Provision for loan loss
    15       1,015       (98.52 )%     (1,000 )
Net interest income after
                               
provision for loan loss
    3,448       3,490       (1.20 )%     (42 )
                                 
Total noninterest income
    270       404       (33.17 )%     (134 )
Total noninterest expense
    3,417       3,400       0.50 %     17  
                                 
Income before income taxes
    301       494       (39.07 )%     (193 )
                                 
Provision for income taxes
    49       150       (67.33 )%     (101 )
                                 
Net income
  $ 252     $ 344       (26.74 )%   $ (92 )

 
24

 

Net Interest Income-Net interest income represents the amount by which interest earned on various earning assets exceeds interest paid on deposits and other interest-bearing liabilities.  Net interest income is also the most significant component of our earnings.  For the three months ended March 31, 2011, net interest income before the provision for loan loss, decreased $1.0 million or 23.13% over the same period of 2010.  Cornerstone’s interest rate spread on a tax equivalent basis (which is the difference between the average yield on earning assets and the average rate paid on interest bearing liabilities) was 3.28% compared to 3.43% for the three month periods ended March 31, 2011 and 2010, respectively. The net interest margin on a tax equivalent basis was 3.44% and 3.64% for the three month periods ended March 31, 2011 and 2010, respectively.  Significant items related to the changes in net interest income, net interest yields and rates, and net interest margin are presented below:

The Bank’s net interest income has been negatively impacted by a reduction in the Bank’s loan portfolio.  As of March 31, 2010, the Bank’s total loans equaled approximately $325.9 million compared to approximately $273.7 million as of March 31, 2011.  The reduction in loans is a result of increased loan competition in the Bank’s local market resulting in refinances and loans that have been transferred into the Bank’s other real estate owned asset category as a result of foreclosure.  In response to the decrease in loans, the Bank’s Asset-Liability Committee is proactively managing the Bank’s interest-bearing deposits which enabled the Bank to reduce its interest expense by approximately $841 thousand or 32.40% from March 31, 2010 to March 31, 2011.  Currently, the Bank is attempting to increase its loan portfolio and thereby improve its net interest income.

The Bank’s loan portfolio yield decreased to 6.62% for the three months ended March 31, 2011 compared to 7.31% for the three months ended March 31, 2010 and 6.90% for the year ended December 31, 2010.

For the three month periods ended March 31, 2011, the Bank’s investment portfolio yielded 2.41% compared to 3.62% for the same time period in 2010.  The Bank decreased the amount of its investment portfolio from approximately $150.6 million as of March 31, 2010 to approximately $100.9 million as of March 31, 2011.  The reduction in investments is due in part to a decrease in pledging requirements as the Bank has repaid $17 million in Federal Home Loan Bank advances since March 31, 2010.  Further, the Bank liquidated the majority of its fixed rate mortgage backed securities during 2010.  A portion of the proceeds from the securities sold were reinvested into variable rate mortgage backed securities.  However, the Bank intends to increase its loan portfolio over the remainder of 2011, instead of reacquiring securities that would equal the 2010 portfolio amount of approximately $150.6 million.

Provision for Loan Losses-The provision for loan losses represents a charge to earnings necessary to establish an allowance for loan losses that, in management’s evaluation, should be adequate to provide coverage for the inherent losses on outstanding loans.  The provision for loan losses amounted to $15 thousand for the three months ended March 31, 2011 and approximately $1 million for the three months ended March 31, 2010.

Noninterest Income-Items reported as noninterest income include service charges on checking accounts, insufficient funds charges, automated clearing house (“ACH”) processing fees and the Bank’s secondary mortgage department earnings.  Increases in income derived from service charges and ACH fees are primarily a function of the Bank’s growth while fees from the origination of mortgage loans will often reflect market conditions and fluctuate from period to period.
 
The following table presents the components of noninterest income for the three months ended March 31, 2011 and 2010 (dollars in thousands):
 
         
2011-2010
 
   
Three months ended
   
Percent
 
   
March 31,
   
Increase
 
   
2011
   
2010
   
(Decrease)
 
Service charges on deposit accounts
  $ 216     $ 342       (36.84 )%
Net gains on sale of loans and other assets
    34       41       (17.07 )%
Other noninterest income
    20       21       (4.76 )%
Total noninterest income
  $ 270     $ 404       (33.17 )%

Significant matters relating to the changes in noninterest income are presented below:

The Bank has experienced a decrease in its service charges on deposit accounts during 2011 due to a continued reduction in customer overdraft charges.

The Bank exited the ACH payroll processing business during 2010 due to increased regulatory requirements and expects service charges on deposit accounts to drop $20 thousand a month as a result.

 
25

 

Noninterest Expense-Items reported as noninterest expense include salaries and employee benefits, occupancy and equipment expense, depository insurance, net foreclosed assets expense and other operating expense.

The following table presents the components of noninterest expense for the three months ended March 31, 2011 and 2010 (dollars in thousands).

         
2011-2010
 
   
Three months ended
   
Percent
 
   
March 31,
   
Increase /
 
   
2011
   
2010
   
(Decrease)
 
Salaries and employee benefits
  $ 1,543     $ 1,633       (5.51 )%
Occupancy and equipment expense
    406       355       14.37 %
Foreclosed assets expense, net
    362       196       84.69 %
Depository insurance
    323       270       19.63 %
Other operating expense
    783       946       (17.23 )%
Total noninterest expense
  $ 3,417     $ 3,400       0.50 %

Significant matters relating to the changes to noninterest expense are presented below:

Cornerstone reduced its employee expense by controlling cost of living adjustment raises over the last three years.  The Bank anticipates employee expense will increase slightly as Cornerstone adds additional talent to handle the increasing regulatory documentation.  The Bank expects employee expense to continue to climb into 2012 as  employee benefits are resumed as the Bank’s performance improves.

As of March 31, 2011, the Bank had incurred $242 thousand in write-down of other real estate and repossessed assets.  The majority of the write-down was centered on a houseboat that the Bank had owned for approximately one year.  The Bank has subsequently sold the asset for approximately $100 thousand.

Depository insurance increased from approximately $270 thousand as of March 31, 2010 to approximately $323 thousand as of March 31, 2011.  The increase in insurance assessment was the result of the Bank’s decline in regulatory risk ratings.  However, as of March 31, 2011, these risk ratings have stabilized.  Therefore, the Bank’s depository insurance assessment should decrease as the amount of deposits begins to decrease.

Financial Condition

Overview-Cornerstone’s consolidated assets totaled approximately $441.5 million as of December 31, 2010.  As of March 31, 2011, total consolidated assets had increased $6.0 million or 1.37% to approximately $447.5 million.

Liabilities as of March 31, 2011 and December 31, 2010 totaled approximately $420.3 million and $415.7 million, respectively.

Stockholders’ equity as of March 31, 2011 and December 31, 2010 totaled approximately $27.3 million and $25.8 million, respectively.
 
Securities-The Bank’s investment portfolio, primarily consisting of Ginnie Mae Agency, mortgage-backed securities and municipal securities, amounted to approximately $100.9 million as of March 31, 2011 compared to approximately $108.3 million as of December 31, 2010. The primary purposes of the Bank’s investment portfolio are to provide liquidity, satisfy pledging requirements, collateralize the Bank’s repurchase accounts and secure the Bank’s FHLB borrowings.

 
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Loans-The composition of loans at March 31, 2011 and at December 31, 2010 and the percentage (%) of each classification to total loans are summarized in the following table (dollars in thousands):
   
March 31, 2011
   
December 31, 2010
 
   
Amount
   
Percent
   
Amount
   
Percent
 
Commercial real estate-mortgage
                       
Owner-occupied
  $ 64,492       23.56 %   $ 64,971       22.78 %
All other
    59,303       21.66 %     64,060       22.46 %
Consumer real estate-mortgage
    70,260       25.67 %     71,878       25.20 %
Construction and land development
    30,599       11.18 %     29,848       10.46 %
Commercial and industrial
    45,980       16.80 %     51,160       17.94 %
Consumer and other
    3,116       1.13 %     3,330       1.16 %
Total loans
    273,750       100.00 %     285,247       100.00 %
Less:  Allowance for loan losses
    (7,914 )             (9,132 )        
                                 
Loans, net
  $ 265,836             $ 276,115          

Allowance for Loan Losses-The allowance for loan losses represents Cornerstone’s assessment of the risks associated with extending credit and its evaluation of the quality of the loan portfolio. Management analyzes the loan portfolio to determine the adequacy of the allowance for loan losses and the appropriate provisions required to maintain a level considered adequate to absorb anticipated loan losses.  The Bank uses a risk based approach to calculate the appropriate loan loss allowance in accordance with guidance issued by the Federal Financial Institutions Examination Council.  Although the Bank performs prudent credit underwriting, no assurances can be given that adverse economic circumstances will not result in increased losses in the loan portfolio and require greater provisions for possible loan losses in the future.

During the first quarter of 2011, the Bank added minimal provision to the loan loss allowance. Management believes that it has established an allowance for loan losses that adequately accounts for the Bank’s identified loan impairment.  However, additional provision to the loan loss allowance may be needed in future quarters as the Bank works its problem assets through the collection cycle.  The Bank saw its past due loans surge during the first quarter as two large loans became delinquent, one of these loans will move toward foreclosure and the Bank has many interested investors for this income producing property.

The following is a summary of changes in the allowance for loan losses for the three months ended March 31, 2011 and for the year ended December 31, 2010 and the ratio of the allowance for loan losses to total loans as of the end of each period (dollars in thousands):

   
March 31,
   
December 31,
 
   
2011
   
2010
 
Balance, beginning of period
  $ 9,132     $ 5,905  
Loans charged-off
    (1,350 )     (4,688 )
Recoveries of loans previously charged-off
    117       624  
Provision for loan losses
    15       7,291  
Balance, end of period
  $ 7,914     $ 9,132  
                 
Total loans
  $ 273,750     $ 285,247  
                 
Ratio of allowance for loan losses to loans outstanding at the end of the period
    2.89 %     3.20 %
                 
Ratio of net charge-offs to total loans outstanding for the period
    0.45 %     1.42 %

 
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 Non-Performing Assets-The specific economic and credit risks associated with the Bank’s loan portfolio include, but are not limited to, a general downturn in the economy which could affect employment rates in our market area, general real estate market deterioration, interest rate fluctuations, deteriorated or non-existent collateral, title defects, inaccurate appraisals, financial deterioration of borrowers, fraud, and violation of laws and regulations.

The Bank attempts to reduce these economic and credit risks by adherence to a lending policy approved by the Bank’s board of directors.  The Bank’s lending policy establishes loan to value limits, collateral perfection, credit underwriting criteria and other acceptable lending standards.  The Bank classifies loans that are ninety (90) days past due and still accruing interest, renegotiated loans, non-accrual loans, foreclosures and repossessed property as non-performing assets. The Bank’s policy is to categorize a loan on non-accrual status when payment of principal or interest is contractually ninety (90) or more days past due.  At the time the loan is categorized as non-accrual the interest previously accrued but not collected may be reversed and charged against current earnings.

The Bank has experienced a stabilization in its loan quality as the Chattanooga, Tennessee Metropolitan Statistical Area begins to recover from a long economic downturn.  The number and dollar amount of impaired loans remained consistent during the first quarter of 2011 even with the Bank continuing to systematically review its loan portfolio to proactively identify possible impaired loans.  Management anticipates that its loan asset quality will improve as the economy recovers from the current economic recession.

The following table summarizes Cornerstone’s non-performing assets at each quarter end from June 30, 2010 to March 31, 2011 (amounts in thousands):

   
March 31,
   
December 31,
   
September 30,
   
June 30,
 
   
2011
   
2010
   
2010
   
2010
 
Non-accrual loans
  $ 6,271     $ 13,633     $ 10,532     $ 13,030  
Foreclosed assets
    20,464       12,809       13,427       10,212  
Total non-performing assets
  $ 26,735     $ 26,442     $ 23,959     $ 23,242  
                                 
30-89 days past due loans
  $ 8,438     $ 2,306     $ 1,595     $ 6,655  
                                 
Total loans outstanding
  $ 273,750     $ 285,247     $ 292,046     $ 318,796  
                                 
Allowance for loan losses
    7,914       9,132       6,271       6,967  
                                 
Ratio of non-performing assets to total loans outstanding at the end of the period
    9.77 %     9.27 %     8.20 %     7.29 %
                                 
Ratio of non-performing assets to total allowance for loan losses at the end of the period
    337.82 %     289.55 %     382.06 %     333.60 %
 
As of March 31, 2011, the Bank has experienced an increase in 30-89 days past due loans when compared to previous quarters of 2010.   The increase is primarily attributable to two relationships.  Both of these relationships are secured by income producing properties which should allow the loans to return to a current payment status or  allow the Bank to process the properties through the collection cycle quickly.
 
Non-accrual loans decreased to approximately $6.3 million as of March 31, 2011 down from approximately $13.6 million as of December 31, 2010.  The majority of non-accrual loans are concentrated in one loan relationship of approximately $4.6 million. The relationship is in bankruptcy and the courts are presently making payments on several income producing parcels of commercial real estate.

 
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The Bank’s foreclosed assets increased from approximately $12.8 million as of December 31, 2010 to approximately $20.5 million as of March 31, 2011.  During the first quarter of 2011, six properties totaling approximately $5.0 million were foreclosed on and recorded in the Bank’s foreclosed assets.  Five of the properties are mini-warehouses in the Chattanooga, Tennessee area and are currently producing approximately $30 thousand per month in net income.  Management believes that due to the income producing nature of these properties that the Bank will be able to liquidate these properties by the end of 2011.
 
The Bank is experiencing increasing interest in its properties and expects a material decrease in the amount of foreclosed assets.  The Bank currently has approximately $3 million under contract to sell during the second quarter of 2011.  Management expects further sales to finalize during the second quarter of 2011 as well.
 
Deposits and Other Borrowings-The Bank’s deposits consist of non-interest bearing demand deposits, interest- bearing demand accounts, savings and money market accounts, and time deposits.  The Bank has agreements with some customers to sell certain of its securities under agreements to repurchase the security the following day.  The Bank has also obtained advances from the FHLB.

The following table presents the Bank’s deposits and other borrowings as either core funding or non-core funding.  Core funding consists of all deposits except for time deposits issued in denominations of $100,000 or greater.  All other funding is classified as non-core (amounts in thousands).

   
March 31, 2011
   
December 31, 2010
 
 
 
Amount
   
Percent
   
Amount
   
Percent
 
Core funding:                         
Non-interest bearing demand deposits
  $ 33,529       8.07 %   $ 28,980       7.07 %
Interest-bearing demand deposits
    27,946       6.73 %     24,834       6.06 %
Savings & money market accounts
    34,776       8.37 %     34,042       8.31 %
Time deposits under $100,000
    132,161       31.83 %     133,626       32.61 %
Total core funding
    228,412       55.00 %     221,482       54.05 %
                                 
Non-core funding:
                               
Time deposit of $100,000 or more
  $ 109,075       26.27 %   $ 113,965       27.81 %
Fed funds purchased and securities sold under agreements to repurchase
    27,790       6.69 %     24,325       5.94 %
Federal Home Loan Bank advances
    50,000       12.04 %     50,000       12.20 %
Total non-core funding
    186,865       45.00 %     188,290       45.95 %
                                 
Total
  $ 415,277       100.00 %   $ 409,772       100.00 %

The Bank has seen relative stability in its core deposit base but has purposely reduced its certificates of deposit as the loan portfolio decreased.  The Bank will continue to reduce its assets but will see future reduction primarily in cash and security balances.  To offset these future reductions the Bank expects new reductions in its securities sold under agreements to repurchase account balances and continued reductions in certificates of deposit accounts and Federal Home Loan Bank borrowings.

Capital Resources-At March 31, 2011 and December 31, 2010, Cornerstone’s stockholders’ equity amounted to approximately $27.3 million and approximately $25.8 million, respectively.

Cornerstone’s stockholders’ equity increased $1.5 million during the first quarter of 2011.  The increase in equity can be attributed to Cornerstone’s first quarter 2011 earnings of approximately $252,000, additional capital from Cornerstone’s preferred stock offering of approximately $852,000 and an increase in unrealized gain on securities available for sale of approximately $347,000.  Following is a summary of the Bank’s capital ratios as of March 31, 2011:

Tier 1 leverage ratio of 6.13% to average assets.
Tier 1 risk-based capital ratio of 9.21% to risk weighted assets.
Total risk-based capital ratio of 10.46% to risk weighted assets.

 
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Cornerstone has requested permission from the Federal Reserve Bank of Atlanta (the “Federal Reserve”) to pay its scheduled February 2011 dividend to its series A convertible preferred stock in the amount of $0.625 per share. Cornerstone is waiting for a final decision from the Federal Reserve authorizing the payment of the dividend.

Cornerstone had total outstanding borrowings of approximately $3.5 million as of March 31, 2011 with the Federal Deposit Insurance Corporation as Receiver for Silverton Bank, N.A.

Market and Liquidity Risk Management

Interest Rate Sensitivity

The Bank’s Asset Liability Management Committee (“ALCO”) is responsible for making decisions regarding liquidity and funding solutions based upon approved liquidity, loan, capital and investment policies.  The ALCO must consider interest rate sensitivity and liquidity risk management when rendering a decision on funding solutions and loan pricing.  To assist in this process the Bank has contracted with an independent third party to prepare quarterly reports that summarize several key asset-liability measurements.  In addition, the third party will also provide recommendations to the Bank’s ALCO regarding future balance sheet structure, earnings and liquidity strategies.  The following is a brief discussion of the primary tools used by the ALCO to perform its responsibilities:

  Earnings at Risk Model
The Bank uses an earnings at risk model to analyze interest rate risk.  Forecasted levels of earning assets, interest-bearing liabilities, and off-balance sheet financial instruments are combined with ALCO forecasts of interest rates for the next 12 months and are combined with other factors in order to produce various earnings simulations.

  Economic Value of Equity
The Bank’s economic value of equity model measures the extent that estimated economic values of the Bank’s assets and liabilities will change as a result of interest rate changes. Economic values are determined by discounting expected cash flows from assets and liabilities, which establishes a base case economic value of equity.

   Liquidity Analysis
The Bank uses a liquidity analysis model to examine the current liquidity position and analyze the potential sources of coverage in the event of a liquidity crisis.  The following is a brief description of the key measurements contained in the analysis:

Regular Liquidity Position-This is a measurement used to capture the ability of an institution to cover its current debt obligations.

Basic Surplus-The basic surplus ratio is used to determine the number of times non-obligated assets could be used to meet immediate liquidity needs.

Dependency Ratio-The dependency ratio determines the reliance on short-term liabilities.

  Leverage Analysis
The leverage analysis examines the potential of the institution to absorb additional debt.  The key measurements included in this analysis are the Bank’s tier 1 capital, leverage and total capital ratios.

  Balance Sheet Analytics
Balance sheet analytics involve an in depth examination of the balance sheet structure, including diversification of structure and most recent pricing practices. This review uses trend analysis to compare previous balance sheet positions.  The analysis enables the ALCO to review significant changes in the Bank’s loan and security portfolios as well as the Bank’s deposit composition.

 
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Liquidity Risk Management

Liquidity is measured by the Bank's ability to raise cash at a reasonable cost or with a minimum of loss.  These funds are used primarily to fund loans and satisfy deposit withdrawals.  Several factors must be considered by management when attempting to minimize liquidity risk.  Examples include changes in interest rates, competition, loan demand, and general economic conditions.  Minimizing liquidity risk is a responsibility of the ALCO and is reviewed by the Bank’s regulatory agencies on a regular basis.

Item 3.  Quantitative and Qualitative Disclosures About Market Risk

A comprehensive qualitative and quantitative analysis regarding market risk was disclosed in Cornerstone’s Annual Report on Form 10-K for the year ended December 31, 2010. No material changes in the assumptions used in preparing, or results obtained from, the model have occurred since December 31, 2010.

Item 4T. Controls and Procedures

Under the supervision and with the participation of management, including Cornerstone’s Chief Executive Officer, Cornerstone has evaluated the effectiveness of its disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), as of March 31, 2011 (the “Evaluation Date”). Based on such evaluation, such officers have concluded that, as of the Evaluation Date, Cornerstone’s disclosure controls and procedures were effective in alerting them on a timely basis to material information relating to Cornerstone (including its consolidated subsidiary) required to be included in Cornerstone’s periodic filings under the Exchange Act.

There were no changes in Cornerstone’s internal control over financial reporting during Cornerstone’s fiscal quarter ended March 31, 2011 that have materially affected, or are reasonably likely to materially affect, Cornerstone’s internal control over financial reporting.

 
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PART II. OTHER INFORMATION

Item 1. Legal Proceedings

There are various claims and lawsuits in which the Bank is periodically involved incidental to the Bank’s business. In the opinion of management, no material loss is expected from any of such pending claims or lawsuits.

Item 1A. Risk Factors

Cornerstone, as a smaller reporting company, is not required to provide the information required by this Item.

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

None

Item 3. Defaults Upon Senior Securities

None

Item 4.  [Removed and Reserved]

Item 5. Other Information

None

Item 6. Exhibits

Exhibit Number
 
Description
31
 
Certifications under Section 302 of the Sarbanes-Oxley Act of 2002.
32
 
Certifications under Section 906 of the Sarbanes-Oxley Act of 2002.

 
32

 

SIGNATURES

In accordance with the requirements of the Exchange Act, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

   
Cornerstone Bancshares, Inc.
     
Date:
May 13, 2011
/s/ Nathaniel F. Hughes
   
Nathaniel F. Hughes,
   
President
   
(principal executive officer)
     
Date:
May 13, 2011
/s/ Gary W. Petty, Jr.
   
Gary W. Petty, Jr.
   
Senior Vice President and Chief Financial Officer
   
(principal financial officer and accounting officer)

EXHIBIT INDEX

Exhibit Number
 
Description
31
 
Certifications under Section 302 of the Sarbanes-Oxley Act of 2002.
32
 
Certifications under Section 906 of the Sarbanes-Oxley Act of 2002.

 
33