10-Q 1 v113020_10q.htm
United States Securities and Exchange Commission
Washington, D.C. 20549
 
FORM 10-Q
(Mark One)
 
x
QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended March 31, 2008
 
o
TRANSITION REPORT PURSUANT SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from __________to                         .
 
Commission File Number: 000-30497
 
Logo of Cornerstone Bancshares, Inc.
 
(Exact name of small business issuer as specified in its charter)

Tennessee
 
62-1173944
(State or other jurisdiction of incorporation or organization)
 
(I.R.S. Employer Identification No.)
     
835 Georgia Avenue Chattanooga, Tennessee
 
37402
(Address of principal executive offices)
 
(Zip Code)
     
423-385-3000
 
Not Applicable
(Registrant’s telephone number, including area code)
 
(Former name, former address and former fiscal year, if changes since last report)

Check whether the issuer (1) filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act during the past 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 o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. (See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act.) (Check one):
Large accelerated filer o Accelerated filer x Non-accelerated filer o Smaller reporting company o
 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
Yes o No x
 
As of March 31, 2008 there were 6,319,718 shares of common stock, $1.00 par value per share, issued and outstanding.
 


TABLE OF CONTENTS
   
   
Item 1. Consolidated Financial Statements and Notes (Unaudited)
 2
   
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
 12
   
Item 3. Quantitative and Qualitative Disclosures about Market Risk
 17
   
Item 4. Evaluation of Controls and Procedures
 17
   
PART II
Item 1. Legal Proceedings
 18
   
Item 1A. Risk Factors
 18
   
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
 20
   
Item 3. Defaults Upon Senior Securities
 21
   
Item 4. Submission of Matters to a Vote of Security Holders
 21
   
Item 5. Other Information
 21
   
Item 6. Exhibits and Reports on Form 8-K
 21



FORWARD-LOOKING STATEMENTS

Cornerstone Bancshares, Inc. (“Cornerstone”) may from time to time make written or oral statements, including statements contained in this report which may constitute forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934 (the “Exchange Act”). The words “expect,” “anticipate,” “intend,” “consider,” “plan,” “believe,” “seek,” “should,” “estimate,” and similar expressions are intended to identify such forward-looking statements, but other statements may constitute forward-looking statements. These statements should be considered subject to various risks and uncertainties. Such forward-looking statements are made based upon management’s belief as well as assumptions made by, and information currently available to, management pursuant to “safe harbor” provisions of the Private Securities Litigation Reform Act of 1995. Cornerstone’s actual results may differ materially from the results anticipated in forward-looking statements due to a variety of factors. Such factors are described below and in Cornerstone’s Form 10-K, as updated by Item 1A of part II of this Form 10-Q and include, without limitation, (i) unanticipated deterioration in the financial condition of borrowers resulting in significant increases in loan losses and provisions for those losses, (ii) increased competition with other financial institutions, (iii) lack of sustained growth in the economy in the Chattanooga, Tennessee area, (iv) rapid fluctuations or unanticipated changes in interest rates, (v) the inability of our bank subsidiary, Cornerstone Community Bank to satisfy regulatory requirements for its expansion plans, (vi) the inability of Cornerstone to achieve its targeted expansion goals in the Knoxville, Tennessee and Dalton, Georgia markets, (vii) the inability of Cornerstone to grow its loan portfolio at historic or planned rates and (viii) changes in the legislative and regulatory environment, including compliance with the various provisions of the Sarbanes-Oxley Act of 2002. Many of such factors are beyond Cornerstone’s ability to control or predict, and readers are cautioned not to put undue reliance on such forward-looking statements. Cornerstone does not intend to update or reissue any forward-looking statements contained in this report as a result of new information or other circumstances that may become known to Cornerstone.
 
1

 
Cornerstone Bancshares, Inc. and Subsidiaries
Consolidated Balance Sheets

PART I — FINANCIAL INFORMATION
Item 1. Financial Statements
 
   
Unaudited
     
   
March 31
 
December 31,
 
 
 
2008
 
2007
 
           
ASSETS
             
Cash and due from banks
 
$
12,052,498
 
$
14,933,349
 
Federal funds sold
   
-
   
-
 
Cash and cash equivalents
   
12,052,498
   
14,933,349
 
               
Securities available for sale
   
42,469,452
   
34,751,985
 
Securities held to maturity
   
193,608
   
200,037
 
Federal Home Loan Bank stock, at cost
   
2,019,200
   
1,911,600
 
Loans, net of allowance for loan losses of
$7,616,532 at March 31, 2008
and $13,710,109 at December 31, 2007
   
374,416,787
   
369,883,009
 
Bank premises and equipment, net
   
6,464,941
   
6,470,893
 
Accrued interest receivable
   
2,075,764
   
2,407,977
 
Goodwill and amortizable intangibles
   
2,928,868
   
2,941,798
 
Other assets
   
10,110,649
   
10,920,605
 
Total Assets
 
$
452,731,767
 
$
444,421,253
 
               
LIABILITIES AND STOCKHOLDERS' EQUITY
             
               
Deposits:
             
Noninterest-bearing demand deposits
 
$
41,338,338
 
$
45,284,518
 
Interest-bearing demand deposits
   
31,482,892
   
31,984,590
 
Savings deposits and money market accounts
   
61,524,760
   
49,970,489
 
Time deposits of $100,000 or more
   
60,489,904
   
71,505,272
 
Time deposits of less than $100,000
   
120,046,433
   
114,504,856
 
Total deposits
   
314,882,327
   
313,249,725
 
Federal funds purchased and securities sold under agreements to repurchase
   
38,373,370
   
41,560,355
 
Federal Home Loan Bank advances and line of credit
   
61,100,000
   
47,100,000
 
Accrued interest payable
   
429,546
   
216,086
 
Other liabilities
   
1,192,301
   
5,967,737
 
Total Liabilities
   
415,977,544
   
408,093,903
 
               
Stockholders' Equity
             
Preferred stock - no par value; 2,000,000 shares authorized; no shares issued
   
-
   
-
 
Common stock - $l.00 par value; 10,000,000 shares authorized;
6,522,718 and 6,522,718 issued in 2008 and 2007;
6,319,718 and 6,369,718 outstanding in 2008 and 2007
   
6,319,718
   
6,369,718
 
Additional paid-in capital
   
20,149,781
   
20,532,787
 
Retained earnings
   
9,886,855
   
9,317,878
 
Accumulated other comprehensive income
   
397,869
   
106,967
 
Total Stockholders' Equity
   
36,754,223
   
36,327,350
 
Total Liabilities and Stockholders' Equity
 
$
452,731,767
 
$
444,421,253
 

The Notes to Consolidated Financial Statements are an integral part of these statements.
 
2


Cornerstone Bancshares, Inc. and Subsidiaries
Consolidated Statements of Income

   
Unaudited
 
   
Three months ended
 
 
 
March 31
 
   
2008
 
2007
 
INTEREST INCOME
             
Loans, including fees
 
$
7,553,295
 
$
7,659,895
 
Investment securities
   
498,009
   
443,810
 
Federal funds sold
   
1,855
   
630
 
Other earning assets
   
6,905
   
2,952
 
Total interest income
   
8,060,064
   
8,107,287
 
               
INTEREST EXPENSE
             
Interest bearing demand accounts
   
66,819
   
127,686
 
Money market accounts
   
337,850
   
475,245
 
Savings accounts
   
15,816
   
18,921
 
Time deposits of less than $100,000
   
1,406,934
   
1,218,070
 
Time deposits of more than $100,000
   
827,745
   
604,311
 
Federal funds purchased and securities sold under agreements to repurchase
   
173,800
   
252,188
 
Other borrowings
   
640,912
   
436,647
 
Total interest expense
   
3,469,876
   
3,133,068
 
               
Net interest income before provision for loan losses
   
4,590,188
   
4,974,219
 
Provision for loan losses
   
317,000
   
2,000
 
Net interest income after the provision for loan losses
   
4,273,188
   
4,972,219
 
               
NONINTEREST INCOME
             
Service charges
   
405,332
   
334,468
 
Net gains / (losses) from sale of loans and other assets
   
(52,247
)
 
15,713
 
Other income
   
41,221
   
24,765
 
Total noninterest income
   
394,306
   
374,946
 
               
NONINTEREST EXPENSE
             
Salaries and employee benefits
   
1,841,033
   
1,675,086
 
Occupancy and equipment expense
   
379,881
   
347,909
 
Other operating expense
   
875,714
   
723,971
 
Total noninterest expense
   
3,096,628
   
2,746,966
 
               
Income before provision for income taxes
   
1,570,866
   
2,600,199
 
Provision for income taxes
   
556,007
   
948,422
 
               
NET INCOME
 
$
1,014,859
 
$
1,651,777
 
               
EARNINGS PER COMMON SHARE
             
Basic net income per common share
 
$
0.16
 
$
0.25
 
Diluted net income per common share
 
$
0.15
 
$
0.24
 
               
DIVIDENDS DECLARED PER COMMON SHARE
 
$
0.07
 
$
0.05
 

The Notes to Consolidated Finanical Statements are an integral part of these statements.
 
3


Cornerstone Bancshares, Inc. and Subsidiaries
Consolidated Statements of Cash Flows

 
 
Unaudited
 
   
Three months ended March 31,
 
   
2008
 
2007
 
           
CASH FLOWS FROM OPERATING ACTIVITIES
             
Net income
 
$
1,014,859
 
$
1,651,777
 
Adjustments to reconcile net income to net cash (used in) provided by operating activities:
             
Depreciation and amortization
   
156,054
   
143,059
 
Provision for loan losses
   
317,000
   
2,000
 
Stock compensation expense
   
70,000
   
55,004
 
Net (Gains) / Losses on sales of loans and other assets
   
52,247
   
(15,713
)
Deferred income taxes
   
2,994,108
   
334,822
 
Changes in other operating assets and liabilities:
             
Net change in loans held for sale
   
327,750
   
5,500
 
Accrued interest receivable
   
332,213
   
(120,409
)
Accrued interest payable
   
213,460
   
3,340
 
Other assets and liabilities
   
(7,238,441
)
 
283,395
 
Net cash (used in) provided by operating activities
   
(1,760,750
)
 
2,342,775
 
               
               
CASH FLOWS FROM INVESTING ACTIVITIES
             
Proceeds from security transactions:
             
Securities available for sale
   
5,489,515
   
230,911
 
Securities held to maturity
   
6,497
   
6,964
 
Purchase of securities available for sale
   
(12,767,252
)
 
(650,000
)
Purchase of Federal Home Loan Bank stock
   
(107,600
)
 
(24,300
)
Loan originations and principal collections, net
   
(5,100,818
)
 
(25,984,004
)
Purchase of bank premises and equipment
   
(137,172
)
 
(283,862
)
Proceeds from sale of other real estate and other assets
   
-
   
579,468
 
Net cash used in investing activities
   
(12,616,830
)
 
(26,124,823
)
               
               
CASH FLOWS FROM FINANCING ACTIVITIES
             
Net increase in deposits
   
1,632,602
   
19,023,777
 
(Decrease) in federal funds purchased and securities sold under agreements to repurchase
   
(3,186,985
)
 
(934,889
)
Net proceeds from Federal Home Loan Bank advances and other borrowings
   
14,000,000
   
(250,000
)
Purchase of common stock
   
(503,006
)
 
(15,250
)
Issuance of common stock
   
-
   
17,456
 
Payment of dividends
   
(445,882
)
 
(325,752
)
Net cash provided by financing activities
   
11,496,729
   
17,515,342
 
               
NET (DECREASE) IN CASH AND CASH EQUIVALENTS
   
(2,880,851
)
 
(6,266,706
)
               
CASH AND CASH EQUIVALENTS, beginning of period
   
14,933,349
   
17,635,956
 
CASH AND CASH EQUIVALENETS, end of period
 
$
12,052,498
 
$
11,369,250
 
               
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION
             
Cash paid during the period for interest
 
$
3,256,416
 
$
3,185,717
 
Cash paid during the period for taxes
   
122,500
   
50,000
 

The Notes to Consolidated Financial Statements are an integral part of these statements.
 
4

 
Cornerstone Bancshares, Inc. and Subsidiaries
Consolidated Statement of Changes in Stockholders' Equity - Unaudited
For the three months ended March 31, 2008

   
Comprehensive Income
 
Common Stock
 
Additional Paid-in Capital
 
Retained Earnings
 
Other Comprehensive Income
 
Total
Stockholders' Equity
 
                           
BALANCE, December 31, 2007
       
$
6,369,718
 
$
20,532,787
 
$
9,317,878
 
$
106,967
 
$
36,327,350
 
                                       
Issuance of common stock under Director's compensation option plan
         
-
   
-
   
-
   
-
   
-
 
 
                                     
Issuance of common stock under employee compensation option plan
         
-
   
-
   
-
   
-
   
-
 
                                       
Employee compensation stock option expense
         
-
   
70,000
   
-
   
-
   
70,000
 
                                       
Dividend - $0.07 per share
         
-
   
-
   
(445,882
)
 
-
   
(445,882
)
                                       
Purchase of common stock
         
(50,000
)
 
(453,006
)
 
-
   
-
   
(503,006
)
                                       
Comprehensive income:
                                     
Net income
 
$
1,014,859
   
-
   
-
   
1,014,859
   
-
   
1,014,859
 
 
                                     
Other comprehensive income, net of tax:
                                     
Unrealized holding gains (losses) on securities available for sale, net of reclassification adjustment
   
290,902
   
-
   
-
   
-
   
290,902
   
290,902
 
                                       
Total comprehensive income
 
$
1,305,761
                               
 
                                     
BALANCE, March 31, 2008
       
$
6,319,718
 
$
20,149,781
 
$
9,886,855
 
$
397,869
 
$
36,754,223
 

The Notes to Consolidated Financial Statements are an integral part of these statements.
 
5

 
CORNERSTONE BANCSHARES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

Note 1. Presentation of Financial Information

Nature of Business-Cornerstone Bancshares, Inc. (“Cornerstone”) is a bank holding company whose primary business is performed by its wholly-owned subsidiaries, Cornerstone Community Bank (“Bank”) and Eagle Financial, Inc. (“Eagle”). The Bank provides a full range of banking services to the Chattanooga, Tennessee market. The Bank has also established a loan production office (“LPO”) in Dalton, Georgia and an LPO in Knoxville, Tennessee to further enhance the Bank’s lending markets. The Bank specializes in asset based lending, commercial lending and payment processing. Eagle is a commercial factoring company that provides financing to businesses that are relatively new or experiencing significant growth.

 Interim Financial Information (Unaudited)-The financial information in this report for March 31, 2008 and March 31, 2007 has not been audited. The information included herein should be read in conjunction with the annual consolidated financial statements and footnotes thereto included in the 2007 Annual Report to Shareholders which was furnished to each shareholder of Cornerstone in March of 2008. The consolidated financial statements presented herein conform to generally accepted accounting principles and to general industry practices. In the opinion of Cornerstone’s management, the accompanying interim financial statements contain all material adjustments, consisting only of normal recurring adjustments necessary to present fairly the financial condition, the results of operations, and cash flows for the interim period. Results for interim periods are not necessarily indicative of the results to be expected for a full year.

Use of Estimates-The preparation of financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities as of the balance sheet date and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Material estimates that are particularly susceptible to significant change in the near term include the determination of the allowance for loan losses.

Consolidation-The accompanying consolidated financial statements include the accounts of Cornerstone and its subsidiaries Bank and Eagle. Substantially all intercompany transactions, profits and balances have been eliminated.

Reclassification-Certain amounts in the prior consolidated financial statements have been reclassified to conform to the current period presentation. The reclassifications had no effect on net income or stockholder’s equity as previously reported.

Accounting Policies-During interim periods, Cornerstone follows the accounting policies set forth in its 10-K for the year ended December 31, 2007 as filed with the Securities and Exchange Commission. Except as discussed on Note No. 7, since December 31, 2007 there have been no significant changes in any accounting principles or practices, or in the method of applying any such principles or practices.
 
Earnings per Common Share- Basic earnings per share (“EPS”) is computed by dividing income available to common shareholders (numerator) by the weighted average number of common shares outstanding during the period (denominator). Diluted EPS is computed by dividing income available to common shareholders (numerator) by the adjusted weighted average number of shares outstanding (denominator). The adjusted weighted average number of shares outstanding reflects the potential dilution occurring if securities or other contracts to issue common stock were exercised or converted into common stock resulting in the issuance of common stock that share in the earnings of the entity.
 
6


CORNERSTONE BANCSHARES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

The following is a summary of the basic and diluted earnings per share for the three month periods ended March 31, 2008 and 2007.

   
Three Months Ended March 31,
 
   
2008
   
2007
 
Basic earnings per share calculation:
             
Numerator: Net income available to common shareholders
 
$
1,014,859
 
$
1,651,777
 
               
Denominator: Weighted avg. common shares outstanding
   
6,336,751
   
6,512,361
 
Effect of dilutive stock options
   
220,753
   
385,534
 
Diluted Shares
   
6,557,504
   
6,897,895
 
               
Basic Earnings per share
 
$
0.16
 
$
0.25
 
Diluted Earnings per share
 
$
0.15
 
$
0.24
 

Note 2. Stock Based Compensation

Accounting Policies- Cornerstone, as required by FASB, applies the fair value recognition provisions of SFAS No. 123(R) Share-Based Payment. As a result, for the period ended March 31, 2008, the compensation cost charged to earnings related to the vested incentive stock options was approximately $70,000, which reduced basic earnings per share by $0.01 per share.

Officer and Employee Plans-Cornerstone has two stock option plans under which officers and employees can be granted incentive stock options or non-qualified stock options to purchase a total of up to 1,420,000 shares of Cornerstone’s common stock. The option price for incentive stock options shall be not less than 100 percent of the fair market value of the common stock on the date of the grant. The non-qualified stock options may be equal to or more or less than the fair market value of the common stock on the date of the grant. The stock options vest at 30 percent on the second and third anniversaries of the grant date and 40 percent on the fourth anniversary. The options expire ten years from the grant date. At March 31, 2008, the total remaining compensation cost to be recognized on non-vested options is approximately $725,000. A summary of the status of this stock option plan is presented in the following table:

   
Number
 
Weighted-
Average
Exercisable
Price
 
Weighted-
Average
Contractual
Remaining
Term
(in years)
 
Aggregate
Intrinsic
Value
 
Outstanding at December 31, 2007
   
715,075
 
$
6.52
   
5.5 Years
 
$
5,177,118
 
Granted
   
71,500
   
7.99
             
Exercised
   
-
   
-
             
Forfeited
   
(7,000
)
 
14.11
             
Outstanding at March 31, 2008
   
779,575
 
$
6.55
   
6.2 Years
 
$
2,781,103
 
Options exercisable at March 31, 2008
   
571,810
 
$
4.72
             

The weighted average grant-date fair value of share options granted during the three months ended March 31, 2008 was $2.23. This was determined using the Black-Scholes option pricing model with the following weighted -average assumptions. Dividend Yield: 1.470%, Expected Life: 8.0 years, Expected Volatility: 20.27%, Risk-free Interest Rate: 4.220%

Board of Directors Plan-Cornerstone has a stock option plan under which members of the Board of Directors, at the formation of the Bank, were granted options to purchase a total of up to 600,000 shares of the Bank's common stock. On October 15, 1997, the Bank stock options were converted to Cornerstone stock options. Only non-qualified stock options may be granted under the Plan. The exercise price of each option equals the market price of Cornerstone’s stock on the date of grant and the option’s maximum term is ten years. Vesting for options granted during 2008, are 50% on the first and second anniversary of the grant date. At March 31, 2008, the total remaining compensation cost to be recognized on non-vested options is approximately $100,000. A summary of the status of this stock option plan is presented in the following table:
 
7


   
Number
 
Weighted-
Average
Exercisable
Price
 
Weighted-
Average
Contractual
Remaining
Term
(in years)
 
Aggregate
Intrinsic
Value
 
Outstanding at December 31, 2007
   
69,000
 
$
11.23
   
7.7 Years
 
$
164,214
 
Granted
   
12,800
   
7.99
             
Exercised
   
-
   
-
             
Forfeited
   
-
   
-
             
Outstanding at March 31, 2008
   
81,800
 
$
10.73
   
8.7 Years
 
$
72,582
 
Options exercisable at March 31, 2008
   
64,500
 
$
10.95
             

The weighted average grant-date fair value of share options granted during the three months ended March 31, 2008 was $2.23. This was determined using the Black-Scholes option pricing model with the following weighted -average assumptions. Dividend Yield: 1.470%, Expected Life: 8.0 years, Expected Volatility: 20.27%, Risk-free Interest Rate: 4.220%

Note 3. Stockholder’s Equity

During 2008, Cornerstone’s Board of Director declared the following dividends:

Dividend Rate
 
Declaration Date
 
Record Date
 
Payment Date
(per share)
           
$0.07
 
February 29, 2008
 
March 14, 2008
 
April 4, 2008

Any determinations relating to future dividends will be made at the discretion of Cornerstone’s Board of Directors and will depend on a number of factors, including our earnings, capital requirements, financial conditions, future prospects, regulatory restrictions and other factors that Cornerstone’s Board of Directors may deem relevant.

Note 4. Securities

The amortized cost and fair value of securities available-for-sale and held-to-maturity at March 31, 2008 and December 31, 2007 are summarized as follows:

   
March 31, 2008
 
   
Amortized
Cost
 
Gross
Unrealized
Gains
 
Gross
Unrealized
Losses
 
Market
Value
 
Securities Available-for-Sale:
                         
U.S. Government agencies
 
$
22,461,141
 
$
433,561
 
$
-
 
$
22,894,702
 
                           
State and municipal securities
   
3,435,130
   
93,595
   
(528
)
 
3,528,197
 
                           
Mortgage-backed securities
   
15,970,349
   
96,420
   
(20,216
)
 
16,046,553
 
   
$
41,866,620
 
$
623,576
 
$
(20,744
)
$
42,469,452
 
                           
Securities Held-to-Maturity:
                         
Mortgage-backed securities
 
$
193,608
 
$
941
 
$
(353
)
$
194,196
 
 
8

 
   
December 31, 2007
 
   
Amortized
Cost
 
Gross
Unrealized
Gains
 
Gross
Unrealized
Losses
 
Market
Value
 
Securities Available-for-Sale:
                         
U.S. Government agencies
 
$
27,335,992
 
$
116,624
 
$
(38,942
)
$
27,413,674
 
                           
State and municipal securities
   
3,436,399
   
66,369
   
(3
)
 
3,502,765
 
                           
Mortgage-backed securities
   
3,817,522
   
20,427
   
(2,403
)
 
3,835,546
 
                           
   
$
34,589,913
 
$
203,420
 
$
(41,348
)
$
34,751,985
 
                           
Securities Held-to-Maturity:
                         
Mortgage-backed securities
 
$
200,037
 
$
424
 
$
(783
)
$
199,678
 

 At March 31, 2008 approximately $33 million of Cornerstone’s investment portfolio was pledged to secure public funds and other deposits and securities sold under agreements to repurchase.

Note 5. Loans and Allowance for Loan Losses

At March 31, 2008 and December 31, 2007 loans are summarized as follows (in thousands):

   
March 31, 2008
 
December 31, 2007
 
   
Amount
 
Percent
 
Amount
 
Percent .
 
Commercial, financial and agricultural
 
$
87,181
   
22.8
%   
$
98,065
   
25.6
%
Real estate-construction
   
80,480
   
21.1
%
 
76,832
   
20.0
%
Real estate-mortgage
   
67,402
   
17.6
%
 
64,585
   
16.8
%
Real estate-commercial
   
141,573
   
37.1
%
 
138,074
   
36.0
%
Consumer loans
   
5,397
   
1.4
%
 
6,037
   
1.6
%
Total loans
 
$
382,033
   
100.0
%
$
383,593
   
100.0
%

A summary of transactions in the allowance for loan losses for the three months ended March 31, 2008 and year ended December 31, 2007 is as follows:

   
March 31,
 
December 31,
 
 
 
2008
 
2007
 
Balance, beginning of period
 
$
13,710
 
$
4,258
 
Loans charged-off
   
(6,533
)
 
(1,075
)
Recoveries of loans previously charged-off
   
123
   
118
 
Provision for loan losses
   
317
   
10,409
 
Balance, end of period
 
$
7,617
 
$
13,710
 

Note 6. Commitments and Contingent Liabilities

In the normal course of business, the Bank has entered into off-balance sheet financial instruments which include commitments to extend credit (i.e., including unfunded lines of credit) and standby letters of credit. Commitments to extend credit are usually the result of lines of credit granted to existing borrowers under agreements that the total outstanding indebtedness will not exceed a specific amount during the term of the indebtedness. Typical borrowers are commercial concerns that use lines of credit to supplement their treasury management functions, thus their total outstanding indebtedness may fluctuate during any time period based on the seasonality of their business and the resultant timing of their cash flows. Other typical lines of credit are related to home equity loans granted to consumers. Commitments to extend credit generally have fixed expiration dates or other termination clauses and may require payment of a fee.
 
9


Standby letters of credit are generally issued on behalf of an applicant (our customer) to a specifically named beneficiary and are the result of a particular business arrangement that exists between the applicant and the beneficiary. Standby letters of credit have fixed expiration dates and are usually for terms of two years or less unless terminated beforehand due to criteria specified in the standby letter of credit. A typical arrangement involves the applicant routinely being indebted to the beneficiary for such items as inventory purchases, insurance, utilities, lease guarantees or other third party commercial transactions. The standby letter of credit would permit the beneficiary to obtain payment from the Bank under certain prescribed circumstances. Subsequently, the Bank would then seek reimbursement from the applicant pursuant to the terms of the standby letter of credit.
     
The Bank follows the same credit policies and underwriting practices when making these commitments as it does for on-balance sheet instruments. Each customer’s creditworthiness is evaluated on a case-by-case basis, and the amount of collateral obtained, if any, is based on management’s credit evaluation of the customer. Collateral held varies but may include cash, real estate and improvements, marketable securities, accounts receivable, inventory, equipment, and personal property.

The contractual amounts of these commitments are not reflected in the consolidated financial statements and would only be reflected if drawn upon. Since many of the commitments are expected to expire without being drawn upon, the contractual amounts do not necessarily represent future cash requirements. However, should the commitments be drawn upon and should our customers default on their resulting obligation to us, the Bank’s maximum exposure to credit loss, without consideration of collateral, is represented by the contractual amount of those instruments.

A summary of the Bank’s total contractual amount for all off-balance sheet commitments at March 31, 2008 is as follows:
 
Commitments to extend credit
 
$
70.1 million
 
Standby letters of credit
 
$
4.7 million
 

Various legal claims also arise from time to time in the normal course of business. In the opinion of management, the resolution of claims outstanding at March 31, 2008 will not have a material effect on Cornerstone’s consolidated financial statements.

Note 7. Recent Relevant Accounting Pronouncements

Cornerstone adopted FASB Statement No. 157 (SFAS 157), “Fair Value Measurements” in January 2008. SFAS 157 defines fair value, establishes a framework for measuring fair value and expands disclosures about fair value measurements. SFAS 157 applies whenever other standards require (or permit) assets or liabilities to be measured at fair value but does not expand the use of fair value in any new circumstances. The adoption of SFAS 157 did not have a material impact on Cornerstone’s consolidated financial statements in 2008.

Cornerstone adopted FASB Statement No. 159 (SFAS 159), “The Fair Value Option for Financial Assets and Financial Liabilities – Including an Amendment of FASB Statement No. 115” in January 2008. This Statement permits entities to choose to measure many financial instruments and certain other items at fair value. Unrealized gains and losses on items for which the fair value option has been elected will be reported in earnings. The objective is to improve financial reporting by providing entities with the opportunity to mitigate volatility in reported earnings caused by measuring related assets and liabilities differently without having to apply complex hedge accounting provisions. This Statement is expected to expand the use of fair value measurement, which is consistent with the FASB’s long-term measurement objectives for accounting for financial instruments. Cornerstone has not elected the fair value option for any financial assets or liabilities at March 31, 2008.
 
10

 
CORNERSTONE BANCSHARES, INC.
CONSOLIDATED AVERAGE BALANCE SHEET
INTEREST INCOME/EXPENSE AND
YIELD/RATES
Taxable Equivalent Basis
 
Year-to-Date
 
(in thousands)
 
March 31
 
 
2008
 
2007
 
   
Average
Balance
   
Income/
Expense
   
Yield/
Rate
   
Average
Balance
   
Income/
Expense
   
Yield/
Rate
 
Assets                                      
Earning assets:
                                     
Loans, net of unearned income
 
$
386,056
 
$
7,553
   
7.85
%   
$
320,296
 
$
7,660
   
9.70
%
Investment securities
   
42,456
   
507
   
5.13
%
 
37,111
   
447
   
5.20
%
Other earning assets
   
0
   
0
   
0.00
%
 
0
   
0
   
0.00
%
Total earning assets
   
428,512
 
$
8,060
   
7.58
%
 
357,407
 
$
8,107
   
9.23
%
Allowance for loan losses
   
(11,271
)
         
(4,196
)
       
Cash and other assets
   
29,232
             
24,935
           
TOTAL ASSETS
 
$
446,473
             
$
378,146
             
                                       
Liabilities and Stockholders' Equity
                                     
                                       
Interest bearing liabilities:
                                     
Interest bearing demand deposits
 
$
32,202
 
$
67
   
0.83
%
$
38,294
 
$
128
   
1.35
%
Savings deposits
   
7,642
   
16
   
0.84
%
 
7,700
   
19
   
1.01
%
MMDA's
   
53,566
   
338
   
2.53
%
 
44,472
   
475
   
4.33
%
Time deposits of less than $100,000
   
117,169
   
1,407
   
4.82
%
 
99,867
   
1,218
   
4.95
%
Time deposits of $100,000 or more
   
65,370
   
828
   
5.08
%
 
47,757
   
604
   
5.13
%
Federal funds purchased and securities sold under agreements to repurchase
   
26,597
   
174
   
2.62
%
 
20,230
   
252
   
5.06
%
Other borrowings
   
60,046
   
641
   
4.28
%
 
39,850
   
437
   
4.44
%
Total interest bearing liabilities
   
362,592
   
3,470
   
3.84
%
 
298,170
   
3,133
   
4.26
%
Net interest spread
       
$
4,590
   
3.74
%
     
$
4,974
   
4.97
%
Noninterest bearing demand deposits
   
44,503
               
38,315
             
Accrued expenses and other liabilities
   
2,247
               
2,410
             
Stockholders' equity
   
37,131
               
39,252
             
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY
 
$
446,473
             
$
378,146
             
Net yield on earning assets
               
4.33
%
             
5.68
%
                                   
Taxable equivalent adjustment:
                                     
Loans
         
0
               
0
       
Investment securities
         
36
               
28
       
Total adjustment
         
36
               
28
       

11


ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Cornerstone Bancshares, Inc. (“Cornerstone”) is a bank holding company and the parent of Cornerstone Community Bank, (the “Bank”) a Tennessee banking corporation, and Eagle Financial, Inc., (“Eagle”), an accounts receivable financing company that operate primarily in and around Hamilton County, Tennessee. The Bank has also established loan production offices in Knoxville, Tennessee and Dalton, Georgia. The Bank’s business consists primarily of attracting deposits from the general public and, with these and other funds, originating real estate loans, consumer loans, business loans, and residential and commercial construction loans. The principal sources of income for the Bank are interest and fees collected on loans, fees collected on deposit accounts, and interest and dividends collected on other investments. The principal expenses of the Bank are interest paid on deposits, employee compensation and benefits, office expenses, and other overhead expenses. Eagle’s principal source of income is revenue received from the purchase of receivables. Expenses are related to employee compensation and benefits, office and overhead expenses.

The following is a discussion of our financial condition at March 31, 2008 and December 31, 2007 and our results of operations for the three months ended March 31, 2008 and 2007. The purpose of this discussion is to focus on information about our financial condition and results of operations which is not otherwise apparent from the consolidated financial statements. The following discussion and analysis should be read along with our consolidated financial statements and the related notes included elsewhere herein.

Review of Financial Performance

As of March 31, 2008 Cornerstone had total consolidated assets of $452.7 million, total loans of $382.0 million, total deposits of $314.9 million and stockholders equity of $36.8 million. Net income for the three month period ended March 31, 2008 was $1,014,859.

Results of Operations

Net income for the three months ended March 31, 2008 was $1,014,859 or $0.16 basic earnings per share, compared to $1,651,777 or $0.25 basic earnings per share, for the same period in 2007.

The following table presents our results for the three months ended March 31, 2008 (amounts in thousands).

   
For the three months
Ended March 31,
 
Change from
the prior year
 
   
2008
 
2007
 
Amount
 
%
 
                   
Interest Income
 
$
8,060
 
$
8,107
 
$
(47
)
 
(0.6
)%
Interest Expense
   
3,470
   
3,133
   
337
   
10.8
%
                           
Net interest income before provision for loan loss
   
4,590
   
4,974
   
(384
)
 
(7.7
)%
                           
Provision for loan loss
   
317
   
2
   
315
   
15750.0
%
                           
Net interest income after provision for loan loss
   
4,273
   
4,972
   
(699
)
 
(14.1
)%
                           
Total noninterest income
   
394
   
375
   
19
   
5.1
%
Total noninterest expense
   
3,097
   
2,747
   
350
   
12.7
%
                           
Income before provision for income taxes
   
1,571
   
2,600
   
(1,029
)
 
(39.6
)%
Provision for income taxes
   
556
   
948
   
(392
)
 
(41.4
)%
                           
NET INCOME
 
$
1,015
 
$
1,652
   
(637
)
 
(38.6
)%
 
Net Interest Income-Net interest income represents the amount by which interest earned on various earning assets exceeds interest paid on deposits and other interest bearing liabilities. Net interest income is also the most significant component of our earnings. For the three months ended March 31, 2008, net interest income before the provision for loan loss, decreased $384 thousand or (7.7)% over the same period of 2007. Cornerstone’s interest rate spread on a tax equivalent basis (which is the difference between the average yield on earning assets and the average rate paid on interest bearing liabilities) was 3.74% for the three month period ended March 31, 2008 compared to 4.97% for the same period in 2007. The net interest margin on a tax equivalent basis was 4.33% for the three month period ended March 31, 2008 compared to 5.68% for the same period in 2007. Management expects that downward pressure will continue to be exerted on the net interest margin for the remainder of 2008. Other matters related to the changes in net interest income, net interest yields and rates, and net interest margin are presented below:
 
12

 
The Bank’s loan yield declined during the first three months of 2008. The loan yield was 7.85% for the first three months of 2008 compared to 9.70% during the first three months of 2007. The decline in loan yield is primarily attributable to the Federal Reserve Bank’s interest rate reductions over the past six months.

For the three month period ended March 31, 2008, the Bank’s investment portfolio resulted in a yield of 5.13% compared to 5.20% for the same time period in 2007. The Bank continues its bias towards loans and is currently purchasing securities primarily for pledging requirements.
 
As mentioned previously, the Federal Reserve Bank’s interest rate reductions have impacted the Bank’s loan yield during 2008. The rate reductions have also impacted the Bank’s interest bearing liabilities. Rates on funding sources such as money market and interest checking accounts have been repriced as rate reductions occurred. However, certificate of deposit interest rate adjustments lag behind the repricing of the loan portfolio and are not excepted to catch up until third or fourth quarter of 2008.

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 $317 thousand and $2 thousand for the three months ended March 31, 2008 and 2007, respectively.

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.
 
The following table presents the components of non interest income for the three months ended March 31, 2008 (dollars in thousands).

   
Three months ended
March 31,
 
2008-2007
Percent
Increase
(decrease)
 
   
2008
 
2007
 
Service charges on deposit accounts
 
$
405
 
$
334
   
21.3
%
Net gains / (losses) on sale of loans and other assets
   
(52
)
 
16
   
(425.0
)%
Other income
   
41
   
25
   
64.0
%
Total non interest income
 
$
394
 
$
375
   
5.1
%

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

The increase in the amount of depository accounts is primarily attributable to the addition of the Bank’s payroll processor clients. Currently, the Bank has nine payroll processors processing ACH transactions and expects to add approximately five more during the remainder of 2008.This line of business has the ability to produce a material amount of non-interest income with a relatively low amount of credit and transaction risk.

13


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

The following table presents the components of non interest expense for the three months ended March 31, 2008 (dollars in thousands).

   
Three months ended
March 31,
 
2008-2007
Percent
Increase
(decrease)
 
   
2008
 
2007
 
Salaries and employee benefits
 
$
1,841
 
$
1,675
   
9.9
%
Occupancy and equipment expense
   
380
   
348
   
9.2
%
Other operating expense
   
876
   
724
   
21.0
%
Total non interest expense
 
$
3,097
 
$
2,747
   
12.7
%

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

The increase in salaries and employee benefits is primarily attributable to the increase in Bank staff during 2007 with the addition of relationship managers and employees in the Bank’s operations.

A significant item leading to the increase in occupancy and equipment expense during the first quarter of 2008 was Cornerstone’s expansion of its operational center to accommodate the additional staff hired in the risk management department.

Significant items included in Cornerstone’s other operating expense include data processing fees and other professional services such as accounting and legal fees. Compliance with legal and regulatory requirements resulted in a significant increase in accounting and audit fees that were incurred by Cornerstone during the first quarter of 2008 to perform appropriate level of testing of internal controls over financial statement reporting.

Financial Condition

Overview-Cornerstone’s consolidated assets totaled $444.4 million as of December 31, 2007. As of March 31, 2008 total consolidated assets had increased $8.3 million or 1.9% to $452.7 million. The Bank’s security portfolio accounted for the $7.7 million of the total increase during the first quarter of 2008. The increase in the security portfolio was needed to provide additional liquidity and for pledging requirements.
 
Securities-The Bank’s investment portfolio, primarily consisting of Federal Agency, mortgage-backed securities and municipal securities, amounted to $42.7 million as of March 31, 2008 compared to $35.0 million as of December 31, 2007. The increase in securities during the first quarter of 2008 was primarily for pledging requirements to collateralize the Bank’s repurchase accounts.
 
Loans-The composition of loans at March 31, 2008 and at December 31, 2007 and the percentage (%) of each classification to total loans are summarized in the following table (dollars in thousands):
 
14

 
   
March 31, 2008
 
December 31, 2007
 
 
 
Amount
 
Percent
 
Amount
 
Percent
 
Commercial, financial and agricultural
 
$
87,181
   
22.8
%   
$
98,065
   
25.6
%
Real estate-construction
   
80,480
   
21.1
%
 
76,832
   
20.0
%
Real estate-mortgage
   
67,402
   
17.6
%
 
64,585
   
16.8
%
Real estate-commercial
   
141,573
   
37.1
%
 
138,074
   
36.0
%
Consumer loans
   
5,397
   
1.4
%
 
6,037
   
1.6
%
Total loans
 
$
382,033
   
100.0
%
$
383,593
   
100.0
%
 
 Allowance for Loan Losses-The allowance for loan losses represents Cornerstone’s assessment of the risks associated with extending credit and its evaluation of the quality of the loan portfolio. Management analyzes the loan portfolio to determine the adequacy of the allowance for loan losses and the appropriate provisions required to maintain a level considered adequate to absorb anticipated loan losses. The Bank uses a risk based approach to calculate the appropriate loan loss allowance in accordance with guidance issued by the Federal Financial Institutions Examination Council. Although the Bank performs prudent credit underwriting, no assurances can be given, however, that adverse economic circumstances will not result in increased losses in the loan portfolio and require greater provisions for possible loan losses in the future.

During the first quarter of 2008, the Bank charged off $6 million on one commercial loan relationship. The provision was taken at the end of 2007 as announced in Cornerstone’s Form 10-K, and after an investigation in 2008 the loan was considered a loss. Management expects minimal recovery from the loss. The remaining $1.6 million, of the total $7.6 million relationship, is secured by two pieces of real estate. Subsequent to the end of the first quarter 2008 the largest piece of real estate collateral was liquidated at no loss and the smaller piece is well collateralized and no loss is expected.

The following is a summary of changes in the allowance for loan losses for the three months ended March 31, 2008 and for the year ended December 31, 2007 and the ratio of the allowance for loan losses to total loans as of the end of each period (dollars in thousands):

   
March 31,
2008
 
December 31,
2007
 
Balance, beginning of period
 
$
13,710
 
$
4,258
 
Loans charged-off
   
(6,533
)
 
(1,075
)
Recoveries of loans previously charged-off
   
123
   
118
 
Provision for loan losses
   
317
   
10,409
 
Balance, end of period
 
$
7,617
 
$
13,710
 
               
Total Loans
 
$
382,033
 
$
383,593
 
             
Ratio of allowance for loan losses to loans outstanding at the end of the period
   
1.99
%
 
3.57
%
             
Ratio of net charge-offs to total loans outstanding for the period
   
1.68
%
 
0.25
%
 
Non-Performing Assets-The specific economic and credit risks associated with the Bank’s loan portfolio include, but are not limited to, a general downturn in the economy which could affect employment rates in our market area, general real estate market deterioration, interest rate fluctuations, deteriorated or non-existent collateral, title defects, inaccurate appraisals, financial deterioration of borrowers, fraud, and violation of laws and regulations.

The Bank attempts to reduce these economic and credit risks by adherence to a lending policy approved by the Bank’s board of directors. The Bank’s lending policy establishes loan to value limits, collateral perfection, credit underwriting criteria and other acceptable lending standards. The Bank classifies loans that are ninety (90) days past due and still accruing interest, renegotiated, non-accrual loans, foreclosures and repossessed property as non-performing assets. The Bank’s policy is to categorize a loan on non-accrual status when payment of principal or interest is contractually ninety (90) or more days past due. At the time the loan is categorized as non-accrual the interest previously accrued but not collected may be reversed and charged against current earnings.
 
15

The following table presents the Bank’s non-performing assets (dollars in thousands):

   
March 31,
 
December 31,
 
   
2008
 
2007
 
Non-accrual loans
 
$
2,446
 
$
685
 
Repossessed assets
   
10
   
0
 
Foreclosed properties
   
938
   
1,038
 
Total non-performing assets
 
$
3,394
 
$
1,723
 
               
Total loans outstanding
 
$
382,033
 
$
383,593
 
               
Ratio of nonperforming assets to total loans
             
outstanding at the end of the period
   
0.89
%
 
0.45
%
               
Ratio of nonperforming assets to total allowance
             
for loan losses at end of period
   
44.56
%
 
12.57
%
 
Deposits and Other Borrowings-The Bank’s deposits consist of non-interest bearing demand deposits, interest bearing demand accounts, savings and money market accounts, and time deposits. The Bank has agreements with some customers to sell certain of its securities under agreements to repurchase the security the following day. The Bank has also obtained advances from the Federal Home Loan Bank.

The following table presents the Bank’s deposits and other borrowings as either core funding or non-core funding. Core funding consists of all deposits except for time deposits issued in denominations of $100,000 or greater. All other funding is classified as non-core.

   
March 31, 2008
 
December 31, 2007
 
   
Amount
 
Percent
 
Amount
 
Percent
 
Core funding:
                         
Non interest bearing demand deposits
 
$
41,338
   
10.1
%
$
45,285
   
11.3
%
Interest-bearing demand deposits
   
31,483
   
7.7
%
 
31,985
   
8.0
%
Savings & money market accounts
   
61,525
   
15.0
%
 
49,970
   
12.4
%
Time deposits under $100,000
   
120,046
   
29.3
%
 
114,505
   
28.5
%
Total core funding
 
$
254,392
   
62.1
%
$
241,745
   
60.2
%
Non-core funding:
                         
Time deposit accounts greater than $100,000
                         
Public funds
 
$
502
   
0.1
%
$
0
   
0.0
%
Brokered deposits
   
6,074
   
1.5
%
 
13,255
   
3.3
%
Other time deposits
   
53,914
   
13.1
%
 
58,250
   
14.5
%
Federal funds purchased
   
19,415
   
4.7
%
 
28,450
   
7.1
%
Securities sold under agreements to repurchase
   
18,958
   
4.6
%
 
13,110
   
3.3
%
Federal Home Loan Bank advances
   
57,000
   
13.9
%
 
47,000
   
11.7
%
Total non-core funding
 
$
155,863
   
37.9
%
$
160,065
   
39.8
%
Total
 
$
410,255
   
100.0
%
$
401,810
   
100.0
%
 
Federal funds purchased are lines of credit established with other financial institutions that allow the Bank to meet short term funding requirements. These lines can be used as frequently as daily with large variations in balances depending upon the Bank’s immediate funding requirements. As of March 31, 2008 the Bank had established $44 million in available federal funds lines.
 
16

 
Federal Home Loan Bank of Cincinnati (the “FHLB”) borrowings are secured by certain qualifying residential mortgage loans and, pursuant to a blanket lien, all qualifying commercial mortgage loans as collateral. Management believes that FHLB borrowings provide an additional source of funding at lower interest rates than alternative sources. The borrowings are structured as either term loans with call and put options after a stated conversion date and an overnight borrowing arrangement. As of March 31, 2008 the Bank had borrowed a total of $57 million from the FHLB consisting of structured term loans.
 
Capital Resources-At March 31, 2008 and December 31, 2007 Cornerstone’s stockholders’ equity amounted to $36.8 million and $36.3 million, respectively.

Cornerstone had borrowed $4.1 million from Silverton Bank as of March 31, 2008. The proceeds from the advance were used to repurchase 200 thousand shares of Cornerstone’s stock during 2007 and 2008 and provide for a $2.5 million capital injection into the Bank. This injection resulted in a change in the Bank’s regulatory capital classification from adequately capitalized to a well capitalized position. Cornerstone’s line of credit with Silverton Bank consists of an $8.5 million line of credit with an interest rate of prime minus one and a half.
 
Market and Liquidity Risk Management

Interest Rate Sensitivity

The Bank’s Asset Liability Management Committee (“ALCO”) is responsible for making decision regarding liquidity and marketing solutions based upon approved liquidity, loan, capital and investment policies. The ALCO committee must consider interest rate sensitivity and liquidity risk management when rendering a decision on funding solutions and loan pricing. The following is a brief discussion of one of the primary tools used by the ALCO committee to perform its responsibilities:

Gap Analysis is a technique of asset-liability management that can be used to assess interest rate risk or liquidity risk. The Bank has developed a gap analysis to assist the ALCO committee in its decision making. The analysis provides the committee information regarding the interest rate-sensitivity of the Bank. The interest rate-sensitivity is the difference between the interest-earning assets and interest-bearing liabilities scheduled to mature or reprice within a stated time period. The gap is considered positive when the amount of interest rate-sensitive assets exceeds the amount of interest rate-sensitive liabilities. Conversely, the gap is considered negative when the amount of interest rate-sensitive liabilities exceeds the amount of interest rate-sensitive assets. The gap position coupled with interest rate movements will result in either an increase or decrease in net interest income depending upon the Bank’s position and the nature of the movement.

Liquidity Risk Management

Liquidity is measured by the Bank's ability to raise cash at a reasonable cost or with a minimum of loss. These funds are used to primarily fund loans and satisfy deposit withdrawals. Several factors must be considered by management when attempting to minimize liquidity risk. Examples include changes in interest rates, competition, loan demand, and general economic conditions. Minimizing liquidity risk is a responsibility of the ALCO committee and is reviewed by the Bank’s regulatory agencies on a regular basis.

Item 3. Quantitative and Qualitative Disclosures About Market Risk

A comprehensive qualitative and quantitative analysis regarding market risk was disclosed in Cornerstone’s Form 10-K for the year ended December 31, 2007. No material changes in the assumptions used in preparing, or results obtained from, the model have occurred since December 31, 2007.

Item 4.  Controls and Procedures

Cornerstone’s Chief Executive Officer and Treasurer have evaluated the effectiveness of Cornerstone’s disclosure controls and procedures (as such term is defined in Rules 13a-14(c) and 15d-14(c) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)) as of a date within 90 days prior to the filing date of this quarterly report (the “Evaluation Date”). Based on such evaluation, such officers have concluded that, as of the Evaluation Date, Cornerstone’s disclosure controls and procedures are effective in alerting them on a timely basis to material information relating to Cornerstone (including its consolidated subsidiaries) required to be included in Cornerstone’s periodic filings under the Exchange Act. Since the Evaluation Date, there have not been any significant changes in Cornerstone’s internal controls or in other factors that could significantly affect such controls.
 
17

 
PART II. OTHER INFORMATION

Item 1. Legal Proceedings

There are various claims and lawsuits in which the Bank is periodically involved incidental to the Bank’s business. In the opinion of Management, no material loss is expected from any of such pending claims or lawsuits.

 Item 1a. Risk Factors

Growth Strategy-Cornerstone intends to continue pursuing a growth strategy for its business through acquisitions and de novo branching. Cornerstone’s prospects must be considered in light of the risks, expenses and difficulties occasionally encountered by financial services companies in growth stages, including maintaining loan quality, maintaining adequate management personnel and information systems to oversee such growth while maintaining adequate controls and compliance functions. Failure to successfully address the growth effectively and efficiently could have a material adverse effect on Cornerstone’s business, future prospects, financial condition or results of operations and could adversely affect Cornerstone’s ability to successfully implement its business strategy.

Cornerstone may also consider and enter into new lines of business or offer new products or services. 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, and 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.

In the case of acquisitions or mergers, the success of integrating the separate operations depends on the ability to consolidate systems, procedures, operations and controls while eliminating redundant costs. Integration difficulties may have an adverse affect on any economic benefits Cornerstone expects to achieve.
 
18

 
Competition-Much of Cornerstone’s recent growth has been focused in the highly competitive Chattanooga metropolitan markets. We compete with commercial banks, credit unions, savings and loan associations, mortgage banking firms, consumer finance companies, securities brokerage firms, insurance companies, money market funds, and other mutual funds, as well as other community banks and super-regional and national financial institutions that operate offices in Cornerstone’s primary market areas. Cornerstone’s continued expansion into this market may be impacted if it is unable to meet customer demands or compete effectively with the financial institutions operating in these markets. Cornerstone’s historical accomplishments may not be indicative of future results. There is no assurance that existing offices or future offices will maintain or achieve deposit levels, loan balances or other operating results necessary to avoid losses or produce profits.
 
Economic Conditions-Cornerstone’s success significantly depends upon the growth in population, income levels, deposits and housing starts in its market areas. If the communities in which Cornerstone operates do not grow or prevailing economic conditions locally or nationally are unfavorable, Cornerstone’s business may not succeed. Adverse economic conditions in Cornerstone’s specific market areas could reduce its growth rate, affect the ability of its customers to repay their loans to the Bank and generally affect its financial condition and results of operations.

In addition, the market value of the real estate securing loans as collateral could be adversely affected by unfavorable changes in market and economic conditions. Any sustained period of increased payment delinquencies, foreclosures or losses caused by adverse market or economic conditions in the state of Tennessee could adversely affect the value of Cornerstone’s assets, revenues, results of operations and financial condition.

Liquidity-Cornerstone relies on dividends from the Bank as its primary source of funds. The Bank’s primary sources of funds are 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 borrowers’ resources can be adversely affected by changes in economic conditions, adverse trends or events affecting business industry group, reductions in real estate values or markets, natural disasters or international instability. Accordingly, Cornerstone may be required from time to time to rely on secondary sources of liquidity to accommodate any funding needs. Such sources include Federal Home Loan Bank advances 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 should such sources not be adequate.

Credit Risks-The risk of credit losses 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. Management maintains an allowance for credit losses based upon historical experience and regular analysis of the ultimate collectibility of the loan portfolio. Capital could be significantly adversely affected if these assumptions and adjustments in the allowance for loan losses prove to be inadequate to absorb unforeseen losses.

Regulatory-Cornerstone’s growth and expansion plans may be adversely affected by a number of regulatory developments or events. Failure to obtain required regulatory approvals, changes in laws and regulations may prevent or adversely affect Cornerstone’s continued growth and expansion. Cornerstone operates in a highly regulated industry and is subject to examination, supervision, and comprehensive regulation by various federal and state agencies including the Board of Governors of the Federal Reserve Bank (FRB), the FDIC and the Tennessee Department of Financial Institutions. Cornerstone’s regulatory compliance is costly and restricts certain of its activities, including payment of dividends, mergers and acquisitions, investments, loans, and interest rates charged, interest rates paid on deposits and locations of offices. Cornerstone is also subject to capitalization guidelines established by its regulators, which require it to maintain adequate capital to support its growth.

Loss of Key Employees-Cornerstone depends on the strategies and management services of Gregory B. Jones, its Chairman of the Board and Chief Executive Officer. Although Cornerstone has entered into an employment agreement with him, the loss of Mr. Jones’ 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 daily operations. Changes in key personnel and their responsibilities may be disruptive to Cornerstone’s business and could have a material adverse effect on Cornerstone’s business, financial condition and results of operations. Cornerstone believes that its future results will also depend in part upon its attracting and retaining highly skilled and qualified management, sales and marketing personnel.

Interest Rate Fluctuations-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 up or down could ultimately affect Cornerstone’s earnings. Changes in the level of interest rates also may negatively affect the Bank’s ability to originate real estate loans and may lower the value of Cornerstone’s assets.
 
19

 
Risks of Corporate Buyout-As a Tennessee corporation, Cornerstone is subject to various legislative acts which impose restrictions on and require compliance with procedures designed to protect shareholders against unfair or coercive mergers and acquisitions. These statutes may delay or prevent offers to acquire Cornerstone and increase the difficulty of consummating any such offers, even if the acquisition of Cornerstone would be in its shareholders’ best interests.

The amount of common stock owned by, and other compensation arrangements with, Cornerstone’s officers and directors may make it more difficult to obtain shareholder approval of potential takeovers that they oppose. Also, these arrangements with Cornerstone’s senior management provide for significant payments under certain circumstances following a change in control.

Capital Adequacy and Market Fluctuations-Cornerstone is required by federal and state regulatory authorities to maintain adequate levels of capital to support its operations. While Cornerstone’s capital resources will satisfy its capital requirements for the foreseeable future, Cornerstone may at some point, however, need to raise additional capital to support its continued growth. Cornerstone’s ability to raise additional capital, if needed, will depend on conditions in the capital markets at that time and on its financial performance. We cannot assure you of our ability to raise additional capital if needed on terms acceptable to us.

In order to maintain its capital at desired levels or required regulatory levels, or to fund future growth, Cornerstone’s board of directors may decide from time to time to issue additional shares of common stock or securities convertible into, exchangeable for or representing rights to acquire shares of its common stock. The sale of these shares may significantly dilute Cornerstone’s shareholders’ ownership interest as a shareholder and the per share book value of its common stock. New investors in the future may also have rights, preferences and privileges senior to its current shareholders which may adversely impact its current shareholders.

Cornerstone cannot predict the effect, if any, that future sales of its common stock in the market, or availability of shares of its common stock for sale in the market, will have on the market price of Cornerstone’s common stock. The market price of Cornerstone’s common stock may fluctuate in the future, and these fluctuations may be unrelated to its performance. General market price declines or overall market volatility in the future could adversely affect the price of our common stock, and the current market price may not be indicative of future market prices. 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.

Ability to Pay Dividends-Cornerstone derives its income solely from dividends on the shares of common stock of the Bank. The Bank’s ability 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 Tennessee Department of Financial Institutions. In addition, the FRB 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.
 
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds

ISSUER PURCHASES OF EQUITY SECURITIES

   
 
     
(c) Total Number of Shares
 
(d) Maximum Number of
 
   
(a) Total Number of
 
(b) Average Price
 
Purchased as Part of
 
Shares that May Yet be
 
Period
 
Shares Purchased
 
Paid Per Share
 
Publically Announced Plans
 
Purchased Under the Plan
 
Prior to 2008
   
153,000
   
11.47
   
150,000
       
                           
Jan. 2008
   
50,000
     
10.00
     
50,000