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CSBQ > SEC Filings for CSBQ > Form 10-Q on 15-May-2013All 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


15-May-2013

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 March 31, 2013 and December 31, 2012 and our results of operations for the three months ended March 31, 2013 and 2012. 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, "Presentation of Financial Information," 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, 2012 for more information.

Review of Financial Performance

As of March 31, 2013, Cornerstone had total consolidated assets of approximately $432 million, total loans of approximately $273 million, total securities of approximately $91 million, total deposits of approximately $ 337 million and stockholders' equity of approximately $41 million. Net income for the three month period ended March 31, 2013 totaled $452,128.

Results of Operations

Net income for the three months ended March 31, 2013 was $452,128 or $0.01 basic earnings per common share, compared to a net income of $356,517 or $0.01 basic earnings per common share, for the same period in 2012.

The following table presents our results for the three months ended March 31, 2013 compared to the three months ended March 31, 2012 (amounts in thousands).

                                                                        2013-2012
                                               Three months              Percent          Dollar
                                             ended March 31,            Increase          Amount
                                           2013            2012        (Decrease)         Change
Interest income                         $     4,603     $    4,626           (0.50 )%   $       (23 )
Interest expense                                962          1,314          (26.79 )%          (352 )
Net interest income before provision
for loan loss                                 3,641          3,312            9.93 %            329

Provision for loan loss                         300              -             100 %            300
Net interest income after provision
for loan loss                                 3,341          3,312            0.88 %             29

Total noninterest income                        355            267           32.96 %             88
Total noninterest expense                     2,976          3,074           (3.19 )%           (98 )

Income before income taxes                      721            505          (42.77 )%           216

Provision for income taxes                      269            149          (80.54 )%           120

Net income                              $       452     $      356          (26.97 )%   $        96

Net Interest Income-Net interest income represents the amount by which interest earned on various earning assets exceeds interest paid on deposits and other interest-bearing liabilities. Net interest income is also the most significant component of our earnings. For the three months ended March 31, 2013, net interest income before the provision for loan losses, increased approximately $329 thousand or 9.93 percent over the same period of 2012. 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 3.62 percent compared to 3.43 percent for the three month periods ended March 31, 2013 and 2012, respectively. The net interest margin on a tax equivalent basis was 3.79 percent and 3.59 percent for the three month periods ended March 31, 2013 and 2012, 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 net interest income as of March 31, 2013 has been positively impacted by a reduction in interest expense of the funding of the Bank. The primary savings have been a reduction in the Federal Home Loan Bank balances and a migration of funding from certificates of deposit into transactional accounts. First quarter 2013 interest income remains stable when compared to the first quarter of 2012. While yield on earning assets decreased 0.21 percent the Bank compensated by increasing the balance of average earning assets by approximately $17 million.

[[Image Removed]] The Bank's loan portfolio yield decreased to 6.09 percent for the three months ended March 31, 2013 compared to 6.27 percent for the three months ended March 31, 2012. Management anticipates interest rates to continue to decrease in the loan portfolio but anticipates consistent revenue by increasing the amount of the loan portfolio.

[[Image Removed]] For the three month period ended March 31, 2013, the Bank was successful in maintaining an investment portfolio yield of 2.35 percent compared to 2.43 percent for the same time period in 2012. This was accomplished primarily by the Bank's stable municipal bond portfolio and floating rate instruments that are at the floor of their interest rate structure. The Bank decreased the amount of its investment portfolio to an average balance of approximately $87 million as of March 31, 2013 from approximately $89 million as of March 31, 2012. 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 increased from March 31, 2012 to March 31, 2013 by 20 basis points. The majority of the increase is due to reduced interest expense relating to fewer FHLB borrowings and a migration from certificates of deposit to transactional accounts. Management believes that the balance sheet will remain at the present level or increase slightly and expects to see a conversion of cash into loans which should increase the Bank's 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. Cornerstone recorded $300 thousand in provision for loan losses for the three months ended March 31, 2013. Cornerstone did not record provision for loan losses for the three months ended March 31, 2012.

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

The following table presents the components of noninterest income for the three months ended March 31, 2013 and 2012 (dollars in thousands):

                                                                             2013-2012
                                                 Three months ended           Percent
                                                      March 31,              Increase
                                                2013            2012        (Decrease)
Service charges on deposit accounts           $     188       $     197           (4.57 )%
Net gains on sale of loans and other assets         149              50            198. %
Other noninterest income                             18              20          (10.00 )%
Total noninterest income                      $     355       $     267           32.96 %

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

[[Image Removed]] The Bank continues to experience a slight decrease in its service charges on deposit accounts during 2013 due to a continued reduction in customer overdraft charges.

[[Image Removed]] During the first quarter of 2013, the Bank recorded a $100 thousand fee from the sale of a Small Business Administration ( "SBA") 7A loan. The Bank expects to continue originating SBA 7A loans and estimates loan fees from the sale of future loans during 2013 to be approximately $250 thousand.

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

The following table presents the components of noninterest expense for the three months ended March 31, 2013 and 2012 (dollars in thousands).

                                                               2013-2012
                                    Three months ended          Percent
                                         March 31,             Increase
                                     2013          2012       (Decrease)
Salaries and employee benefits    $    1,597      $ 1,591            0.38 %
Occupancy and equipment expense          338          336            0.60 %
Foreclosed assets expense, net           129          150          (14.00 )%
FDIC depository insurance                160          203          (21.18 )%
Other operating expense                  752          794           (5.29 )%
Total noninterest expense         $    2,976      $ 3,074           (3.19 )%

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

[[Image Removed]] Cornerstone employee expense remained stable during the first quarter of 2013. The Bank does intend to hire additional sales staff but does not expect a material increase in salaries and benefits during 2013.

[[Image Removed]] As of March 31, 2013, the Bank had incurred $7 thousand in write-down of other real estate and repossessed assets. The Bank incurred approximately $122 thousand in net carrying cost for its foreclosed assets during the first quarter of 2013. A majority of the incremental expense was due to maintenance and repairs of the existing properties. Management anticipates a total of $1.2 million of expense and write-downs on its foreclosed assets during 2013. Management nets the expense and write-downs of other real estate owned against the income generated from income producing real estate to calculate net foreclosed asset expense.

[[Image Removed]] Depository insurance decreased from approximately $203 thousand as of March 31, 2012 to approximately $160 thousand as of March 31, 2013. Management anticipates the FDIC expense to reduce further as the Bank's regulatory status improves.

Financial Condition

Overview-Cornerstone's consolidated assets totaled approximately $443 million as of December 31, 2012. As of March 31, 2013, total consolidated assets had decreased approximately $11 million or 2.48 percent to approximately $432 million.

Liabilities as of March 31, 2013 and December 31, 2012 totaled approximately $391 million and $403 million, respectively.

Stockholders' equity as of March 31, 2013 and December 31, 2012 totaled approximately $41 million.

Securities-The Bank's investment portfolio, primarily consisting of Ginnie Mae Agency, mortgage-backed securities and municipal securities, amounted to approximately $91 million as of March 31, 2013 compared to approximately $76 million as of December 31, 2012. 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 March 31, 2013 and at December 31, 2012 and the percentage (%) of each classification to total loans are summarized in the following table (dollars in thousands):

                                        March 31, 2013           December 31, 2012
                                     Amount       Percent       Amount       Percent
Commercial real estate-mortgage
  Owner-occupied                    $  62,460        22.91 %   $  58,425        21.09 %
  All other                            64,483        23.66 %      66,747        24.10 %
Consumer real estate-mortgage          70,260        25.78 %      71,195        25.70 %
Construction and land development      33,220        12.19 %      38,557        13.92 %
Commercial and industrial              40,302        14.79 %      40,140        14.49 %
Consumer and other                      1,825         0.67 %       1,927         0.70 %
Total loans                           272,550       100.00 %     276,991       100.00 %
Less: Allowance for loan losses        (5,669 )                   (6,141 )

Loans, net                          $ 266,881                  $ 270,850

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.

[[Image Removed]] During the first quarter of 2013, the Bank recorded $300 thousand in provision expense to the loan loss allowance. Management also elected to change its historic loan loss analysis to incorporate a two and half year look-back period for loan charge-offs and recoveries. Previously, the Bank had used a one year look-back period in its loan loss allowance. The change was made to more accurately compare the Bank's history of loan losses and recoveries to the possible future loan losses and recoveries. Management believes that it has established an allowance for loan losses that adequately accounts for the Bank's identified loan impairment. However, additional provision to the loan loss allowance may be needed in future quarters as the Bank works its problem assets through the collection cycle.

The following is a summary of changes in the allowance for loan losses for the three months ended March 31, 2013 and for the year ended December 31, 2012 and the ratio of the allowance for loan losses to total loans as of the end of each period (dollars in thousands):

                                                              March 31,       December 31,
                                                                2013              2012
Balance, beginning of period                                 $     6,141     $        7,400
  Loans charged-off                                               (1,004 )           (2,869 )
  Recoveries of loans previously charged-off                         232              1,180
  Provision for loan losses                                          300                430
Balance, end of period                                       $     5,669     $        6,141

Total loans                                                  $   272,550     $      276,991

Ratio of allowance for loan losses to loans outstanding at
the end of the period                                               2.08 %             2.22 %

Ratio of net charge-offs to total loans outstanding for
the period                                                          0.28 %             0.61 %

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

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

[[Image Removed]] The Bank has experienced a stabilization in its loan quality as the Chattanooga, Tennessee Metropolitan Statistical Area begins to recover from a long economic downturn. The number and dollar amount of impaired loans remained consistent during the first quarter of 2013. Management anticipates that its loan asset quality will improve as the economy recovers from the current economic recession.

The following table summarizes Cornerstone's non-performing assets at each quarter end from June 30, 2012 to March 31, 2013 (amounts in thousands):

                                         March 31,       December 31,       September 30,       June 30,
                                           2013              2012               2012              2012
   Non-accrual loans                    $     6,364     $        6,005     $         7,971     $    7,124
   Foreclosed assets                         21,159             20,332              22,376         22,144
Total non-performing assets             $    27,523     $       26,337     $        30,347     $   29,268

30-89 days past due loans               $     4,023     $        6,594     $         3,819     $    2,495

Total loans outstanding                 $   272,550     $      276,991     $       273,820     $  263,749

Allowance for loan losses                     5,669              6,141               5,280          6,029

Ratio of non-performing loans to
total loans outstanding at the end of
the period                                     2.33 %             2.17 %              2.91 %         2.70 %

Ratio of non-performing assets to
total allowance for loan losses at
the end of the period                        485.50 %           428.87 %            574.75 %       485.45 %

[[Image Removed]] The Bank's non-accrual balances decreased dramatically during the first quarter of 2013 compared to the first quarter of 2012. 30-89 days past due loans also declined in the first quarter of 2013 when compared to the first quarter of 2012.

[[Image Removed]] Management believes non-accrual loans will continue to decrease during the remainder of 2013 and expects to charge-off loans of $2-3 million to reduce the outstanding balances on several large impaired loans that are fully provided for in the Bank's current allowance for loan losses. As a result, management does not anticipate a negative impact to the Bank's earnings.

[[Image Removed]] The Bank's foreclosed assets remained constant at approximately $21 million as of March 31, 2013. The Bank has seen an improvement in the level of interest in its properties by potential buyers. Management is targeting a reduction in foreclosed asset levels by approximately $6 million during the remainder of 2013.

Deposits and Other Borrowings-The Bank's deposits consist of non-interest bearing demand deposits, interest- bearing demand accounts, savings and money market accounts, and time deposits. The Bank has agreements with some customers to sell certain of its securities under agreements to repurchase the security the following day. The Bank has also obtained advances from the FHLB.

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

                                              March 31, 2013                December 31, 2012
                                          Amount         Percent         Amount          Percent
Core funding:
Noninterest-bearing demand deposits     $   55,400            14.3 %   $    60,054            15.0 %
Interest-bearing demand deposits            26,457             6.8 %        30,179             7.6 %
Savings & money market accounts             89,564            23.1 %        80,994            20.3 %
. . .
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