10-K 1 v216859_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, 2010
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 whether the Registrant has submitted electronically and posted on its corporate Website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the Registrant was required to submit and post such files).
Yes ¨    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 ¨       Smaller reporting company x
 
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, 2010 was $12 million. The market value calculation was determined using the closing sale price of the Registrant’s common stock on June 30, 2010, as reported on the 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, 2010 there were 6,500,396 shares of the Registrant’s common stock outstanding.
 
DOCUMENTS INCORPORATED BY REFERENCE
 
Portions of the Registrant’s Proxy Statement for the 2011 Annual Meeting of Shareholders (the “2011 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
4
   
ITEM 1.  BUSINESS
4
ITEM 1A. RISK FACTORS
10
ITEM 1B. UNRESOLVED STAFF COMMENTS
16
ITEM 2.  PROPERTIES
16
ITEM 3.  LEGAL PROCEEDINGS
17
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
17
   
PART II
17
   
ITEM 5.  MARKET FOR THE REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
17
ITEM 6.  SELECTED FINANCIAL DATA
18
ITEM 7.   MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
20
ITEM 7A.  QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
40
ITEM 8.  FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
42
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
86
ITEM 9A(T).  CONTROLS AND PROCEDURES
86
ITEM 9B. OTHER INFORMATION
86
   
PART III
86
   
ITEM 10.  DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE
86
ITEM 11. EXECUTIVE COMPENSATION
87
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS
87
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE
87
ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES
87
ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES
88
 
 
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FORWARD-LOOKING STATEMENTS

Cornerstone Bancshares, Inc. (“Cornerstone”) may from time to time make written or oral statements, including statements contained in this report (including, without limitation, certain statements in “Management Discussion and Analysis of Financial Condition and Results of Operations” in Item 7), that constitute forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934 (the “Exchange Act”). The words “expect,” “anticipate,” “intend,” “consider,” “plan,” “believe,” “seek,” “should,” “estimate,” and similar expressions are intended to identify such forward-looking statements, but other statements may constitute forward-looking statements. These statements should be considered subject to various risks and uncertainties. Such forward-looking statements are made based upon management’s belief as well as assumptions made by, and information currently available to, management pursuant to “safe harbor” provisions of the Private Securities Litigation Reform Act of 1995. Cornerstone’s actual results may differ materially from the results anticipated in forward-looking statements due to a variety of factors. Such factors include, without limitation, those specifically described in Item 1A of Part I of this Annual Report on Form 10-K, as well as the following:  (i) the ability of Cornerstone Community Bank (the “Bank”) to comply with the requirements of the consent order issued by the Federal Deposit Insurance Corporation on April 2, 2010 or the written agreement entered with the Tennessee Department of Financial Institutions on April 8, 2010 (collectively, the “Action Plans”); (ii) the ability of Cornerstone to raise additional capital necessary to retire certain holding company loans and enable the Bank to achieve and maintain the elevated capital levels required under the Action Plans; (iii) unanticipated deterioration in the financial condition of borrowers resulting in significant increases in loan losses and provisions for those losses; (iv) increased competition with other financial institutions; (v) changes in economic conditions in Cornerstone’s market area; (vi) rapid fluctuations or unanticipated changes in interest rates; (vii) the effect on Cornerstone and the financial institutions and banking industry from difficult market conditions, unprecedented volatility and the soundness of other financial institutions; (viii) the ability of Cornerstone to restructure its loan portfolio to regulatory acceptable levels and composition; (ix) the effect of recent legislative regulatory initiatives; and (x) changes in the legislative and regulatory environment. 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.
 
 
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PART I

ITEM 1.  BUSINESS

OVERVIEW

Cornerstone was incorporated on September 19, 1983 under the laws of the State of Tennessee.  Cornerstone 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 one wholly-owned subsidiary: Cornerstone Community Bank, a Tennessee banking corporation (the “Bank”), which resulted from the merger of The Bank of East Ridge and Cornerstone Community Bank effective October 15, 1997.  The Bank has one wholly-owned subsidiary: 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.  In prior years, Eagle was owned and operated by Cornerstone.  However, on June 30, 2009, Eagle was sold to the Bank.  This transaction allowed the Bank to consolidate additional capital and improve its regulatory capital position.

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, 2010, the Bank had five full-service banking offices located in Hamilton County, Tennessee and one loan production office located in Dalton, Georgia.

Eagle

Eagle’s business concentrates on the purchase of accounts receivable 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 employee compensation and benefits, office expenses and other overhead expenses.

Employees

As of December 31, 2010, Cornerstone had 112 full-time equivalent employees.  The employees are not represented by a collective bargaining unit.  Cornerstone believes that its relationship with its employees is good.
 
 
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Competition

All phases of the Bank’s banking activities are highly competitive.  The Bank competes actively with over 20 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 $335 million as of December 31, 2010.  The deposit base represents approximately 5% of the deposit base in the Chattanooga, Tennessee Metropolitan Statistical Area (MSA).  Three major regional banks represent approximately 70% of the deposits in the Chattanooga, 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 Chattanooga, Tennessee MSA.  There are also several credit unions located in Hamilton County, Tennessee.  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 focuses 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 “Federal Reserve Board”).  Cornerstone is required to file with the Federal Reserve Board annual reports and such additional information as the Federal Reserve Board may require pursuant to the Act.  The Federal Reserve Board may also make examinations of Cornerstone and its subsidiary.  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 Deposit Insurance Fund (the “DIF”) 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 operations 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.  In accordance with and as a result of the exercise of this general authority, the Bank is currently prohibited from paying dividends without prior regulatory approval.  The TDFI, FDIC and Federal Reserve 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 DIF.  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 other analyses, and require establishment of general or 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.  The FDIC may determine that an insured institution needs to maintain a higher capital level based on the institution’s particular risk profile. The FDIC used this authority under the Action Plans as to the Bank.  Specifically, the Action Plans require the Bank to maintain higher capital ratios, for a more detailed discussion please see below und the caption “Consent Order”.  When determining an insured institution’s minimum capital level, the FDIC will consider whether the financial history or condition; managerial resources; the future earnings prospects; significant risks from concentrations of credit or nontraditional activities; excessive interest rate risk exposure; or a significant volume of criticized assets poses a risk to the insured institution’s capital adequacy.

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 Federal Reserve Board regulations that require the Bank to maintain reserves against its transaction accounts (primarily checking accounts).  Because reserves generally must be maintained in cash or in noninterest-bearing accounts, the effect of the reserve requirements is to increase the Bank's cost of funds.  The Federal Reserve 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 commercial bank chartered and regulated by the TDFI, the Bank is subject to various state laws and regulations which limit the amount that can be loaned to a single borrower and the borrower’s related interests, 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 Federal Reserve 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’s 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 Federal Reserve Board, and the Bank is supervised and examined by the FDIC.  Cornerstone is required to file with the Federal Reserve Board annual reports and other information regarding its business operations and the business operations of the Bank. Approval of the Federal Reserve 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 Federal Reserve 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 offer and sale of securities of Cornerstone, as well as the securities of the Bank, is subject to compliance with applicable federal and state securities laws.  Accordingly, any such offering must be registered under both the Securities Act of 1933 (the “Securities Act”) and applicable state securities laws or qualify for exemptions from such requirements.

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 Cornerstone, the Bank (other than a loan, discount, deposit, or trust service) or any other subsidiary of Cornerstone; (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 Federal Reserve 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 Federal Reserve 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, Federal Reserve Board order or directive or any condition imposed by, or written agreement with, the Federal Reserve Board.  The prior notice requirement does not apply to certain "well-capitalized" bank holding companies that meet specified criteria.

In November 1985, the Federal Reserve Board adopted its Policy Statement on Cash Dividends Not Fully Covered by Earnings.  The Policy Statement sets forth various guidelines that the Federal Reserve Board believes that a bank holding company should follow in establishing its dividend policy.  In general, the Federal Reserve 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.
 
 
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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 commercial 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 Bank Insurance Fund (now called the Deposit Insurance Fund);
 
§
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
 
 
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§
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 Federal Reserve 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.  Such unlimited insurance coverage expired and was not extended under the Dodd-Frank Act (defined below).  The $250,000 deposit insurance coverage limit was scheduled to return to $100,000 on January 1, 2010, but was extended by congressional action until December 31, 2012 and the NOW and IOLTA accounts are subject to such $250,000 insurance coverage limit.  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.

The Dodd-Frank Act

On July 21, 2010, President Obama signed into law the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (the “Dodd-Frank Act”).  The impact of the Dodd-Frank Act on the financial services industry will be broad, with enhanced regulatory oversight and compliance, including, among other things, (i) enhanced resolution authority of troubled and failing banks and their holding companies; (ii) increased capital and liquidity requirements; (iii) increased regulatory examination fees; (iv) changes to assessments to be paid to the FDIC for federal deposit insurance; and (v) numerous other provisions designed to improve supervision and oversight of, and strengthening safety and soundness for, the financial services sector.  In addition, the Dodd-Frank Act established a new framework for systemic risk and oversight in the industry which has resulted and will continue to result in sweeping changes in the regulation of financial institutions aimed at strengthening safety and soundness for the financial services sector. A summary of certain provisions of the Dodd-Frank Act is set forth below:

 
·
Increased Capital Standards and Enhanced Supervision. The federal banking agencies are required to establish minimum leverage and risk-based capital requirements for banks and bank holding companies. These new standards will be no lower than current regulatory capital and leverage standards applicable to insured depository institutions and may, in fact, be higher when established by the agencies. The Dodd-Frank Act also increases regulatory oversight, supervision and examination of banks, bank holding companies and their respective subsidiaries by the appropriate regulatory agency.
 
·
Federal Deposit Insurance. The Dodd-Frank Act makes permanent the $250,000 deposit insurance limit for insured deposits and provides unlimited federal deposit insurance on non-interest bearing transaction accounts at all insured depository institutions until December 31, 2012. The Dodd-Frank Act also changes the assessment base for federal deposit insurance from the amount of insured deposits to consolidated assets less tangible equity, eliminates the ceiling on the size of the DIF and increases the floor of the size of the DIF.
 
·
The Consumer Financial Protection Bureau (“Bureau”). The Dodd-Frank Act centralizes responsibility for consumer financial protection by creating a new agency, the Bureau, responsible for implementing, examining and, for large financial institutions, enforcing compliance with federal consumer financial laws. Because the Bank has under $10 billion in total assets, however, the FDIC will still continue to examine it at the federal level for compliance with such laws.
 
 
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·
Interest on Demand Deposit Accounts. The Dodd-Frank Act repeals the prohibition on the payment of interest on demand deposit accounts effective one year after the date of enactment, thereby permitting depository institutions to pay interest on business checking and other accounts.
 
·
Mortgage Reform. The Dodd-Frank Act provides for mortgage reform addressing a customer’s ability to repay, restricts variable-rate lending by requiring the ability to repay to be determined for variable rate loans by using the maximum rate that will apply during the first five years of a variable-rate loan term, and makes more loans subject to requirement for higher-cost loans, new disclosures and certain other restrictions.
 
We expect that many of the requirements called for in the Dodd-Frank Act will be implemented over time, and most will be subject to implementing regulations over the course of several years. Given the uncertainty associated with the manner in which the provisions of the Dodd-Frank Act will be implement by the various regulatory agencies and through regulations, the full extent of the impact such requirements will have on financial institutions’ operations is unclear. The changes resulting from the Dodd-Frank Act may impact the profitability of our business activities, require changes to certain of our business practices, impose upon us more stringent capital, liquidity and leverage ratio requirements or otherwise adversely affect our business. These changes may also require us to invest significant management attention and resources to evaluate and make necessary changes in order to comply with new statutory and regulatory requirements.

Future Legislation

Legislation is regularly introduced in both the United States Congress and the Tennessee General Assembly that contains 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.

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.
 
RISKS ASSOCIATED WITH OUR BUSINESS

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.
 
 
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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. For example, Cornerstone initiated a Series A Preferred Stock Offering during 2010 which is expected to continue through much of 2011.  The Series A Preferred Stock is convertible subject to certain terms and conditions into common stock.  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.

The Bank’s loan portfolio includes an elevated, although declining level, of residential construction and land development loans, which have a greater credit risk than residential mortgage loans.

The Bank engages in residential construction and land development loans to developers. This type of lending is generally considered to have more complex credit risks than traditional single-family residential lending because the principal is concentrated in a limited number of loans with repayment dependent on the successful operation of the related real estate project. Consequently, these loans are more sensitive to the current adverse conditions in the real estate market and the general economy. These loans are generally less predictable and more difficult to evaluate and monitor and collateral may be difficult to dispose of in a market decline. Furthermore, during adverse general economic conditions, such as are now being experienced in residential real estate construction nationwide, borrowers involved in the residential real estate construction and development business may suffer above normal financial strain. As the residential real estate development and construction market in the Bank’s markets has deteriorated, the Bank’s borrowers in this segment have begun to experience difficulty repaying their obligations to the Bank. As a result, the Bank’s loans to these borrowers have deteriorated and may deteriorate further and may result in additional charge-offs negatively impacting the Bank’s (and consequently, Cornerstone’s) results of operations. Additionally, to the extent repayment is dependent upon the sale of newly constructed homes or lots, such sales are likely to be at lower prices or at a slower rate than was expected when the loan was made, which may result in such loans being placed on non-accrual status and subject to higher loss estimates even if the borrower keeps interest payments current. These adverse economic and real estate market conditions may lead to further increases in non-performing loans and other real estate owned, increased charge-offs from the disposition of non-performing assets, and increases in provision for loan losses, all of which would negatively impact the Bank’s (and, consequently, Cornerstone’s) financial condition and results of operations.

If the Bank’s asset quality continues to decline or it continues to experience greater loan losses than anticipated, the earnings and overall financial condition of the Bank and Cornerstone will be adversely affected even further.

The assets of Cornerstone and the Bank are primarily comprised of loans. The risk of credit losses on loans varies with, among other things, general economic conditions, the type of loan being made, the creditworthiness of the borrower over the term of the loan and, in the case of a collateralized loan, the value and marketability of the collateral for the loan. While the risk of nonpayment of loans is inherent in banking, the Bank has experienced higher nonpayment levels than it anticipated, which has had a significant adverse effect on its (and, consequently, Cornerstone’s) earnings and overall financial condition. Although the Bank has taken actions to prevent further decline, including the creation of a special asset committee to develop and review action plans for minimizing loan losses and the dedication of resources to assist in the collection and recovery process, there can be no assurance that the outcome of such actions will be successful. To minimize the likelihood of a substandard loan portfolio, the Bank assesses the credit worthiness of customers and performs collateral valuations. Management also maintains an allowance for loan losses based upon, among other things, historical experience and an evaluation of economic conditions and regular reviews of delinquencies and loan portfolio quality. Based upon such factors, management makes various assumptions and judgments about the ultimate collectability of the loan portfolio and provides an allowance for loan losses based upon a percentage of the outstanding balances and takes a charge against earnings with respect to specific loans when their ultimate collectability is considered questionable. If management’s assumptions and judgments prove to be incorrect and the allowance for loan losses is inadequate to absorb losses, or if regulatory authorities require the Bank to increase its allowance for loan losses as a part of their examination process, additional provision expense would be incurred and the earnings and capital of the Bank and Cornerstone could be significantly and adversely affected. For example, for the fourth quarter of 2010 the Bank was required to fund an additional provision of $3.2 million for loan losses following a joint examination of the Bank by the FDIC and the TDFI.  Moreover, additions to the allowance may be necessary based on changes in economic and real estate market conditions, new information regarding existing loans, identification of additional problem loans and other factors, both within and outside of management’s control. These additions may require increased provision expense which would negatively impact Cornerstone’s results of operations.

Cornerstone has increased levels of other real estate, primarily as a result of foreclosures.

As the Bank has begun to resolve non-performing real estate loans, Cornerstone has increased the level of foreclosed properties, primarily those acquired from builders, residential land developers and commercial properties. Foreclosed real estate expense consists of three types of charges: maintenance and insurance costs, valuation adjustments due to new appraisal values and gains or losses on disposition. As levels of other real estate increase and also as local real estate values decline, these charges will likely increase, negatively affecting Cornerstone’s results of operations.
 
 
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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. However, in November 2009, following the conclusion of a joint examination of the Bank by the FDIC and the TDFI, the FDIC placed restrictions on the Bank’s ability to pay cash dividends, requiring that the Bank first obtain a non-objection from the FDIC. Furthermore, 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 currently is, and may from time to time in the future be, required 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.

The Bank has a significant deferred tax asset and cannot assure you that it will be fully realized.

The Bank has net deferred tax assets of $1.7 million as of December 31, 2010. The Bank did not establish a valuation allowance against its federal net deferred tax assets as of December 31, 2010 because it believes that it is more likely than not that all of these assets will be realized. In evaluating the need for a valuation allowance, the Bank estimated future taxable income based on management prepared forecasts. This process required significant judgment by management about matters that are by nature uncertain. If future events differ significantly from current forecasts, the Bank may need to establish a valuation allowance, which could have a material temporary adverse effect on its results of operations and financial condition.

Competition from financial institutions and other financial service providers may adversely affect Cornerstone’s profitability.

The banking business is highly competitive and the Bank experiences competition in each of its markets from many other financial institutions. The Bank 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 the Bank’s primary market areas and elsewhere.

Additionally, the Bank 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 the Bank’s customers, and may attempt to hire the Bank’s management and employees.

The Bank competes with these other financial institutions both in attracting deposits and in making loans. In addition, the Bank has to attract its customer base from other existing financial institutions and from new residents. The Bank 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.

If the Bank’s allowance for loan losses is not sufficient to cover actual loan losses, Cornerstone’s earnings will decrease.

If loan customers with significant loan balances fail to repay their loans, Cornerstone’s earnings and capital levels will suffer. The Bank makes various assumptions and judgments about the probable losses in its loan portfolio, including the creditworthiness of borrowers and the value of any collateral securing the loans. The Bank maintains an allowance for loan losses to cover the estimated probable losses in the loan portfolio. In determining the size of this allowance, management relies on an analysis of the loan portfolio based on volume and types of loans, internal loan grade classifications, trends in classifications, volume and trends in delinquencies, nonaccruals and charge-offs, loss experience by loan categories, national and local economic conditions, industry and peer bank loan quality indications, and other pertinent factors and information. If management’s assumptions are inaccurate, the current allowance may not be sufficient to cover potential loan losses, and additional provisions may be necessary which would decrease Cornerstone’s earnings.
 
 
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Certain deposits of the Bank may be volatile and impact its liquidity.

In addition to the traditional core deposits, such as demand deposit accounts, interest checking, money market savings and certificates of deposits, the Bank uses several noncore funding sources, such as Federal Home Loan Bank (FHLB) of Cincinnati advances and certificates of deposit across the United States obtained via the Internet.   Management uses these sources of funding to provide liquidity for the ongoing operations and loan demand of the Bank. The availability of these funding sources is subject to broad economic conditions and to investor assessment of Cornerstone’s financial strength and, as such, the cost of funds may fluctuate significantly and/or be restricted, thus impacting net interest income, immediate liquidity and/or access to additional liquidity.

 To address this risk the Bank adheres to certain internal limits as to the absolute level of funding from these sources.  Should the Bank exceed those limitations, management may need to modify growth plans, liquidate certain assets, participate loans to correspondents or execute other actions to allow the Bank to return to an acceptable level of funding within a reasonable amount of time.

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.

Cornerstone relies heavily on the services of key personnel and the unexpected loss of any of those personnel could adversely affect its operations.

Cornerstone relies on the strategies and management services of Nathaniel F. Hughes. Although Cornerstone entered into an employment agreement with Mr. Hughes, such employment agreement has expired pursuant to its terms and has not been renewed.  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.

Cornerstone is subject to Tennessee’s anti-takeover statutes and certain charter provisions that 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 that 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 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, certain of Cornerstone’s officers and directors may make it more difficult to obtain shareholder approval of potential takeovers that they oppose.  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.
  
 
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RISK RELATED TO RECENT ECONOMIC, LEGISLATIVE AND REGULATORY EVENTS
 
Cornerstone’s success depends significantly upon economic conditions in the local markets where the Bank operates.

Substantially all of the Bank’s loan and deposit customers live, work and bank in the Chattanooga, Tennessee MSA. As a result, the success of the Bank and, in turn, Cornerstone depends upon a sound local economy to provide opportunities for new business ventures, increased loan demand and the need for deposit services. Cornerstone’s profitability is impacted by these local factors as well as general economic conditions and interest rates. For example, Cornerstone’s earnings may be negatively impacted by increases in unemployment rates or reductions in population, income levels, deposits and housing starts. Adverse economic conditions in the local markets where the Bank operates may reduce its growth rate and diminish the ability of its customers to service their loan obligations. The prolonged economic downturn has also negatively impacted collateral values or cash flows of borrowing businesses, and as a result the Bank’s primary source of repayment could be insufficient to service the debt. In addition, adverse consequences to the Bank (and, consequently, to Cornerstone) as a result of the prolonged economic downturn in its local markets could be compounded by the fact that many of the Bank’s commercial and real estate loans are secured by real estate located in those market areas. Significant declines in real estate values in these market areas would mean that the collateral for many of the Bank’s loans would provide less security. As a result, the Bank would be more likely to suffer losses on defaulted loans because its ability to fully recover on defaulted loans by selling the real estate collateral would be diminished. Adverse economic conditions in the Bank’s local markets, including sustained periods of increased payment delinquencies, foreclosures or losses in the State of Tennessee or the State of Georgia, could impair the Bank’s ability to collect loans and could otherwise have a negative effect on the Bank’s and Cornerstone’s assets, revenues, results of operations and financial condition.

Continuing negative developments in the financial services industry and U.S. and global capital and credit markets may lead to additional regulation and further deterioration of Cornerstone’s results of operations and financial condition.

Negative developments in the capital and credit markets during 2009 and 2010 have resulted in uncertainty in the financial markets.  It is anticipated that some of the negative economic developments will continue into 2011.  Financial institutions across the United States, including the Bank, have experienced deteriorating asset quality.  Loan portfolios include impaired loans to businesses struggling to stay in operation or achieve adequate cash flow. A decline in collateral values supporting these loans have also impacted the ability of businesses or consumers 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 companies’, 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 or Cornerstone’s inability to respond to these new operating and regulatory requirements could further negatively impact Cornerstone’s results of operations.  The negative consequences could limit Cornerstone’s ability to originate new loans or obtain adequate funding or increase costs associated with regulatory compliance.   Ultimately, these changes could result in modifications to Cornerstone’s existing or future strategic plans, capital requirements, compensation, financial performance and/or stock performance.

Implementation of the various provisions of the Dodd-Frank Act may increase Cornerstone’s operating costs or otherwise have a material affect on our business, financial condition or results of operations.

On July 21, 2010, President Obama signed the Dodd-Frank Act. This landmark legislation includes, among other things, (i) the creation of a Financial Services Oversight Counsel to identify emerging systemic risks and improve interagency cooperation; (ii) the elimination of the Office of Thrift Supervision and the transfer of oversight of federally chartered thrift institutions and their holding companies to the Office of the Comptroller of the Currency and the Federal Reserve; (iii) the creation of a Consumer Financial Protection Agency authorized to promulgate and enforce consumer protection regulations relating to financial products that would affect banks and non-bank finance companies; (iv) the establishment of new capital and prudential standards for banks and bank holding companies; (v) the termination of investments by the U.S. Treasury under TARP; (vi) enhanced regulation of financial markets, including the derivatives, securitization and mortgage origination markets; (vii) the elimination of certain proprietary trading and private equity investment activities by banks; (viii) the elimination of barriers to de novo interstate branching by banks; (ix) a permanent increase of the previously implemented temporary increase of FDIC deposit insurance to $250,000; (x) the authorization of interest-bearing transaction accounts; and (xi) changes in how the FDIC deposit insurance assessments will be calculated and an increase in the minimum designated reserve ratio for the Deposit Insurance Fund. Certain provisions of the legislation are not immediately effective or are subject to required studies and implementing regulations. Further, community banks with less than $10 billion in assets are exempt from certain provisions of the legislation. Cornerstone cannot predict how this significant new legislation may be interpreted and enforced or how implementing regulations and supervisory policies may affect us. There can be no assurance that these or future reforms will not significantly increase the Bank’s compliance or operating costs or otherwise have a significant impact on our business, financial condition and results of operations.
 
 
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Cornerstone and the Bank are subject to federal and state regulations that impact their operations and financial performance.

Cornerstone and the Bank operate in a highly regulated industry and are subject to examination, supervision and comprehensive regulation by various federal and state agencies, including the Federal Reserve Board, the FDIC and the TDFI. Compliance with the numerous banking regulations is costly and requires investment in human and information technology resources. Certain activities of Cornerstone and/or the Bank, such as the payment of dividends, mergers and acquisitions, investments, loans and interest rates charged, interest rates paid on deposits and locations of offices, are impacted by these regulations. The Bank 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 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 in general and Cornerstone and the Bank in particular. Because government regulation greatly affects the business and financial results of all commercial banks and bank holding companies, the cost of compliance for Cornerstone and the Bank could adversely affect their ability to operate profitably.

The Sarbanes-Oxley Act of 2002, and the related rules and regulations promulgated by the Commission, 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.

As of December 31, 2010, the most recent notification from the Federal Deposit Insurance Corporation (FDIC) categorized the Bank as adequately capitalized under the regulatory framework for prompt corrective action.

RISKS ASSOCIATED WITH INVESTMENT IN CORNERSTONE’S COMMON STOCK

The Bank may require additional capital which may not be able to be obtained.

The Bank may require capital from sources other than earnings generation. In November 2009, the FDIC downgraded the Bank’s status to an “adequately capitalized” institution, which, among other things, restricts the interest rates payable by the Bank for time deposits. To restore the Bank’s status as a “well capitalized” institution, Cornerstone intends to provide capital to the Bank through additional sources, which may include additional equity investments, public or private offerings of common stock (including securities convertible into common stock), preferred stock or trust preferred securities, 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 rebuild the Bank’s capital reserves may be impaired.

The Series A Convertible Preferred Stock issued during 2010 and 2011 impacts the net income available to our common stockholders and our earnings per common share.

During the 3rd quarter of 2010, Cornerstone initiated a Series A Convertible Preferred Stock (the “Series A Preferred Stock”) offering with a stated goal of $15 million in additional capital.  Holders of Series A Preferred Stock have a priority on the receipt of dividends relative to the holders or our common stock.  Until, Cornerstone has declared and paid or set aside for full payment of the quarterly dividends on the Series A Preferred Stock for all past dividend periods, Cornerstone may not declare or pay dividends on shares of common stock.  The payment of the Series A Preferred Stock dividends will limit the amount of net income available to common stockholders and the amount of dividends to be paid to common stockholders.

Holders of the Series A Preferred Stock have rights that are senior to those of our common stockholders.

The shares of Series A Preferred Stock that Cornerstone has issued are senior to shares of our common stock.  These rights include senior positions with respect to dividend payments and liquidation preference over shares of common stock in the event of dissolution or winding-up.

Conversion of Series A Preferred Stock.

Cornerstone, at its option, at any time on or after July 31, 2015, may cause some or all of the shares of Series A Preferred Stock to be converted into shares of our common stock at the then applicable conversion rate if the closing price of Cornerstone’s common stock equals or exceeds 150% of the then applicable conversion price of the Series A Preferred Stock on each of the 30 consecutive trading days immediately preceding the date we give notice of our election to covert.
 
 
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Cornerstone may issue 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 regulatory-required levels or to replace existing capital, Cornerstone may be required to issue shares of common stock, preferred stock or other securities, including securities convertible into, exchangeable for or representing rights to acquire shares of common stock. The sale of these shares may significantly dilute shareholder ownership. New investors in the future may also have rights, preferences and privileges senior to our current shareholders which may adversely impact our current shareholders.

Even though Cornerstone’s common stock is currently traded on the OTC Bulletin Board, the trading volume in its common stock has been limited, and 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’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. The ability of the Bank 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 TDFI. On November 12, 2009, the FDIC placed restrictions on the Bank’s ability to pay cash dividends, requiring that the Bank first obtain a non-objection from the FDIC. In addition, the Federal Reserve 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.

An investment in Cornerstone’s common stock is not an insured deposit.

Cornerstone’s common stock is not a bank deposit and, therefore, is not insured against loss by the FDIC, any other deposit insurance fund or by any other public or private entity. Investment in our common stock is inherently risky for the reasons described in this “Risk Factors” section and elsewhere in this report and is subject to the equity market forces like other common stocks. As a result, if you acquire our common stock, you could lose some or all of your investment.

ITEM 1B. UNRESOLVED STAFF COMMENTS

None

ITEM 2.  PROPERTIES

As of December 31, 2010, the principal offices of Cornerstone are located at 835 Georgia Avenue, Chattanooga, Tennessee 37402.  In addition, the Bank operates five full-service branches and one loan production office that are located at:

 
Banking Branches
4154 Ringgold Road, East Ridge, Tennessee (owned by the Bank)
5319 Highway 153, Hixson, Tennessee (owned by the Bank)
2280 Gunbarrel Road, Chattanooga, Tennessee (owned by the Bank)
8966 Old Lee Highway, Ooltewah, Tennessee (owned by the Bank)
835   Georgia Avenue, Chattanooga, Tennessee (leased by the Bank)

 
Loan Production Office
202   West Crawford Street, Dalton, Georgia (leased by the Bank)

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 also owns a vacant building and lot at 103 S. Campbell Station Road Knoxville, Tennessee, which is currently for sale.  Cornerstone leases and operates a service center located at 6401 Lee Corners, Suite 119, Chattanooga, Tennessee. to facilitate all of its noncustomer contact functions.
 
 
16

 

ITEM 3.  LEGAL PROCEEDINGS

As of the end of 2010, 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 2010 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 March 11, 2011, Cornerstone had 6,500,396 shares of common stock outstanding. Cornerstone’s common stock is quoted on the OTC Bulletin Board under the symbol “CSBQ” 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 550 holders of record of the common stock as of December 31, 2010.   This number does not include shareholders with shares in nominee name held by the Depository Trust Company (DTC).  As of the end of 2010, there were approximately 3,871,000 shares held in nominee name by DTC.  Cornerstone paid quarterly cash dividends in 2009 in the amount of $0.10 per common share.  No cash dividends on common stock were paid in 2010.  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 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.  Currently, the Bank is under a restriction from the FDIC that no dividend can be paid from the Bank to the holding company without prior approval.

Table 1 presents the high and low closing prices of Cornerstone’s common stock for the periods indicated, as reported by published sources and cash dividends declared on its common stock for the last two fiscal years.  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 Cornerstone
 
Cash Dividends
 
 
 
       Low       
   
       High       
 
Paid Per Share
 
2011 Fiscal Year
               
First Quarter (through March 11, 2011)
  $ 1.57     $ 1.90     -  
                       
2010 Fiscal Year
                     
First Quarter
  $ 2.10     $ 2.75     -  
Second Quarter
  $ 1.75     $ 4.75     -  
Third Quarter
  $ 1.35     $ 3.00     -  
Fourth Quarter
  $ 1.58     $ 2.00     -  
                       
2009 Fiscal Year
                     
First Quarter
  $ 3.50     $ 6.00   $ 0.07  
Second Quarter
  $ 4.00     $ 6.00   $ 0.03  
Third Quarter
  $ 2.65     $ 5.77     -  
Fourth Quarter
  $ 1.95     $ 3.71     -  

 
17

 

ITEM 6.  SELECTED FINANCIAL DATA

Table 2 presents selected financial data for the periods indicated (amounts in thousands, except per share data).

TABLE 2
   
At and for the Fiscal Years Ended December 31,
 
   
2010
   
2009
   
2008
   
2007
   
2006
 
Total interest income
  $ 25,211     $ 26,308     $ 30,680     $ 34,784     $ 29,158  
Total interest expense
    9,202       11,189       12,698       14,414       10,306  
Net interest income
    16,009       15,119       17,982       20,370       18,852  
Provision for loan losses
    7,291       14,899       3,498       10,409       1,106  
Net interest income after provision for loan losses
    8,718       220       14,484       9,961       17,746  
Noninterest income
    3,081       2,327       1,887       1,695       2,111  
Noninterest expense
    18,042       16,062       12,563       10,926       10,718  
Income before income taxes
    (6,243 )     (13,515 )     3,808       730       9,139  
Income tax (benefit) / expense
    (1,535 )     (5,336 )     1,296       (141 )     3,328  
Net (loss) income
  $ (4,708 )   $ (8,179 )   $ 2,512     $ 871     $ 5,811  
                                         
Per Common Share Data:
                                       
Net (loss) / income, basic
  $ (0.73 )   $ (1.26 )   $ 0.39     $ 0.13     $ 0.87  
Net (loss) / income, assuming dilution
  $ (0.73 )   $ (1.26 )   $ 0.38     $ 0.12     $ 0.83  
Cash dividends paid
  $     $ 0.10     $ 0.28     $ 0.22     $ 0.12  
Book value
  $ 3.55     $ 4.28     $ 5.78     $ 5.70     $ 5.86  
Tangible book value(1)
  $ 3.55     $ 3.89     $ 5.24     $ 5.24     $ 5.40  
                                         
Financial Condition Data:
                                       
Assets
  $ 441,499     $ 532,404     $ 471,803     $ 444,421     $ 374,942  
Loans, net of unearned interest
  $ 276,115     $ 330,787     $ 378,472     $ 369,883     $ 305,879  
Cash and investments
  $ 133,651     $ 164,982     $ 57,286     $ 51,798     $ 51,577  
Federal funds sold
  $     $     $ 11,025     $     $  
Deposits
  $ 335,447     $ 404,742     $ 326,583     $ 313,250     $ 275,816  
FHLB advances and other borrowings
  $ 54,715     $ 72,350     $ 71,250     $ 47,100     $ 39,500  
Federal funds purchased and repurchase agreements
  $ 24,325     $ 26,322     $ 35,790     $ 41,560     $ 19,249  
Shareholders’ equity
  $ 25,819     $ 27,837     $ 36,502     $ 36,327     $ 38,183  
Tangible shareholders’ equity(1)
  $ 25,782     $ 25,258     $ 33,661     $ 33,386     $ 35,137  
                                         
Selected Ratios:
                                       
Interest rate spread
    3.24 %     2.95 %     3.67 %     4.51 %     5.16 %
Net interest margin(2)
    3.43 %     3.27 %     4.16 %     5.22 %     5.80 %
Return on average assets
    (0.94 )%     (1.69 )%     0.55 %     0.21 %     1.69 %
Return on average equity
    (15.79 )%     (24.34 )%     6.71 %     2.14 %     16.27 %
Return on average tangible equity(1)
    (15.81 )%     (26.36 )%     7.26 %     2.31 %     17.78 %
Average equity to average assets
    5.95 %     6.93 %     8.27 %     9.86 %     10.36 %
Dividend payout ratio
    N/A       N/A       70.59 %     149.71 %     13.33 %
Ratio of nonperforming assets to total assets
    5.99 %     3.36 %     1.48 %     0.40 %     0.40 %
Ratio of allowance for loan losses to nonperforming loans
    66.98 %     80.24 %     226.23 %     791.16 %     25.90 %
Ratio of allowance for loan losses to total average loans, net of unearned income
    2.93 %     1.63 %     2.49 %     3.88 %     1.50 %
(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.

GAAP Reconciliation and Management Explanation of Non-GAAP Financial Measures
 
Certain financial information included in Cornerstone’s 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.” Management uses these non-GAAP measures in its analysis of Cornerstone’s financial performance.
 
 
18

 
 
“Tangible book value per share” is defined as total equity reduced by recorded preferred stock, 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 common 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 3 presents a reconciliation to provide a more detailed analysis of these non-GAAP performance measures:
 
TABLE 3
   
At and for the Fiscal Years Ended December 31,
 
   
2010
   
2009
   
2008
   
2007
   
2006
 
Number of common shares outstanding
    6,500,396       6,500,396       6,319,718       6,369,718       6,511,848  
                                         
Total stockholders’ equity
  $ 25,819,153     $ 27,837,479     $ 36,501,509     $ 36,327,350     $ 38,183,265  
Less: preferred stock
    2,727,424       -       -       -       -  
Book value
    23,091,729       27,837,479       36,501,509       36,327,350     $ 38,183,265  
Book value per common share
  $ 3.55     $ 4.28     $ 5.78     $ 5.70     $ 5.86  
                                         
Book value
  $ 23,091,729     $ 27,837,479     $ 36,501,509     $ 36,327,350     $ 38,183,265  
Less: goodwill and other intangible assets
    37,317       2,579,211       2,840,773       2,941,798       3,046,287  
Tangible book value
    23,054,412       25,258,268       33,660,736       33,385,552       35,136,978  
Effect of intangible assets per common share
  $ -     $ 0.39     $ 0.45     $ 0.46     $ 0.46  
                                         
Tangible book value per common share
  $ 3.55     $ 3.89     $ 5.33     $ 5.24     $ 5.40  
                                         
Net (loss) / income
  $ (4,707,521 )   $ (8,178,639 )   $ 2,511,824     $ 871,152     $ 5,811,600  
Average equity
    29,820,000       33,600,000       37,435,000       40,737,000       35,728,000  
Return on average equity
    (15.79 )%     (24.34 )%     6.71 %     2.14 %     16.27 %
                                         
Average equity
  $ 29,820,000     $ 33,600,000     $ 37,435,000     $ 40,737,000     $ 35,728,000  
Less: goodwill and other intangible assets
    37,317       2,579,211       2,840,773       2,941,798       3,046,287  
Average tangible equity
  $ 29,782,683     $ 31,020,789     $ 34,594,227     $ 37,795,202     $ 32,681,713  
Effect of intangible assets
    (0.02 )%     (2.02 )%     0.55 %     0.17 %     1.51 %
Return on average tangible equity
    (15.81 )%     (26.36 )%     7.26 %     2.31 %     17.78 %
 
 
19

 

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 Cornerstone, 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.

Financial Covenant Considerations

Prior to 2009, Cornerstone Community Bank (the “Bank”) had a history of profitable operations and sufficient sources of liquidity to meet its funding needs.  However, the Bank’s parent holding company, Cornerstone Bancshares, Inc. (“Cornerstone”), relies primarily on dividends from the Bank to meet its funding needs.  Cornerstone’s funding needs as of December 31, 2009 and 2010 primarily consisted of principal and interest payments on two holding company loans totaling approximately $5.4 million and $4.7 million, respectively, secured by 100% of the Bank’s common stock.  In January 2010, the loans were renewed and Cornerstone received a waiver regarding previous covenant violations through December 31, 2009.  The uncertainty surrounding the lender’s intention to continue granting quarterly waivers of the covenant defaults on the loans through December 31, 2010, combined with the lender’s unwillingness to amend the loan covenants, resulted in our independent registered public accounting firm stating in its opinion with regard to our 2009 financial statements substantial doubt about our ability to continue as a going concern.  However, on March 29, 2011, Cornerstone received an additional waiver regarding all previous covenant violations in existence through December 31, 2010 and a waiver of any covenant violation that occurs through December 31, 2011.  The one year covenant waiver is conditional upon, among other things, Cornerstone’s payment in full for the outstanding principal balance in the amount of $750,000 of one of the two outstanding notes.  Therefore, as of April 1, 2011, Cornerstone will be subject to only one outstanding holding company loan.  Further, our independent registered public accounting firm has issued an unqualified opinion with regard to our 2010 financial statements without a going concern consideration - See Our Audited Consolidated Financial Statements in Item 8.

Management's Discussions and Analysis of Financial Condition and Results of Operations

Cornerstone is a bank holding company and the parent company of the Bank, a Tennessee banking corporation which operates primarily in and around Chattanooga, Tennessee.  The Bank has one wholly owned subsidiary Eagle Financial, Inc., (“Eagle”) an accounts receivable financing company.  The Bank has five full-service banking offices located in Hamilton County, Tennessee, and one loan production office located in Dalton, Georgia.  The Bank’s business consists primarily of attracting deposits from the general public and, with these and other funds, originating real estate loans, consumer loans, business loans, and residential and commercial construction loans. The principal sources of income for the Bank are interest and fees collected on loans, fees collected on deposit accounts, and interest and dividends collected on other investments.  The principal expenses of the Bank are interest paid on deposits, employee compensation and benefits, office expenses, and other overhead expenses. 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 Cornerstone’s financial condition at December 31, 2010 and December 31, 2009 and Cornerstone’s results of operations for each of the three-years ended December 31, 2010, 2009 and 2008. The purpose of this discussion is to focus on information about Cornerstone’s financial condition and results of operations which is not otherwise apparent from the consolidated financial statements. The following discussion and analysis should be read along with Cornerstone’s consolidated financial statements and the related notes included elsewhere herein.
 
 
20

 
 
Review of Financial Performance

As of December 31, 2010, Cornerstone had total consolidated assets of approximately $441 million, total loans of approximately $285 million, total deposits of approximately $335 million and stockholders’ equity of approximately $26 million.  Cornerstone incurred a net loss of $4.7 million for 2010 compared to a net loss of $8.2 million for 2009 and net income of $2.5 million for 2008.

Results of Operations

Net Interest Income-Net interest income represents the amount by which interest earned on various earning assets exceeds interest paid on deposits and other interest-bearing liabilities.  Net interest income is also the most significant component of Cornerstone’s earnings.  For the year ended December 31, 2010, Cornerstone recorded net interest income of approximately $16,010,000, which resulted in a net interest margin of 3.43%.  For the year ended December 31, 2009, Cornerstone recorded net interest income of approximately $15,119,000, which resulted in a net interest margin of 3.27%.  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%.

Table 4 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 4
Yields Earned on Average Earning Assets and
Rates Paid on Average Interest Bearing Liabilities
 
Years Ended December 31,
 
   
2010
   
2009
   
2008
 
(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)
  $ 311,407     $ 21,498       6.90 %   $ 363,146     $ 24,402       6.72 %   $ 385,957     $ 28,661       7.43 %
Investment securities(3)
    128,795       3,633       3.06 %     63,854       1,840       3.10 %     47,096       1,996       4.36 %
Other earning assets
    36,319       80       0.22 %     40,085       66       0.16 %     869       23       2.70 %
Total interest-earning assets
    476,521       25,211       5.36 %     467,085       26,308       5.66 %     433,922       30,680       7.08 %
Allowance for loan losses
    (6,454 )                     (8,088 )                     (8,496 )                
Cash and other assets
    31,277                       25,672                       27,179                  
Total assets
  $ 501,344                     $ 484,669                     $ 452,605                  
TOTAL LIABILITIES AND EQUITY
                                                                       
Interest-bearing liabilities:
                                                                       
Deposits:
                                                                       
NOW accounts
  $ 32,338       111       0.34 %   $ 27,864     $ 98       0.35 %   $ 30,106     $ 211       0.70 %
Money market / savings
    32,240       269       0.83 %     35,269       303       0.86 %     51,600       826       1.60 %
Time deposits
    281,251       5,839       2.08 %     256,551       7,608       2.97 %     190,221       8,262       4.34 %
Total interest-bearing deposits
    345,829       6,219       1.80 %     319,684       8,009       2.51 %     271,927       9,299       3.42 %
Federal funds purchased
    197       1       0.51 %     -       -       -       12,952       339       2.62 %
Securities sold under
                                                                       
agreement to repurchase
    22,519       126       0.56 %     21,624       174       0.80 %     18,580       261       1.41 %
Other borrowings
    66,208       2,856       4.31 %     72,150       3,006       4.17 %     68,578       2,799       4.08 %
Total interest-bearing
                                                                       
Liabilities
    434,753       9,202       2.12 %     413,458       11,189       2.71 %     372,037       12,698       3.41 %
Net interest spread
                    3.24 %                     2.95 %                     3.67 %
                                                                         
Other liabilities:
                                                                       
Demand deposits
    39,104                       40,816                       42,915                  
Accrued interest payable and
                                                                       
other liabilities
    (2,333 )                     (3,205 )                     218                  
Stockholders' equity
    29,820                       33,600                       37,435                  
Total liabilities and stockholders' equity
  $ 501,344                     $ 484,669                     $ 452,605                  
                                                                         
Net interest margin
          $ 16,009       3.43 %           $ 15,119       3.27 %           $ 17,982       4.16 %
 
(1)  Interest income on loans includes amortization of deferred loan fees and other discounts of $46 thousand, $78 thousand and $227 thousand for the fiscal years ended December 31, 2010, 2009 and 2008, 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.
 
 
21

 

Other matters related to the changes in net interest income, net interest yields and rates, and net interest margin are presented below:

The net interest margin increased 16 basis points from 3.27% as of December 31, 2009 to 3.43% as of December 31, 2010.  The increase in net interest margin can be attributed primarily to a change in the yield earned on the Bank’s loan portfolio and a decrease in interest expense paid on certificates of deposit.  The yield on the Bank’s loan portfolio increased from 6.72% as of December 31, 2009 to 6.90% as of December 31, 2010.  While the yield on loans actually increased, the total amount of interest income on loans was negatively affected by a reduction of the average loans outstanding for 2010.   This decrease was partially offset by an increase in interest income realized on the Bank’s security portfolio.  Next, the Bank experienced a decrease in the interest rates on certificates of deposit accounts.  This decrease is seen in the decline in rate from 2.97% as of December 31, 2009 compared to 2.08% as of December 31, 2010.

As of December 31, 2010, the Bank’s investment portfolio resulted in a yield of 3.06% compared to 3.10% as of December 31, 2009.  The Bank’s investment portfolio is used primarily for pledging purposes with the State of Tennessee Collateral Pool, Federal Reserve Bank discount window, to secure repurchase agreements and to provide additional collateral to the Federal Home Loan Bank to secure the Bank’s fixed rate term advances.  As of December 31, 2010, the Bank’s securities portfolio was invested approximately 77% in Government National Mortgage Association (GNMA) securities, approximately 19% in municipal general obligation securities and 4% in agency-backed securities.

The Bank’s primary source of funding during 2010 came from certificates of deposit of which approximately 40% came from Internet deposits that allowed the Bank to have longer term maturities at a lower cost than the Chattanooga, TN market could provide.  The rates of certificates of deposit decreased sharply in 2010 to 2.08% compared to 2.97% in 2009.
 
Tables 5 and 6 present the changes in interest income and interest expense that are attributable to three factors:

(i)
A change in volume or amount of an asset or liability.
(ii)
A change in interest rates.
(iii)
A change caused by the combination of changes in asset or deposit mix.

The tables describe the extent to which changes in interest rates and changes in volume of interest-earning assets and interest-bearing liabilities have affected Cornerstone’s interest income and expense during the periods indicated.  For each category of interest-earning assets and interest-bearing liabilities, information is provided as to changes attributable to change in volume (change in volume multiplied by current rate) and change in rates (change in rate multiplied by current volume).  The remaining difference has been allocated to mix.
 
 
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TABLE 5
INTEREST INCOME AND EXPENSE ANALYSIS
 
       
   
Year Ended December 31,
 
   
2010 Compared to 2009
 
(In Thousands)
 
Volume
   
Rate
   
Mix
   
Net
Change
 
Interest income:
                       
Loans (1)(2)
  $ (3,570 )   $ 561     $ 105     $ (2,904 )
Investment securities
    1,987       (52 )     (142 )     1,793  
Other earning assets
    (8 )     22       0       14  
Total interest income
                            (1,097 )
                                 
Interest expense:
                               
NOW accounts
    15       (3 )     1       13  
Money market and savings accounts
    (26 )     -       (8 )     (34 )
Time deposits
    514       (2,503 )     220       (1,769 )
Other borrowings
    (256 )     93       13       (150 )
Federal funds purchased
    (1 )     -       2       1  
Securities sold under agreement to repurchase
    7       (54 )     (1 )     (48 )
Total interest expense
                            (1,987 )
Change in net interest income (expense)
                          $ 890  

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

TABLE 6
INTEREST INCOME AND EXPENSE ANALYSIS

   
Year Ended December 31,
 
   
2009 Compared to 2008
 
(In Thousands)
 
Volume
   
Rate
   
Mix
   
Net
Change
 
Interest income:
                       
Loans (1)(2)
  $ (1,533 )   $ (2,578 )   $ (148 )   $ (4,259 )
Investment securities
    520       (805 )     129       (156 )
Other earning assets
    63       (1,018 )     998       43  
Total interest income
                            (4,372 )
                                 
Interest expense:
                               
NOW accounts
    (8 )     (98 )     (7 )     (113 )
Money market and savings accounts
    (140 )     (261 )     (122 )     (523 )
Time deposits, $100,000 and over
    73       (911 )     516       (322 )
Time deposits, less than $100,000
    1,897       (2,594 )     365       (332 )
Other borrowings
    146       14       47       207  
Federal funds purchased
    -       -       (339 )     (339 )
Securities sold under agreement to repurchase
    32       (80 )     (39 )     (87 )
Total interest expense
                            (1,509 )
Change in net interest income (expense)
                          $ (2,863 )

 (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 $7.3 million for the year ended December 31, 2010 compared to $14.9 million for the year ended December 31, 2009.  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 (and, for 2009 and 2010, in fact did) 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:
 
 
23

 

Cornerstone’s provision for loan losses during 2010, was needed to address multiple credits that continued to deteriorate as a result of the prolonged economic downturn.  The large provision for the fourth quarter of 2010 was primarily designated for unimpaired credits in the Bank’s loan portfolio.  During the fourth quarter of 2010, management changed its methodology for estimating the allowance for loan and lease losses.  First, the Bank revised several specific loan impairments to account for appraisals that were older than one year.  The second change in methodology was a reduction in the number of years included in the Bank’s historical loss look-back period.  These changes in methodology resulted in an additional $3.2 million in provision expense during the fourth quarter of 2010.  Management believes that these changes in estimate are appropriate and consistent with generally accepted accounting principles and interagency policy statements published by the Bank’s regulatory agencies.

To address the problem credits within the Bank’s loan portfolio a Special Asset Committee was created during 2008.  This committee has instructed the Bank’s loan review department to identify potential problem loans as quickly as possible.  This committee is also responsible for developing and reviewing action plans that identify possible strategies to minimize the Bank’s losses.  The early detection and proactive resolution process serves to assist customers with the severe economic environment while potentially minimizing losses.  During 2010, the Bank dedicated additional human resources to the Special Asset department to assist in the collection and recovery process.
 
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.
 
Table 7 presents the components of non interest income for the years ended December 31, 2010, 2009 and 2008 (in thousands).
 
TABLE 7
   
2010
   
2009
   
2008
 
Customer service fees
  $ 1,273     $ 1,630     $ 1,727  
Other noninterest income
    90       97       102  
Net gain from sale of securities
    1,698       400       -  
Net gain from sale of loans & other assets
    20       200       58  
Total noninterest income
  $ 3,081     $ 2,327     $ 1,887  

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

The Bank experienced a material decrease in its customer service fees from 2009 to 2010.  The primary reason for this decrease was the decision by management and the board of directors to exit the payroll processor Automated Clearing House payments (“ACH”) line of business.  The Bank elected to exit this line of business to reduce its risk profile and reduce the strain on the Bank’s liquidity due to the high amount of cash balances that the Bank was required to maintain at the Federal Reserve Bank of Atlanta.  Exiting the line of business resulted in a significant reduction in the Bank’s commercial analysis fee income and ACH income.  However, management believes this decision was appropriate given its current asset quality and liquidity needs.

  The Bank realized approximately $1.7 million of security gains during 2010 as management elected to restructure its investment portfolio.  The goal of the restructure was to maintain high credit quality investments while enabling the Bank to decrease its interest rate risk.  To accomplish this goal, management selected several fixed rate GNMA mortgage-backed securities to sell.  Once the sale transaction was complete, the Bank’s investment committee purchased LIBOR based floating rate GNMA collateralized mortgage obligations.  Management also believes that the restructuring was needed due to the acceleration of prepayment speeds, during 2010, associated with the fixed rate GNMA securities.
 
Non Interest Expense-Items reported as non interest expense include salaries and employee benefits, occupancy and equipment expense, depository insurance, impairment of goodwill, net foreclosed assets and other operating expenses.
 
 
24

 
 
Table 8 presents the components of non interest expense for the years ended December 31, 2010, 2009 and 2008 (in thousands).
 
TABLE 8
   
2010
   
2009
   
2008
 
Salaries and employee benefits
  $ 6,195     $ 6,970     $ 7,140  
Net occupancy and equipment expense
    1,501       1,548       1,520  
Depository insurance
    1,288       1,199       321  
Impairment of goodwill
    2,541       -       -  
Foreclosed assets, net
    2,790       2,571       219  
Other operating expenses
    3,727       3,774       3,362  
Total noninterest expense
  $ 18,042     $ 16,062     $ 12,563  

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

Salary expense decreased 11.1% from 2009 to 2010.  The reduction is resulted from the Bank’s reduced employee benefits, management’s election not to replace certain staff positions if an employee decided to leave the Bank and the conclusion of payments owed to Gregory B. Jones in May of 2010.

The Bank experienced an increase in regulatory insurance cost during 2010 as its average deposits increased over 2009 average amounts.  Management anticipates regulatory insurance to decrease slightly in 2011 as average deposits decline.

Cornerstone’s goodwill was determined to be completely impaired due to the company’s substandard performance and the decline in value of community banks, particularly in the Southeastern portion of the United States.  The write-off of the holding company’s goodwill is a one time expense to earnings.  However, the write-off of goodwill will not negatively affect Cornerstone’s capital ratios since the calculation of capital ratios requires that any goodwill be excluded before the calculation is performed.

The Bank continued to see elevated foreclosed asset expenses as the amount of other real estate owned increased during 2010. Examples of expenses associated with foreclosed assets include property taxes, property maintenance and insurance.  However, the foreclosed asset expense was slightly offset by rental income generated from the properties.  These expenses were higher in 2010 than in 2009 due to an increase in the number of properties.  Additionally, net losses from the sale of foreclosed assets are reflected in foreclosed assets expense.  Management anticipates a decrease in its foreclosed asset expenses as more of the Bank’s properties become income producing and as the general economy stabilizes.

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 and the write-off of goodwill.

Financial Condition

Overview-Cornerstone’s consolidated balance sheet reflects significant changes over the last two years.  Total assets decreased approximately $91 million or 17.1% from $532 million as of December 31, 2009 to $441 million as of December 31, 2010.  During 2010, total loans decreased $52 million or 15.4% from approximately $337 million as of December 31, 2009 to approximately $285 million as of December 31, 2010.  The reduction in loans was a result of the Bank’s collection process, and an increase in the Bank’s loan underwriting requirements.  Finally, stockholders’ equity decreased to approximately $26 million as of December 31, 2010 from approximately $28 million as of December 31, 2009.

Investments-The Bank’s investment portfolio totaled $110.7 million or 25.1% of total assets as of December 31, 2010, compared to a total of $126.8 million or 23.8% of total assets as of December 31, 2009.  The decrease was a result of the Bank reducing its FHLB borrowings by $17 million, thereby reducing the need for the security collateral.

 
25

 
 
The portfolio is accounted for in two classifications:  “Held to Maturity” and “Available for Sale”.  The Bank also has an investment in Federal Home Loan Bank stock.   The objective of the Bank’s investment policy is to invest funds not otherwise needed to meet the loan demand of the Bank’s market area and to meet the following five objectives: Gap Management, Liquidity, Pledging, Return, and Local Community Support.  In doing so, the Bank uses the portfolio to provide structure and liquidity that the loan portfolio cannot.  The management investment committee balances the market and credit risks against the potential investment return, ensures investments are compatible with the pledge requirements of the Bank’s deposit of public funds, maintains compliance with regulatory investment requirements, and assists various public entities with their financing needs.  The management investment committee is authorized to execute security transactions for the investment portfolio based on the decisions of the Directors Asset Liability Committee of the Board of Directors (“ALCO”).  All investment transactions occurring since the previous ALCO meeting are reviewed by the ALCO at its next quarterly meeting, in addition to the entire portfolio.  The investment policy allows portfolio holdings to include short-term securities purchased to provide the Bank’s needed liquidity and longer-term securities purchased to generate stable income for the Bank during periods of interest rate fluctuations.

Table 9 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 9
Investment Portfolio
 
Years Ended December 31,
 
   
2010
   
2009
   
2008
 
Securities available for sale:
                 
U.S. Government agency obligations
  $ 4,587     $ 4,774     $ 8,252  
Mortgage-backed securities
    82,927       102,885       31,182  
State & political subdivisions tax-exempt
    20,736       16,756       4,623  
Totals
  $ 108,250     $ 124,415     $ 44,057  
                         
Securities held to maturity:
                       
Mortgage-backed securities
  $ 96     $ 135     $ 169  
Totals
  $ 96     $ 135     $ 169  
                         
Federal Home Loan Bank stock, at cost
    2,323       2,229       2,188  
                         
Total Investments
  $ 110,669     $ 126,779     $ 46,414  

During 2010, the Bank’s Asset-Liability Committee elected to decrease the amount of fixed rate GNMA mortgage backed securities and increase its GNMA LIBOR based collateralized mortgage obligations.  The change was made in order to reduce the Bank’s overall interest rate risk profile.  The change did not reduce the portfolio’s high credit quality, which is needed to provide collateral for the Bank’s funding purposes.   The Bank also increased its municipal security holdings to take advantage of the large credit risk spread over U.S. Treasury securities.  Management anticipates the general level of security holdings to decrease during 2011 as the Bank’s collateral requirements decrease.

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, correspondent banks and the Federal Reserve discount window.  As of December 31, 2010, the Bank’s borrowing capacity with the Federal Reserve discount window was approximately $10 million.  The Bank also secured availability with a correspondent bank of approximately $4 million as of December 31, 2010.

During 2009, the Federal Home Loan Bank (“FHLB”) notified the Bank that as a result of the decline in the Bank’s loan asset quality, additional collateral was required to secure the Bank’s fixed rate term advances.  As of December 31, 2010, the Bank had pledged securities with a market value of approximately $50 million to the FHLB.

For December 31, 2010, tables 10 and 11 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.  Tables 12 and 13 present this information for December 31, 2009.
 
 
26

 
 
TABLE 10 (amounts in thousands)

Weighted Average Yields on the Available For Sale Investments
 
Periods of Maturity from December 31, 2010
 
   
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
  $ -       -     $ -       -     $ -       -     $ 4,571       1.08 %
Mortgage-backed securities (2)
    4,932       1.45 %     3       6.94 %     30       5.42 %     78,358       1.53 %
Tax-exempt municipal bonds
    -       -       599       6.31 %     4,456       5.30 %     15,814       5.58 %
Totals
  $ 4,932       1.45 %   $ 602       6.31 %   $ 4,486       5.30 %   $ 98,743       2.16 %
                                                                 
Total Securities Available for Sale
  $ 108,763       2.28 %                                                 
   (1)    The weighted average yields on tax-exempt securities have been computed on a tax-equivalent basis.
   (2)    Mortgages are allocated by maturity and not amortized.

TABLE 11 (amounts in thousands)
Weighted Average Yields on the Held to Maturity Investments
 
Periods of Maturity from December 31, 2010
 
   
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)
  $ -       -     $ -       -     $ 20       2.53 %   $ 75       3.57 %
Totals
  $ -       -     $ -       -     $ 20       2.53 %   $ 75       3.57 %
                                                                 
Total Securities Held to Maturity
  $ 95       3.35 %                                                
                                                                 
Federal Home Loan Bank stock, at cost
  $ 2,323       4.35 %                                                
                                                                 
Total Investments
  $ 111,181       2.32 %                                                
   (1)    The weighted average yields on tax-exempt securities have been computed on a tax-equivalent basis.
   (2)    Mortgages are allocated by maturity and not amortized.

TABLE 12 (amounts in thousands)
Weighted Average Yields on the Available For Sale Investments
 
Periods of Maturity from December 31, 2009
 
   
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
  $ -       -     $ -       -     $ -       -     $ 4,772       1.15 %
Mortgage-backed securities (2)
    -       -       -       -       39       5.68 %     103,329       3.01 %
Tax-exempt municipal bonds
    -       -       599       6.31 %     2,468       5.62 %     13,594       5.77 %
Totals
  $ -       -     $ 599       6.31 %   $ 2,507       5.62 %   $ 121,695       3.25 %
                                                                 
Total Securities Available for Sale
  $ 124,801       3.31 %                                                      

   (1)    The weighted average yields on tax-exempt securities have been computed on a tax-equivalent basis.
   (2)    Mortgages are allocated by maturity and not amortized.
 
 
27

 

TABLE 13 (amounts in thousands)
Weighted Average Yields on the Held to Maturity Investments
 
Periods of Maturity from December 31, 2009
 
   
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)
  $ 1       6.43 %   $ -       -     $ 23       3.45 %   $ 111       4.47 %
Totals
  $ 1