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CSBQ > SEC Filings for CSBQ > Form 10-K on 31-Mar-2014All Recent SEC Filings

Show all filings for CORNERSTONE BANCSHARES INC

Form 10-K for CORNERSTONE BANCSHARES INC


31-Mar-2014

Annual Report


ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

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 that 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, 2013 and December 31, 2012, and Cornerstone's results of operations for each of the three-years ended December 31, 2013, 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.

Review of Financial Performance

As of December 31, 2013, Cornerstone had total consolidated assets of approximately $432 million, total loans of approximately $289 million, total deposits of approximately $341 million and stockholders' equity of approximately $40 million. Cornerstone earned net income of approximately $1.7 million for 2013 compared to net income of approximately $1.4 million for 2012 and approximately $1.0 million for 2011.

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, 2013, Cornerstone recorded net interest income of approximately $14,930,000, which resulted in a net interest margin of 3.80%. 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%.

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.

TABLE 5

                                                        Yields Earned on Average Earning Assets and
                                                    Rates Paid on Average Interest-Bearing Liabilities
                                                                 Years Ended December 31,
                                         2013                                         2012                                         2011
(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)            $ 278,975     $     16,705          5.99 %   $ 268,828     $     17,289          6.43 %   $ 273,523     $     18,129          6.63 %
Investment
securities(3)             98,108            1,694          1.94 %      89,587            2,004          2.53 %     108,705            2,312          2.38 %
Other earning assets      20,749               54          0.26 %      27,010               60          0.22 %      23,232               53          0.23 %
Total
interest-earning
assets                   397,832           18,453          4.69 %     385,425           19,353          5.09 %     405,460           20,494          5.12 %
Allowance for loan
losses                    (4,547 )                                     (6,140 )                                     (7,496 )
Cash and other
assets                    35,409                                       35,756                                       32,721
Total assets           $ 428,694                                    $ 415,041                                    $ 430,685
TOTAL LIABILITIES
AND EQUITY
Interest-bearing
liabilities:
Deposits:
NOW accounts           $  26,196     $         55          0.21 %   $  26,483     $         87          0.33 %   $  25,741     $         84          0.33 %
Money market /
savings                   88,912              419          0.47 %      62,958              460          0.73 %      38,899              341          0.88 %
Time deposits            165,748            1,766          1.07 %     187,733            2,471          1.32 %     226,720            3,768          1.66 %
Total
interest-bearing
deposits                 280,856            2,240          0.80 %     277,174            3,018          1.09 %     291,360            4,193          1.44 %
Securities sold
under agreement to
repurchase                22,041               74          0.34 %      21,312               94          0.44 %      22,808              125          0.55 %
Other borrowings          31,634            1,209          3.82 %      39,282            1,673          4.26 %      47,745            2,044          4.28 %
Total
interest-bearing
liabilities              334,531            3,523          1.05 %     337,768            4,785          1.42 %     361,913            6,362          1.76 %
Net interest spread                                        3.64 %                                       3.67 %                                       3.36 %

Other liabilities:
Demand deposits           51,614                                       39,936                                       39,042
Accrued interest
payable and other
liabilities                1,785                                          222                                          (10 )
Stockholders' equity      40,764                                       37,115                                       29,740
Total liabilities
and stockholders'
equity                 $ 428,694                                    $ 415,041                                    $ 430,685

Net interest margin                  $     14,930          3.80 %                 $     14,568          3.85 %                 $     14,132          3.55 %

(1) Interest income on loans includes amortization of deferred loan fees and other discounts of $176 thousand, $168 thousand and $67 thousand for the fiscal years ended December 31, 2013, 2012 and 2011, 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 decreased 5 basis points from 3.85% as of December 31, 2012 to 3.80% as of December 31, 2013. The decrease in net interest margin can be attributed primarily to a 40 basis point decrease in interest on earning assets from December 31, 2012 to December 31, 2013. The majority of this decrease was offset be a decrease of 37 basis points in interest-bearing liabilities. The decrease in interest-bearing liability cost was comprised of a 29 basis point decrease in money market accounts and a 25 point decrease in certificates of deposit. The Bank also experienced a significant decline in its FHLB and other borrowings during 2013 as $10 million in fixed rate advances were repaid according to contractual terms. The repayment decreased the Bank's interest cost from approximately $1.7 million to $1.2 million.

[[Image Removed]] As of December 31, 2013, the Bank's loan portfolio yield had decreased from 6.43% as of December 31, 2012 to 5.99% as of December 31, 2013. Management believes loan yields will continue to see downward pressure during 2014 as customers continue to refinance existing loans and general market conditions. Cornerstone will attempt to increase its outstanding loan balances during 2014 to offset the possible yield reduction.

[[Image Removed]] As of December 31, 2013, the Bank's investment portfolio resulted in a yield of 1.94% compared to 2.53% as of December 31, 2012. The Bank's investment portfolio is used primarily for liquidity and pledging purposes with the State of Tennessee Collateral Pool, the Federal Reserve Bank discount window, correspondent bank lines and to secure repurchase agreements. As of December 31, 2013, the Bank's securities portfolio was invested approximately 85% in United States Government agency or sponsored agency securities and approximately 15% in municipal general obligation securities.

[[Image Removed]] During 2014, the Bank intends to increase its loan portfolio. Management anticipates that the liquidity needed for this increase will be derived from liquidation of foreclosed assets and cash flow associated with the Bank's mortgage-backed security portfolio. Management believes this increase will offset the interest rate compression that exists in the general market.

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.

TABLE 6

                            INTEREST INCOME AND EXPENSE ANALYSIS

                                                          Year Ended December 31,
                                                           2013 Compared to 2012
                                                                                     Net
(In Thousands)                                  Volume        Rate        Mix       Change
Interest income:
Loans (1)(2)                                    $   608     $ (1,227 )   $  35     $   (584 )
Investment securities                               165         (579 )     104         (310 )
Other earning assets                                (16 )          8         2           (6 )
Total interest income                               757       (1,798 )     141         (900 )

Interest expense:
NOW accounts                                         (1 )        (31 )       -          (32 )
Money market and savings accounts                   122         (231 )      68          (41 )
Time deposits                                      (235 )       (414 )     (56 )       (705 )
Other borrowings                                   (292 )       (139 )     (33 )       (464 )
Securities sold under agreement to repurchase         2          (22 )       -          (20 )
Total interest expense                             (404 )       (837 )     (21 )     (1,262 )
Change in net interest income (expense)                                            $    362

(1) Loan amounts include interest income recognized on a cash basis on nonaccrual loans.

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

TABLE 7

                            INTEREST INCOME AND EXPENSE ANALYSIS

                                                         Year Ended December 31,
                                                          2012 Compared to 2011
                                                                                    Net
(In Thousands)                                  Volume       Rate       Mix        Change
Interest income:
Loans (1)(2)                                    $  (302 )   $ (538 )   $    -     $   (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 )
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 interest income recognized on a cash basis on nonaccrual 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 $300 thousand for the year ended December 31, 2013 compared to $430 thousand for the year ended December 31, 2012. 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 decrease in provision for loan losses during 2013 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 from 2011 to 2013. 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 thedevelopment 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.

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, 2013, 2012 and 2011 (in thousands).

TABLE 8

                                              2013        2012        2011
Customer service fees                        $   821     $   803     $   869
Other noninterest income                          63          64          72
Net gain from sale of securities                 652           -         107
Net gain from sale of loans & other assets       404         152         135
Total noninterest income                     $ 1,940     $ 1,019     $ 1,183

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

[[Image Removed]] The Bank was able to increase its total noninterest income during 2013 when compared to 2012. The primary components of this increase were the realized gain on security sales and the gain on sale of loans and other assets. The Bank elected to liquidate a portion of its municipal securities portfolio to take advantage of market conditions and offset losses associated with the disposal of foreclosed assets. The gain on sale of loans and other assets is primarily the result of Small Business Administration lending activities during 2013.

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 expenses.

Table 9 presents the components of noninterest expense for the years ended December 31, 2013, 2012 and 2011 (in thousands).

TABLE 9

                                        2013         2012         2011
Salaries and employee benefits        $  6,555     $  6,327     $  6,177
Net occupancy and equipment expense      1,335        1,447        1,432
Depository insurance                       645          804        1,053
Foreclosed assets, net                   2,002        1,101        1,923
Other operating expenses                 3,309        3,499        3,127
 Total noninterest expense            $ 13,846     $ 13,178     $ 13,652

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

[[Image Removed]] Salaries and employee benefits increased slightly during 2013 as a result of the Bank addressing employee cost of living adjustments and wage increases. The Bank had not provided additional cost of living adjustments in the past three years. The approximate cost of living adjustments recorded in 2013 totaled approximately $385 thousand.

[[Image Removed]] The Bank experienced a decrease in regulatory insurance cost during 2013 as total assets decreased and as the rate charged by the FDIC was reduced. Management anticipates regulatory insurance to continue to decrease during 2014 as the Bank's problem assets decrease. Problem assets contribute to the Bank's rating which in turn sets the regulatory insurance cost.

[[Image Removed]] During 2013, the Bank recorded approximately $2.0 million in foreclosed assets expense compared to approximately $1.1 million in 2012. The Bank's foreclosed asset holding cost remained relatively constant year over year. In 2012, the Bank recorded $1.3 million in foreclosed asset holding cost compared to $1.4 million in 2013. The majority of the $2.0 million in foreclosed asset expense was comprised of appraisal write-downs, the losses incurred on the disposal of foreclosed assets and the decline in operating revenue collected by the Bank on income producing properties. Management anticipates elevated foreclosed asset expense until the Bank is able to reduce its foreclosed assets balances.

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. During 2013, total assets decreased approximately $11 million or 2.53% from approximately $443 million as of December 31, 2012 to approximately $432 million as of December 31, 2013. Total loans increased approximately $12 million or 4.49% from approximately $277 million as of December 31, 2012 to approximately $289 million as of December 31, 2013. Finally, stockholders' equity decreased approximately $1 million or 1.85% from approximately $41 million as of December 31, 2012 to approximately $40 million as of December 31, 2013.

Investments-The Bank's investment portfolio totaled approximately $95 million or 21.88% of total assets as of December 31, 2013, compared to a total of approximately $78 million or 17.69% of total assets as of December 31, 2012. The increase was a result of investing cash that accumulated due to decreased loan demand in previous years and continued prepayment amounts associated with the Bank's mortgage-backed security portfolio.

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).

TABLE 10

                              Investment Portfolio
                            Years Ended December 31,
Securities available for sale:                2013         2012         2011
U.S. Government agency obligations          $  3,481     $  4,018     $  4,190
Mortgage-backed securities                    73,479       48,445       57,431
State & political subdivisions tax-exempt     15,249       23,634       24,436
Totals                                        92,209       76,097       86,057

Securities held to maturity:
Mortgage-backed securities                        34           45           69
Totals                                      $     34     $     45     $     69

Federal Home Loan Bank stock, at cost          2,323        2,323        2,323

Total Investments                           $ 94,566     $ 78,465     $ 88,449

[[Image Removed]] Management anticipates the Bank's investment portfolio to slightly decrease during 2014 as the Bank receives . . .

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