10-Q 1 v166343_10q.htm Unassociated Document
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 September 30, 2009

¨
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 shorter 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 November 9, 2009 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
    22  
         
Item 3.  Quantitative and Qualitative Disclosures about Market Risk
    30  
         
Item 4T.Controls and Procedures
    30  
         
PART II – OTHER INFORMATION
Item 1. Legal Proceedings
    30  
         
Item 1A. Risk Factors
    30  
         
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
    30  
         
Item 3. Defaults Upon Senior Securities
    30  
         
Item 4. Submission of Matters to a Vote of Security Holders
    30  
         
Item 5. Other Information
    30  
         
Item 6. Exhibits
    30  
 
 
2

 

FORWARD-LOOKING STATEMENTS

Cornerstone Bancshares, Inc. (“Cornerstone”) may from time to time make written or oral statements, including statements contained in this report which constitute forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934 (the “Exchange Act”). Forward-looking statements are those not based on historical information, but rather related to future operations, strategies, financial results or other developments.  Generally, the words “expect,” “anticipate,” “intend,” “consider,” “plan,” “believe,” “seek,” “should,” “estimate,” and similar expressions may be used to identify such forward-looking statements, but other statements may constitute forward-looking statements. These statements are 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 and speak only as of the date made.  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 II of this report and in Cornerstone’s Annual Report on Form 10-K for the year ended December 31, 2008, as well as the following:  (i) unanticipated deterioration in the financial condition of borrowers resulting in significant increases in loan losses and provisions for those losses, (ii) increased competition with other financial institutions, (iii) lack of sustained growth in the economy in the Chattanooga, Tennessee area, (iv) rapid fluctuations or unanticipated changes in interest rates, (v) the inability of our bank subsidiary, Cornerstone Community Bank, to satisfy regulatory requirements for its expansion plans, (vi) the inability of Cornerstone to achieve its targeted expansion goals in the Dalton, Georgia  market, (vii) the inability of Cornerstone to grow its loan portfolio at historic or planned rates and (viii) changes in the legislative and regulatory environment, including compliance with the various provisions of the Sarbanes-Oxley Act of 2002. 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

PART I — FINANCIAL INFORMATION
Item 1.       Financial Statements

   
Unaudited
       
   
September 30,
   
December 31,
 
   
 
2009
   
2008
 
ASSETS
           
             
Cash and due from banks
  $ 73,288,166     $ 10,872,390  
Federal funds sold
    -       11,025,000  
Cash and cash equivalents
    73,288,166       21,897,390  
                 
Securities available for sale
    59,134,602       44,056,559  
Securities held to maturity
    141,352       169,284  
Federal Home Loan Bank stock, at cost
    2,229,200       2,187,500  
Loans, net of allowance for loan losses of $7,398,212 at September 30, 2009 and $9,618,265 at December 31, 2008
    341,651,523       378,471,619  
Bank premises and equipment, net
    8,041,869       8,471,955  
Accrued interest receivable
    1,712,276       1,771,091  
Goodwill and amortizable intangibles
    2,560,818       2,840,773  
Other assets
    20,739,556       11,937,004  
Total Assets
  $ 509,499,362     $ 471,803,175  
                 
LIABILITIES AND STOCKHOLDERS' EQUITY
               
                 
Deposits:
               
Noninterest-bearing demand deposits
  $ 40,795,512     $ 40,077,977  
Interest-bearing demand deposits
    23,919,357       26,908,572  
Savings deposits and money market accounts
    31,581,290       35,847,667  
Time deposits of $100,000 or more
    89,529,840       59,056,590  
Time deposits of less than $100,000
    200,262,309       164,692,417  
Total deposits
    386,088,308       326,583,223  
Federal funds purchased and securities sold under agreements to repurchase
    18,136,273       35,790,246  
Federal Home Loan Bank advances  and line of credit
    72,350,000       71,250,000  
Accrued interest payable
    753,525       469,586  
Other liabilities
    867,551       1,208,611  
Total Liabilities
    478,195,657       435,301,666  
                 
Stockholders' Equity:
               
Preferred stock - no par value; 2,000,000 shares authorized; no shares issued
    -       -  
Common stock - $l.00 par value; 10,000,000 shares authorized; 6,577,646 issued in 2009 and 6,522,718 issued in 2008; 6,372,937 outstanding in 2009 and 6,319,718 outstanding in 2008
    6,372,937       6,319,718  
Additional paid-in capital
    20,741,824       20,311,638  
Retained earnings
    3,885,474       10,056,680  
Accumulated other comprehensive income
    303,470       (186,527 )
Total Stockholders' Equity
    31,303,705       36,501,509  
Total Liabilities and Stockholders' Equity
  $ 509,499,362     $ 471,803,175  

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

 
4

 

Cornerstone Bancshares, Inc. and Subsidiary
Consolidated Statements of Income

   
Unaudited
   
Unaudited
 
   
Three months ended
   
Nine months ended
 
   
September 30,
   
September 30,
 
   
2009
   
2008
   
2009
   
2008
 
INTEREST INCOME
                       
Loans, including fees
  $ 6,018,409     $ 6,977,340     $ 18,495,619     $ 21,730,315  
Investment securities
    357,677       482,119       1,157,803       1,533,231  
Federal funds sold
    30,439       3,014       45,085       15,895  
Total interest income
    6,406,525       7,462,473       19,698,507       23,279,441  
                                 
INTEREST EXPENSE
                               
Interest bearing demand accounts
    20,554       56,513       76,559       180,030  
Money market accounts
    55,548       151,946       204,836       681,350  
Savings accounts
    10,721       15,717       30,879       46,903  
Time deposits of  more than $100,000
    476,611       579,186       1,534,269       2,092,277  
Time deposits of less than $100,000
    1,407,611       1,322,111       4,214,280       4,150,336  
Federal funds purchased and securities sold under agreements to repurchase
    37,227       157,141       135,157       501,927  
Other borrowings
    757,682       744,145       2,231,717       2,067,266  
Total interest expense
    2,765,954       3,026,759       8,427,697       9,720,089  
                                 
Net interest income before provision for loan losses
    3,640,571       4,435,714       11,270,810       13,559,352  
Provision for loan losses
    3,390,000       440,000       10,748,898       927,000  
Net interest income after the provision for loan losses
    250,571       3,995,714       521,912       12,632,352  
                                 
NONINTEREST INCOME
                               
Service charges
    416,908       439,664       1,259,646       1,278,485  
Net gains / (losses) from sale of loans and other assets
    (262,019 )     18,107       (252,323 )     27,638  
Other income
    29,343       18,962       170,314       89,487  
Total noninterest income
    184,232       476,733       1,177,637       1,395,610  
                                 
NONINTEREST EXPENSE
                               
Salaries and employee benefits
    1,622,766       1,856,162       5,331,916       5,531,873  
Occupancy and equipment expense
    382,601       371,943       1,176,735       1,134,996  
Other operating expense
    1,273,589       922,932       3,836,405       2,796,781  
Total noninterest expense
    3,278,956       3,151,037       10,345,056       9,463,650  
                                 
Income / (loss) before provision for income taxes
    (2,844,153 )     1,321,410       (8,645,507 )     4,564,312  
Provision / (benefit)  for income taxes
    (1,144,617 )     461,194       (3,431,673 )     1,616,182  
                                 
NET INCOME / (LOSS)
  $ (1,699,536 )   $ 860,216     $ (5,213,834 )   $ 2,948,130  
                                 
EARNINGS / (LOSS) PER COMMON SHARE
                               
Basic net income / ( loss) per common share
  $ (0.27 )   $ 0.14     $ (0.82 )   $ 0.46  
Diluted net income / (loss) per common share
  $ (0.27 )   $ 0.13     $ (0.82 )   $ 0.45  
                                 
DIVIDENDS DECLARED PER COMMON SHARE
    -     $ 0.07     $ 0.10     $ 0.21  

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

 
5

 

Cornerstone Bancshares, Inc. and Subsidiary
Consolidated Statement of Changes in Stockholders' Equity - Unaudited
For the nine months ended September 30, 2009

               
Additional
         
Other
   
Total
 
   
Comprehensive
   
Common
   
Paid-in
   
Retained
   
Comprehensive
   
Stockholders'
 
   
Income
   
Stock
   
Capital
   
Earnings
   
Income
   
Equity
 
                                     
BALANCE, December 31, 2008
        $ 6,319,718     $ 20,311,638     $ 10,056,680     $ (186,527 )   $ 36,501,509  
                                               
Employee compensation stock option expense
          -       164,094       -       -       164,094  
                                               
Dividend - $0.10 per share
          -       -       (638,061 )     -       (638,061 )
                                               
Stock Dividend
          53,219       266,092       (319,311 )     -       -  
                                               
Comprehensive income / (loss):
                                             
Net loss
  $ (5,213,834 )     -       -       (5,213,834 )     -       (5,213,834 )
                                                 
Other comprehensive income, net of tax:
                                               
Unrealized holding gains (losses) on securities available for sale, net of reclassification adjustment
    489,997       -       -       -       489,997       489,997  
                                                 
Total comprehensive loss
  $ (4,723,837 )                                        
                                                 
BALANCE, September 30, 2009
          $ 6,372,937     $ 20,741,824     $ 3,885,474     $ 303,470     $ 31,303,705  

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

 
6

 

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

   
Unaudited
 
   
Nine months ended September 30,
 
   
2009
   
2008
 
             
CASH FLOWS FROM OPERATING ACTIVITIES
           
Net income / (loss)
  $ (5,213,834 )   $ 2,948,130  
Adjustments to reconcile net income / (loss) to net cash provided by operating activities:
               
Depreciation and amortization
    617,555       422,877  
Provision for loan losses
    10,748,898       927,000  
Stock compensation expense
    164,094       209,600  
Net (Gains) / Losses on sales of loans and other assets
    252,323       (27,638 )
Deferred income taxes
    1,100,978       3,202,078  
Changes in other operating assets and liabilities:
               
Net change in loans held for sale
    389,700       205,600  
Accrued interest receivable
    58,815       522,255  
Accrued interest payable
    283,939       30,776  
Other assets and liabilities
    (4,012,949 )     (6,850,146 )
Net cash provided by operating activities
    4,389,519       1,590,532  
                 
CASH FLOWS FROM INVESTING ACTIVITIES
               
Proceeds from security transactions:
               
Securities available for sale
    29,963,560       21,722,393  
Securities held to maturity
    27,536       24,087  
Purchase of securities available for sale
    (44,327,958 )     (28,320,718 )
Purchase of Federal Home Loan Bank stock
    (41,700 )     (247,500 )
Loan originations and principal collections, net
    17,119,771       (15,947,942 )
Purchase of bank premises and equipment
    (144,726 )     (450,096 )
Proceeds from sale of other real estate and other assets
    2,548,311       2,142,594  
Net cash provided by (used in) investing activities
    5,144,794       (21,077,182 )
                 
CASH FLOWS FROM FINANCING ACTIVITIES
               
Net increase / (decrease)in deposits
    59,505,085       (10,434,478 )
Net increase / (decrease) in federal funds purchased and securities sold under agreements to repurchase
    (17,653,973 )     1,891,619  
Net proceeds from Federal Home Loan Bank advances and other borrowings
    1,100,000       25,100,000  
Purchase of common stock
    -       (503,006 )
Payment of dividends
    (1,094,649 )     (1,591,933 )
Net cash provided by financing activities
    41,856,463       14,462,202  
                 
NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS
    51,390,776       (5,024,448 )
                 
CASH AND CASH EQUIVALENTS,  beginning of period
    21,897,390       14,933,349  
CASH AND CASH EQUIVALENTS, end of period
  $ 73,288,166     $ 9,908,901  
                 
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION
               
Cash paid during the period for interest
  $ 8,143,758     $ 9,689,313  
Cash paid during the period for taxes
    -       738,886  
                 
NONCASH INVESTING AND FINANCING ACTIVITIES
               
Acquisition of real estate through foreclosure
  $ 8,638,408     $ 2,500,560  

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 Bancshares, Inc. (“Cornerstone”) is a bank holding company whose primary business is performed by its wholly-owned subsidiary, Cornerstone Community Bank (“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 September 30, 2009 and September 30, 2008 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 2008 Annual Report to Shareholders which was furnished to each shareholder of Cornerstone in March of 2009. The consolidated financial statements presented herein conform to 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 and its wholly-owned subsidiary Bank.  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 stockholder’s 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, 2008 as filed with the Securities and Exchange Commission.  Since December 31, 2008, there have been no significant changes in any accounting principles or practices, or in the method of applying any such principles or practices other than those indicated below.

In April 2009, the Financial Accounting Standards Board (“FASB”) issued FSP No. FAS 157-4, Determining Fair Value When the Volume and Level of Activity for the Asset or Liability have Significantly Decreased and Identifying Transactions That Are Not Orderly (“FSP 157-4”) (ASC 820, Fair Value Measurements and Disclosures). FSP 157-4 provides that if an entity determines that either the volume and/or level of activity for an asset or liability has significantly decreased (from normal conditions for that asset or liability) or price quotations or observable inputs are not associated with orderly transactions, increased analysis and management judgment will be required to estimate fair value. FSP 157-4 is effective for interim and annual periods ending after June 15, 2009, with early adoption permitted. FSP 157-4 must be applied prospectively. The provisions of FSP 157-4 became effective for Cornerstone's fiscal quarter ending on June 30, 2009, and its adoption did not have a significant impact on the consolidated financial statements.

In April 2009, the FASB issued FSP No. 107-1 and APB 28-1, Interim Disclosures about Fair Value of Financial Instruments (“FSP 107-1 and APB 28-1”) (ASC 825, Financial Instruments).   FSP 107-1 and APB 28-1 amends SFAS 107 to require disclosures about fair value of financial instruments for interim reporting periods of publicly traded companies as well as in annual financial statements. This FSP also amends APB 28, Interim Financial Reporting, to require those disclosures in summarized financial information at interim reporting periods. The provisions of FSP 107-1 and APB 28-1 became effective for the Bank's interim period ending on June 30, 2009 and resulted in the applicable fair value disclosures being included in the June 30, 2009 and September 30, 2009 periods.

 
8

 

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

 
In April 2009, the FASB issued FSP No. FAS 115-2 and FAS 124-2, Recognition and Presentation of Other-Than-Temporary Impairments (“FSP 115-2 and 124-2”) (ASC 320, Investment – Debt and Equity Securities). FSP 115-2 and 124-2 clarifies the interaction of the factors that should be considered when determining whether a debt security is other-than-temporarily impaired. For debt securities, management must assess whether (a) it has the intent to sell the security and (b) it is more likely than not that it will be required to sell the security prior to its anticipated recovery. These steps are done before assessing whether the entity will recover the cost basis of the investment. This change does not affect the need to forecast recovery of the value of the security through either cash flows or market price. In instances when a determination is made that an other-than-temporary impairment exists but the investor does not intend to sell the debt security and it is not more likely than not that it will be required to sell the debt security prior to its anticipated recovery, FSP 115-2 and 124-2 changes the presentation and amount of the other-than-temporary impairment recognized in the income statement. The other-than-temporary impairment is separated into (a) the amount of the total other-than-temporary impairment related to a decrease in cash flows expected to be collected from the debt security (the credit loss) and (b) the amount of the total other-than-temporary impairment related to all other factors. The amount of the total other-than-temporary impairment related to the credit loss is recognized in earnings. The amount of the total other-than-temporary impairment related to all other factors is recognized in other comprehensive income. FSP 115-2 and 124-2 also requires substantial additional disclosures. The provisions of FSP 115-2 and 124-2 became effective for Cornerstone’s fiscal quarter ended period ending on June 30, 2009, and there was no impact from the adoption on Cornerstone’s financial position, results of operations or cash flows.  The expanded disclosures related to FSP 115-2 and 124-2 are included in Note 4.

 On May 28, 2009, the FASB issued SFAS No. 165, Subsequent Events (ASC 855, Subsequent Events).  Under SFAS 165, companies are required to evaluate events and transactions that occur after the balance sheet date but before the date the financial statements are issued, or available to be issued in the case of non-public entities.  SFAS 165 requires entities to recognize in the financial statements the effect of all events or transactions that provide additional evidence of conditions that existed at the balance sheet date, including the estimates inherent in the financial preparation process.  Entities shall not recognize the impact of events or transactions that provide evidence about conditions that did not exist at the balance sheet date but arose after that date.  SFAS 165 also requires entities to disclose the date through which subsequent events have been evaluated.  SFAS 165 was effective for interim and annual reporting periods ending after June 15, 2009.  Cornerstone adopted the provisions of SFAS 165 for the quarter ended June 30, 2009, as required, and adoption did not have a material impact on the financial statements taken as a whole.  Management has evaluated subsequent events through November 13, 2009, the date these statements were available for release.
 
On June 30, 2009 the FASB issued SFAS No. 168, The FASB Accounting Standards Codification and the Hierarchy of Generally Accepted Accounting Principles — a Replacement of FASB Statement No. 162 (the “FASB Codification”). The purpose of the FASB Codification was to reorganize all existing U.S. accounting and reporting standards issued by the FASB and other related private-sector standard setters into one authoritative body of literature, which will ease research of accounting literature and reduce the risk of noncompliance. Going forward, all revisions will be made in real time to the FASB Codification. The FASB Codification is effective for all financial statements issued for interim and annual periods ending after September 15, 2009. As a result of the adoption of the FASB Codification, all references in public company financial statements and related notes will be to the classification system set forth in the FASB Codification, rather than to the applicable previously existing literature. Conforming changes will also need to be made throughout a company’s disclosure documents, with changes most likely arising in the Management’s Discussion and Analysis of Financial Condition and Results of Operations and, most particularly, in the discussion of critical accounting policies usually contained in that discussion.
 
On August 18, 2009 the Securities and Exchange Commission published interpretive guidance titled Commission Guidance Regarding the Financial Accounting Standards Board’s Accounting Standards Codification. In its guidance, the SEC stated that concurrent with the Effective Date, references in the SEC’s rules and SEC staff guidance to specific standards under U.S. generally accepted accounting principles should be understood to mean the corresponding reference in the FASB Codification. The SEC also stated that the FASB Codification does not supersede any SEC rules or regulations, is not the authoritative source for SEC rules or SEC staff guidance, and the inclusion of any SEC rules or SEC staff guidance in the FASB Codification will not affect how such items may be updated in the future by the SEC.

 
9

 

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

 
In August 2009, the FASB issued Accounting Standards Update No. 2009-05 (ASU 2009-05), Fair Value Measurements and Disclosures (ASC 820, Measuring Liabilities at Fair Value).  ASU 2009-05 amends subtopic 820-10, Fair Value Measurements and Disclosures – Overall, and provides clarification for the fair value measurement of liabilities.  ASU 2009-05 is effective for the first reporting period including interim period beginning after issuance.  Cornerstone  does not expect the adoption of ASU 2009-05 to have a material impact on its consolidated financial statements.

     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 September 30, 2009 and 2008.

   
Three Months Ended September 30,
 
 
 
2009
   
2008
 
Basic earnings / (loss) per share calculation:
               
Numerator: Net income / (loss) available to common shareholders
  $ (1,699,536 )   $ 860,216  
Denominator: Weighted avg. common shares outstanding
    6,371,202       6,371,202  
Effect of dilutive stock options
    -       57,375  
Diluted shares
    6,371,202       6,428,577  
                 
Basic earnings / (loss) per share
  $ (0.27 )   $ 0.14  
Diluted earnings / (loss) per share
  $ (0.27 )   $ 0.13  

 
The following is a summary of the basic and diluted earnings per share for the nine month periods ended September 30, 2009 and 2008.

 
   
Nine Months Ended September 30,
 
 
 
2009
   
2008
 
Basic earnings / (loss) per share calculation:
           
Numerator: Net income / (loss) available to common shareholders
  $ (5,213,834 )   $ 2,948,130  
Denominator: Weighted avg. common shares outstanding
    6,337,066       6,350,272  
Effect of dilutive stock options
    -       161,459  
Diluted shares
    6,337,066       6,511,731  
                 
Basic earnings / (loss) per share
  $ (0.82 )   $ 0.46  
Diluted earnings / (loss) per share
  $ (0.82 )   $ 0.45  

As of September 30, 2009, Cornerstone had paid a stock dividend totaling 0.8421 percent per share with a record date of June 12, 2009 and a payment date of July 3, 2009.  The average number of common shares outstanding and the effect of dilutive stock options for 2008 have been retroactively adjusted to reflect these transactions.

Note 2. Stock Based Compensation

   Accounting Policies- Cornerstone, as required by the FASB, applies the fair value recognition provisions of ASC 718, Compensation-Stock Compensation.  As a result, for the nine month period ended September 30, 2009, the compensation cost charged to earnings related to the vested incentive stock options was approximately $164,000, which reduced basic earnings per share by $0.03 per share.

 
10

 

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

 
   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 option price for incentive stock options shall 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 stock options vest at 30 percent on the second and third anniversaries of the grant date and 40 percent on the fourth anniversary.  The options expire ten years from the grant date.  At September 30, 2009, the total remaining compensation cost to be recognized on non-vested options was approximately $547,000.  A summary of the status of these stock option plans 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, 2008
    755,425     $ 6.63  
5.0 Years
  $ 1,634,022  
Granted
    115,850       3.60            
Exercised
    -       -            
Forfeited
    (25,400 )     4.69            
Outstanding at September 30, 2009
    845,875     $ 6.27  
5.1 Years
  $ 505,462  
Options exercisable at September 30, 2009
    595,378     $ 5.46            

The weighted average grant-date fair value of stock options granted during the nine months ended September 30, 2009 was $1.13.  This was determined using the Black-Scholes option pricing model with the following weighted –average assumptions:  Dividend Yield-2.97%, Expected Life-7.0 years, Expected Volatility-38.74%, Risk-free Interest Rate- 2.69%.

    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 option’s maximum term is ten years.  Vesting for options granted during 2009, are 50% on the first and second anniversary of the grant date.  At September 30, 2009, the total remaining compensation cost to be recognized on non-vested options was approximately $45,000.  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, 2008
    81,800     $ 10.73  
7.9 Years
  $ 29,608  
Granted
    20,500       3.60            
Exercised
    -       -            
Forfeited
    -       -            
Outstanding at September 30, 2009
    102,300     $ 9.30  
7.5 Years
  $ 21,523  
Options exercisable at September 30, 2009
    75,400     $ 10.96            

The weighted average grant-date fair value of stock options granted during the nine months ended September 30, 2009 was $1.13.  This was determined using the Black-Scholes option pricing model with the following weighted –average assumption:  Dividend Yield-2.97%, Expected Life-7.0 years, Expected Volatility-38.74%, Risk-free Interest Rate- 2.69%.

 
11

 

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

 
Note 3. Stockholder’s Equity
During 2009, Cornerstone’s Board of Directors declared the following cash dividends:

Cash Dividend Rate
 
Declaration Date
 
Record Date
 
Payment Date
(per share)
           
$ 0.07  
February 25, 2009
 
March 13, 2009
 
April 3, 2009
$ 0.03  
June 2, 2009
 
June 12, 2009
 
July 3, 2009

Any determinations relating to future dividends will be made at the discretion of Cornerstone’s Board of Directors and will depend on a number of factors, including our earnings, capital requirements, financial conditions, future prospects, regulatory restrictions and other factors that Cornerstone’s Board of Directors may deem relevant.

Note 4. Securities

The amortized cost and fair value of securities available-for-sale and held-to-maturity at September 30, 2009 and December 31, 2008 are summarized as follows:

   
September 30, 2009
 
         
Gross
   
Gross
       
   
Amortized
   
Unrealized
   
Unrealized
   
Market
 
     
 
Cost
   
Gains
   
Losses
   
Value
 
Securities Available-for-Sale:
                               
U.S. Government securities
  $ 8,239,619     $ 9,439     $ (56,629 )   $ 8,192,429  
                                 
State and municipal securities
    8,049,936       399,502       (3,572 )     8,445,866  
                                 
Mortgage-backed securities (1)
    42,385,245       251,345       (140,283 )     42,496,307  
                                 
    $ 58,674,800     $ 660,286     $ (200,484 )   $ 59,134,602  
Securities Held-to-Maturity:
                               
Mortgage-backed securities (1)
  $ 141,352     $ 1,245     $ (143 )   $ 142,454  

   
December 31, 2008
 
         
Gross
   
Gross
       
   
Amortized
   
Unrealized
   
Unrealized
   
Market
 
 
 
Cost
   
Gains
   
Losses
   
Value
 
Securities Available-for-Sale:
                       
U.S. Government securities
  $ 7,976,040     $ 275,731     $ -     $ 8,251,771  
                                 
State and municipal securities
    4,609,632       82,013       (68,830 )     4,622,815  
                                 
Mortgage-backed securities(1)
    31,753,504       160,387       (731,918 )     31,181,973  
                                 
    $ 44,339,176     $ 518,131     $ (800,748 )   $ 44,056,559  
Securities Held-to-Maturity:
                               
Mortgage-backed securities(1)
  $ 169,284     $ 1,158     $ (683 )   $ 169,759  

(1)  With the exception of one private label security with an amortized cost of approximately $250,000 and a market value of approximately $243,000 as of September 30, 2009 the mortgage backed security portfolio is comprised of U.S. Government Agency securities with residential mortgage loans as collateral.  As of December 31, 2008 the private label security had an amortized cost of approximately $364,000 and a market value of approximately $297,000.

 
12

 

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

    At September 30, 2009, approximately $56 million of Cornerstone’s investment portfolio was pledged to secure public funds, securities sold under agreements to repurchase and serve as collateral for borrowings at the Federal Reserve Discount Window.

The amortized cost and estimated market value of securities at September 30, 2009, 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
   
Market
   
Amortized
   
Market
 
   
Cost
   
Value
   
Cost
   
Value
 
Due in one year or less
  $ 125,000     $ 125,460     $ -     $ -  
Due from one year to five years
    599,102       630,810       -       -  
Due from five years to ten years
    2,292,995       2,429,284       -       -  
Due after ten years
    13,272,458       13,452,741       -       -  
      16,289,555       16,638,295       -       -  
                                 
Mortgage-backed securities
    42,385,245       42,496,307       141,352       142,454  
                                 
    $ 58,674,800     $ 59,134,602     $ 141,352     $ 142,454  

The following tables present the gross unrealized losses and market 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 September 30, 2009:

   
As of September 30, 2009
 
   
Less than 12 Months
   
12 Months or Greater
   
Total
 
         
Gross
         
Gross
         
Gross
 
   
Market
   
Unrealized
   
Market
   
Unrealized
   
Market
   
Unrealized
 
   
Value
   
Losses
   
Value
   
Losses
   
Value
   
Losses
 
Securities available for sale:
                                   
U.S. Governmental Securities
  $ 5,142,950     $ (56,629 )   $ -     $ -     $ 5,142,950     $ (56,629 )
                                                 
State and municipal securities
    -       -       221,247       (3,572 )     221,247       (3,572 )
                                                 
Mortgage-backed securities
    14,918,819       (91,946 )     4,358,623       (48,337 )     19,277,442       (140,283 )
                                                 
    $ 20,061,769     $ (148,575 )   $ 4,579,870     $ (51,909 )   $ 24,641,639     $ (200,484 )
                                                 
Securities held to maturity:
                                               
Mortgage-backed securities
  $ 1,771     $ (1 )   $ 23,013     $ (142 )   $ 24,784     $ (143 )
 
 
13

 

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

   
As of December 31, 2008
 
   
Less than 12 Months
   
12 Months or Greater
   
Total
 
         
Gross
         
Gross
         
Gross
 
   
Market
   
Unrealized
   
Market
   
Unrealized
   
Market
   
Unrealized
 
   
Value
   
Losses
   
Value
   
Losses
   
Value
   
Losses
 
Securities available for sale:
                                   
State and municipal securities
  $ 1,125,144     $ (48,772 )   $ 206,650     $ (20,058 )   $ 1,331,794     $ (68,830 )
                                                 
Mortgage-backed securities
    19,234,621       (719,051 )     642,457       (12,867 )     19,877,078       (731,918 )
                                                 
    $ 20,359,765     $ (767,823 )   $ 849,107     $ (32,925 )   $ 21,208,872     $ (800,748 )
                                                 
Securities held to maturity:
                                               
Mortgage-backed securities
  $ 26,405     $ (289 )   $ 30,897     $ (394 )   $ 57,302     $ (683 )

Management performs periodic reviews for impairment in accordance with ASC 320, Investment-Debt and Equity Securities.

At September 30, 2009, the 16 (unaudited) securities with unrealized losses have depreciated 0.81 percent (unaudited) from the Bank’s amortized cost basis.  Most of these securities are guaranteed by either U.S. government corporations or agencies or had investment grade ratings upon purchase. Further, the issuers of these securities have not established any cause for default.  The unrealized losses associated with these investment securities are primarily driven by changes in interest rates and are not due to the credit quality of the securities.  These securities will continue to be monitored as a part of Cornerstone’s ongoing impairment analysis, but are expected to perform even if the rating agencies reduce the credit rating of the bond insurers.  Management evaluates the financial performance of each issuer on a quarterly basis to determine if it is probable that the issuers can make all contractual principal and interest payments.

ASC 320 requires an entity to assess whether the entity has the intent to sell the debt security or more likely than not will be required to sell the debt security before its anticipated recovery.  The Bank does not intend to sell these securities and it is not more likely than not that it will be required to sell the investments before the recovery of its amortized cost bases. In making this determination, management has considered cash flow and liquidity requirements, capital requirements, economic factors, and contractual or regulatory obligations for indication that these securities will be required to be sold before a forecasted recovery occurs.  Therefore, in management’s opinion, all securities that have been in a continuous unrealized loss position for the past 12 months or longer as of September 30, 2009 are not other-than-temporarily impaired, and therefore, no impairment charges at September 30, 2009 are warranted.

 
14

 

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

Note 5. Loans and Allowance for Loan Losses

At September 30, 2009 and December 31, 2008, loans are summarized as follows (in thousands):

   
September 30, 2009
   
December 31, 2008
 
   
Amount
   
Percent
   
Amount
   
Percent
 
Commercial, financial and agricultural
  $ 60,734       17.4 %   $ 83,140       21.4 %
Real estate-construction
    57,072       16.4 %     70,456       18.2 %
Real estate-mortgage
    70,733       20.3 %     72,737       18.7 %
Real estate-commercial
    155,778       44.6 %     155,728       40.1 %
Consumer loans
    4,733       1.3 %     6,029       1.6 %
Total loans
  $ 349,050       100.0 %   $ 388,090       100.0 %

A summary of transactions in the allowance for loan losses for the nine months ended September 30, 2009 and year ended December 31, 2008 is as follows (in thousands):

   
September 30,
   
December 31,
 
   
2009
   
2008
 
Balance, beginning of period
  $ 9,618     $ 13,710  
Loans charged-off
    (13,380 )     (7,979 )
Recoveries of loans previously charged-off
    411       389  
Provision for loan losses
    10,749       3,498  
Balance, end of period
  $ 7,398     $ 9,618  

Note 6. Commitments and Contingent Liabilities

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.
 
 
15

 

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

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 our customers default on their resulting obligation to us, 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 September 30, 2009 is as follows:

Commitments to extend credit
$ 41.0 million
Standby letters of credit
$ 3.5 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 September 30, 2009 will not have a material effect on Cornerstone’s consolidated financial statements.

Note 7. Fair Value Disclosures

Fair Value Measurements:

ASC 820, Fair Measurements and Disclosures, defines fair value as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. ASC 820 also establishes a 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. The standard describes three levels of inputs that may be used to measure fair value.

Level 1: Quoted prices (unadjusted) or identical assets or liabilities in active markets that the entity has the ability to access as of the measurement date.

Level 2: Significant other observable inputs other than Level 1 prices, such as quoted prices for similar assets or liabilities, 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.

Cornerstone utilizes fair value measurements to record fair value adjustments to certain assets and determine fair value disclosures.  Accordingly, securities available for sale are recorded at fair value on a recurring basis. Additionally, from time to time, Cornerstone may be required to record other assets at fair value on a nonrecurring basis, such as loans held for sale, and impaired loans.  These nonrecurring fair value adjustments typically involve application of lower of cost or market accounting or write-downs of individual assets.

Following is a description of valuation methodologies used for assets and liabilities recorded at fair value.

Securities available for sale-Investment securities available for sale are recorded at fair value on a recurring basis. Fair value measurement is based upon quoted prices, if available. If quoted prices are not available, fair values are measured using independent pricing models or other model-based valuation techniques such as the present value of future cash flows, adjusted for the security’s credit rating, prepayment assumptions and other factors such as credit loss assumptions. Level 1 securities include those traded on an active exchange, such as the New York Stock Exchange, U.S. Treasury securities that are traded by dealers or brokers in active over-the-counter markets and money market funds. Level 2 securities include mortgage-backed securities, U.S. Government securities and municipal bonds.

 
16

 

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

 
Impaired loans-Cornerstone does not record loans at fair value on a recurring basis. However, from time to time, a loan is considered impaired and an allowance for loan losses is established. 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 310, Receivables. The fair value of impaired loans is estimated using one of 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. In accordance with ASC 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, we record 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, we record the impaired loan as nonrecurring Level 3.
  
Assets and liabilities recorded at fair value on a recurring basis are as follows (amounts in thousands).
 
 
Balance as of
September 30,
2009
   
Quoted Prices
In Active
Markets for
Identical
Assets
(Level 1)
   
Significant
Other
Observable
Inputs
(Level 2)
   
Significant
Unobservable
Inputs
(Level 3)
 
                         
Securities available for sale
  $ 59,135     $ -     $ 59,135     $ -  
Cornerstone has no assets or liabilities whose fair values are measured on a recurring basis using Level 3 inputs.

Assets measured at fair value on a nonrecurring basis are included in the table below (amounts in thousands).
 
 
Balance as of
September 30,
2009
   
Quoted Prices
In Active
Markets for
Identical
Assets
(Level 1)
   
Significant
Other
Observable
Inputs
(Level 2)
   
Significant
Unobservable
Inputs
(Level 3)
 
                         
Impaired loans
  $ 21,362     $ -     $ 21,362     $ -  
 
Impaired loans, which are measured for impairment using the fair value of the collateral for collateral-dependent loans, had a carrying amount of approximately $24,821,000, with a valuation allowance of approximately $3,459,000 at September 30, 2009.  Losses derived from Level 2 inputs were calculated primarily by models utilizing estimated collateral value or the discounted present value of expected cash flows.

Fair Value of Financial Instruments:

Fair value estimates are made at a specific point in time, based on relevant market information about the financial instrument.  These estimates do not reflect any premium or discount that could result from offering for sale at one time Cornerstone's entire holdings of a particular financial instrument.  Because no market exists for a significant portion of Cornerstone’s financial instruments, fair value estimates are based on judgments regarding future expected loss experience, current economic conditions, risk characteristics of various financial instruments, and other factors.  These estimates are subjective in nature; involve uncertainties and matters of judgment; and, therefore, cannot be determined with precision.  Changes in assumptions could significantly affect the estimates.

Fair value estimates are based on existing financial instruments without attempting to estimate the value of anticipated future business and the value of assets and liabilities that are not considered financial instruments.  The following methods and assumptions were used to estimate the fair value of each class of financial instruments:

 
17

 

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

Cash and cash equivalents:

For cash and cash equivalents, the carrying amount is a reasonable estimate of fair value.

Securities:

The fair value of securities is estimated based on bid prices published in financial newspapers or bid quotations received from securities dealers.

Federal Home Loan Bank stock:

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

Loans, net:

The fair value of loans is calculated by discounting scheduled cash flows through the estimated maturity using estimated market discount rates, adjusted for credit risk and servicing costs.  The estimate of maturity is based on historical experience with repayments for each loan classification, modified, as required, by an estimate of the effect of current economic and lending conditions.

Deposits:

The fair value of deposits with no stated maturity, such as demand deposits, money market accounts, and savings deposits, is equal to the amount payable on demand.  The fair value of time deposits is based on the discounted value of contractual cash flows.  The discount rate is estimated using the rates currently offered for deposits of similar remaining maturities.

Federal funds purchased and securities sold under agreements to repurchase:

The fair value of these liabilities, which are extremely short term, approximates their carrying value.

Federal Home Loan Bank advances and line of credit:

The carrying amounts of the FHLB advances and the line of credit approximate their fair value.

Commitments to extend 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.

 
18

 

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

The carrying amount and estimated fair value of Cornerstone's financial instruments at September 30, 2009 and December 31, 2008 is follows (in thousands):

   
September 30, 2009
   
December 31, 2008
 
   
Carrying
   
Estimated
   
Carrying
   
Estimated
 
   
Amount
   
Fair Value
   
Amount
   
Fair Value
 
Assets:
                       
Cash and cash equivalents
  $ 73,288     $ 73,288     $ 21,897     $ 21,897  
Securities
    59,276       59,277       44,226       44,226  
Federal Home Loan Bank Stock
    2,229       2,229       2,188       2,188  
Loans, net
    341,652       343,271       378,472       380,394  
                                 
Liabilities:
                               
Noninterest-bearing demand deposits
    40,796       40,796       40,078       40,078  
Interest-bearing demand deposits
    23,919       23,919       26,909       26,909  
Savings deposits and money market accounts
    31,581       31,581       35,848       35,848  
Time deposits
    289,792       292,147       223,749       225,882  
Federal funds purchased and securities sold under agreements to repurchase
    18,136       18,136       35,790       35,790  
Federal Home Loan Bank advances and line of credit
    72,350       72,350       71,250       71,250  
                                 
Unrecognized financial instruments (net of contract amount):
                               
Commitments to extend credit
    -       -       -       -  

Note 8.  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 month and nine month periods ended September 30, 2009 and 2008.

   
Three Months Ended
   
Nine Months Ended
 
   
September 30,
   
September 30,
 
   
2009
   
2008
   
2009
   
2008
 
Net Income
  $ (1,699,536 )   $ 860,216     $ (5,213,834 )   $ 2,948,130  
Unrealized holding gains (losses) on securities available for sale, net of reclassification
   
249,453
     
(99,349
   
489,997
     
(163,982
                                 
Comprehensive income (loss)
  $ (1,450,083 )   $ 760,867     $ (4,723,837 )   $ 2,784,148  

 
19

 

CORNERSTONE BANCSHARES, INC.
CONSOLIDATED AVERAGE BALANCE
  INTEREST INCOME/EXPENSE AND
  YIELD/RATES

Taxable Equivalent Basis
 
Three months ended
 
(in thousands)
 
September 30
 
 
 
2009
   
2008
 
   
Average
   
Income/
   
Yield/
   
Average
   
Income/
   
Yield/
 
 
 
Balance
   
Expense
   
Rate
   
Balance
   
Expense
   
Rate
 
Assets
                                   
                                     
Earning assets:
                                   
Loans, net of unearned income
  $ 354,246     $ 6,018       6.74 %   $ 381,342     $ 6,977       7.26 %
Investment securities
    54,335       358       2.61 %     48,508       482       4.06 %
Other earning assets
    45,477       31       0.25 %     70       3       2.39 %
Total earning assets
    454,058     $ 6,407       5.60 %     429,920     $ 7,462       6.90 %
Allowance for loan losses
    (6,703 )                     (7,409 )                
Cash and other assets
    41,515                       26,542                  
TOTAL ASSETS
  $ 488,870                     $ 449,053                  
                                                 
Liabilities and Shareholder's Equity
                                               
                                                 
Interest bearing liabilities:
                                               
Interest bearing demand deposits
  $ 25,236     $ 21       0.32 %   $ 29,581     $ 57       0.76 %
Savings deposits
    8,317       11       0.51 %     8,313       16       0.75 %
MMDA's
    23,246       56       0.95 %     40,683       152       1.48 %
Time deposits of $100,000 or less
    207,530       1,408       2.69 %     128,591       1,322       4.08 %
Time deposits of $100,000 or more
    64,511       477       2.93 %     57,486       579       4.00 %
Federal funds purchased and securities sold under agreements to repurchase
    18,897       37       0.78 %     33,712       157       1.85 %
Other borrowings
    72,350       758       4.15 %     72,329       744       4.08 %
Total interest bearing liabilities
    420,086       2,766       2.61 %     370,695       3,027       3.24 %
Net interest spread
          $ 3,641       2.99 %           $ 4,436       3.66 %
Noninterest bearing demand deposits
    39,490                       41,204                  
Accrued expenses and other liabilities
    (3,544 )                     (587 )                
Shareholder's equity
    32,838                       37,741                  
TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY
  $ 488,870                     $ 449,053                  
Net yield on earning assets
                    3.18 %                     4.11 %
                                                 
Taxable equivalent adjustment:
                                               
Loans
            0                       0          
Investment securities
            0                       14          
Total adjustment
            0                       14          

 
20

 

CORNERSTONE BANCSHARES, INC.
CONSOLIDATED AVERAGE BALANCE
  INTEREST INCOME/EXPENSE AND
  YIELD/RATES

Taxable Equivalent Basis
 
Year-to-Date
 
(in thousands)
 
September 30
 
 
 
2009
   
2008
 
   
Average
   
Income/
   
Yield/
   
Average
   
Income/
   
Yield/
 
 
 
Balance
   
Expense
   
Rate
   
Balance
   
Expense
   
Rate
 
Assets 
                                   
                                     
Earning assets: 
                                   
Loans, net of unearned income
  $ 369,394     $ 18,496       6.69 %   $ 383,966     $ 21,730       7.57 %
Investment securities
    54,757       1,158       2.83 %     46,439       1,533       4.54 %
Other earning assets
    17,169       45       0.27 %     285       16       2.72 %
Total earning assets
    441,320     $ 19,699       5.97 %     430,690     $ 23,279       7.24 %
Allowance for loan losses
    (8,379 )                     (8,733 )                
Cash and other assets
    39,984                       27,300                  
TOTAL ASSETS
  $ 472,925                     $ 449,257                  
                                                 
Liabilities and Shareholder's Equity
                                               
                                                 
Interest bearing liabilities:
                                               
Interest bearing demand deposits
  $ 28,574     $ 77       0.36 %   $ 31,069     $ 179       0.77 %
Savings deposits
    8,080       31       0.51 %     7,938       47       0.80 %
MMDA's
    28,316       205       0.97 %     46,865       682       1.94 %
Time deposits of $100,000 or less
    179,614       4,214       3.14 %     123,277       4,150       4.50 %
Time deposits of $100,000 or more
    60,565       1,534       3.39 %     60,240       2,092       4.64 %
Federal funds purchased and securities sold under agreements to repurchase
    21,955       135       0.82 %     32,050       502       2.09 %
Other borrowings
    72,082       2,232       4.14 %     67,297       2,067       4.11 %
Total interest bearing liabilities
    399,186       8,427       2.82 %     368,736       9,720       3.52 %
Net interest spread
          $ 11,271       3.15 %           $ 13,559       3.72 %
Noninterest bearing demand deposits
    41,756                       42,687                  
Accrued expenses and other liabilities
    (2,539 )                     426                  
Shareholder's equity
    34,522                       37,408                  
TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY
  $ 472,925                     $ 449,257                  
Net yield on earning assets
                    3.41 %                     4.22 %
                                                 
Taxable equivalent adjustment:
                                               
Loans
            0                       0          
Investment securities
            0                       43          
Total adjustment
            0                       43          

 
21

 

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

Cornerstone Bancshares, Inc. (“Cornerstone”) is a bank holding company and the parent of Cornerstone Community Bank (the “Bank”), a Tennessee banking corporation, that operates primarily in and around Hamilton County, Tennessee. The Bank has also established a loan production office in Dalton, Georgia and owns Eagle Financial, Inc. (“Eagle”).  Eagle generates loans which are secured by accounts receivable.  Eagle has a primary focus of lending to temporary staffing companies.   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.

The following is a discussion of our financial condition at September 30, 2009 and December 31, 2008 and our results of operations for the three and nine months ended September 30, 2009 and 2008. 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 September 30, 2009, Cornerstone had total consolidated assets of $509.5 million, total loans of $349.0 million, total deposits of $386.1 million and stockholders’ equity of $31.3 million. Net loss for the three and nine month periods ended September 30, 2009 totaled ($1,699,536) and ($5,213,834), respectively.

Results of Operations

Net loss for the three months ended September 30, 2009 was ($1,699,536) or ($0.27) basic earnings per share, compared to net income of $860,216 or $0.14 basic earnings per share for the same period in 2008.  Net loss for the nine months ended September 30, 2009 was ($5,213,834) or ($0.82) basic earnings per share, compared to net income of $2,948,130 or $0.46 basic earnings per share, for the same period of 2008.

The following table presents our results for the three and nine months ended September 30, 2009 and 2008 (amounts in thousands).

         
2009-2008
                     
2009-2008
       
   
Three months
   
Percent
   
Dollar
   
Nine months
   
Percent
   
Dollar
 
   
ended September 30,
   
Increase
   
Amount
   
ended September 30,
   
Increase
   
Amount
 
   
2009
   
2008
   
(Decrease)
   
Change
   
2009
   
2008
   
(Decrease)
   
Change
 
Interest income
  $ 6,407     $ 7,462       (14.14 )%   $ (1,055 )   $ 19,699     $ 23,279       (15.38 )%   $ (3,580 )
Interest expense
    2,766       3,026       (8.59 )%     (260 )     8,428       9,720       (13.29 )%     (1,292 )
Net interest income
                                                               
before provision for loss
    3,641       4,436       (17.92 )%     (795 )     11,271       13,559       (16.87 )%     (2,288 )
                                                                 
Provision for loan loss
    3,390       440       670.45 %     2,950       10,749       927       1059.55 %     9,822  
Net interest income after
                                                               
Provision for loan loss
    251       3,996       (93.72 )%     (3,745 )     522       12,632       (95.87 )%     (12,110 )
                                                                 
Total noninterest income
    184       476       (61.34 )%     (292 )     1,178       1,396       (15.62 )%     (218 )
Total noninterest expense
    3,279       3,151       4.06 %     128       10,345       9,464       9.31 %     881  
                                                                 
Income / (loss) before income taxes
    (2,844 )     1,321       (315.29 )%     (4,165 )     (8,645 )     4,564       (289.42 )%     (13,209 )
                                                                 
Provision for income taxes
    (1,145 )     461       (348.37 )%     (1,606 )     (3,432 )     1,616       (312.38 )%     (5,048 )
                                                                 
Net income / (loss)
  $ (1,699 )   $ 860       (297.56 )%   $ (2,559 )   $ (5,213 )   $ 2,948       (276.83 )%   $ (8,161 )

      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 nine months ended September 30, 2009, net interest income before the provision for loan loss, decreased $(2,288) thousand or (16.87)% over the same period of 2008.  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 3.15% for the nine month period ended September 30, 2009 compared to 3.72% for the same period in 2008. The net interest margin on a tax equivalent basis was 3.41% for the nine month period ended September 30, 2009 compared to 4.22% for the same period in 2008.    Significant items related to the changes in net interest income, net interest yields and rates, and net interest margin are presented below:
 
 
22

 
 
Future changes in the net interest margin will be impacted due to increased competition for funding.  Presently, banks are paying premiums over overnight borrowing rates in order to retain transactional accounts.  In addition, certificates of deposit continue to require a premium to investment instruments with similar maturities.  Management anticipates that this condition will continue until interest rates rise to a more historic level.

Due to the recent recession, liquidity metrics at the Bank’s usual sources of funding have tightened as community banks asset quality deteriorated across the country.  The Bank’s asset quality mirrors this trend.  As a result, the Bank has materially increased its asset allocation in securities to provide collateral to these funding sources to guarantee access to these funds as required.  The consequence of this action will be a substantial drop in the Bank’s asset yield and net interest margin.

Due to the Bank’s present strategic position and capital position of adequately capitalized, the Bank plans to reduce its loan portfolio by approximately $20 million to regain a well capitalized position.  This move will also impact the Bank’s asset allocation and ultimately reduce net interest margin.

The Bank’s loan portfolio yield has declined to 6.74% for the three months ended September 30, 2009 compared to 7.26% for the quarter ended September 30, 2008.  The Bank’s loan portfolio yield has declined to 6.69% for the nine months ended September 30, 2009 compared to 7.57% for the nine months ended September 30, 2008.  The decrease in loan yields is due primarily to difficult economic conditions in Chattanooga, TN, the increase in the amount of non-accrual and restructured loans in the Bank’s loan portfolio and the prolonged low interest rate environment.

For the three month period ended September 30, 2009, the Bank’s investment portfolio resulted in a yield of 2.61% compared to 4.06% for the same time period in 2008.  For the nine month period ended September 30, 2009, the Bank’s investment portfolio resulted in a yield of 2.83% compared to 4.54% for the same time period in 2008.  The decline in the investment portfolio yield from September 30, 2008 to September 30, 2009 is primarily attributable to the Bank’s portfolio composition which includes approximately 50% variable rate securities, indexed to the London Interbank Offered  Rate or “LIBOR” to account for future increases in interest rates.  Presently, the Bank is focusing on liquidity and is retaining unusually large cash balances at the Federal Reserve Bank of Atlanta.   This liquidity will be deployed during the fourth quarter of 2009 in zero credit risk fixed rate mortgage backed securities that provide some protection from rate increases in accordance with the Bank’s bar bell strategy.

Management believes the net interest margin is approaching the lowest level for the reasons mentioned above.    The Bank’s rationale for this forecast is as follows:

First, while management believes the net interest margin will be negatively impacted as a result of loan revenue declining as the Bank’s average loans outstanding are reduced, however management anticipates that this decline in the net interest margin will be offset by the conversion of the Bank’s excess cash position to higher yielding securities.  The net result is expected to be a stable net interest margin for the fourth quarter of 2009.

Second, during 2010, management anticipates that  the Bank’s loan portfolio number of non-accrual and restructured loans will decrease and that the portfolio’s yield will recover to more normal levels and will result in a higher net interest margin.

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 $10.7 million for the nine months ended September 30, 2009.

      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.

 
23

 

The following table presents the components of noninterest income for the three and nine months ended September 30, 2009 and 2008 (dollars in thousands).

         
2009-2008
         
2009-2008
 
   
Three months ended
   
Percent
   
Nine months ended
   
Percent
 
   
September 30,
   
Increase
   
September 30,
   
Increase
 
   
2009
   
2008
   
(Decrease)
   
2009
   
2008
   
(Decrease)
 
Service charges on deposit accounts
  $ 417     $ 440       (5.23 )%   $ 1,260     $ 1,278       (1.41 )%
Net gains / (losses) on sale of loans and other assets
    (262 )     18       (1555.56 )%     (252 )     28       (1000.00 )%
Other fee income
    29       18       61.11 %     170       90       88.89 %
Total noninterest income
    184       476       (61.34 )%     1,178       1,396       (15.62 )%

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

The Bank realized $724 thousand of loss relating to the disposal of other real estate and repossessed assets during the first nine months of 2009.  This amount was partially offset by gains resulting from the sale of investment securities.  In the current economic environment, further losses relating to the disposal of other real estate and repossessed assets are possible.

    Noninterest Expense-Items reported as noninterest expense include salaries and employee benefits, occupancy and equipment expense and other operating expense.

The following table presents the components of noninterest expense for the three and nine months ended September 30, 2009 and 2008 (dollars in thousands). 

                         
   
Three months ended
   
2009-2008
   
Nine months ended
   
2009-2008
 
   
September 30,
   
Percent
   
September 30,
   
Percent
 
   
2009
   
2008
   
Increase/Decrease
   
2009
   
2008
   
Increase/Decrease
 
Salaries and employee benefits
  $ 1,623     $ 1,856       (12.55 )%   $ 5,332     $ 5,532       (3.62 )%
Occupancy and equipment expense
    383       372       2.96 %     1,177       1,135       3.70 %
Other operating expense
    1,273       923       37.92 %     3,836       2,797       37.15 %
Total noninterest expense
    3,279       3,151       4.06 %     10,345       9,464       9.31 %

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

For the nine months ended September 30, 2009, the Bank paid approximately $500,000 in insurance assessments to the Federal Deposit Insurance Corporation (“FDIC”) compared to approximately $189,000 in FDIC insurance assessments for the same period of 2008.

For the nine months ended September 30, 2009, the Bank incurred additional expense related to other real estate.  These expenses total approximately $268,000 for the nine months ended September 30, 2009 compared to approximately $94,000 for the same time period in 2008.  These expenses include legal, insurance, maintenance, and sales cost.  Management expects these costs to continue to increase throughout the remainder of 2009.

Financial Condition

      Overview-The following is a summary of Cornerstone’s financial condition as of September 30, 2009 compared to December 31, 2008:

Cornerstone’s consolidated assets totaled $471.8 million as of December 31, 2008.  As of September 30, 2009, total consolidated assets had increased $37.7 million or 7.99% to $509.5 million.

The Bank’s loan portfolio totaled $349.0 million as of September 30, 2009, a decrease of $39.0 million or (10.06)%  from December 31, 2008.

 
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The Bank’s investment portfolio increased by approximately $15.1 million to a total of $59.3 million as of September 30, 2009 compared to a total of $44.2 million as of December 31, 2008.

Liabilities as of September 30, 2009 and December 31, 2008 totaled approximately $478.2 million and $435.3 million, respectively.

Stockholders’ equity as of September 30, 2009 and December 31, 2008 totaled approximately $31.3 million and $36.5 million, respectively.

      Securities-The Bank’s investment portfolio, primarily consisting of Federal Agency, mortgage-backed securities and municipal securities, amounted to $59.3 million as of September 30, 2009 compared to $44.2 million as of December 31, 2008. The primary purpose of the Bank’s investment portfolio is to satisfy pledging requirements, to collateralize the Bank’s repurchase accounts and provide additional liquidity at the Federal Reserve Discount Window.

      Loans-The composition of loans at September 30, 2009 and at December 31, 2008 and the percentage (%) of each classification to total loans are summarized in the following table (dollars in thousands):

   
September 30, 2009
   
December 31, 2008
 
   
Amount
   
Percent
   
Amount
   
Percent
 
Commercial, financial and agricultural
  $ 60,734       17.4 %   $ 83,140       21.4 %
Real estate-construction
    57,072       16.4 %     70,456       18.2 %
Real estate-mortgage
    70,733       20.3 %     72,737       18.7 %
Real estate-commercial
    155,778       44.6 %     155,728       40.1 %
Consumer loans
    4,733       1.3 %     6,029       1.6 %
Total loans
  $ 349,050       100.0 %   $ 388,090       100.0 %

For the nine months ended September 30, 2009, the Bank has seen a decrease in total loans of 10.1% when compared to December 31, 2008.  One reason for the decrease is the Bank’s emphasis on credit quality and properly pricing loan interest rates based upon the identified risks.  Specifically, the decline in real estate construction lending from $70.5 million as of December 31, 2008 compared to $57.1 million as of September 30, 2009 is a result of the Bank’s attempt to minimize its risk given the current real estate market.

       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 third quarter of 2009, the Bank experienced continued loan quality deterioration.  During the quarter, management deemed several large loans to be impaired which resulted in an increase in provision expense.  Currently, the Bank 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 if the Bank’s loan portfolio continues to deteriorate.

The following is a summary of changes in the allowance for loan losses for the nine months ended September 30, 2009 and for the year ended December 31, 2008 and the ratio of the allowance for loan losses to total loans as of the end of each period (dollars in thousands):

 
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September 30,
   
December 31,
 
   
2009
   
2008
 
Balance, beginning of period
  $ 9,618     $ 13,710  
Loans charged-off
    (13,380 )     (7,979 )
Recoveries of loans previously charged-off
    411       389  
Provision for loan losses
    10,749       3,498  
Balance, end of period
  $ 7,398     $ 9,618  
                 
Total loans
  $ 349,050     $ 388,090  
                 
Ratio of allowance for loan losses to loans outstanding at the end of the period
    2.12 %     2.48 %
                 
Ratio of net charge-offs to total loans outstanding for the period
    3.72 %     1.96 %

    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, 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 following is a summary of changes in Cornerstone’s impaired loans for the nine months ended September 30, 2009 and for the year ended December 31, 2008:

   
September 30,
   
December 31,
 
   
2009
   
2008
 
Impaired loans without a valuation allowance
  $ 4,310,096     $ 2,543,320  
                 
Impaired loans with a valuation allowance
  $ 24,820,603     $ 17,375,043  
                 
Total impaired loans
  $ 29,130,699     $ 19,918,363  
                 
Valuation allowance related to impaired loans
  $ 3,458,663     $ 5,872,373  
                 
Total non-accrual loans
  $ 8,138,831     $ 4,252,791  
                 
Total loans past-due ninety days or more and still accruing
  $ -     $ -  

 
26

 

   
Nine Months
   
Year Ended
 
   
September 30,
   
December 31,
 
   
2009
   
2008
 
Average investment in impaired loans (1)
  $ 26,989,776     $ 10,891,357  
                 
Interest income recognized on impaired loans
  $ 2,159,010     $ 966,011  

(1) The average investment in impaired loans is calculated using the following criteria:

(a) Loans with a risk grade of 5 or greater and have been assigned an impairment amount based upon management’s quarterly ASC 310 analysis;

(b) All Loans with a risk grade of 5 or greater that are at least sixty days past due as of the reporting date even if an impairment amount has not been assigned.

Finally, the average investment in impaired loans is calculated using the quarter end balances for the reporting period starting with the fourth quarter of the preceding year.

The Bank’s loan portfolio has experienced a general deterioration in loan quality as the Chattanooga, TN MSA endures the current economic recession.  The number and dollar amount of impaired loans decreased slightly during the third quarter of 2009 as the Bank continued to systematically review its loan portfolio to proactively identify possible impaired loans.  Management anticipates that its loan asset quality will not improve until the economy recovers from the current economic recession.

The following table summarizes Cornerstone’s non-performing assets at September 30, 2009, June 30, 2009, March 31, 2009 and December 31, 2008 (dollars in thousands):

   
September 30,
   
June 30,
   
March 31,
   
December 31,
 
   
2009
   
2009
   
2009
   
2008
 
Non-accrual loans
  $ 8,139     $ 13,397     $ 8,620     $ 4,252  
Repossessed assets
    98       181       256       257  
Foreclosed properties
    7,695       4,783       2,476       2,459  
Total non-performing assets
  $ 15,932     $ 18,361     $ 11,352     $ 6,968  
                                 
Total loans outstanding
  $ 349,050     $ 360,615     $ 378,993     $ 388,090  
                                 
Allowance for loan losses
    7,398       7,383       12,885       9,618  
                                 
Ratio of non-performing assets to total loans outstanding at the end of the period 
    4.56     5.09     3.00     1.80
                                 
Ratio of non-performing assets to total allowance for loan losses at the end of the period 
    215.36     248.69     88.09     72.45

 
27

 

As of September 30, 2009, the Bank’s non-accrual loans decreased from the second to the third quarter of 2009 as impaired loans progressed through the collection process and shifted from non-accrual to other real estate.  Furthermore, management estimates a loss of five percent associated with the disposal of these assets.  The Bank will continue to place a high priority on the conversion of non-accruing loans to disposable assets, which should result in non-accrual loans decreasing in the future while other real estate increases are projected for the short term until the assets are sold.

Deposits and Other Borrowings-The Bank’s deposits consist of noninterest 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 securities the following day.  The Bank has also obtained advances from the Federal Home Loan Bank.

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.

   
September 30, 2009
   
December 31, 2008
 
 
 
Amount
   
Percent
   
Amount
   
Percent
 
Core funding: 
                               
Non-interest bearing demand deposits
  $ 40,796       8.7 %   $ 40,078       9.3 %
Interest-bearing demand deposits
    23,919       5.1 %     26,909       6.3 %
Savings & money market accounts
    31,581       6.7 %     35,848       8.3 %
Time deposits under $100,000
    200,262       42.5 %     164,692       38.4 %
Total core funding
    296,558       63.0 %     267,527       62.3 %
                                 
Non-core funding:
                               
Time deposit accounts greater than $100,000
    89,530       19.0 %     59,057       13.8 %
Securities sold under agreements to repurchase
    18,136       3.8 %     35,790       8.3 %
Federal Home Loan Bank advances
    67,000       14.2 %     67,000       15.6 %
Total non-core funding
    174,666       37.0 %     161,847       37.7 %
                                 
Total
  $ 471,224       100.0 %   $ 429,374       100.0 %

Federal funds purchased are lines of credit established with other financial institutions that allow the Bank to meet short term funding requirements.  These lines can be used as frequently as daily with large variations in balances depending upon the Bank’s immediate funding requirements.  As of September 30, 2009, the Bank had established $9.0 million in available federal funds lines.

The Federal Reserve Bank of Atlanta encourages the Bank to use its Discount Window to borrow funds on an overnight basis.  The Bank presently has availability and collateral in place to fund $15 million in borrowings and plans to increase its borrowing capacity to $20 million by the end of the fourth quarter of 2009.

 
28

 

Federal Home Loan Bank of Cincinnati (“FHLB”) borrowings are secured by certain qualifying residential mortgage loans and, pursuant to a blanket lien, all qualifying commercial mortgage loans.  The   borrowings are structured as either term loans with call and put options after a stated conversion date and an overnight borrowing arrangement.  As of September 30, 2009, the Bank had total outstanding of $67 million from FHLB consisting of structured term loans.  The Bank is seeking the FHLB’s release of the Bank’s loan portfolio that is pledged as collateral in exchange for a combination of pledged cash and securities.  This exchange is sought because of the FHLB’s increased collateral maintenance required on loans pledged by the Bank.  The Bank believes the cost associated with this maintenance to be in excess of the revenue and liquidity lost by pledging the securities.  Once the exchange is completed the Bank will have only securities pledged against FHLB borrowings and will match the durations of the securities to have sufficient cash flow to payoff the loans as they mature.

   Capital Resources-At September 30, 2009 and December 31, 2008, Cornerstone’s stockholders’ equity amounted to $31.3 million and $36.5 million, respectively.

Cornerstone’s stockholders’ equity decreased $5.2 million during the nine months ended September 30, 2009.  Factors contributing to the reduction in capital include cash dividends totaling $0.10 per share for the six months ended June 30, 2009, of which $0.03 per share was declared during the second quarter of 2009, and operating losses of $1.7 million during the third quarter of 2009 resulting in a year to date loss of $5.2 million.

As of September 30, 2009, the Bank dipped under the regulatory minimums required to be a well-capitalized institution.  The Bank had $32.2 million of Tier 1 capital and $36.9 million of total risk-based capital.  Following is a summary of the Bank’s capital ratios as of September 30, 2009:

Tier 1 leverage ratio of 6.71% to average assets.
Tier 1 capital ratio of 8.69% to risk weighted assets.
Total risk based capital ratio of 9.94% to risk weighted assets.

Management anticipates returning to a well-capitalized position by the end of 2009.

Cornerstone had total outstanding borrowings of $5.35 million from Silverton Bank, currently in FDIC receivership, as of September 30, 2009.  The $5.35 million is comprised of a $4.35 million term loan amortizing over a five year period and $1.0 million under a revolving line of credit.

On October 15, 2009, Cornerstone notified the FDIC of its decision to withdraw its application for funding under the U.S. Treasury’s Capital Purchase Program.

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 committee must consider interest rate sensitivity and liquidity risk management when rendering a decision on funding solutions and loan pricing.  The following is a brief discussion of one of the primary tools used by the ALCO committee to perform its responsibilities:

Gap analysis is a technique of asset-liability management that can be used to assess interest rate risk or liquidity risk. The Bank has developed a gap analysis to assist the ALCO committee in its decision making.  The analysis provides the committee information regarding the interest rate-sensitivity of the Bank.  The interest rate-sensitivity is the difference between the interest-earning assets and interest-bearing liabilities scheduled to mature or reprice within  a stated time period.  The gap is considered positive when the amount of interest rate-sensitive assets exceeds the amount of interest rate-sensitive liabilities.  Conversely, the gap is considered negative when the amount of interest   rate-sensitive liabilities exceeds the amount of interest rate-sensitive assets.  The gap position coupled with interest   rate movements will result in either an increase or decrease in net interest income depending upon the Bank’s position and the nature of the movement.

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 committee and is reviewed by the Bank’s regulatory agencies on a regular basis.

 
29

 

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, 2008. No material changes in the assumptions used in preparing, or results obtained from, the model have occurred since December 31, 2008.

Item 4T. Controls and Procedures

Under the supervision and with the participation of management, including Cornerstone’s principal executive officer and principal financial 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 September 30, 2009 (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 subsidiaries) 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 September 30, 2009 that have materially affected, or are reasonably likely to materially affect, Cornerstone’s internal control over financial reporting.

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

There have been no material changes to Cornerstone’s risk factors as previously disclosed in Part I, Item 1A of Cornerstone’s Annual Report on Form 10-K for the fiscal year ended December 31, 2008.

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

None

Item 3. Defaults Upon Senior Securities

None

Item 4. Submission of Matters to a Vote of Security Holders

None

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.

 
30

 

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: November 13, 2009
/s/ Nathaniel F. Hughes
 
Nathaniel F. Hughes,
 
(Acting) President & Chief Executive Officer
 
(principal executive officer)
   
Date: November 13, 2009
/s/ Gary W. Petty, Jr.
 
Gary W. Petty, Jr.
 
(Acting) Treasurer
 
(principal financial officer)

31

 
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.

 
32