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CSBQ > SEC Filings for CSBQ > Form 10-Q on 14-Nov-2012All Recent SEC Filings

Show all filings for CORNERSTONE BANCSHARES INC | Request a Trial to NEW EDGAR Online Pro

Form 10-Q for CORNERSTONE BANCSHARES INC


14-Nov-2012

Quarterly Report


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

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

The following is a discussion of Cornerstone's financial condition at September 30, 2012 and December 31, 2011 and our results of operations for the three and nine months ended September 30, 2012 and 2011. The purpose of this discussion is to focus on information about Cornerstone's 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 Cornerstone's consolidated financial statements and the related notes included elsewhere herein.

Critical Accounting Policies

Cornerstone's accounting and reporting policies are in accordance with accounting principles generally accepted in the United States of America and conform to general practices within the banking industry. Our significant accounting policies are described in Note 1, "Summary of Significant Accounting Policies," to the consolidated financial statements and are integral to understanding the MD&A. Critical accounting policies include the initial adoption of an accounting policy that has a material impact on our financial presentation as well as accounting estimates reflected in our financial statements that require us to make estimates and assumptions about matters that were highly uncertain at the time. Disclosure about critical estimates is required if different estimates that Cornerstone reasonably could have used in the current period would have a material impact on the presentation of our financial condition, changes in financial condition or results of operations. The following is a description of our critical accounting policies.

Allowance for Loan Losses

The allowance for loan losses is established and maintained at levels management deems adequate to absorb credit losses inherent in the portfolio as of the balance sheet date. The allowance is increased through the provision for loan losses and reduced through loan charge-offs, net of recoveries. The level of the allowance is based on known and inherent risks in the portfolio, past loan loss experience, underlying estimated values of collateral securing loans, current economic conditions and other factors as well as the level of specific impairments associated with impaired loans. This process involves our analysis of complex internal and external variables and it requires that management exercise judgment to estimate an appropriate allowance.

Changes in the financial condition of individual borrowers, economic conditions or changes to our estimated risks could require us to significantly decrease or increase the level of the allowance. Such a change could materially impact Cornerstone's net income as a result of the change in the provision for loan losses. Refer to Note 1 and 4 in the notes to Cornerstone's consolidated financial statements for a discussion of Cornerstone's methodology of establishing the allowance.

Estimates of Fair Value

Fair value is used on a recurring basis for certain assets and liabilities in which fair value is the primary basis of accounting. Cornerstone's available for sale securities and cash surrender value of life insurance are measured at fair value on a recurring basis. Additionally, fair value is used to measure certain assets and liabilities on a nonrecurring basis. Cornerstone uses fair value on a nonrecurring basis for foreclosed assets and collateral associated with impaired collateral-dependent loans. Fair value is also used in certain impairment valuations, including assessments of goodwill, other intangible assets and long-lived assets.

Fair value is the price that could be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants. Estimating fair value in accordance with applicable accounting guidance requires that Cornerstone make a number of significant judgments. Accounting guidance provides three levels of fair value. Level 1 fair value refers to observable market prices for identical assets or liabilities. Level 2 fair value refers to similar assets or liabilities with observable market data. Level 3 fair value refers to assets and liabilities where market prices are unavailable or impracticable to obtain for similar assets or liabilities. Level 3 valuations require modeling techniques, such as discounted cash flow analyses. These modeling techniques incorporate Cornerstone's assessments regarding assumptions that market participants would use in pricing the asset or the liability.

Changes in fair value could materially impact our financial results. Refer to Note 6, "Fair Value Disclosures," in the notes to Cornerstone's consolidated financial statements for a discussion of the methodology in calculating fair value.

Income Taxes

Cornerstone is subject to various taxing jurisdictions where Cornerstone conducts business. Cornerstone estimates income tax expense based on amounts expected to be owed to these jurisdictions. Cornerstone evaluates the reasonableness of our effective tax rate based on a current estimate of annual net income, tax credits, non-taxable income, non-deductible expenses and the applicable statutory tax rates. The estimated income tax expense or benefit is reported in the consolidated statements of income.

The accrued tax liability or receivable represents the net estimated amount due or to be received from tax jurisdictions either currently or in the future and are reported in other liabilities or other assets, respectively, in Cornerstone's consolidated balance sheets. Cornerstone assesses the appropriate tax treatment of transactions and filing positions after considering statutes, regulations, judicial precedent and other pertinent information and maintains tax accruals consistent with management's evaluation. Changes in the estimate of accrued taxes occur periodically due to changes in tax rates, interpretations of tax laws, the status of examinations by tax authorities and newly enacted statutory, judicial and regulatory guidance that could impact the relative merits of tax positions. These changes, if or when they occur, could impact accrued taxes and future tax expense and could materially affect our financial results.

Cornerstone periodically evaluates uncertain tax positions and estimates the appropriate level of tax reserves related to each of these positions. Additionally, Cornerstone evaluates its deferred tax assets for possible valuation allowances based on the amounts expected to be realized. The evaluation of uncertain tax positions and deferred tax assets involves a high degree of judgment and subjectivity. Changes in the results of these evaluations could have a material impact on our financial results. Refer to Note 9, "Income Taxes," in the notes to Cornerstone's consolidated financial statements set forth in its Annual Report on Form 10-K for the year ended December 31, 2011 for more information.

Consent Order and Written Agreement

On April 2, 2010, Cornerstone Community Bank (the "Bank"), the wholly owned subsidiary bank of Cornerstone, entered into a Stipulation to the Issuance of a Consent Order (the "Stipulation") with the Federal Deposit Insurance Corporation (the "FDIC"). Pursuant to the Stipulation, the Bank consented, without admitting or denying any charges of unsafe or unsound banking practices or violations of law or regulations, to the issuance of a Consent Order (the "Order") by the FDIC, also effective as of April 2, 2010. On April 8, 2010, the Bank also executed a written agreement (the "Agreement") with the Tennessee Department of Financial Institutions ("TDFI").

The Order and the Agreement (collectively, the "Action Plans") contained substantially similar terms and were based on the findings of the FDIC and TDFI during their joint examination of the Bank commenced on October 8, 2009 (the "Examination"), as disclosed in the Joint Report of Examination (the "Report"). The Order and the Agreement represented agreements between the Bank, on the one hand, and the FDIC and the TDFI, respectively, on the other hand, as to areas of the Bank's operations that warranted improvement and presented plans for making those improvements. The Action Plans imposed no fines or penalties on the Bank.

The Action Plans required the Bank to implement several governance, budgeting, credit management, risk management and reporting procedures. The Bank substantially complied with the terms of the Action Plans.

On August 17, 2012, the FDIC and the TDFI issued written confirmation to the Bank's Board of Directors that the Action Plans had been terminated.

Some of the procedures established by the Action Plans remain in place, including the requirement for approval by the Regional director of the FDIC and the Commissioner of the Tennessee Department of Financial Institutions of any dividends declared or paid by the Bank to its parent, Cornerstone.

Federal Reserve Bank of Atlanta (FRBA) Letter

Cornerstone received a letter dated March 30, 2010 from its primary banking regulator, the FRBA. The letter directs Cornerstone to obtain the FRBA's written approval before Cornerstone (i) incurs any indebtedness; (ii) declares or pays any dividends; (iii) redeems any corporate stock; or (iv) makes any other payment representing a reduction in its capital, except for the payment of normal and routine operating expenses. As noted above, Cornerstone has received FRBA's approval for dividends with respect to the Preferred Shares. The letter notes that the condition of the Bank has caused Cornerstone to be in "troubled condition" under Regulation Y. As a result, notice to the FRBA is required before Cornerstone undertakes any changes in senior executive management or directorships, and approval of the FRBA (with the written concurrence of the FDIC) must be obtained before Cornerstone grants or enters into any agreement to provide a golden parachute or severance payment. To date, Cornerstone is in compliance with the requirements of the FRBA letter.

To date the most significant impact of the FRBA's letter relates to the payment of dividends on the Preferred Shares. However, Cornerstone has been able to consistently raise additional capital and the company has generated positive earnings during 2012. These two elements coupled with the Bank's stabilization of asset quality have, in Cornerstone's estimation, led to the approval of the Preferred Shares dividend payments.

Review of Financial Performance

As of September 30, 2012, Cornerstone had total consolidated assets of approximately $425 million, total loans of approximately $274 million, total securities of approximately $82 million, total deposits of approximately $329 million and stockholders' equity of approximately $38 million. Net income for the three and nine month period ended September 30, 2012 totaled $364,246 and $1,031,348, respectively.

Results of Operations

Net income for the three months ended September 30, 2012 was $364,246 or $0.01 basic earnings per common share, compared to a net income of $523,668 or $0.05 basic earnings per common share, for the same period in 2011. Net income for the nine months ended September 30, 2012 was $1,031,348 or $0.02 basic earnings per common share, compared to a net income of $917,230 or $0.07 basic earnings per common share, for the same period in 2011.

The following table presents our results for the three and nine months ended September 30, 2012 compared to the three and nine months ended September 30, 2011 (amounts in thousands).

                                                     2012-2011                                                   2012-2011
                            Three months              Percent         Dollar             Nine months              Percent         Dollar
                         ended September 30,         Increase         Amount         ended September 30,         Increase         Amount
                         2012            2011       (Decrease)        Change          2012           2011       (Decrease)        Change
Interest income       $    4,735       $  5,114           (7.41 )%   $    (379 )   $    14,178     $ 15,493           (8.48 )%   $ (1,315 )
Interest expense           1,172          1,510          (22.36 )%        (338 )         3,703        4,957          (25.29 )%     (1,254 )
Net interest income
before provision
for loan loss              3,563          3,604           (1.14 )%         (41 )        10,475       10,536           (0.58 )%        (61 )

Provision for loan
loss                         100            115          (13.04 )%         (15 )           100          145          (31.03 )%        (45 )
Net interest income
after provision for
loan loss                  3,463          3,489           (0.75 )%         (26 )        10,375       10,391           (0.15 )%        (16 )

Total noninterest
income                       258            323          (19.94 )%         (65 )           778          909          (14.41 )%       (131 )
Total noninterest
expense                    3,203          3,076            4.13 %          127           9,700       10,151           (4.44 )%       (451 )

Income before
income taxes                 519            736          (29.55 )%        (217 )         1,453        1,149           26.48 %         304

Provision for
income taxes                 154            212          (27.22 )%         (58 )           422          232           81.90 %         190

Net income            $      364       $    524          (30.50 )%   $    (160 )   $     1,031     $    917           12.46 %    $    114

Net Interest Income-Net interest income represents the amount by which interest earned on various earning assets exceeds interest paid on deposits and other interest-bearing liabilities. Net interest income is also the most significant component of our earnings. For the three months ended September 30, 2012, net interest income before the provision for loan loss, decreased approximately $41 thousand or 1.14 percent over the same period of 2011. For the nine months ended September 30, 2012, net interest income before the provision for loan loss decreased $61 thousand or 0.58 percent.

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 3.53 percent compared to 3.49 percent for the three month periods ended September 30, 2012 and 2011, respectively. The interest rate spread on a tax equivalent basis was 3.55 percent compared to 3.33 percent for the nine month periods ended September 30, 2012 and 2011, respectively.

The net interest margin on a tax equivalent basis was 3.70 percent and 3.69 percent for the three months ending, September 30, 2012 and 2011, respectively. The net interest margin on a tax equivalent basis was 3.73 percent and 3.51 percent for the nine months ending, September 30, 2012 and 2011, respectively.

Significant items related to the changes in net interest income, net interest yields and rates, and net interest margin are presented below:

[[Image Removed]]  The Bank's interest income has been negatively impacted when comparing the
                   three and nine months ended  September 30, 2012 to September 30, 2011.  The
                   primary reason for the decline has resulted from the decrease in the Bank's
                   loan yield.

Loan yield for the three months ended September 30, 2012, equaled 6.23 percent compared to 6.67 percent as of September 30, 2011.

Loan yield for the nine months ended September 30, 2012, equaled 6.31 percent compared to 6.65 percent as of September 30, 2011.

The decrease in interest income has been offset by a reduction in cost of funds.

Total interest cost for the three months ended September 30, 2012, equaled 1.37 percent compared to 1.71 percent as of September 30, 2011.

Total interest cost for the nine months ended September 30, 2012, equaled 1.46 percent compared to 1.79 percent as of September 30, 2011.

The cost of funds reduction was the result of a decrease in interest rates paid by the Bank and a change in the deposit mix with customers choosing to place deposits in transactional accounts rather than certificates of deposit. The Bank's cost of funds were approximately $1.2 million for the three months ended September 30, 2012 compared to $1.5 million during the same time period in 2011.

[[Image Removed]]  The Bank's loan portfolio yield decreased to 6.23 percent for the three
                   months ended September 30, 2012 compared to 6.67 percent for the three
                   months ended September 30, 2011.  Management believes the interest rates on
                   loans will continue to decrease as the Bank attempts to increase its
                   outstanding loan balances in a very competitive market. However, if
                   management is successful in increasing the amount of outstanding loans, the
                   resulting change in asset mix would increase the Bank's total interest
                   income.

[[Image Removed]]  For the three month period ended September 30, 2012, the Bank's investment
                   portfolio yielded 2.36 percent compared to 2.40 percent for the same time
                   period in 2011.  The Bank decreased the amount of its investment portfolio
                   from a nine months ended average balance of approximately $113 million as of
                   September 30, 2011 to approximately $92 million as of September 30, 2012.
                   The reduction in investments is due, in part, to a decrease in pledging
                   requirements as the Bank has repaid $32 million in Federal Home Loan Bank
                   advances since March 31, 2010.  Management believes the present level of
                   investment securities is sufficient to provide for all pledging needs and
                   represents an appropriate amount of the balance sheet  to provide liquidity
                   and interest rate protection.

[[Image Removed]]  The Bank's net interest margin for the nine month period ending September
                   30, 2012 compared to September 30, 2011 increased by 22 basis points.  The
                   primary reason for the improvement resulted from a reduction in cost of
                   funds.  The Bank expects the net interest margin to continue to increase
                   over the next four quarters as the Bank converts cash and foreclosed assets
                   into earning assets such as loans.

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. Cornerstone recorded $100 thousand in provision for loan losses for the three months ended September 30, 2012 compared to $115 thousand for the three months ended September 30, 2011.

Noninterest Income-Items reported as noninterest income include service charges on checking accounts, insufficient funds charges, automated clearing house ("ACH") processing fees and the Bank's secondary mortgage department earnings. Increases in income derived from service charges and ACH fees are primarily a function of the Bank's growth while fees from the origination of mortgage loans will often reflect market conditions and fluctuate from period to period.

The following table presents the components of noninterest income for the three and nine months ended September 30, 2012 and 2011 (dollars in thousands):

                                                                  2012-2011                                     2012-2011
                                      Three months ended           Percent           Nine months ended           Percent
                                         September 30,            Increase             September 30,            Increase
                                     2012            2011        (Decrease)         2012            2011       (Decrease)
Service charges on deposit
accounts                           $     198       $     216           (8.33 )%   $     602       $    657           (8.37 )%
Realized gains on sale of
securities                                 -              60         (100.00 )%           -            107         (100.00 )%
Net gains / (losses) on sale of
loans and other assets                    48              32           50.00 %          124             88           40.91 %
Other noninterest income                  13              15          (13.33 )%          52             57           (8.77 )%
Total noninterest income           $     259       $     323          (19.81 )%   $     778       $    909          (14.41 )%

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

[[Image Removed]]  The Bank has experienced a decrease in its service charges on deposit
                   accounts during 2012 due to a continued reduction in customer overdraft
                   charges.

[[Image Removed]]  The Bank continued to exit the ACH payroll processing business during 2011
                   due to increased regulatory requirements. The decrease in service charges on
                   deposit accounts associated with exiting this line of business was
                   approximately $20 thousand a month.

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

The following table presents the components of noninterest expense for the three and nine months ended September 30, 2012 and 2011 (dollars in thousands).

                                                                2012-2011                                   2012-2011
                                     Three months ended          Percent          Nine months ended          Percent
                                        September 30,           Increase            September 30,           Increase
                                      2012          2011       (Decrease)         2012          2011       (Decrease)
Salaries and employee benefits     $    1,566      $ 1,459            7.33 %    $   4,727     $  4,504            4.95 %
Occupancy and equipment expense           355          362           (1.93 )%       1,038        1,118           (7.16 )%
Foreclosed asset expense, net             314          307            2.28 %          945        1,385          (31.77 )%
FDIC depository insurance                 237          234            1.28 %          683          798          (14.41 )%
Other operating expense                   731          715            2.24 %        2,307        2,346           (1.66 )%
Total noninterest expense          $    3,203      $ 3,077            4.09 %    $   9,700     $ 10,151           (4.44 )%

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

[[Image Removed]]  Cornerstone's employee expense increased slightly when comparing the three
                   and nine months ended September 30, 2011 to September 30, 2012.  The
                   increase is primarily attributable to an increase in the number of
                   commercial relationship managers.  These employees will assist the Bank in
                   obtaining its future loan growth goals.  Management expects employee expense
                   to continue to increase slightly during 2012-2013 as employee benefits are
                   increased as the Bank's performance improves.

[[Image Removed]]  As of September 30, 2012, the Bank had incurred approximately $945 thousand
                   pertaining to net foreclosed asset expenses compared to approximately $1.4
                   million as of September 30, 2011 for the nine months ended. Management, in
                   its financial reporting process, nets the foreclosed assets expense and
                   write-downs against the revenue generated from income producing real estate.
                   Management anticipates elevated foreclosed asset expense for the remainder
                   of 2012 and 2013.

[[Image Removed]]   For the nine months ended, depository insurance decreased from
                   approximately $798 thousand as of September 30, 2011 to approximately $683
                   thousand as of September 30, 2012.  The reduction in expense is primarily
                   due to a reduction of deposit levels during the year.  Management
                   anticipates a further reduction in depository insurance expense as a result
                   of the FDIC upgrading the Bank's safety and soundness classification.  The
                   reduction in expense is estimated to be 40 percent.

Financial Condition

Overview-Cornerstone's consolidated assets totaled approximately $423 million as of December 31, 2011. As of September 30, 2012, total consolidated assets had increased approximately $2 million to approximately $425 million.

Liabilities as of September 30, 2012 and December 31, 2011 totaled approximately $387 million.

Stockholders' equity as of September 30, 2012 and December 31, 2011 totaled approximately $38 million and $35 million, respectively.

Securities-The Bank's investment portfolio, primarily consisting of Ginnie Mae Agency, mortgage-backed securities and municipal securities, amounted to approximately $82 million as of September 30, 2012 compared to approximately $86 million as of December 31, 2011. The primary purposes of the Bank's investment portfolio are to provide liquidity, satisfy pledging requirements, collateralize the Bank's repurchase accounts and secure the Bank's FHLB borrowings.

Loans-The composition of loans at September 30, 2012 and at December 31, 2011 and the percentage (%) of each classification to total loans are summarized in the following table (dollars in thousands):

                                      September 30, 2012          December 31, 2011
                                      Amount       Percent       Amount       Percent
Commercial real estate-mortgage
Owner-occupied                      $   61,229        22.36 %   $  62,999        23.53 %
All other                               65,501        23.92 %      63,058        23.55 %
Consumer real estate-mortgage           71,050        25.95 %      70,543        26.35 %
Construction and land development       33,612        12.28 %      31,031        11.59 %
Commercial and industrial               40,012        14.61 %      37,458        13.98 %
Consumer and other                       2,416         0.88 %       2,676         1.00 %
Total loans                            273,820       100.00 %     267,765       100.00 %
Less:  Allowance for loan losses        (5,280 )                   (7,400 )

Loans, net                          $  268,540                  $ 260,365

. . .

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