10-K 1 v143458_10k.htm Unassociated Document
 
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-K

x
ANNUAL REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended December 31, 2008
OR

¨
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For transition period from __________  to  __________

Commission file number 000-30497
 

(Exact Name of Registrant as Specified in its Charter)
Tennessee
 
62-1173944
(State of Incorporation)
 
(I.R.S. Employer Identification No.)
835 Georgia Avenue,
Chattanooga, TN  37402
(Address of principal executive offices)(Zip Code)

(423) 385-3000
(Registrant’s telephone number, including area code)

Securities registered pursuant to Section 12(b) of the Act: None

Securities registered pursuant to Section 12(g) of the Act:
Common Stock, $1.00 Par Value

Indicate by check mark if Registrant is a well known seasoned issuer, as defined in Rule 405 of the of the Securities Act.
Yes ¨ No x

Indicate by check mark if Registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Exchange Act.
Yes ¨   No x

Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities and Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. 
Yes x   No ¨

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (229.405 of this chapter) is not contained herein, and will not be contained, to the best of Registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  ¨
 
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company.  See the definitions of “large accelerated filer”, “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

Large accelerated filer ¨ 
Accelerated filer ¨
Non-accelerated filer x
Smaller reporting company ¨
 
Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act)    
Yes  ¨  No  x
 
The aggregate market value of the common stock held by non-affiliates of the Registrant on June 30, 2008 was $38 million. The market value calculation was determined using the closing sale price of the Registrant’s common stock on June 30, 2008, as reported on the Over the Counter (“OTC”) Bulletin Board. For purposes of this calculation, the term “affiliate” refers to all directors, executive officers and 10% shareholders of the Registrant. As of the close of business on December 31, 2008 there were 6,319,718 shares of the Registrant’s common stock outstanding.
 
DOCUMENTS INCORPORATED BY REFERENCE
 
Portions of the Registrant’s Proxy Statement for the 2009 Annual Meeting of Shareholders (the “2009 Proxy Statement”) are incorporated by reference into Part III of this Annual Report on Form 10-K to the extent described herein.

 
 

 

TABLE OF CONTENTS

Item No.  
Page No.
   
PART I
 
 
1.
Business
4
       
 
1A.
Risk Factors
9
       
 
1B.
Unresolved Staff Comments
14
       
 
2.
Properties
14
       
 
3.
Legal Proceedings
14
       
 
4.
Submission of Matters to a Vote of Security Holders
14
       
   
PART II
 
       
 
5.
Market for the Registrant’s Common Equity, Related Stockholders Matters and Issuer Purchases of Equity Securities
14
       
 
6.
Selected Financial Data
16
       
 
7.
Management's Discussion and Analysis of Financial Condition and Results of Operations
17
       
 
7A.
Quantitative and Qualitative Disclosures About Market Risk
36
       
 
8.
Financial Statements and Supplementary Data
38
       
 
9.
Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
76
       
 
9A(T).  
Controls and Procedures
76
       
 
9B.
Other Information
76
       
   
PART III
 
       
 
10.
Directors, Executive Officers and Corporate Governance
76
       
 
11.
Executive Compensation
77
       
 
12.
Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
77
 
     
 
13.
Certain Relationships and Related Transactions and Director Independence
77
       
 
14.
Principal Accountant Fees and Services
77
       
 
15.
Exhibits and Financial Statement Schedules
77
 
 
2

 

FORWARD-LOOKING STATEMENTS

Cornerstone Bancshares, Inc. (“Cornerstone”) may from time to time make written or oral statements, including statements contained in this report which may 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) unanticipated deterioration in the financial condition of borrowers resulting in significant increases in loan losses and provisions for those losses, (ii) increased competition with other financial institutions, (iii) lack of sustained growth in the economy in the Chattanooga, Tennessee area, (iv) rapid fluctuations or unanticipated changes in interest rates, (v) the inability of our bank subsidiary, Cornerstone Community Bank, to satisfy regulatory requirements for its expansion plans, (vi) the inability of Cornerstone to achieve its targeted expansion goals in the Knoxville, Tennessee and Dalton, Georgia  markets, (vii) the inability of Cornerstone to grow its loan portfolio at historic or planned rates and (viii) changes in the legislative and regulatory environment, including compliance with the various provisions of the Sarbanes-Oxley Act of 2002. 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.

 
3

 

PART I

ITEM 1.  BUSINESS

OVERVIEW

Cornerstone was incorporated on September 19, 1983 under the laws of the State of Tennessee and is a bank holding company registered under the Bank Holding Company Act of 1956, as amended, and was formerly known as East Ridge Bancshares, Inc.  It has two wholly-owned subsidiaries: Cornerstone Community Bank, a Tennessee banking corporation (the “Bank”), resulted from the merger of The Bank of East Ridge and Cornerstone Community Bank effective October 15, 1997, and Eagle Financial Inc., a Tennessee corporation (“Eagle”), created December 1, 2005 with the assets acquired from Eagle Financial, LLC, a Tennessee limited liability company, and Eagle Funding, LLC, a Nevada limited liability company.

Cornerstone

The primary activity of Cornerstone currently is, and is expected to remain for the foreseeable future, the ownership and operation of the Bank.  As a bank holding company, Cornerstone intends to facilitate the Bank's ability to serve its customers' requirements for financial services.  The holding company structure also provides flexibility for expansion through the possible acquisition of other financial institutions and the provision of additional banking-related services, as well as certain non-banking services, which a traditional commercial bank may not provide under present laws.  The holding company structure also affords additional flexibility in terms of capital formation and financing opportunities.

While Cornerstone may seek in the future to acquire additional banks or bank holding companies or to engage in other activities appropriate for bank holding companies under appropriate circumstances as permitted by law, Cornerstone currently has no plans, understandings or agreements concerning any other activities other than as described below.  The results of operations and financial condition of Cornerstone for the foreseeable future, therefore, will be determined primarily by the results of operations and financial condition of the Bank.

The Bank

The Bank is a Tennessee-chartered commercial bank established in 1985 which has its principal executive offices in Chattanooga, Tennessee. The principal business of the Bank consists of attracting deposits from the general public and investing those funds, together with funds generated from operations and from principal and interest payments on loans, primarily in commercial loans, commercial and residential real estate loans, consumer loans and residential and commercial construction loans.  Funds not invested in the loan portfolio are invested by the Bank primarily in obligations of the U.S. Government, U.S. Government agencies, various states and their political subdivisions.  In addition to deposits, sources of funds for the Bank loans and other investments include amortization and prepayment of loans, sales of loans or participations in loans, sales of its investment securities and borrowings from other financial institutions.  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.

At December 31, 2008, the Bank had 5 full-service banking offices located in Hamilton County, Tennessee.

During 2007, the Bank established two loan production offices (“LPO”).  The first LPO opened by the Bank is located in Dalton, Georgia.  The LPO, which is located in Whitfield County, Georgia, expanded the Bank’s presence in North Georgia.  The second LPO is located in Knoxville, Tennessee.  The Knoxville LPO offers a new market for the Bank to compete for loans.

Eagle

Eagle’s business concentrates on the purchase of account receivables from small businesses and commercial loan placement on a conduit basis.  The principal sources of Eagle’s income are fees derived from the collection of accounts receivable and fees generated from the placement of loans with conduit financial institutions.  Eagle’s principal expenses are interest paid on borrowings, employee compensation and benefits, office expenses and other overhead expenses.

 
4

 

Employees

As of December 31, 2008, Cornerstone had 121 full-time equivalent employees.  The employees are not represented by a collective bargaining unit.  Cornerstone believes that its relationship with its employees is good.

Competition

All phases of the Bank’s banking activities are highly competitive.  The Bank competes actively with 24 commercial banks, as well as finance companies, credit unions, and other financial institutions located in its service area, which includes Hamilton County, Tennessee.

The Bank’s deposits totaled approximately $327 million as of December 31, 2008.  The deposit base represents approximately 5.5% of the deposit base in the Hamilton County Tennessee Metropolitan Statistical Area.  Three major regional banks represent approximately 74% of the deposits in the Hamilton County Tennessee MSA.  These larger financial institutions have greater resources, higher lending limits than the Bank, and each of the three institutions has over 20 branches in the Hamilton County MSA.  There are also several credit unions located in Hamilton County.  Credit unions are not subject to the same income tax structure as commercial banks.  This advantage enables credit unions to offer competitive rates to potential customers.  The Bank also faces competition in certain areas of its business from mortgage banking companies, consumer finance companies, insurance companies, money market mutual funds and investment banking firms, some of which are not subject to the same degree of regulation as the Bank.

The Bank competes for deposits principally by offering depositors a variety of deposit programs with competitive interest rates, quality service and convenient locations and hours.  The Bank will focus its resources to seek out and attract small business relationships and take advantage of the Bank’s ability to provide flexible service that meets the needs of this customer class.  Management feels this market niche is the most promising business area for the future growth of the Bank.

Supervision and Regulation

Cornerstone is a bank holding company within the meaning of the Bank Holding Company Act of 1956, as amended (the “Act”) and is registered with and regulated by the Board of Governors of the Federal Reserve System (the “Board”).  Cornerstone is required to file with the Board annual reports and such additional information as the Board may require pursuant to the Act.  The Board may also make examinations of Cornerstone and its subsidiaries.  Cornerstone is also required to comply with the rules and regulations of the Securities and Exchange Commission (the “Commission”) under federal securities laws.

The Bank is a Tennessee-chartered commercial bank and is subject to the supervision and regulation of the Tennessee Department of Financial Institutions (the “TDFI”).  In addition, the Bank’s deposit accounts are insured up to applicable limits by the Bank Insurance Fund (the “BIF”) of the Federal Deposit Insurance Corporation (the “FDIC”) and consequently, the Bank is also subject to regulation and supervision by the FDIC.  The Bank is not a member of the Federal Reserve System.

Federal and state banking laws and regulations govern all areas of the operation of Cornerstone and the Bank, including reserves, loans, mortgages, capital, issuance of securities, payment of dividends and establishment of branches.  Federal and state banking agencies also have the general authority to limit the dividends paid by insured banks if such payments should be deemed to constitute an unsafe or unsound banking practice.  The TDFI, FDIC and Board have the authority to impose penalties, initiate civil and administrative actions and take other steps intended to prevent banks from engaging in unsafe or unsound practices.

FDIC Insurance of Deposit Accounts

Deposits of the Bank are insured by the FDIC to a maximum of $250,000 for each insured depositor through the BIF.  As an insurer, the FDIC issues regulations, conducts examinations and generally supervises the operations of its insured institutions (institutions insured by the FDIC hereinafter are referred to as "insured institutions").  Any insured institution which does not operate in accordance with or conform to FDIC regulations, policies and directives, may be sanctioned for non-compliance.  For example, proceedings may be instituted against an insured institution if the institution or any director, officer or employee thereof engages in unsafe and unsound practices, is operating in an unsafe or unsound condition, or has violated any applicable law, regulation, rule, order or condition imposed by the FDIC.  If insurance of accounts is terminated by the FDIC, the deposits in the institution will continue to be insured by the FDIC for a period of two years following the date of termination.  The FDIC recommends an annual audit by independent accountants and also periodically makes its own examinations of the Bank.  The FDIC may revalue assets of an institution, based upon appraisals, and require establishment of specific reserves in amounts equal to the difference between such reevaluation and the book value of the assets.

 
5

 

On September 15, 1992, the FDIC approved final regulations adopting a risk-related deposit insurance system.  The risk-related regulations, which became effective January 1, 1993, resulted in a significant spread between the highest and lowest deposit insurance premiums.  Under the risk-related insurance regulations, each insured depository institution is assigned to one of three risk classifications: "well capitalized," "adequately capitalized," or "under capitalized."  Within each risk classification, there are three subgroups.  Each insured depository institution is assigned to one of these subgroups within its risk classification based upon supervisory evaluations submitted to the FDIC by the institution’s primary federal regulator.  The FDIC may terminate its insurance of deposits if it finds that the institution has engaged in unsafe and unsound practices, is in an unsafe or unsound condition to continue operations, or has violated any applicable law, regulation, rule, order or condition imposed by the FDIC.

Subsequent to the enactment of the Financial Institutions Reform, Recovery and Enforcement Act of 1989 (“FIRREA”), the FDIC issued risk-based bank capital guidelines which went into effect in stages through 1992.  In accordance with the FDIC's risk-based standards, an institution's assets and off-balance sheet activities are categorized into one of four risk categories, with either a 0%, 20%, 50%, or 100% amount of capital to be held against these assets.  In addition, the guidelines divide capital instruments into Tier 1 (core) capital and Tier 2 (supplementary) capital.  The risk-based capital adequacy guidelines require that (i) Tier 1 capital equal or exceed 4% of risk-weighted assets; (ii) Tier 2 capital may not exceed 100% of Tier 1 capital, although certain Tier 2 capital elements are subject to additional limitations; (iii) assets and off-balance sheet items must be weighted according to risk; and (iv) the total capital to risk-weighted assets ratio must be at least 8.0%.  The FDIC's current leverage capital requirement requires banks receiving the highest regulatory rating based upon the FDIC's routine examination process, to maintain Tier 1 capital equal to 3.0% of the bank's total assets.  Banks receiving lower regulatory ratings are required to maintain Tier 1 capital in an amount that is at least 100 to 200 basis points higher than 3.0% of total assets.

Certain provisions of the Federal Reserve Act, made applicable to the Bank by Section 18(j) of the Federal Deposit Insurance Act (“FDIA”) (12 U.S.C. §1828(j)) and administered with respect to the Bank by the FDIC, establish standards for the terms of, limit the amount of, and establish collateral requirements with respect to any loans or extensions of credit to, and investments in, affiliates by the Bank as well as set arms-length criteria for such transactions and for certain other transactions (including payment by the Bank for services) between the Bank and its affiliates.  In addition, related provisions of the Federal Reserve Act and the Federal Reserve regulations (also administered with respect to the Bank by the FDIC) limit the amounts of, and establish required procedures and credit standards with respect to, loans and other extensions of credit to officers, directors and principal shareholders of the Bank and to related interests of such persons.

The FDIC may impose sanctions on any insured bank that does not operate in accordance with FDIC regulations, policies and directives.  Proceedings may be instituted against any insured bank or any director, officer or employee of the bank that is believed by the FDIC to be engaged in unsafe or unsound practices, including violation of applicable laws and regulations.  The FDIC is also empowered to assess civil penalties against companies or individuals who violate certain federal statutes, orders or regulations.  In addition, the FDIC has the authority to terminate insurance of accounts, after notice and hearing, upon a finding by the FDIC that the insured institution is or has engaged in any unsafe or unsound practice that has not been corrected, or is in an unsafe or unsound condition to continue operations or has violated any applicable law, regulation, rule or order of, or condition imposed by, the FDIC.  Neither Cornerstone nor the Bank knows of any past or current practice, condition or violation that might lead to termination of its deposit insurance.

Although the Bank is not a member of the Federal Reserve System, it is subject to Board regulations that require it to maintain reserves against its transaction accounts (primarily checking accounts).  Because reserves generally must be maintained in cash or in non-interest bearing accounts, the effect of the reserve requirements is to increase the Bank's cost of funds.  The Board regulations currently require that average daily reserves be maintained against transaction accounts in the amount of 3% of the aggregate of such net transaction accounts up to $52.6 million, plus 10% of the total in excess of $52.6 million.

State of Tennessee Supervision and Regulation

As a State of Tennessee-chartered commercial bank, the Bank is subject to various state laws and regulations which limit the amount that can be loaned to a single borrower, the types of permissible investments, and geographic and new product expansion, among other things.  The Bank must submit an application to, and receive the approval of, the TDFI before opening a new branch office or merging with another financial institution.  The Commissioner of the TDFI has the authority to enforce state laws and regulations by ordering a director, officer or employee of the Bank to cease and desist from violating a law or regulation or from engaging in unsafe or unsound banking practices.

Tennessee law contains limitations on the interest rates that may be charged on various types of loans and restrictions on the nature and amount of loans that may be granted and on the type of investments which may be made.  The operations of banks are also affected by various consumer laws and regulations, including those relating to equal credit opportunity and regulation of consumer lending practices.  All Tennessee banks, including the Bank, must become and remain insured under the FDIA.
 
 
6

 

State banks are subject to regulation by the TDFI with regard to capital requirements and the payment of dividends.  Tennessee has adopted the provisions of the Board’s Regulation O with respect to restrictions on loans and other extensions of credit to bank “insiders”.  Further, under Tennessee law, state banks are prohibited from lending to any one person, firm or corporation amounts more than fifteen percent (15%) of the Bank equity capital accounts, except (i) in the case of certain loans secured by negotiable title documents covering readily marketable nonperishable staples, or (ii) with the prior approval of the Bank’s board of directors or finance committee (however titled), the Bank may make a loan to any person, firm or corporation of up to twenty-five percent (25%) of its equity capital accounts.  Tennessee law requires that dividends be paid only from retained earnings (or undivided profits) except that dividends may be paid from capital surplus with the prior, written consent of the TDFI.  Tennessee laws regulating banks require certain charges against and transfers from an institution’s undivided profits account before undivided profits can be made available for the payment of dividends.

Federal Supervision and Regulation

Cornerstone is regularly examined by the Board, and the Bank is supervised and examined by the FDIC.  Cornerstone is required to file with the Board annual reports and other information regarding its business operations and the business operations of its subsidiaries. Approval of the Board is required before Cornerstone may acquire, directly or indirectly, ownership or control of the voting shares of any bank, if, after such acquisition, Cornerstone would own or control, directly or indirectly, more than 5% of the voting stock of the bank.  In addition, pursuant to the provisions of the Act and the regulations promulgated thereunder, Cornerstone may only engage in, or own or control companies that engage in, activities deemed by the Board to be so closely related to banking as to be a proper incident thereto.

The Bank and Cornerstone are “affiliated” within the meaning of the Act.  Certain provisions of the Act establish standards for the terms of, limit the amount of, and establish collateral requirements with respect to, any loans or extensions of credit to, and investments in, affiliates by the Bank, as well as set arms-length criteria for such transactions and for certain other transactions (including payment by the Bank for services under any contract) between the Bank and its affiliates.  In addition, related provisions of the Act and the regulations promulgated under the Act limit the amounts of, and establish required procedures and credit standards with respect to, loans and other extensions of credit to officers, directors, and principal shareholders of the Bank, Cornerstone and any other subsidiary of Cornerstone, and to related interests of such persons.

In addition to the banking regulations imposed on Cornerstone, the securities of Cornerstone are not exempt from the federal and state securities laws as are the securities of the Bank.  Accordingly, an offering of Cornerstone’s securities must be registered under both the Securities Act of 1933 (the “Securities Act”) and state securities laws or qualify for exemptions from registration.

Under Section 106(b) of the 1970 Amendments to the Act (12 U.S.C. § 1972), the Bank is prohibited from extending credit, selling or leasing property or furnishing any service to any customer on the condition or requirement that the customer (i) obtain any additional property, service or credit from the Company, the Bank (other than a loan, discount, deposit, or trust service) or any other subsidiary of the Company; (ii) refrain from obtaining any property, credit or service from any competitor of Cornerstone, the Bank or any subsidiary of Cornerstone; or (iii) provide any credit, property or service to Cornerstone, the Bank (other than those related to and usually provided in connection with a loan, discount, deposit or trust service) or any subsidiary of Cornerstone.

Most bank holding companies are required to give the Board prior written notice of any purchase or redemption of their outstanding equity securities if the gross consideration for the purchase or redemption, when combined with the net consideration paid for all such purchases or redemptions during the preceding 12 months, is equal to 10% or more of the bank holding company's consolidated net worth.  The Board may disapprove such a purchase or redemption if it determines that the proposal constitutes an unsafe or unsound practice that would violate any law, regulation, Board order or directive or any condition imposed by, or written agreement with, the Board.  The prior notice requirement does not apply to certain "well-capitalized" bank holding companies that meet specified criteria.

In November 1985, the Board adopted its Policy Statement on Cash Dividends Not Fully Covered by Earnings.  The Policy Statement sets forth various guidelines that the Board believes that a bank holding company should follow in establishing its dividend policy.  In general, the Board stated that bank holding companies should not pay dividends except out of current earnings and unless the prospective rate of earnings retention by the holding company appears consistent with its capital needs, asset quality and overall financial condition.

 
7

 

Legislation Affecting Cornerstone and the Bank

The following information describes certain statutory and regulatory provisions affecting Cornerstone and the Bank and is qualified in its entirety by reference to such statutory and regulatory provisions.

FIRREA and FDICIA

Far-reaching legislation, including FIRREA and the Federal Deposit Insurance Corporation Improvement Act of 1991 (“FDICIA”) have for years impacted the business of banking.  FIRREA primarily affected the regulation of savings institutions rather than the regulation of state banks and bank holding companies like the Bank and Cornerstone, but did include provisions affecting deposit insurance premiums, acquisitions of thrifts by banks and bank holding companies, liability of commonly controlled depository institutions, receivership and conservatorship rights and procedures and substantially increased penalties for violations of banking statutes, regulations and orders.

FDICIA resulted in extensive changes to the federal banking laws.  The primary purpose of FDICIA was to authorize additional borrowings by the FDIC in order to assist in the resolution of failed and failing financial institutions.  However, the law also instituted certain changes to the supervisory process and contained various provisions affecting the operations of banks and bank holding companies.

The additional supervisory powers and regulations mandated by FDICIA, include a "prompt corrective action" program based upon five regulatory zones for banks, in which all banks are placed largely based on their capital positions.  Regulators are permitted to take increasingly harsh action as a bank's financial condition declines.  Regulators are also empowered to place in receivership or require the sale of a bank to another depository institution when a bank's capital leverage ratio reaches two percent.  Better capitalized institutions are generally subject to less onerous regulation and supervision than banks with lesser amounts of capital.  The FDIC has adopted regulations implementing the prompt corrective action provisions of the FDICIA, which place financial institutions in the following five categories based upon capitalization ratios: (1) a "well capitalized" institution has a total risk-based capital ratio of at least 10%, a Tier 1 risk-based ratio of at least 6% and a leverage ratio of at least 5%; (2) an "adequately capitalized" institution has a total risk-based ratio of at least 8%, a Tier 1 risk-based ratio of at least 4% and a leverage ratio of at least 4%; (3) an "undercapitalized" institution has a total risk-based capital ratio of under 8%, a Tier 1 risk-based capital ratio of under 4% or a leverage ratio of under 4%; (4) a "significantly undercapitalized" institution has a total risk-based capital ratio of under 6%, a Tier 1 risk-based ratio of under 3% or a leverage ratio of under 3%; and (5) a "critically undercapitalized" institution has a leverage ratio of 2% or less.  Institutions in any of the three undercapitalized categories would be prohibited from declaring dividends or making capital distributions.  The proposed regulations also establish procedures for "downgrading" an institution to a lower capital category based on supervisory factors other than capital.  Various other sections of the FDICIA impose substantial audit and reporting requirements and increase the role of independent accountants and outside directors.  Set forth below is a list containing certain significant provisions of the FDICIA:

 
§
annual on-site examinations by regulators (except for smaller, well-capitalized banks with high management ratings, which must be examined every 18 months);
 
§
mandated annual independent audits by independent public accountants and an independent audit committee of outside directors for institutions with more than $500,000,000 in assets;
 
§
new uniform disclosure requirements for interest rates and terms of deposit accounts;
 
§
a requirement that the FDIC establish a risk-based deposit insurance assessment system;
 
§
authorization for the FDIC to impose one or more special assessments on its insured banks to recapitalize the BIF;
 
§
a requirement that each institution submit to its primary regulators an annual report on its financial condition and management, which report will be available to the public;
 
§
a ban on the acceptance of brokered deposits except by well capitalized institutions and by adequately capitalized institutions with the permission of the FDIC and the regulation of the brokered deposit market by the FDIC;
 
§
restrictions on the activities engaged in by state banks and their subsidiaries as principal, including insurance underwriting, to the same activities permissible for national banks and their subsidiaries unless the state bank is well capitalized and a determination is made by the FDIC that the activities do not pose a significant risk to the insurance fund;
 
§
a review by each regulatory agency of accounting principles applicable to reports or statements required to be filed with federal banking agencies and a mandate to devise uniform requirements for all such filings;
 
§
the institution by each regulatory agency of noncapital safety and soundness standards for each institution it regulates which cover (1) internal controls, (2) loan documentation, (3) credit underwriting, (4) interest rate exposure, (5) asset growth, (6) compensation, fees and benefits paid to employees, officers and directors, (7) operational and managerial standards, and (8) asset quality, earnings and stock valuation standards for preserving a minimum ratio of market value to book value for publicly traded shares (if feasible);
 
§
uniform regulations regarding real estate lending; and

 
8

 

 
§
a review by each regulatory agency of the risk-based capital rules to ensure they take into account adequate interest rate risk, concentration of credit risk, and the risks of non-traditional activities.

Gramm-Leach-Bliley Act

The activities permissible to Cornerstone and the Bank were substantially expanded by the Gramm-Leach-Bliley Act (the “Gramm Act”).  The Gramm Act repeals the anti-affiliation provisions of the Glass-Steagall Act to permit the common ownership of commercial banks, investment banks and insurance companies.  The Gramm Act amended the Act to permit a financial holding company to engage in any activity and acquire and retain any company that the Board determines to be (i) financial in nature or incidental to such financial activity, or (ii) complementary to a financial activity and that does not pose a substantial risk to the safety and soundness of depository institutions or the financial system generally.  The Gramm Act also modifies current law relating to financial privacy and community reinvestment.  The new financial privacy provisions generally prohibit financial institutions, including the Bank and Cornerstone, from disclosing nonpublic personal financial information to third parties unless customers have the opportunity to “opt out” of the disclosure.

Temporary Liquidity Guarantee Program

On November 21, 2008, the Board of Directors of the FDIC adopted a final rule relating to the Temporary Liquidity Guarantee Program (“TLGP”).  The TLGP was announced by the FDIC on October 14, 2008, preceded by the determination of systemic risk by the U.S. Treasury, as an initiative to counter the system-wide crisis in the nation’s financial sector.  Under the TLGP, the FDIC will (i) guarantee, through the earlier of maturity or June 30, 2012, certain newly issued senior unsecured debt issued by participating institutions and (ii) provide unlimited FDIC deposit insurance coverage for noninterest bearing transaction deposit accounts, Negotiable Order of Withdrawal Accounts (commonly known as NOW accounts) paying less than 0.5% interest per annum and Interest on Lawyers Trust Accounts (commonly known as IOLTA) held at participating FDIC-insured institutions through December 31, 2009.  Coverage under the TLG Program was available for the first 30 days without charge.  The fee assessment for coverage of senior unsecured debt ranges from 50 basis points to 100 basis points per annum, depending on the initial maturity of the debt.  The fee assessment for deposit insurance coverage is 10 basis points per quarter on amounts in covered accounts exceeding $250,000.  The Bank elected to participate in the unlimited deposit insurance coverage for noninterest bearing transaction deposit accounts, but declined to participate in the senior unsecured debt guarantee coverage.

Future Legislation

Legislation is regularly introduced in both the United States Congress and the Tennessee General Assembly that contain wide-ranging proposals for altering the structures, regulations and competitive relationships of the nation’s financial institutions.  Such legislation may change banking statutes and the operating environment of Cornerstone and/or the Bank in substantial and unpredictable ways and could increase or decrease the cost of doing business, limit or expand permissible activities or affect the competitive balance, depending upon whether any of this potential legislation will be enacted and, if enacted, the effect that it or any implementing regulations would have on the financial condition or results of operations of Cornerstone and/or the Bank.  With the recent enactments of the EESA and the ARRA, the nature and extent of future legislative and regulatory changes affecting financial institutions is uncertain.  It cannot be predicted whether or what form any proposed legislation will be adopted or the extent to which the business of Cornerstone and/or the Bank may be affected thereby.

ITEM 1A. RISK FACTORS

Investing in our common stock involves various risks which are particular to Cornerstone, its industry and its market area.  Several risk factors regarding investing in our common stock are discussed below.  This listing should not be considered as all-inclusive.  If any of the following risks were to occur, we may not be able to conduct our business as currently planned and our financial condition or operating results could be negatively impacted.  These matters could cause the trading price of our common stock to decline in future periods.

 Cornerstone’s business strategy includes expansion into new markets and the development of new products.

Cornerstone intends to continue pursuing a growth strategy for its business through acquisitions and de novo branch openings. Cornerstone’s prospects must be considered in light of the risks, expenses and difficulties occasionally encountered by financial services companies in growth stages, which may include the following: 
 
maintaining loan quality;
 
maintaining adequate management personnel and information systems to oversee such growth; and
 
maintaining adequate internal control and compliance functions.

 
9

 

Cornerstone may face risks with respect to future expansion.

From time to time Cornerstone may engage in additional de novo branch expansion as well as the acquisition of other financial institutions or parts of those institutions. Cornerstone may also consider and enter into new lines of business or offer new products or services. In addition, Cornerstone may receive future inquiries and have discussions regarding an acquisition. Acquisitions and mergers involve a number of risks, including:
 
the time and costs associated with identifying and evaluating potential acquisitions and merger partners;
 
inaccuracies in the estimates and judgments used to evaluate credit, operations, management and market risks with respect to the target institution;
 
the time and costs of evaluating new markets, hiring experienced local management and opening new offices, and the time lags between these activities and the generation of sufficient assets and deposits to support the costs of the expansion;
 
Cornerstone’s ability to finance an acquisition and possible dilution to its existing shareholders;
 
the diversion of Cornerstone’s management’s attention to the negotiation of a transaction, and the integration of the operations and personnel of the combining businesses;
 
entry into new markets where Cornerstone lacks experience;
 
the introduction of new products and services into Cornerstone’s business;
 
the incurrence and possible impairment of goodwill associated with an acquisition and possible adverse short-term effects on Cornerstone’s results of operations; and
 
the risk of loss of key employees and customers.
 
Cornerstone may incur substantial costs to expand. There can be no assurance that integration efforts for any future mergers or acquisitions will be successful. Also, Cornerstone may issue equity securities, including common stock and securities convertible into shares of Cornerstone’s common stock in connection with future acquisitions, which could cause ownership and economic dilution to Cornerstone’s shareholders. There is no assurance that, following any future mergers or acquisitions, Cornerstone’s integration efforts will be successful or after giving effect to the acquisition, will achieve profits comparable to or better than its historical experience.

Cornerstone is subject to the success of the local economies where it operates.

With the exception of the Bank’s loan production office in Knoxville, Tennessee substantially all of our loan and deposit customers live, work and bank in the Chattanooga, TN MSA.  Cornerstone’s success depends upon a sound local economy to provide opportunities for new business ventures, increased loan demand and the need for deposit services.  Cornerstone’s profit is impacted by these local factors as well as general economic conditions and interest rates.  For example, Cornerstone’s earnings could be impacted by changes in population, income levels, deposits and housing starts.  Adverse economic conditions in specific market areas could reduce Cornerstone’s growth rate and affect the ability of its customers to repay their loans.  Secondly, adverse market conditions could affect the market value of the real estate or other collateral securing Cornerstone’s loan portfolio.  Sustained periods of increased payment delinquencies, foreclosures or losses in the State of Tennessee or the State of Georgia could adversely affect the value of the collateral and potentially affect Cornerstone’s assets, revenues, results of operations and financial condition.

Impact of recent negative developments in the financial services industry and U.S. and global credit markets may adversely impact Cornerstone’s operations and results.

Recent developments in the capital markets have resulted in uncertainty in the financial markets.  It is anticipated that these negative economic developments will continue into 2009.  Financial institutions across the U.S. have experienced deteriorating asset quality.  Loan portfolios include impaired loans to businesses struggling to stay in operation or achieve adequate cash flow.  Further a decline in collateral values supporting these loans have also impacted the ability of a business or consumer to obtain loans or increased financial institutions losses in the event of foreclosure and liquidation.  At the same time financial institutions have experienced concerns regarding liquidity.  This concern has increased the competition for deposits in Cornerstone’s local market as well as wholesale funding options.  These events have impacted Cornerstone’s, as well as other bank holding company, stock prices.  The potential impact of these events may be an expansion of existing or creation of new federal or state laws and regulations regarding lending and funding practices, liquidity standards and compliance issues.  Continued negative developments as well as Cornerstone’s ability to respond to these new operating and regulatory requirements could negatively impact Cornerstone’s operations.  The negative consequences could limit our ability to originate new loans, obtain adequate funding or increase costs associated with regulatory compliance.   Ultimately, these changes could result in modifications to Cornerstone’s existing or future strategic plan, capital requirements, compensation, financial performance and stock performance.

 
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There can be no assurance that recently enacted legislation will stabilize the U.S. financial system.

Under the Temporary Liquidity Guarantee Program (“TLGP”) the FDIC may offer a guarantee of certain financial institution indebtedness in exchange for an insurance premium to be paid to the FDIC by issuing financial institutions.  Participation in the TLGP likely will require the payment of additional insurance premiums to the FDIC.  We may be required to pay higher FDIC premiums than those published for 2009 because market developments have depleted the deposit insurance fund of the FDIC and reduced the ratio of reserves to insured deposits.  The U.S. Congress enacted the Emergency Economic Stabilization Act of 2008 (“EESA”) in response to the impact of the volatility and disruption in the capital and credit markets on the financial sector.  The U.S. Department of the Treasury (“U.S. Treasury”) and the federal banking regulators are implementing a number of programs under this legislation that are intended to address these conditions and the asset quality, capital and liquidity issues they have caused for certain financial institutions and to improve the general availability of credit for consumers and businesses.  In addition, the U.S. Congress recently enacted the American Recovery and Reinvestment Act of 2009 (“ARRA”) in an effort to save and create jobs, stimulate the U.S. economy and promote long-term growth and stability.  There can be no assurance as to the actual impact that the TLGP, the EESA, the ARRA and their implementing regulations, the FDIC programs, or any other governmental program will have on the financial markets.  The failure of the TLGP, the EESA, the ARRA, the FDIC or the U.S. government to stabilize the financial markets and a continuation or worsening of current financial market conditions could materially and adversely affect Cornerstone’s business, financial condition, results of operations, access to credit and/or the trading price of Cornerstone’s common stock.

Cornerstone may require additional capital which may not be able to be obtained.

Cornerstone may require capital from sources other than earnings generation.  These additional sources may include additional equity investments, trust preferred offerings, borrowed funds or any combination of these sources of funds.  Cornerstone’s ability to access these alternative capital sources may be limited due to regulatory restrictions or the condition of the capital markets.   Therefore, Cornerstone’s ability to enact a bank acquisition, increase its loan portfolio or expand its branch network may be impaired.

Cornerstone is subject to Federal and State regulations that impact its operations and financial performance.

Cornerstone is subject to examinations and supervision from both federal and state regulatory agencies.  These agencies require compliance with numerous banking regulations.  These regulations increase costs and require human and information technology resources to comply.  Certain activities of Cornerstone such as the payment of dividends, investments, acquisitions, and branching are impacted by these regulations.

The laws and regulations applicable to the banking industry are subject to change at any time.  Cornerstone cannot predict the events that will result in regulatory changes nor their impact on the banking industry and Cornerstone’s earnings.

Cornerstone operates in a highly regulated industry and is subject to examination, supervision, and comprehensive regulation by various federal and state agencies including the Board, the FDIC and the TDFI. Cornerstone’s regulatory compliance is costly and restricts and regulates certain of its activities, including payment of dividends, mergers and acquisitions, investments, loans and interest rates charged, interest rates paid on deposits and locations of offices. Cornerstone is also subject to capitalization guidelines established by its regulators, which require it to maintain adequate capital to support its growth.
 
The laws and regulations applicable to the banking industry could change at any time, and Cornerstone cannot predict the effects of these changes on its business and profitability. Because government regulation greatly affects the business and financial results of all commercial banks and bank holding companies, Cornerstone’s cost of compliance could adversely affect its ability to operate profitably.
 
The Sarbanes-Oxley Act of 2002, and the related rules and regulations promulgated by the Securities and Exchange Commission and Nasdaq, have increased the scope, complexity and cost of corporate governance, reporting and disclosure practices. As a result, Cornerstone has experienced, and may continue to experience, greater compliance costs.

Cornerstone could experience declines or losses in earnings if asset quality declines.

Cornerstone’s assets are primarily comprised of loans.  If the Bank’s loan customers fail to repay their loans in accordance with the terms of the loan agreement, the Bank’s earnings would be negatively impacted.  To minimize the likelihood of a substandard loan portfolio the Bank assesses the credit worthiness of a customer as well as performing collateral valuations.  An allowance for loan losses is also maintained in an attempt to address the various risks involved with lending.  In determining the amount of the allowance, Cornerstone relies on an analysis of the loan portfolio based on volume and types of loans, internal loan classifications, delinquency trends, local and economic conditions and other pertinent information.  Negative changes in these valuation methods would result in a decline in asset quality.  Any increase in Cornerstone’s allowance for loan losses would have a negative impact on earnings.

 
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Liquidity needs could adversely affect Cornerstone’s results of operations and financial condition.

Cornerstone relies on dividends from the Bank as its primary source of funds. The majority of the Bank’s funds are comprised  of customer deposits and loan repayments. While scheduled loan repayments are a relatively stable source of funds, they are subject to the ability of borrowers to repay the loans.  The repayment of loans can be adversely affected by a number of factors, including changes in economic conditions, adverse trends or events affecting business industry groups, reductions in real estate values or markets, business closings or lay-offs, inclement weather, natural disasters and international instability. Additionally, deposit levels may be affected by a number of factors, including rates paid by competitors, general interest rate levels, returns available to customers on alternative investments and general economic conditions. Accordingly, Cornerstone may be required from time to time to rely on secondary sources of liquidity to meet withdrawal demands or otherwise fund operations. Alternative sources include advances from the Federal Home Loan Bank and federal funds lines of credit from correspondent banks. While Cornerstone believes that these sources are currently adequate, there can be no assurance they will be sufficient to meet future liquidity demands. Cornerstone may be required to slow or discontinue loan growth, capital expenditures or other investments or liquidate assets if these alternative sources are not adequate.
 
Competition from financial institutions and other financial service providers may adversely affect Cornerstone’s profitability.

The banking business is highly competitive and Cornerstone experiences competition in each of its markets from many other financial institutions. Cornerstone competes with other commercial banks, credit unions, savings and loan associations, mortgage banking firms, consumer finance companies, securities brokerage firms, insurance companies, money market funds, and other mutual funds, as well as other community banks and super-regional and national financial institutions that operate offices in Cornerstone’s primary market areas and elsewhere.

Additionally, Cornerstone faces competition from de novo community banks, including those with senior management who were previously affiliated with other local or regional banks or those controlled by investor groups with strong local business and community ties. These de novo community banks may offer higher deposit rates or lower cost loans in an effort to attract Cornerstone’s customers, and may attempt to hire Cornerstone’s management and employees.

Cornerstone competes with these other financial institutions both in attracting deposits and in making loans. In addition, Cornerstone has to attract its customer base from other existing financial institutions and from new residents. Cornerstone expects competition to increase in the future as a result of legislative, regulatory and technological changes and the continuing trend of consolidation in the financial services industry.
 
Changes in interest rates could adversely affect Cornerstone’s results of operations and financial condition.

Changes in interest rates may affect Cornerstone’s level of interest income, the primary component of its gross revenue, as well as the level of its interest expense. Interest rates are highly sensitive to many factors that are beyond Cornerstone’s control, including general economic conditions and the policies of various governmental and regulatory authorities. Accordingly, changes in interest rates could decrease Cornerstone’s net interest income. Changes in the level of interest rates also may negatively affect Cornerstone’s ability to originate real estate loans, the value of its assets and the ability to realize gains from the sale of its assets, all of which ultimately affects earnings.  Recent economic events have prompted the Federal Reserve to reduce its federal funds rate.  Due to the rapid decline in interest rates, the Bank was unable to recalibrate its liabilities at the same rate at which loan rates declined.  As a result, the net interest margin was impacted negatively during 2008 and will continue into 2009.  If the Federal Reserve’s federal funds rate remains at extremely low levels or does not increase above the Bank’s interest rate floors, Cornerstone’s funding costs may increase which will negatively impact the net interest margin and Cornerstone’s financial performance.
 
Cornerstone relies heavily on the services of key personnel.

Cornerstone relies on the strategies and management services of Gregory B. Jones, its Chairman of the Board and Chief Executive Officer. Although Cornerstone has entered into an employment agreement with Mr. Jones, the loss of his services could have a material adverse effect on Cornerstone’s business, results of operations and financial condition. Cornerstone is also dependent on certain other key officers who have important customer relationships or are instrumental to its lending and depository operations. Changes in key personnel and their responsibilities may be disruptive to operations and could have a material adverse effect on Cornerstone’s financial condition and earnings.  Cornerstone believes that its future results will also depend upon its ability to attract and retain highly skilled and qualified personnel, particularly in those areas where Cornerstone may open new branches.

 
12

 

Cornerstone’s recent results may not be indicative of its future results.

Cornerstone may not be able to sustain its historical rate of growth or could experience very limited or no increase in assets at all.  Various factors, such as the general economic environment, interest rates, regulatory and legislative considerations and competition, may also impede or prohibit Cornerstone’s ability to expand its market presence.
 
Cornerstone is subject to Tennessee’s anti-takeover statutes and certain charter provisions which could decrease its chances of being acquired even if the acquisition is in the best interest of Cornerstone’s shareholders.
 
As a Tennessee corporation, Cornerstone is subject to various legislative acts which impose restrictions on and require compliance with procedures designed to protect shareholders against unfair or coercive mergers and acquisitions. These statutes may delay or prevent offers to acquire Cornerstone and increase the difficulty of consummating any such offers, even if the acquisition would be in its shareholders’ best interests. Cornerstone’s amended and restated charter also contains provisions which may make it difficult for another entity to acquire it without the approval of a majority of the disinterested directors on its board of directors.  Secondly, the amount of common stock owned by, and other compensation arrangements with, Cornerstone’s officers and directors may make it more difficult to obtain shareholder approval of potential takeovers that they oppose.  As of March 2, 2009, directors and executive officers beneficially owned approximately 16.8% of Cornerstone’s common stock. Agreements with Cornerstone’s senior management also provide for significant payments under certain circumstances following a change in control. These compensation arrangements, together with the common stock and option ownership of Cornerstone’s board of directors and management, could make it difficult or expensive to obtain majority support for shareholder proposals or potential acquisition proposals that the board of directors and officers oppose.
 
The success and growth of Cornerstone’s operations will depend on its ability to adapt to technological changes.
 
The banking industry and the ability to deliver financial services is becoming more dependent on technological advancement, such as the ability to process loan applications over the Internet, accept electronic signatures, provide process status updates instantly, reliable on-line banking capabilities and other customer expected conveniences that are cost efficient to Cornerstone’s business processes. As these technologies are improved in the future, Cornerstone may, in order to remain competitive, be required to make significant capital expenditures.
 
Even though Cornerstone’s common stock is currently traded on the OTC Bulletin Board, the trading volume in its common stock has been limited.  Secondly, the sale of substantial amounts of Cornerstone’s common stock in the public market could depress the price.
 
Cornerstone cannot say with any certainty when a more active and liquid trading market for its common stock will develop or be sustained. Because of this, Cornerstone’s shareholders may not be able to sell their shares at the volumes, prices, or times that they desire. Cornerstone cannot predict the effect, if any, that future sales or the availability of common stock will have on the market price.  Cornerstone, therefore, can give no assurance that sales of substantial amounts of its common stock in the market, or the potential for large amounts of sales in the market, would not cause the price of its common stock to decline or impair its ability to raise capital through sales of its common stock.
 
Cornerstone may issue additional common stock or other equity securities in the future which could dilute the ownership interest of existing shareholders.
 
In order to maintain capital at desired or required regulatory levels, Cornerstone’s board of directors may decide from time to time to issue additional shares of common stock, or securities convertible into, exchangeable for or representing rights to acquire shares of its common stock. The sale of these shares may significantly dilute the book value per share of its common stock. New investors in the future may also have rights, preferences and privileges senior to its current shareholders which may adversely impact its current shareholders.
 
Cornerstone’s ability to declare and pay dividends is limited by law and it may be unable to pay future dividends.
 
Cornerstone derives the majority of its income from dividends on the shares of common stock of the Bank and Eagle. The ability of the Bank and Eagle to declare and pay dividends is limited by its obligations to maintain sufficient capital and by other general restrictions on its dividends that are applicable to banks that are regulated by the FDIC and the Department of Financial Institutions. In addition, the Board may impose restrictions on Cornerstone’s ability to pay dividends on its common stock. As a result, Cornerstone cannot assure its shareholders that it will declare or pay dividends on shares of its common stock in the future.
 
 
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ITEM 1B. UNRESOLVED STAFF COMMENTS
 
There are no written comments from the Commission staff regarding our periodic or current reports under the Exchange Act which remain unresolved.

ITEM 2.  PROPERTIES

As of December 31, 2008, the principal offices of Cornerstone are located at 835 Georgia Avenue, Chattanooga, Tennessee 37402.  In addition, the Bank operates five full-service branches and two loan production offices that are located at:

Branches
4154 Ringgold Road, East Ridge, Tennessee
 
5319 Highway 153, Hixson, Tennessee
 
2280 Gunbarrel Road, Chattanooga, Tennessee
 
8966 Old Lee Highway, Ooltewah, Tennessee
 
835   Georgia Avenue, Chattanooga, Tennessee
   
Loan Production Offices
202   West Crawford Street, Dalton, Georgia
 
9724 Kingston Pike Suite 305B Knoxville, Tennessee

The Georgia Avenue facility located in downtown Chattanooga, Tennessee serves as a branch location for the Bank’s customers as well as Cornerstone’s Executive offices.  The Bank owns the properties located at 2280 Gunbarrel Road, 4154 Ringgold Road, 5319 Highway 153 and 8966 Old Lee Highway. The Bank also owns a vacant building and lot at 103 S. Campbell Station Road Knoxville, TN. The Bank intends to renovate the structure into a full service branch opening in 2010. Cornerstone operates a service center to facilitate all of its non-customer contact functions located at 6401 Lee Corners, Suite 119, Chattanooga, Tennessee.

ITEM 3.  LEGAL PROCEEDINGS

As of the end of 2008, neither Cornerstone, the Bank nor Eagle was involved in any material litigation.  The Bank is periodically involved as a plaintiff or defendant in various legal actions in the ordinary course of its business.  Management believes that any claims pending against Cornerstone or its subsidiaries are without merit or that the ultimate liability, if any, resulting from them will not materially affect the Bank’s or Eagle’s financial condition or Cornerstone’s consolidated financial position.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

No matters were submitted during the fourth quarter of 2008 to a vote of security holders of Cornerstone through a solicitation of proxies or otherwise.

PART II

ITEM 5. 
 MARKET FOR THE REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES

On February 20, 2009, Cornerstone had 6,319,718 shares of common stock outstanding. Cornerstone’s common stock is quoted on the OTC Bulletin Board but is not listed on a national securities exchange.  There are ten market makers who provide a market for Cornerstone’s common stock.

There were approximately 549 holders of record of the common stock as of December 31, 2008.   This number does not include shareholders with shares in nominee name held by DTC.  As of the end of 2008, there were 3,728,120 shares held in nominee name by DTC.  Cornerstone paid quarterly cash dividends in 2008 in the amount of $0.07 per share.  Cornerstone announced, in November 2008, a first quarter 2009 dividend of $0.07, which was paid on January 5, 2009.  Cornerstone’s board of directors will continue to evaluate the amount of future dividends, if any, after capital needs required for expected growth of assets are reviewed.  The payment of dividends is solely within the discretion of the board of directors, considering Cornerstone’s expenses, the maintenance of reasonable capital and risk reserves, and appropriate capitalization requirements for state banks.

 
14

 

Table 1 presents the high and low closing prices of Cornerstone’s common stock for the periods indicated, as reported by published sources.  The prices reflect inter-dealer prices, without retail mark-up, mark-down or commission and may not represent actual transactions.

TABLE 1
High and Low Common Stock Share Price for the Company
 
Dividends paid
 
2009 Fiscal Year
 
Low
   
High
   
Per Share
 
First Quarter (through Feb. 24, 2009)
  $ 3.76     $ 6.00     $ .07  
                         
2008 Fiscal Year
                       
First Quarter
  $ 7.99     $ 10.90     $ 0.07  
Second Quarter
  $ 5.85     $ 8.95     $ 0.07  
Third Quarter
  $ 5.25     $ 7.25     $ 0.07  
Fourth Quarter
  $ 4.75     $ 6.00     $ 0.07  
                         
2007 Fiscal Year
                       
First Quarter
  $ 14.25     $ 16.50     $ 0.05  
Second Quarter
  $ 14.30     $ 15.30     $ 0.05  
Third Quarter
  $ 10.95     $ 14.50     $ 0.05  
Fourth Quarter
  $ 10.05     $ 12.40     $ 0.05  

Table 2 presents information regarding the equity compensation plans under which equity securities of Cornerstone are authorized for issuance.  For further information relating to Cornerstone’s equity compensation plans, see Item 12 of this report.

TABLE 2
Equity Compensation Plan
Year Ended December 31, 2008
 
Plan category
 
Number of securities to
be issued upon exercise
of outstanding options
   
Weighted average
exercise price of
outstanding options
   
Number of securities
remaining available
for future issuance
 
Equity compensation plans approved by security holders:
    837,225     $ 7.03       567,525  
Equity compensation plans not approved by security holders:
    -       -       80,000  
Total
    837,225     $ 7.03       647,525  
 
 
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ITEM 6.  SELECTED FINANCIAL DATA

Table 3 presents selected financial data for the periods indicated (amounts in thousands).

TABLE 3
   
At and for the Fiscal Years Ended December 31,
 
   
2008
   
2007
   
2006
   
2005
   
2004
 
                               
Total interest income
  $ 30,680     $ 34,784     $ 29,158     $ 20,672     $ 14,058  
Total interest expense
    12,698       14,414       10,306       6,077       3,575  
Net interest income
    17,982       20,370       18,852       14,594       10,483  
Provision for loan losses
    3,498       10,409       1,106       1,401       840  
Net interest income after provision for loan losses
    14,484       9,961       17,746       13,193       9,643  
Noninterest income:
                                       
Investment securities gains
                             
Other income
    1,892       1,695       2,111       1,904       1,405  
Noninterest expense
    12,568       10,926       10,718       8,216       6,885  
Income before income taxes
    3,808       730       9,139       6,881       4,163  
Income tax expense / (benefit)
  $ 1,296     $ (141 )   $ 3,328     $ 2,556     $ 1,592  
Net income
  $ 2,512     $ 871     $ 5,811     $ 4,325     $ 2,571  
                                         
Per Share Data:
                                       
Net income, basic
  $ 0.40     $ 0.13     $ 0.90     $ 0.71     $ 0.52  
Net income, assuming dilution
  $ 0.39     $ 0.13     $ 0.85     $ 0.66     $ 0.46  
Dividends paid
  $ 0.28     $ 0.20     $ 0.12     $ 0.09     $ 0.03  
Book value
  $ 5.78     $ 5.70     $ 5.86     $ 5.07     $ 4.32  
Tangible book value(1)
  $ 5.33     $ 5.24     $ 5.40     $ 4.54     $ 3.88  
                                         
Financial Condition Data:
                                       
Assets
  $ 471,803     $ 444,421     $ 374,942     $ 323,611     $ 248,614  
Loans, net of unearned interest
  $ 378,472     $ 369,883     $ 305,879     $ 262,008     $ 202,555  
Cash and investments
  $ 57,286     $ 51,798     $ 51,557     $ 46,074     $ 34,614  
Federal funds sold
  $ 11,025     $     $     $     $  
Deposits
  $ 326,583     $ 313,250     $ 275,816     $ 252,435     $ 187,832  
FHLB advances and line of credit
  $ 71,250     $ 47,100     $ 39,500     $ 30,000     $ 27,000  
Subordinated debentures
  $     $     $     $     $  
Federal funds purchased and repurchase agreements
  $ 35,790     $ 41,560     $ 19,249     $ 4,790     $ 7,409  
Shareholders’ equity
  $ 36,502     $ 36,327     $ 38,183     $ 32,466     $ 24,807  
Tangible shareholders’ equity(1)
  $ 33,661     $ 33,386     $ 35,137     $ 29,089     $ 22,266  
                                         
Selected Ratios:
                                       
Interest rate spread
    3.67 %     4.51 %     5.16 %     4.93 %     4.70 %
Net interest margin(2)
    4.16 %     5.22 %     5.80 %     5.43 %     5.02 %
Return on average assets
    0.55 %     0.21 %     1.69 %     1.51 %     1.15 %
Return on average equity
    6.71 %     2.14 %     16.27 %     14.98 %     13.83 %
Return on average tangible equity(1)
    7.26 %     2.31 %     17.78 %     16.96 %     16.02 %
Average equity to average assets
    8.27 %     9.86 %     10.36 %     10.09 %     8.30 %
Dividend payout ratio
    70.59 %     149.71 %     13.33 %     12.17 %     4.84 %
Ratio of nonperforming assets to total assets
    1.48 %     0.40 %     0.40 %     0.47 %     0.08 %
Ratio of allowance for loan losses to nonperforming loans
    226.23 %     791.16 %     25.90 %     20.70 %     5.33 %
Ratio of allowance for loan losses to total average loans, net of unearned income
    2.49 %     3.88 %     1.50 %     1.50 %     1.47 %
 
(1) 
Tangible shareholders’ equity is shareholders’ equity less goodwill and intangible assets.
(2) 
Net interest margin is the net yield on interest earning assets and is the difference between the interest yield earned on interest-earning assets less the interest rate paid on interest bearing liabilities.
 
 
16

 

GAAP Reconciliation and Management Explanation of Non-GAAP Financial Measures
 
Certain financial information included in our summary consolidated financial data is determined by methods other than in accordance with U.S. generally accepted accounting principles (“GAAP”).  These non-GAAP financial measures are “tangible book value per share,” “tangible shareholders’ equity,” and “return on average tangible equity.” Cornerstone’s management uses these non-GAAP measures in its analysis of Cornerstone’s financial performance.
 
“Tangible book value per share” is defined as total equity reduced by recorded goodwill and other intangible assets divided by total common shares outstanding. This measure is important to investors interested in changes from period-to-period in book value per share exclusive of changes in intangible assets. Goodwill, an intangible asset that is recorded in a purchase business combination, has the effect of increasing total book value while not increasing the tangible assets of a company. For companies such as Cornerstone that have engaged in business combinations, purchase accounting can result in the recording of significant amounts of goodwill related to such transactions.

“Tangible shareholders’ equity” is shareholders’ equity less goodwill and other intangible assets.

“Return on average tangible equity” is defined as earnings for the period divided by average equity reduced by average goodwill and other intangible assets.
 
These disclosures should not be viewed as a substitute for results determined in accordance with GAAP, and are not necessarily comparable to non-GAAP performance measures which may be presented by other companies. Table 4 presents a reconciliation to provide a more detailed analysis of these non-GAAP performance measures:
 
TABLE 4
   
At and for the Fiscal Years Ended December 31,
 
   
2008
   
2007
   
2006
   
2005
   
2004
 
Book value per share
  $ 5.78     $ 5.70     $ 5.86     $ 5.07     $ 4.32  
Effect of intangible assets per share
  $ 0.45     $ 0.46     $ 0.47     $ 0.53     $ 0.44  
Tangible book value per share
  $ 5.33     $ 5.24     $ 5.40     $ 4.54     $ 3.88  
Return on average equity
    6.71 %     2.14 %     16.27 %     14.98 %     13.83 %
Effect of intangible assets
    0.55 %     0.17 %     1.51 %     1.98 %     2.19 %
Return on average tangible equity
    7.26 %     2.31 %     17.78 %     16.96 %     16.02 %
 
ITEM 7. 
  MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Forward-Looking Statements

Management’s discussion and analysis of Cornerstone’s operations, prospects, and other matters, may include forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 and other provisions of applicable federal and state securities laws.  Although Cornerstone believes that the assumptions underlying such forward-looking statements contained in this report are reasonable, any of the assumptions could be inaccurate and, accordingly, there can be no assurance that the forward-looking statements included herein will prove to be accurate.  The use of such words as “expect,” “anticipate,” “forecast,” and comparable terms should be understood by the reader to indicate that the statement is “forward-looking” and thus subject to change in a manner that can be unpredictable.  Factors that could cause actual results to differ from the results anticipated, but not guaranteed, in this report, include (without limitation) economic and social conditions, competition for loans, mortgages, and other financial services and products, changes in interest rates, unforeseen changes in liquidity, results of operations, and financial conditions affecting Cornerstone’s customers, and other risks that cannot be accurately quantified or completely identified.  Many factors affecting Cornerstone’s financial condition and profitability, including changes in economic conditions, the volatility of interest rates, political events and competition from other providers of financial services simply cannot be predicted.  These factors are unpredictable and beyond Cornerstone’s control.  Earnings may fluctuate from period to period.  The purpose of this type of information is to provide readers with information relevant to understanding and assessing the financial condition and results of operations of the Company, and not to predict the future or to guarantee results.  Cornerstone is unable to predict the types of circumstances, conditions and factors that can cause anticipated results to change.  Cornerstone undertakes no obligation to publish revised forward-looking statements to reflect the occurrence of changes or unanticipated events, circumstances, or results.

 
17

 

Management's Discussion And Analysis of Financial Condition and Results of Operations

Cornerstone Bancshares, Inc. (“Cornerstone”) is a bank holding company and the parent of Cornerstone Community Bank, (the “Bank”) a Tennessee banking corporation, and Eagle Financial, Inc., (“Eagle”), an accounts receivable financing company that operate primarily in and around Hamilton County, Tennessee. The Bank has also established loan production offices in Knoxville, Tennessee and 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. Eagle’s principal source of income is revenue received from the purchase of receivables. Expenses are related to employee compensation and benefits, office and overhead expenses.

The following is a discussion of our financial condition at December 31, 2008 and December 31, 2007 and our results of operations for each of the three-years ended December 31, 2008, 2007 and 2006. The purpose of this discussion is to focus on information about our 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 our consolidated financial statements and the related notes included elsewhere herein.

Review of Financial Performance

As of December 31, 2008, Cornerstone had total consolidated assets of approximately $472 million, total loans of approximately $388 million, total deposits of approximately $327 million and stockholders’ equity of approximately $37 million.  Cornerstone’s net income increased to $2.5 million for 2008 compared to $871 thousand for 2007 and $5.8 million for 2006.

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 our earnings.  For the year ended December 31, 2008, Cornerstone recorded net interest income of approximately $17,982,000, which resulted in a net interest margin of 4.16%.  For the year ended December 31, 2007, Cornerstone recorded net interest income of approximately $20,370,000, which resulted in a net interest margin of 5.22%.  For the year ended December 31, 2006, Cornerstone recorded net interest income of approximately $18,853,000, which resulted in a net interest margin of 5.80%.
 
18

 
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,
 
   
2008
   
2007
   
2006
 
(In thousands)
 
ASSETS
 
Average
Balance
   
Interest
Income/
Expense(1)
   
Yield/
Rate
   
Average
Balance
   
Interest
Income/
Expense(1)
   
Yield/
Rate
   
Average
Balance
   
Interest
Income/
Expense(1)
   
Yield/
Rate
 
Interest-earning assets:
                                                     
Loans(1)(2)
  $ 385,957     $ 28,661       7.43 %   $ 353,278     $ 32,981       9.34 %   $ 284,105     $ 27,317       9.61 %
Investment securities(3)
    47,096       1,996       4.36 %     37,673       1,750       4.80 %     36,218       1,584       4.48 %
Federal funds sold
    869       23       2.70 %     760       52       6.86 %     4,686       258       5.51 %
Total interest-earning assets
    433,922       30,680       7.08 %     391,711       34,783       8.89 %     325,009       29,159       8.98 %
Allowance for loan losses
    (8,496 )                     (5,009 )                     (4,104 )                
Cash and other assets
    27,179                       26,341                       23,836                  
Total assets
  $ 452,605                     $ 413,043                     $ 344,741                  
TOTAL LIABILITIES AND EQUITY
                                                                       
Interest-bearing liabilities:
                                                                       
Deposits:
                                                                       
NOW accounts
  $ 30,106     $ 211       0.70 %   $ 36,327     $ 802       2.21 %   $ 34,701     $ 427       1.23 %
Money market / Savings
    51,600       826       1.60 %     55,808       2,018       3.61 %     58,477       2,225       3.80 %
Time deposits, $100m and over
    59,083       2,371       4.01 %     61,172       3,134       5.12 %     43,692       1,993       4.56 %
Time deposits, under $100m
    131,138       5,891       4.49 %     107,498       5,387       5.01 %     88,773       3,899       4.39 %
Total interest-bearing deposits
    271,927       9,299       3.42 %     260,805       11,341       4.35 %     225,643       8,544       3.78 %
Federal funds purchased
    12,952       339       2.62 %     11,374       613       5.39 %     4,570       232       5.07 %
Securities sold under agreement to repurchase
    18,580       261       1.41 %     8,103       244       3.01 %     4,020       116       2.88 %
Other borrowings
    68,578       2,799       4.08 %     48,282       2,216       4.59 %     35,429       1,414       3.98 %
Total interest-bearing Liabilities
    372,037       12,698       3.41 %     328,564       14,414       4.39 %     269,662       10,306       3.82 %
Net interest spread
                    3.67 %                     4.51 %                     5.16 %
                                                                         
Other liabilities:
                                                                       
Demand deposits
    42,915                       41,503                       37,056                  
Accrued interest payable and other liabilities
    218                       2,240                       2,295                  
Stockholders' equity
    37,435                       40,737                       35,728                  
Total liabilities And stockholders' equity
  $ 452,605                     $ 413,043                     $ 344,741                  
                                                                         
Net interest margin
          $ 17,982       4.16 %           $ 20,369       5.22 %           $ 18,853       5.80 %

(1)  Interest income on loans includes amortization of deferred loan fees and other discounts of $227 thousand, $302 thousand, and $288 thousand for the fiscal years ended December 31, 2008, 2007, and 2006, 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:

Starting in September 2007, the Federal Reserve Bank initiated a series of interest rate reductions, that as of January 30, 2009, resulted in a Federal Funds Target rate of 0.25%.  This 500 basis point reduction has placed downward pressure on the banking industry’s net interest margins.  Cornerstone was also impacted by this reduction which lowered its net interest margin to 4.16% for the year-end 2008 compared to 5.22% for the year-end 2007.  Currently, the variable portion of the Bank’s loan portfolio, indexed to the prime interest rate, has reached interest rate floors ranging from 5.00% to 7.00%.  To compensate for the reduction in loan yields the Bank lowered its interest bearing liabilities from 4.39% in 2007 to 3.41% for 2008.  However, uncertainty of liquidity in the national market resulted in certificate of deposit rates to remain abnormally elevated throughout 2008.  This resulted in a disintermediation within the Bank’s deposit base as balances migrated from transactional accounts to certificate of deposit accounts.  Finally, the Bank expects rate pressure on its interest rate loan floors throughout 2009.  However, the Bank anticipates a return to more traditional certificate of deposit interest rates in early 2009.  The Bank anticipates that its net interest margin will remain in the low 4.00% range throughout 2009.

 
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As of December 31, 2008, the Bank’s investment portfolio resulted in a yield of 4.36% compared to 4.80% for the same time period in 2007.  The Bank’s investment portfolio is used primarily for pledging purposes with the State of Tennessee Collateral Pool, Federal Reserve Bank discount window and to secure repurchase agreements.  As of December 31, 2008, approximately 50% of the security portfolio was invested in Agency LIBOR floaters to protect the Bank from rapid increases in interest rates.  In the future, the Bank intends to purchase longer term securities with artificially high spreads in relation to the U.S. Treasury yields to balance the security portfolio’s current yield and protect against potential rapid increases in interest rates or if inflation concerns materialize.  These artificially high spreads to the U.S. Treasuries are a result of perceived principal risk to the underlying credit.  However, once the economy starts to improve these spreads should reduce to more historic yield levels.

During 2008 the Bank contracted with Promontory Interfinancial Network, LLC to offer the Certificate of Deposit Account Registry Service (“CDARS”) to the Bank’s existing depository base as well as potential new deposit customers in the Chattanooga, TN MSA that had been previously unavailable.  The CDARS program allows the Bank to provide FDIC insurance coverage for certificates of deposit accounts in excess of $100,000.  Effectively, the CDARS program allows the Bank to obtain certificate of deposit accounts greater than $100,000 and break the large deposit into smaller amounts which are placed with other banks that are part of the CDARS network.  This program enables the customer to interact with one bank and still receive the same FDIC insurance coverage of multiple banking institutions.  The CDARS network also gives the Bank further access to brokered deposits, at a competitive interest rate, as an additional source of wholesale funding.

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 describes 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,
 
   
2008 Compared to 2007
 
 
(In Thousands)
 
Volume
   
Rate
   
Mix
   
Net
Change
 
Interest income:
                       
  Loans (1)(2)
  $ 2,428     $ (7,372 )   $ 622     $ (4,320 )
  Investment securities
    411       (188 )     23       246  
  Federal funds sold
    3       (22 )     (10 )     (29 )
Total interest income
                            (4,103 )
                                 
Interest expense:
                               
  NOW accounts
    (44 )     (455 )     (92 )     (591 )
  Money market and savings accounts
    (67 )     (1,040 )     (85 )     (1,192 )
  Time deposits, $100,000 and over
    (93 )     (402 )     (268 )     (763 )
  Time deposits, less than $100,000
    1,017       (931 )     418       504  
  Other borrowings
    828       (349 )     104       583  
  Federal funds purchased
    41       (359 )     44       (274 )
  Securities sold under agreement to repurchase
    148       (297 )     166       17  
Total interest expense
                            (1,716 )
Change in net interest income (expense)
                          $ (2,387 )
 
 
20

 

TABLE 7
INTEREST INCOME AND EXPENSE ANALYSIS
 
   
Year Ended December 31,
 
   
2007 Compared to 2006
 
 
(In Thousands)
 
Volume
   
Rate
   
Mix
   
Net
Change
 
Interest income:
                       
Loans (1)(2)
  $ 6,461     $ (954 )   $ 157     $ 5,664  
Investment securities
    69       105       (8 )     166  
Federal funds sold
    (204 )     (8 )     6       (206 )
Total interest income
                            5,624  
                                 
Interest expense:
                               
NOW accounts
    36       356       (16 )     376  
Money market and savings accounts
    (96 )     (103 )     (8 )     (207 )
Time deposits, $100,000 and over
    895       343       (98 )     1,140  
Time deposits, less than $100,000
    938       666       (116 )     1,488  
Other borrowings
    590       294       (82 )     802  
Federal funds purchased
    367       36       (22 )     381  
Securities sold under agreement to repurchase
    123       11       (7 )     127  
Total interest expense
                            4,107  
Change in net interest income (expense)
                          $ 1,517  

(1) Loan amounts include non-accruing loans.
(2) Interest income includes the portion of loan fees recognized in the respective periods.

      Provision for Loan Losses-The provision for loan losses represents a charge to earnings necessary to establish an allowance for loan losses that, in management’s evaluation, should be adequate to provide coverage for the inherent losses on outstanding loans.  The provision for loan losses amounted to $3.5 million for the year ended December 31, 2008 compared to $10.4 million for the year ended December 31, 2007.  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:

Cornerstone’s provision for loan losses during 2008 was needed to address multiple credits that were not able to maintain operations or cash flow due in large part to the economic downturn.  The provision allocation differs from the amount charged to earnings in 2007 which was concentrated in two large credits.  These large credits contained alleged fraud perpetrated by the customer against the Bank.  The Bank expects further economic deterioration during 2009.  Therefore, the Bank anticipates that the 2009 provision will be equal to or slightly larger than the charge to earnings for provision in 2008.

To address the problem credits within the Bank’s loan portfolio a Special Asset Committee was created.  This committee has instructed the Bank’s loan review department to identify potential problem loans as quickly as possible.  This early detection will allow the Bank to assist customers with this severe economic environment and potentially minimize losses.  Secondly, during 2008 the Bank hired a special asset consultant to assist in the disposal of problem assets in an optimal manner.

Non Interest Income-Items reported as non interest 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.

 
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Table 8 presents the components of non interest income for the years ended December 31, 2008, 2007 and 2006 (in thousands).

TABLE 8
   
2008
   
2007
   
2006
 
Customer service fees
  $ 1,727     $ 1,426     $ 1,298  
Other noninterest income
    108       165       91  
Operating lease income
    -       -       301  
Net gain from sale of loans & other assets
    57       104       421  
Total noninterest income
  $ 1,892     $ 1,695     $ 2,111  

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

The Bank continues to see moderate increases in its customer service fees.  While traditional account service fees are included in the $1.7 million generated during 2008 the amount also includes fees associated with the Bank’s payroll processing services.  Fiscal year 2008 marked the first full year the Bank provided processing services to payroll processors located across the United States.  The payroll processors generate thousands of payroll transactions each week while depositing relatively large amounts on a short term basis.  These ACH transactions are then forwarded through the Federal Reserve Bank to the recipient’s checking accounts.

One of the major components in other fee income in prior years was the Bank’s operating lease income.  The Bank had entered into an operating lease agreement with one of its customers that resulted in monthly lease income to the Bank.  The lease has been terminated with the customer, who subsequently purchased the assets.  Currently, the Bank has no income from operating lease agreements.

Included in the net gain from sale of loans and other assets is the Bank’s loss of $141 thousand on the sale of assets.  This loss was incurred on multiple pieces of other real estate and foreclosed assets.  Without these losses, the Bank’s non-interest income increased 15.2% over 2007 and should continue to increase during 2009.

Non Interest Expense-Items reported as non interest expense include salaries and employee benefits, occupancy and equipment expense and other operating expense.

Table 9 presents the components of non interest expense for the years ended December 31, 2008, 2007 and 2006 (in thousands).

TABLE 9
   
2008
   
2007
   
2006
 
Salaries and employee benefits
  $ 7,140     $ 6,609     $ 6,018  
Net occupancy and equipment expense
    1,520       1,355       1,075  
Depreciation on leased assets
    -       -       245  
Other operating expenses
    3,908       2,962       3,380  
Total noninterest expense
  $ 12,568     $ 10,926     $ 10,718  

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

Salary expense increased 8.0% over 2007 due primarily to an increase in risk management personnel.  Additional employees included in the risk management department included one employee added to the compliance department, two added to the internal audit department and one consultant contracted to assist in Information Technology security.  This along with cost of living adjustments represented the majority of the Cornerstone’s increase.

Occupancy and equipment expense has increased from prior periods in part due to the relocation of the Bank’s downtown branch and Cornerstone’s corporate headquarters.  While the relocation has increased expenses, the Bank’s presence in downtown Chattanooga, Tennessee, provides existing Bank customers with greater access to the Bank’s services as well as attracting potential new customers.  The Bank also opened two loan production offices during 2007; one in Knoxville, Tennessee, and one in Dalton, Georgia.
 
 
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Significant increases in non interest expense were in the other operating expense category which increased 31.9% over 2007.  The majority of the increases can be segmented into three areas.  First, the FDIC assessment increased $220 thousand; second, other real estate expense increased $167 thousand; and third, legal expense increased $160 thousand.  All three categories are related to the deterioration of asset quality and the expense required to properly obtain and ultimately dispose of collateral securing problem loans.

Income Tax Expense
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 growth since December 31, 2007.  Total assets increased approximately $28 million or 6.3% from $444 million as of December 31, 2007 to $472 million as of December 31, 2008.  During 2008 total loans increased $4 million or 1.2% from approximately $384 million as of December 31, 2007 to approximately $388 million as of December 31, 2008.  Finally, stockholders’ equity remained relatively unchanged during 2008 at approximately $36 million as of December 31, 2008 and December 31, 2007.

Investments-The Bank’s investment portfolio totaled $46.4 million or 9.8% of total assets as of the year end 2008 compared to a total of $36.9 million or 8.3% of total assets as of year end 2007.  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 Board of Directors Asset Liability Committee (“ALCO”).  All the investment transactions occurring since the previous ALCO meeting are reviewed by the ALCO at its next monthly 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 Ending December 31,
 
Securities available for sale:
 
2008
   
2007
   
2006
 
U.S. Government and agency obligations
  $ 8,252     $ 27,414     $ 26,470  
Mortgage-backed and other securities
    31,182       3,836       2,634  
State & political subdivisions tax-exempt
    4,623       3,503       3,249  
Totals
  $ 44,057     $ 34,753     $ 32,353  
                         
Securities held to maturity:
                       
Mortgage-backed and other securities
  $ 169     $ 200     $ 236  
Totals
  $ 169     $ 200     $ 236  
                         
Federal Home Loan Bank stock, at cost
    2,188       1,912       1,332  
                         
Total Investments
  $ 46,414     $ 36,865     $ 33,921  

During 2008 the Bank elected to increase the amount of mortgage backed and municipal securities.  The mortgage backed securities were obtained instead of U.S. Government and agency obligations, as traditionally acquired, to provide increased yield while maintaining a 20% risk weight classification for capital requirements.  During the 4th quarter of 2008 and continuing into 2009, the Bank has purchased mortgage backed securities guaranteed by Government National Mortgage Assocation or “Ginnie Mae.”  These securities qualify for 0% risk weight allocation thereby improving the Bank’s overall risk weighted capital position.   The increase in municipal securities has been obtained due to higher yields when compared to alternative investments and to provide collateral at the Federal Reserve discount window.

 
23

 

A second objective of the security portfolio is to provide adequate collateral to satisfy pledging requirements with the State of Tennessee collateral pool, repurchase agreements and the Federal Reserve discount window.  During 2008 the Bank increased its Federal Reserve discount window borrowing to approximately $4 million by year-end.  This increase allowed the Bank to obtain additional funding, if needed, in the event the Bank’s daily fed fund lines were negatively impacted.

For December 31, 2008 tables 11 and 12 present the book value of the Bank's investments, the weighted average yields on the Bank's investments and the periods to maturity of the Bank's investments for the “Securities Available for Sale” and the “Securities Held to Maturity,” respectively.  Available for Sale and Held to Maturity information relating to December 31, 2007 is presented in tables 13 and 14.

TABLE 11
Weighted Average Yields on the Available For Sale Investments
 
Periods of Maturity from December 31, 2008
 
   
Less than 1 year
   
1 to 5 years
   
5 to 10 years
   
Over 10 years
 
 
Securities available for sale:
 
 
Amount
   
Weighted
Avg.
Yield (1)
   
 
Amount
   
Weighted
Avg.
Yield (1)
   
 
Amount
   
Weighted
Avg.
Yield (1)
   
 
Amount
   
Weighted
Avg.
Yield (1)
 
U.S. Government agencies
  $ 6,127       4.15 %   $ 0       0.00 %   $ 0       0.00 %   $ 2,125       6.12 %
Mortgage-backed securities (2)
    0       0.00 %     0       0.00 %     11       6.99 %     31,171       2.99 %
Tax-exempt municipal bonds
    127       5.02 %     925       6.38 %     1,793       6.06 %     1,778       6.26 %
Totals
  $ 6,254       4.16 %   $ 925       6.38 %   $ 1,804       6.07 %   $ 35,074       3.34 %
                                                                 
Total Securities Available for Sale
  $ 44,057       3.62 %                                                

TABLE 12
Weighted Average Yields on the Held to Maturity Investments
 
Periods of Maturity from December 31, 2008
 
   
Less than 1 year
   
1 to 5 years
   
5 to 10 years
 
Over 10 years
 
 
Securities held to maturity:
 
 
Amount
   
Weighted
Avg.
Yield(1)
   
 
Amount
   
Weighted
Avg.
Yield (1)
   
 
Amount
   
Weighted
Avg.
Yield (1)
   
 
Amount
   
Weighted
Avg.
Yield (1)
 
Mortgage-backed securities (2)
  $ 0       0.00 %   $ 6       6.70 %   $ 17       3.74 %   $ 146       5.54 %
Totals
  $ 0       0.00 %   $ 6       6.70 %   $ 17       3.74 %   $ 146       5.54 %
                                                                 
Total Securities held to maturity
  $ 169       5.40 %                                                
                                                                 
Federal Home Loan Bank stock, at cost
  $ 2,188       5.33 %                                                
                                                                 
Total Investments
  $ 46,414       3.73 %                                                

TABLE 13
Weighted Average Yields on the Available For Sale Investments
 
Periods of Maturity from December 31, 2007
 
   
Less than 1 year
   
1 to 5 years
 
5 to 10 years
   
Over 10 years
 
 
Securities available for sale:
 
 
Amount
   
Weighted
Avg.
Yield (1)
   
 
Amount
   
Weighted
Avg.
Yield (1)
   
 
Amount
   
Weighted
Avg.
Yield (1)
   
 
Amount
   
Weighted
Avg.
Yield (1)
 
U.S. Government agencies
  $ 8,491       4.43 %   $ 16,848       4.57 %   $ 0       0.00 %   $ 2,075       6.12 %
Mortgage-backed securities (2)
    0       0.00 %     2       6.30 %     13       7.01 %     3,821       5.17 %
Tax-exempt municipal bonds
    126       5.14 %     739       4.29 %     1,233