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


14-Nov-2013

Quarterly Report


ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS (MD&A) 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, 2013 and December 31, 2012 and our results of operations for the three and nine months ended September 30, 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 Notes 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 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 September 30, 2013, Cornerstone had total consolidated assets of approximately $430 million, total loans of approximately $284 million, total securities of approximately $95 million, total deposits of approximately $341 million and stockholders' equity of approximately $40 million. Net income for the three and nine month periods ended September 30, 2013 totaled $428,548 and $1,276,707, respectively.

Results of Operations

Net income for the three months ended September 30, 2013 was $428,548 compared to a net income of $364,246 for the same period in 2012. Net income for the nine months ended September 30, 2013 was $1,276,707 compared to a net income of $1,031,348 for the same period in 2012.

The following table presents our results for the three and nine months ended September 30, 2013 compared to the three and nine months ended September 30, 2012 (amounts in thousands).

                                                   2013-2012                                                   2013-2012
                          Three months              Percent         Dollar             Nine months              Percent         Dollar
                       ended September 30,         Increase         Amount         ended September 30,         Increase         Amount
                       2013            2012       (Decrease)        Change          2013           2012       (Decrease)        Change
Interest income     $    4,760       $  4,735            0.53 %    $      25     $    13,939     $ 14,178           (1.69 )%   $    (239 )
Interest expense           869          1,172          (25.85 )%        (303 )         2,750        3,703          (25.74 )%        (953 )
Net interest
income
before provision
for loan loss            3,891          3,563            9.21 %          328          11,189       10,475            6.82 %          714
Provision for
loan loss                    -            100         (100.00 )%        (100 )           300          100          200.00 %          200
Net interest
income after
provision for
loan loss                3,891          3,463           12.36 %          428          10,889       10,375            4.95 %          514
Total noninterest
income                     270            258            4.65 %           12           1,323          778           70.05 %          545
Total noninterest
expense                  3,464          3,203            8.15 %          261          10,142        9,700            4.56 %          442
Income before
income taxes               697            518           34.56 %          178           2,070        1,453           42.46 %          617
Provision for
income taxes               268            154           74.03 %          114             793          422           87.91 %          371
Net income          $      429       $    364           17.86 %           65     $     1,277     $  1,031           23.86 %          246

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, 2013, net interest income before the provision for loan loss increased approximately $328 thousand or 9.21 percent over the same period of 2012. For the nine months ended September 30, 2013, net interest income before the provision for loan loss increased $714 thousand or 6.82 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 3.73 percent compared to 3.53 percent for the three month periods ended September 30, 2013 and 2012, respectively. The interest rate spread on a tax equivalent basis was 3.65 percent compared to 3.55 percent for the nine month periods ended September 30, 2013 and 2012, respectively.

The net interest margin on a tax equivalent basis was 3.89 percent and 3.70 percent for the three months ending September 30, 2013 and 2012, respectively. The net interest margin on a tax equivalent basis was 3.81 percent and 3.73 percent for the nine months ending September 30, 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 before provision for loan loss as of
                      September 30, 2013 has been positively impacted by a reduction in cost of
                      funds. 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 was approximately $869
                      thousand for the three months ended September 30, 2013 compared to $1.2
                      million during the same time period in 2012.

[[Image Removed: *]]  The Bank's loan portfolio yield decreased to 6.05 percent for the three
                      months ended September 30, 2013 compared to 6.23 percent for the three
                      months ended September 30, 2012. 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. 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, 2013, the Bank's investment
                      portfolio yielded 1.89 percent compared to 2.36 percent for the same time
                      period in 2012. The decrease in the investment portfolio yield was due to
                      the liquidation of approximately $5 million in municipal securities during
                      the second quarter of 2013 combined with an increase in variable interest
                      rate mortgage-backed securities.

[[Image Removed: *]]  The Bank's net interest margin for the three month period ending September
                      30, 2013 compared to September 30, 2012 increased by 19 basis points. The
                      Bank was able to achieve this increase primarily due to the decreases in the
                      total interest-bearing liabilities. Specifically, Cornerstone was able to
                      reduce its Federal Home Loan Bank and borrowings cost from 4.19 percent for
                      the three months ended September 30, 2012 to 3.90 percent for the three
                      months ended September 30, 2013.

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. Based upon management's evaluation, Cornerstone determined that its allowance for loan losses was adequate and therefore, did not record additional loan loss expense during the third quarter of 2013. For the year, Cornerstone has recorded $300,000 on provision for loan losses.

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, 2013 and 2012 (dollars in thousands):

                                                             2013-2012                                      2013-2012
                                 Three months ended           Percent            Nine months ended           Percent
                                    September 30,            Increase              September 30,            Increase
                                2013            2012        (Decrease)          2013            2012       (Decrease)
Service charges on deposit
accounts                      $     218       $     197           10.66 %    $       608      $    602            1.00 %
Net gains on sale of
securities                            -               -               -              425             -             N/A
Net gains on sale of loans
and other assets                     39              48          (18.75 )%           241           124           94.35 %
Other noninterest income             13              13            0.00 %             49            52           (5.77 )%
Total noninterest income      $     270       $     258            4.25 %    $     1,323      $    778           70.05 %

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

[[Image Removed: *]]  The Bank has maintained a consistent amount of noninterest income for the
                      three months ended September 30, 2013 and September 30, 2012. The Bank has
                      been able to increase its deposit account balances since September 30,
                      2012. The Bank has only experienced a slight increase in service charges
                      during this time due to a significant reduction in overdraft fees.

[[Image Removed: *]]  The Bank realized a $425 thousand security gain on the liquidation of
                      approximately $5 million in municipal bond securities during the second
                      quarter of 2013.  The security gain is the primary increase in noninterest
                      income for the nine months ended September 30, 2013 compared to the nine
                      months ended September 30, 2012.

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 September30, 2013 and 2012 (dollars in thousands).

                                                                2013-2012                                    2013-2012
                                     Three months ended          Percent           Nine months ended          Percent
                                       September 30,            Increase             September 30,           Increase
                                     2013           2012       (Decrease)          2013          2012       (Decrease)
Salaries and employee benefits    $    1,619      $  1,566            3.38 %    $    4,839     $  4,727            2.37 %
Occupancy and equipment expense          334           355           (5.92 )%        1,011        1,038           (2.60 )%
Foreclosed asset expense, net            382           314           21.66 %         1,309          945           38.52 %
FDIC depository insurance                162           237          (31.65 )%          483          683          (29.28 )%
Other operating expense                  967           731           32.42 %         2,500        2,307            8.37 %
Total noninterest expense         $    3,464      $  3,203            8.18 %    $   10,142     $  9,700            4.56 %

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

[[Image Removed: *]]  Cornerstone's employee expense increased slightly when comparing both the
                      three and nine months ended September 30, 2013 to September 30, 2012. The
                      increase is primarily attributable to an increase in the Bank's employee
                      performance incentive compensation accrual. Management has elected to
                      maintain consistent salary levels as the Bank continues to improve its
                      earnings. The incentive compensation is distributed to employees during the
                      fourth quarter of each year if the Bank achieves certain annual performance
                      goals.

[[Image Removed: *]]  As of September 30, 2013, the Bank had incurred approximately $1.3 million
                      in foreclosed assets expense. The expense consists of asset write-downs
                      based upon current appraisals, carrying cost and losses on the sale of
                      foreclosed assets. Management, in its financial reporting, nets the
                      foreclosed assets expense and write-downs against the revenue generated from
                      income producing real estate. As of September 30, 2012, the Bank had
                      incurred $945 thousand in foreclosed asset expense. The increase in expense
                      when comparing September 30, 2013 to September 30, 2012 can be attributed,
                      in part, to the liquidation of foreclosed assets during the third quarter of
                      2013. During this time period the Bank was able to reduce its foreclosed
                      asset balance by approximately $3.9 million.

[[Image Removed: *]]  Depository insurance during the third quarter decreased from approximately
                      $237 thousand as of September 30, 2012 to approximately $162 thousand as of
                      September 30, 2013. Management anticipates the FDIC expense to reduce
                      further as the Bank's regulatory status improves.

[[Image Removed: *]]  The Bank has experienced only slight increases its other operating cost when
                      comparing the three and nine months ended September 30, 2013 to September
                      30, 2012. The ability to maintain these costs at consistent levels can be
                      attributed to the Bank's employees as cost saving measures have been
                      evaluated and implemented over the last three years.

Financial Condition

Overview-Cornerstone's consolidated assets totaled approximately $443 million as of December 31, 2012. As of September 30, 2013, total consolidated assets had decreased approximately $13.8 million or 3.1 percent to approximately $430 million.

Liabilities as of September 30, 2013 and December 31, 2012 totaled approximately $390 million and $403 million, respectively.

Stockholders' equity as of September 30, 2013 and December 31, 2012 totaled approximately $40 million and $41 million, respectively.

Securities-The Bank's investment portfolio, primarily consisting of Ginnie Mae agency, mortgage-backed securities and municipal securities, amounted to approximately $95 million as of September 30, 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 and collateralize the Bank's repurchase accounts.

Loans-The composition of loans at September 30, 2013 and at December 31, 2012 of each classification are summarized in the following table (dollars in thousands):

                                     September 30,       December 31,
                                         2013                2012
Commercial real estate-mortgage:
  Owner-occupied                    $        66,143     $       58,425
  All other                                  66,721             66,747
Consumer real estate-mortgage                69,911             71,195
Construction and land development            38,970             38,557
Commercial and industrial                    39,782             40,140
Consumer and other                            2,654              1,927
Total loans                                 284,181            276,991
Less: Allowance for loan losses              (3,159 )           (6,141 )

Loans, net                          $       281,022     $      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, quarterly, 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 third quarter of 2013, the Bank did not record a provision
                      expense to the loan loss allowance. Management believes that it has
                      established an allowance for loan losses that adequately accounts for the
                      Bank's identified loan impairment. However, additional provision to the loan
                      loss allowance may be needed in future quarters as the Bank works its
                      problem assets through the collection cycle.

The following is a summary of changes in the allowance for loan losses for the nine months ended September 30, 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 (amounts in thousands):

                                                September 30,       December 31,
                                                    2013                2012
Balance, beginning of period                   $         6,141     $        7,400
  Loans charged-off                                     (4,460 )           (2,869 )
  Recoveries of loans previously charged-off             1,178              1,180
  Provision for loan losses                                300                430
Balance, end of period                         $         3,159     $        6,141

Total loans                                    $       284,181     $      276,991

Ratio of allowance for loan losses to loans
outstanding at the end of the period                      1.11 %             2.22 %

Ratio of net charge-offs to total loans
outstanding for the period                                1.15 %             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.

. . .

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