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CSBQ > SEC Filings for CSBQ > Form 10-K on 28-Mar-2013All Recent SEC Filings

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



Annual Report


Forward-Looking Statements

Cornerstone Bancshares, Inc. ("Cornerstone") may from time to time make written or oral statements, including statements contained in this report (including, without limitation, certain statements in "Management's Discussion and Analysis of Financial Condition and Results of Operations" in Item 7), that constitute forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934 (the "Exchange Act"). The words "expect," "anticipate," "intend," "consider," "plan," "believe," "seek," "should," "estimate," and similar expressions are intended to identify such forward-looking statements, but other statements may constitute forward-looking statements. These statements should be considered subject to various risks and uncertainties. Such forward-looking statements are made based upon management's belief as well as assumptions made by, and information currently available to, management pursuant to "safe harbor" provisions of the Private Securities Litigation Reform Act of 1995. Cornerstone's actual results may differ materially from the results anticipated in forward-looking statements due to a variety of factors. Such factors include, without limitation, those specifically described in Item 1A of Part I of this Annual Report on Form 10-K, as well as the following: (i) the possibility that our asset quality would decline or if we experience greater loan losses than anticipated, (ii) increased levels of other real estate, primarily as a result of foreclosures, (iii) the impact of liquidity needs on our results of operations and financial condition, (iv) competition from financial institutions and other financial service providers (v) economic conditions in the local markets where we operate, (vi) the impact of obtaining regulatory approval prior to the payment of dividends, (vii) the impact of our Series A Preferred Stock on net income available to holders of our Common Stock and earnings per common share, (viii) the impact of negative developments in the financial industry and U.S. and global capital and credit markets, (ix) the impact of recently enacted legislation on our business, (x) the relatively greater credit risk of residential construction and land development loans in our loan portfolio, (xi) adverse impact on operations and financial condition due to changes in interest rates, (xii) our ability to obtain additional capital and, if obtained, the possible significant dilution to current shareholders,
(xiii) the impact of recently enacted legislation on our business, (xiv) the impact of federal and state regulations on our operations and financial performance, (xv) whether a significant deferred tax asset we have can be fully realized, (xvi) our ability to retain the services of key personnel, (xvii) the impact of Tennessee's anti-takeover statutes and certain charter provisions on potential acquisitions of the holding company, and (xviii) our ability to adapt to technological changes. 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.

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 December 31, 2012 and December 31, 2011 and Cornerstone's results of operations for each of the three-years ended December 31, 2012, 2011 and 2010. 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.

Review of Financial Performance

As of December 31, 2012, Cornerstone had total consolidated assets of approximately $443 million, total loans of approximately $277 million, total deposits of approximately $345 million and stockholders' equity of approximately $41 million. Cornerstone achieved a net income of approximately $1.4 million for 2012 compared to a net income of approximately $1.0 million for 2011 and net loss of approximately $4.7 million for 2010.

Results of Operations

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 Cornerstone's earnings. For the year ended December 31, 2012, Cornerstone recorded net interest income of approximately $14,568,000, which resulted in a net interest margin of 3.85%. For the year ended December 31, 2011, Cornerstone recorded net interest income of approximately $14,132,000, which resulted in a net interest margin of 3.55%. For the year ended December 31, 2010, Cornerstone recorded net interest income of approximately $16,010,000, which resulted in a net interest margin of 3.43%.

Table 5 presents information with respect to interest income from average interest-earning assets, expressed both in dollars and yields, and interest expense on average interest-bearing liabilities, expressed both in dollars and rates, for the periods indicated. The table includes loan yields, which reflect the amortization of deferred loan origination and commitment fees. Interest income from investment securities includes the accretion of discounts and amortization of premiums.


                                                           Yields Earned on Average Earning Assets and
                                                        Rates Paid on Average Interest-Bearing Liabilities
                                                                     Years Ended December 31,
                                                  2012                                        2011                                        2010
(In thousands)                                   Interest                                    Interest                                    Interest
                                  Average        Income/         Yield/       Average        Income/         Yield/       Average        Income/         Yield/
ASSETS                            Balance       Expense(1)        Rate        Balance       Expense(1)        Rate        Balance       Expense(1)        Rate
Interest-earning assets:
Loans(1)(2)                      $ 268,828     $     17,289         6.43 %   $ 273,523     $     18,129         6.63 %   $ 311,407     $     21,498         6.90 %
Investment securities(3)            89,587            2,004         2.53 %     108,705            2,312         2.38 %     128,795            3,633         3.06 %
Other earning assets                27,010               60         0.22 %      23,232               53         0.23 %      36,319               80         0.22 %
Total interest-earning assets      385,425           19,353         5.09 %     405,460           20,494         5.12 %     476,521           25,211         5.36 %
Allowance for loan losses           (6,140 )                                    (7,496 )                                    (6,454 )
Cash and other assets               35,756                                      32,721                                      31,277
Total assets                     $ 415,041                                   $ 430,685                                   $ 501,344
Interest-bearing liabilities:
NOW accounts                     $  26,483     $         87         0.33 %   $  25,741     $         84         0.33 %   $  32,338     $        111         0.34 %
Money market / savings              62,958              460         0.73 %      38,899              341         0.88 %      32,240              269         0.83 %
Time deposits                      187,733            2,471         1.32 %     226,720            3,768         1.66 %     281,251            5,839         2.08 %
Total interest-bearing
deposits                           277,174            3,018         1.09 %     291,360            4,193         1.44 %     345,829            6,219         1.80 %
Federal funds purchased                  -                -            -             -                -            -           197                1         0.51 %
Securities sold under
agreement to repurchase             21,312               94         0.44 %      22,808              125         0.55 %      22,519              126         0.56 %
Other borrowings                    39,282            1,673         4.26 %      47,745            2,044         4.28 %      66,208            2,856         4.31 %
Total interest-bearing
liabilities                        337,768            4,785         1.42 %     361,913            6,362         1.76 %     434,753            9,202         2.12 %
Net interest spread                                                 3.67 %                                      3.36 %                                      3.24 %

Other liabilities:
Demand deposits                     39,936                                      39,042                                      39,104

Accrued interest payable and
other liabilities                      222                                         (10 )                                    (2,333 )
Stockholders' equity                37,115                                      29,740                                      29,820
Total liabilities and
stockholders' equity             $ 415,041                                   $ 430,685                                   $ 501,344

Net interest margin                            $     14,568         3.85 %                 $     14,132         3.55 %                 $     16,009         3.43 %

(1) Interest income on loans includes amortization of deferred loan fees and other discounts of $168 thousand, $67 thousand and $46 thousand for the fiscal years ended December 31, 2012, 2011 and 2010, respectively.

(2) Nonperforming loans are included in the computation of average loan balances, and interest income on such loans is recognized on a cash basis.

(3) Yields on securities are calculated on a fully tax equivalent basis.

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

[[Image Removed]] The net interest margin increased 30 basis points from 3.55% as of December 31, 2011 to 3.85% as of December 31, 2012. The increase in net interest margin can be attributed primarily to a 34 basis point decrease in interest expense on interest-bearing liabilities from December 31, 2011 to December 31, 2012. The majority of this decrease was in certificates of deposit which declined 34 basis points. The decrease in interest expense was partially offset by a decrease in interest income attributable to a reduction in general market interest rates on loans.

[[Image Removed]] As of December 31, 2012, the Bank's investment portfolio resulted in a yield of 2.53% compared to 2.38% as of December 31, 2011. The Bank's investment portfolio is used primarily for liquidity and pledging purposes with the State of Tennessee Collateral Pool and the Federal Reserve Bank discount window, and to secure repurchase agreements. As of December 31, 2012, the Bank's securities portfolio was invested approximately 70% in United States Government backed securities and approximately 30% in municipal general obligation securities.

[[Image Removed]] During 2013, the Bank intends to increase its loan portfolio.
Management anticipates that the liquidity needed for this increase will be derived from excess cash and cash flow associated with the Bank's mortgage-backed security inventory. Management believes this increase will offset the interest rate compression that exists in the general market. Management anticipates the Bank's net interest margin could increase by approximately 25 basis points by yearend 2013.

Tables 6 and 7 present the changes in interest income and interest expense that are attributable to three factors:

(i) A change in volume or amount of an asset or liability.

(ii) A change in interest rates.

(iii) A change caused by the combination of changes in asset or deposit mix.

The tables describe the extent to which changes in interest rates and changes in volume of interest-earning assets and interest-bearing liabilities have affected Cornerstone's interest income and expense during the periods indicated. For each category of interest-earning assets and interest-bearing liabilities, information is provided as to changes attributable to change in volume (change in volume multiplied by current rate) and change in rates (change in rate multiplied by current volume). The remaining difference has been allocated to mix.



                                                         Year Ended December 31,
                                                          2012 Compared to 2011
(In Thousands)                                  Volume       Rate       Mix        Change
Interest income:
Loans (1)(2)                                    $  (302 )   $ (538 )   $    0     $   (840 )
Investment securities                              (484 )      135         41         (308 )
Other earning assets                                  8         (3 )        2            7
Total interest income                              (778 )     (406 )       43       (1,141 )

Interest expense:
NOW accounts                                         (2 )        -          5            3
Money market and savings accounts                   176        (94 )       37          119
Time deposits                                      (515 )     (638 )     (144 )     (1,297 )
Other borrowings                                   (361 )       (8 )       (2 )       (371 )
Federal funds purchased                               -          -          -            -
Securities sold under agreement to repurchase        (7 )      (23 )       (1 )        (31 )
Total interest expense                             (709 )     (763 )     (105 )     (1,577 )
Change in net interest income (expense)                                           $    436

(1) Loan amounts include non-accruing loans.

(2) Interest income includes the portion of loan fees recognized in the respective periods.



                                                           Year Ended December 31,
                                                            2011 Compared to 2010
(In Thousands)                                   Volume        Rate        Mix        Change
Interest income:
Loans (1)(2)                                    $ (2,512 )   $   (739 )   $ (118 )   $ (3,369 )
Investment securities                               (478 )       (739 )     (104 )     (1,321 )
Other earning assets                                 (30 )          2          1          (27 )
Total interest income                             (3,020 )     (1,476 )     (221 )     (4,717 )

Interest expense:
NOW accounts                                         (22 )         (3 )       (2 )        (27 )
Money market and savings accounts                     59           19         (6 )         72
Time deposits                                       (905 )       (952 )     (214 )     (2,071 )
Other borrowings                                    (790 )        (15 )       (7 )       (812 )
Federal funds purchased                                -            -          -            -
Securities sold under agreement to repurchase          1           (2 )        -           (1 )
Total interest expense                            (1,657 )       (953 )     (229 )     (2,839 )
Change in net interest income (expense)                                              $ (1,878 )

(1) Loan amounts include non-accruing loans.

(2) Interest income includes the portion of loan fees recognized in the respective periods.

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 $430 thousand for the year ended December 31, 2012 compared to $445 thousand for the year ended December 31, 2011. Cornerstone's policies and procedures used to estimate the allowance for loan losses, as well as the resultant provision for loan losses, are considered adequate by management and are periodically reviewed by regulators. However, there are factors beyond Cornerstone's control, such as conditions in the local and national economy which may negatively impact Cornerstone's asset quality. The measurements are approximations which may require additional provisions to loan losses based upon changing circumstances or when additional information becomes available or known. Other matters relating to the changes in provision for loan losses are presented below:

[[Image Removed]] The relatively small provision for loan losses during 2012 was a result of the stabilization in the Bank's loan asset quality when compared to prior years. The Bank experienced a significant decline in asset quality from 2008 to 2010. However, the rate of deterioration in asset quality improved during 2011 and 2012. Further, management maintained the methodology established in 2010 for estimating the allowance for loan and lease losses. Management believes that its allowance methodology and the inputs used in the estimation process are appropriate and consistent with generally accepted accounting principles and interagency policy statements published by the Bank's regulatory agencies.

[[Image Removed]] To address the problem credits in the Bank's loan portfolio, a Special Asset Committee was created in 2008. The Committee continues to meet at least monthly to review problem loans. The Committee coordinates various activities across multiple departments in the Bank such as reviewing loan grades assigned by the Bank's loan review department and overseeing the development and review of action plans that identify possible strategies to minimize the Bank's losses. The early detection and proactive resolution process serves to assist customers in the current economic environment while potentially minimizing the Bank's losses. During 2011 and continuing into 2012, the Bank dedicated additional human resources to the Special Asset department to assist in the collection and recovery process.

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.

Table 8 presents the components of noninterest income for the years ended December 31, 2012, 2011 and 2010 (in thousands).


                                              2012        2011        2010
Customer service fees                        $   803     $   869     $ 1,273
Other noninterest income                          64          72          90
Net gain from sale of securities                   -         107       1,698
Net gain from sale of loans & other assets       152         135          20
Total noninterest income                     $ 1,019     $ 1,183     $ 3,081

Significant matters relating to the changes to non interest income are presented below:

[[Image Removed]] The Bank continues to experience a decrease in its customer service fees. The primary reason for this decrease from 2011 to 2012, is a general market contraction and "belt tightening" by bank customers in general which resulted in reduced customer overdraft and nonsufficient fund fees. The primary reason for this decrease from 2010 to 2011 was the decision by management and the board of directors to exit the payroll processor Automated Clearing House ("ACH") payments line of business. The Bank made this decision in order to improve its risk profile and reduce the strain on the Bank's liquidity due to the high amount of cash balances that the Bank was required to maintain at the Federal Reserve Bank of Atlanta. Exiting the line of business resulted in a significant reduction in the Bank's commercial analysis fee income and ACH income. However, management believes this decision was appropriate given its current asset quality and liquidity needs. During 2012, the Federal Reserve Bank reduced the amount of cash balances required for ACH processing and the Bank is currently assessing its possibility of reentering the payroll processor line of business.

[[Image Removed]] During 2010, the Bank converted its security portfolio to a more conservative interest rate risk position by selling its fixed rate GNMA's and purchasing floating rate GNMA CMO's. This created an atypical security gain in 2010. During 2011, there was relatively low activity in the Bank's investment portfolio as realized security gains returned to a more normal level. No securities were sold during 2012.

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

Table 9 presents the components of noninterest expense for the years ended December 31, 2012, 2011 and 2010 (in thousands).


                                        2012         2011         2010
Salaries and employee benefits        $  6,327     $  6,117     $  6,195
Net occupancy and equipment expense      1,447        1,432        1,501
Depository insurance                       804        1,053        1,288
Impairment of goodwill                       -            -        2,541
Foreclosed assets, net                   1,101        1,923        2,790
Other operating expenses                 3,499        3,127        3,727
Total noninterest expense             $ 13,178     $ 13,652     $ 18,042

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

[[Image Removed]] Salaries and employee benefits increased slightly during 2012 due to an increased number of relationship managers but was mitigated by a reduced number of operational personnel that retired and were not replaced during the period. Management expects further increase in salary and employee benefits during 2013 as profitability will allow.

[[Image Removed]] The Bank experienced a decrease in regulatory insurance cost during 2012 as its average deposits decreased and as the rate charged by the FDIC was reduced. Management anticipates regulatory insurance to continue to decrease during 2013 as the Bank benefits from a reduced rate charged the FDIC for the entire year.

[[Image Removed]] Management anticipates elevated foreclosed asset expense until the Bank is able to reduce its foreclosed asset balances. The Bank's foreclosed asset expense is offset by commercial and residential properties that are currently receiving rental income.

Income Tax Expense

[[Image Removed]] The difference between Cornerstone's expected income tax expense, computed by multiplying income before income taxes by statutory income tax rates, and actual income tax expense, is primarily attributable to new market tax credits for federal and state purposes, tax exempt loans and tax exempt securities.

Financial Condition

Overview-Cornerstone's consolidated balance sheet reflects significant changes over the last two years. Total assets increased approximately $21 million or 4.92% from $422 million as of December 31, 2011 to $443 million as of December 31, 2012. During 2012, total loans increased $9 million or 3.45% from approximately $268 million as of December 31, 2011 to approximately $277 million as of December 31, 2012. Finally, stockholders' equity increased to approximately $41 million as of December 31, 2012 from approximately $35 million as of December 31, 2011.

Investments-The Bank's investment portfolio totaled approximately $78 million or 17.69% of total assets as of December 31, 2012, compared to a total of approximately $88 million or 20.93% of total assets as of December 31, 2011. The decrease was a result of a decrease in the Bank's security pledging requirements with the FHLB and correspondent banks regarding fed funds lines. Further, continued prepayment amounts associated with the Bank's mortgage-backed security inventory has also decreased investments.

The portfolio is accounted for in two classifications: "Held to Maturity" and "Available for Sale". The Bank also has an investment in Federal Home Loan Bank stock. The objective of the Bank's investment policy is to invest funds not otherwise needed to meet the loan demand of the Bank's market area and to meet the following five objectives: Gap Management, Liquidity, Pledging, Return, and Local Community Support. In doing so, the Bank uses the portfolio to provide structure and liquidity that the loan portfolio cannot. The management investment committee balances the market and credit risks against the potential investment return, ensures investments are compatible with the pledge requirements of the Bank's deposit of public funds, maintains compliance with regulatory investment requirements, and assists various public entities with their financing needs. The management investment committee is authorized to execute security transactions for the investment portfolio based on the decisions of the Directors Asset Liability Committee ("ALCO"). All investment transactions occurring since the previous ALCO meeting are reviewed by the ALCO at its next quarterly meeting, in addition to the entire portfolio. The investment policy allows portfolio holdings to include short-term securities purchased to provide the Bank's needed liquidity and longer-term securities purchased to generate stable income for the Bank during periods of interest rate fluctuations.

Table 10 presents the carrying value of the Bank's investments at the dates indicated. Available for sale securities are carried at fair market value and securities held to maturity are held at their book value (amounts in thousands).


                              Investment Portfolio
                            Years Ended December 31,
                                              2012         2011         2010
Securities available for sale:
. . .
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