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CSBQ > SEC Filings for CSBQ > Form 10-Q on 13-May-2014All Recent SEC Filings

Show all filings for CORNERSTONE BANCSHARES INC

Form 10-Q for CORNERSTONE BANCSHARES INC


13-May-2014

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 March 31, 2014 and December 31, 2013 and our results of operations for the three months ended March 31, 2014 and 2013. 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 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 8, "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, 2013 for more information.

Review of Financial Performance

As of March 31, 2014, Cornerstone had total consolidated assets of approximately $429 million, total loans of approximately $293 million, total securities of approximately $89 million, total deposits of approximately $ 342 million and stockholders' equity of approximately $41 million. Net income for the three month period ended March 31, 2014 totaled $412,151.

Results of Operations

Net income for the three months ended March 31, 2014 was $412,151 or $0.00 basic earnings per common shares, compared to a net income of $452,128 or $0.01 basic earnings per common shares, for the same period in 2013.

The following table presents our results for the three months ended March 31, 2014 compared to the three months ended March 31, 2013 (amounts in thousands).

                                                           2014-2013
                                     Three months           Percent        Dollar
                                   ended March 31,         Increase        Amount
                                   2014        2013       (Decrease)       Change
Interest income                  $  4,533     $ 4,603           (1.52 )%   $   (70 )
Interest expense                      723         962          (24.84 )%      (239 )
Net interest income
before provision for loan loss      3,810       3,641            4.64 %        169

Provision for loan loss               165         300          (45.00 )%      (135 )
Net interest income after
provision for loan loss             3,645       3,341            9.10 %        304

Total noninterest income              323         356           (9.27 )%       (33 )
Total noninterest expense           3,301       2,976           10.92 %        325

Income before income taxes            667         721            7.49 %        (54 )

Provision for income taxes            255         269           (5.20 )%       (14 )

Net income                       $    412     $   452           (8.85 )%   $   (40 )

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, 2014, net interest income before the provision for loan losses, increased approximately $169 thousand or 4.64 percent over the same period of 2013. 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 3.72 percent compared to 3.62 percent for the three month periods ended March 31, 2014 and 2013, respectively. The net interest margin on a tax equivalent basis was 3.90 percent and 3.79 percent for the three month periods ended March 31, 2014 and 2013, 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, 2014 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 and money market accounts into non-interest bearing deposits accounts. First quarter 2014 interest income remains stable when compared to the first quarter of 2013. While yield on earning assets decreased 0.15 percent, the Bank compensated by increasing the balance of average loans and securities by approximately $25 million.

[[Image Removed: *]]The Bank's loan portfolio yield decreased to 5.69 percent for the three months ended March 31, 2014 compared to 6.09 percent for the three months ended March 31, 2013. Management believes loan yields will continue to see downward pressure during 2014 as customers continue to refinance existing loans and due to general market conditions. Cornerstone will attempt to increase its outstanding loan balances during 2014 to offset the possible yield reduction.

[[Image Removed: *]]For the three month period ended March 31, 2014, the Bank investment portfolio yield decreased to 1.99 percent compared to 2.35 percent for the same time period in 2013. The Bank increased the amount of its overall investment portfolio to an average balance of approximately $96 million as of March 31, 2014 from approximately $87 million as of March 31, 2013 to invest cash that accumulated due to decreased loan demand in previous years and continued prepayment amounts associated with the Bank's mortgage-backed security portfolio. 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, 2013 to March 31, 2014 by 11 basis points. The majority of the increase is due to reduced interest expense relating to a migration from certificates of deposits and other interest bearing deposits to non-interest bearing deposits, further decreases in deposit rates and a reduction in FHLB borrowings. Management believes that the balance sheet will remain at the present level or increase slightly. Further, management continues to try and adjust the Bank's balance sheet composition by reducing foreclosed assets and increasing the Bank's loan balances. Management anticipates improvement in the Bank's net interest margin is possible with the increase in loans and reduction of FHLB advances, as they mature, in the next 12 months.

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 $165 thousand in provision for loan losses for the three months ended March 31, 2014. Cornerstone recorded $300 thousand in provision for loan losses for the three months ended March 31, 2013.

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, 2014 and 2013 (dollars in thousands):

                                                                             2014-2013
                                                 Three months ended           Percent
                                                      March 31,              Increase
                                                2014            2013        (Decrease)
Service charges on deposit accounts           $     189       $     188            0.53 %
Net gains on sale of securities                     102               -
Net gains on sale of loans and other assets          19             149          (87.25 )%
Other noninterest income                             13              19          (33.33 )%
Total noninterest income                      $     323       $     356           (9.30 )%

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

[[Image Removed: *]]The Bank sold approximately $2.4 million of securities and recorded a gain of approximately $102 thousand during the first quarter of 2014.

[[Image Removed: *]]During the first quarter of 2013, the Bank recorded approximately a $100 thousand fee from the sale of a Small Business Administration ( "SBA") 7A loan while during the first quarter of 2014, the Bank did not sell any SBA loans.

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

The following table presents the components of noninterest expense for the three months ended March 31, 2014 and 2013 (dollars in thousands).

                                                               2014-2013
                                    Three months ended          Percent
                                         March 31,             Increase
                                     2014          2013       (Decrease)
Salaries and employee benefits    $    1,827      $ 1,597           14.40 %
Occupancy and equipment expense          309          338           (8.58 )%
Foreclosed assets expense, net           349          129          170.54 %
FDIC depository insurance                155          160           (3.13 )%
Other operating expense                  661          752          (12.10 )%
Total noninterest expense         $    3,301      $ 2,976           10.92 %

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

[[Image Removed: *]]Cornerstone recorded compensation expense in the amount of $156 thousand for stock grants issued to the Board of Directors and $40 thousand in stock options compensation expense during the first quarter of March 2014 versus none in the first quarter of March 2013. Management does not anticipate additional stock grants to be issued in 2014. Other salaries and employee benefits increased slightly during the first quarter of 2014 as a result of the Bank addressing employee wage increases. The Bank had not provided wage increases in the past three years.

[[Image Removed: *]]As of March 31, 2014, the Bank recorded approximately $349 thousand in foreclosed asset expense compared to approximately $129 thousand during the first quarter of March 31, 2013. The majority of the $349 thousand in foreclosed asset expense was comprised of approximately $244 thousand in appraisal write downs and losses incurred on the disposal of foreclosed assets. The Bank incurred approximately $104 thousand in net carrying cost for its foreclosed assets during the first quarter of 2014. A majority of the incremental expense was due to maintenance and repairs of the existing properties. Management anticipates approximately $1.2 million of expense and write-downs on its foreclosed assets during 2014. 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.

Financial Condition

Overview-Cornerstone's consolidated assets totaled approximately $432 million as of December 31, 2013. As of March 31, 2014, total consolidated assets had decreased approximately $3 million or 0.74 percent to approximately $429 million.

Liabilities as of March 31, 2014 and December 31, 2013 totaled approximately $388 million and $392 million, respectively.

Stockholders' equity as of March 31, 2014 and December 31, 2013 totaled approximately $41 million and $40 million, respectively.

Securities-The Bank's investment portfolio, primarily consisting of Ginnie Mae Agency, mortgage-backed securities and municipal securities, in the amount of approximately $89 million as of March 31, 2014 compared to approximately $92 million as of December 31, 2013. The primary purposes of the Bank's investment portfolio is 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, 2014 and at December 31, 2013 and the percentage (%) of each classification to total loans are summarized in the following table (dollars in thousands):

                                        March 31, 2014           December 31, 2013
                                     Amount       Percent      Amount        Percent
Commercial real estate-mortgage
  Owner-occupied                    $  68,653        23.43 %   $  65,747        22.72 %
  All other                            70,089        23.93 %      64,052        22.13 %
Consumer real estate-mortgage          77,767        26.55 %      76,315        26.37 %
Construction and land development      32,752        11.18 %      41,597        14.37 %
Commercial and industrial              41,122        14.04 %      38,999        13.47 %
Consumer and other                      2,569         0.87 %       2,730         0.94 %
Total loans                           292,952       100.00 %     289,440       100.00 %
Less: Allowance for loan losses        (3,011 )                   (3,203 )

Loans, net                          $ 289,941                  $ 286,237

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 first quarter of 2014, the Bank recorded $165 thousand in provision expense to the loan loss allowance. Cornerstone utilizes a ten quarter look-back time frame for its historic loan loss analysis for loan charge-offs and recoveries. Management believes its allowance methodology is consistent with generally accepted accounting principles and interagency policy statements published by the Bank's regulatory agencies. 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 and as the loan portfolio continues to grow.

The following is a summary of changes in the allowance for loan losses for the three months ended March 31, 2014 and for the year ended December 31, 2013 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,
                                                  2014             2013
Balance, beginning of period                   $    3,203     $        6,141
  Loans charged-off                                  (486 )           (4,709 )
  Recoveries of loans previously charged-off          129              1,471
  Provision for loan losses                           165                300
Balance, end of period                         $    3,011     $        3,203

Total loans                                    $  292,952     $      289,440

Ratio of allowance for loan losses to loans
outstanding at the end of the period                 1.03 %             1.11 %

Ratio of net charge-offs to total loans
outstanding for the period                           0.12 %             1.12 %

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, nonaccrual loans, foreclosures and repossessed property as non-performing assets. The Bank's policy is to categorize a loan on nonaccrual status when payment of principal or interest is ninety (90) or more days past due. At the time the loan is categorized as nonaccrual the interest previously accrued but not collected may be reversed and charged against current earnings.

[[Image Removed: *]]The Bank has been able to reduce its non-performing assets over the last twelve months. As of March 31, 2014, the Bank had approximately $17.3 million in non-performing assets. The majority of this amount is comprised of foreclosed assets. The Bank has attempted to be proactive in its approach of minimizing the time a loan is recorded in nonaccrual status. Management has been able to transition loans from nonaccrual into foreclosed assets or, in some limited instances, upgrade the loan to a performing status. Management anticipates additional loans could transition into foreclosed assets in the future. However, management anticipates the balance of foreclosed and non-performing assets overall will continue to reduce as the Bank continues to allocate both financial and human resources towards this objective.

The following table summarizes Cornerstone's non-performing assets at each quarter end from June 30, 2013 to March 31, 2014 (amounts in thousands):

                                         March 31,       December 31,       September 30,       June 30,
                                           2014              2013               2013              2013
   Nonaccrual loans                     $     4,779     $        3,566     $         4,096     $    6,883
   Foreclosed assets                         12,559             12,926              14,924         18,867
Total non-performing assets             $    17,338     $       16,492     $        19,020     $   25,750

30-89 days past due loans               $     2,193     $        5,816     $         1,659     $    5,111

Total loans outstanding                 $   292,952     $      289,440     $       284,181     $  276,063

Allowance for loan losses               $     3,011     $        3,203     $         3,159     $    5,095

Ratio of non-performing loans
to total loans outstanding
at the end of the period                       1.63 %             1.23 %              1.44 %         2.49 %

Ratio of non-performing assets
to total allowance for loan losses
at the end of the period                     575.82 %           514.89 %            602.09 %       505.40 %

[[Image Removed: *]]The Bank's nonaccrual balances decreased during the first quarter of 2014 compared to the first quarter of 2013. Loans 30-89 days past due also declined in the first quarter of 2014 when compared to the first quarter of 2013.

[[Image Removed: *]]Management believes nonaccrual loans will decrease during the remainder of 2014.

[[Image Removed: *]]The Bank's foreclosed assets decreased from approximately $21 million as of March 31, 2013 to approximately $13 million as of March 31, 2014. The Bank has seen an improvement in the level of interest in its properties by potential buyers and has provided $1.2 million for foreclosed asset expense again in the 2014 budget to decrease foreclosed assets. Management is targeting a net reduction in foreclosed asset levels by approximately $5 million during the remainder of 2014.

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 securities 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).

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