CORNERSTONE BANCORP/SC - FORM 10-Q

Attached files

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EX-32 - CORNERSTONE BANCORP/SC	cstn10q1-11ex32.htm
EX-31.2 - CORNERSTONE BANCORP/SC	cstn10q1-11ex31_2.htm
EX-31.1 - CORNERSTONE BANCORP/SC	cstn10q1-11ex31_1.htm

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

[ X ] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (d)

OF THE SECURITIES EXCHANGE ACT OF 1934

For The Quarterly Period Ended March 31, 2011

[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 (d)

OF THE SECURITIES EXCHANGE ACT OF 1934

For The Transition Period From _______________ To _________________.

Commission File Number 000-51950

CORNERSTONE BANCORP

(Exact name of registrant as specified in its charter)

South Carolina	57-1077978
(State or other jurisdiction of	(I.R.S. Employer Identification Number)
incorporation or organization)

1670 East Main Street, Easley, South Carolina 29640

(Address of principal executive offices)

(864) 306-1444

(Registrant's telephone number, including Area Code)

Not Applicable

(Former name, former address, and former fiscal year, if changed since last report)

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 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. [X] Yes [ ] No

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes [ ] No [ ] (Not yet applicable to the Registrant)

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 definition 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 [ ](Do not check if a smaller reporting company)	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 [X] No

Indicate the number of shares outstanding of each of the issuer's classes of common equity, as of the latest practicable date:

Common Stock - No Par Value, 2,210,769 shares outstanding on May 1, 2011

PART I

FINANCIAL INFORMATION

Item 1. Financial Statements

CORNERSTONE BANCORP AND SUBSIDIARY

CONSOLIDATED BALANCE SHEETS

	March 31,			December 31,
	2011			2010
Assets	(Unaudited)

Cash and due from banks	$	6,987,595		$	7,043,911
Federal funds sold		7,610,000			5,110,000
Cash and cash equivalents		14,597,595			12,153,911

Investment securities
Available for sale		24,250,828			23,592,336
Other investments		1,063,350			1,063,350

Loans, net		111,958,578			117,210,770
Property and equipment, net		5,168,452			5,230,835
Cash surrender value of life insurance policies		1,924,912			1,908,112
Other real estate owned		12,830,655			10,278,599
Other assets		2,442,210			2,530,552
Total assets	$	174,236,580		$	173,968,465


Liabilities and Shareholders’ Equity

Liabilities
Deposits
Noninterest bearing	$	13,474,431		$	10,382,882
Interest bearing		131,548,583			130,263,510
Total deposits		145,023,014			140,646,392
Customer repurchase agreements		2,717,249			2,945,937
Borrowings from Federal Home Loan Bank of Atlanta		2,554,630			6,592,338
Broker repurchase agreements		5,000,000			5,000,000
Other liabilities		447,620			425,086

Total liabilities		155,742,513			155,609,753


Shareholders’ equity
Preferred stock, 10,000,000 shares authorized, 1,038 shares issued		998,538			998,538
Common stock, no par value, 20,000,000 shares authorized, 2,210,769 shares issued		18,872,599			18,859,924
Retained deficit		(1,435,017	)		(1,418,781	)
Accumulated other comprehensive income		57,947			(80,969	)

Total shareholders’ equity		18,494,067			18,358,712

Total liabilities and shareholders’ equity	$	174,236,580		$	173,968,465

The accompanying notes are an integral part of these consolidated financial statements.

CORNERSTONE BANCORP AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF INCOME (LOSS)

(Unaudited)

	For the three months ended March 31,
	2011			2010
Interest and Dividend Income
Interest and fees on loans	$	1,592,064		$	1,769,282
Investment securities		188,691			268,242
Federal funds sold and interest bearing balances		3,507			2,380
Total interest income		1,784,262			2,039,904

Interest Expense
Deposits		432,388			652,005
Borrowings		78,010			116,374
Total interest expense		510,398			768,379

Net Interest Income		1,273,864			1,271,525
Provision for Loan Losses		150,000			620,000

Net interest income after provision for loan losses		1,123,864			651,525

Noninterest Income
Service charges on deposit accounts		113,035			126,404
Other		42,931			45,799
Total noninterest income		155,966			172,203

Noninterest Expense
Salaries and employee benefits		550,744			565,109
Premises and equipment		135,915			145,921
Loss on sale of repossessed collateral		25,978			4,187
Other real estate owned expenses		139,156			118,990
Professional and regulatory fees		149,629			128,058
Data processing		57,010			54,845
Supplies		19,619			17,178
Advertising		10,464			5,738
Other		207,551			182,676
Total noninterest expense		1,296,066			1,222,702
Net loss before taxes		(16,236	)		(398,974	)
Income tax benefit		-			158,399
Net loss		(16,236	)		(240,575	)
Preferred stock dividend accumulated		(20,476	)		-
Income available to common shareholders	$	(36,712	)	$	(240,575	)

Loss Per Share
Basic	$	(.02	)	$	(.11	)
Diluted	$	(.02	)	$	(.11	)
Weighted Average Shares Outstanding
Basic		2,210,769			2,210,769
Diluted		2,210,769			2,210,769

The accompanying notes are an integral part of these consolidated financial statements.

CORNERSTONE BANCORP AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY

AND COMPREHENSIVE INCOME

For the three months ended March, 2011 and 2010

(Unaudited)

	Preferred Stock				Common stock				Retained earnings			Accumulated other compre- hensive			Total share- holders’
	Shares		Amount		Shares		Amount		(deficit)			income (loss)			equity
Balance, December 31, 2009		-		-		2,105,738	$	18,799,728	$	(921,014	)	$	160,691		$	18,039,405
Net loss		-		-		-		-		(240,575	)		-			(240,575	)
Other comprehensive income, net of income taxes
Unrealized gain on investment securities, net		-		-		-		-		-			107,039			107,039
Comprehensive loss		-		-		-										(133,536	)
Stock based compensation		-		-		-		15,775		-			-			15,775
Stock dividend declared (5%), recorded as a stock split		-		-		105,031		-		-			-			-

Balance, March 31, 2010		-	$	-		2,210,769	$	18,815,503	$	(1,161,589	)	$	267,730		$	17,921,644


Balance, December 31, 2010		1,038	$	998,538		2,210,769	$	18,859,924	$	(1,418,781	)	$	(80,969	)	$	18,358,712
Net loss		-		-		-		-		(16,236	)		-			(16,236	)
Other comprehensive income, net of income taxes
Unrealized gain on investment securities, net		-		-		-		-		-			138,916			138,916
Comprehensive income																122,680
Stock based compensation		-		-		-		12,675		-			-			12,675

Balance, March 31, 2011		1,038	$	998,538		2,210,769	$	18,872,599	$	(1,435,017	)	$	57,947		$	18,494,067

The accompanying notes are an integral part of these consolidated financial statements.

CORNERSTONE BANCORP AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

	For the three months ended March 31,
	2011			2010
Operating Activities
Net loss	$	(16,236	)	$	(240,575	)
Adjustments to reconcile net loss to net cash provided by operating activities
Depreciation and amortization		137,153			112,598
Provision for loan losses		150,000			620,000
Write-down of other real estate owned		36,312			-
Non-cash option expense		12,675			15,775
Loss on sale of property acquired in foreclosure		25,978			4,187
Loss on retirement of fixed assets		3,964			-
Changes in operating assets and liabilities
Change in interest receivable		28,762			(16,632	)
Change in other assets		42,780			439,944
Change in other liabilities		(49,031	)		(146,191	)

Net cash provided by operating activities		372,357			789,106

Investing Activities
Proceeds from maturities and principal repayments of available for sale securities		1,027,860			2,844,144
Purchase of investment securities available for sale		(1,553,811	)		-
Purchase of property and equipment		(794	)		(24,216	)
Proceeds from sale of property acquired in foreclosure		481,592			1,897,985
Capitalization of improvements to foreclosed property		(166,251	)		(50,116	)
Net decrease in loans to customers		2,172,505			1,431,584

Net cash provided by investing activities		1,961,101			6,099,381

Financing Activities
Net increase in demand, savings and time deposits		4,376,622			1,924,861
Net decrease in customer repurchase agreements		(228,688	)		(72,757	)
Repayment of FHLB advances		(4,037,708	)		(1,537,709	)

Net cash provided by financing activities		110,226			314,395
Net increase in cash and cash equivalents		2,443,684			7,202,882
Cash and Cash Equivalents, Beginning of Period		12,153,911			6,039,596

Cash and Cash Equivalents, End of Period	$	14,597,595		$	13,242,478

Supplemental Information
Cash paid for interest	$	539,634		$	776,271
Cash paid for income taxes	$	-		$	-
Non-cash Supplemental Information
Loans transferred to other real estate owned	$	2,929,687		$	2,393,496
Loans charged-off, net	$	226,121		$	269,969

The accompanying notes are an integral part of these consolidated financial statements.

CORNERSTONE BANCORP AND SUBSIDIARY

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

Note 1. Nature of Business and Basis of Presentation

Summary of Significant Accounting Principles

A summary of significant accounting policies is included in the Cornerstone Bancorp (the “Company”) 2010 Annual Report to Shareholders, which also contains the Company's audited financial statements for 2010 and is also included in the Form 10-K for the year ended December 31, 2010.

Principles of Consolidation

The consolidated financial statements include the accounts of Cornerstone Bancorp, the parent company, and Cornerstone National Bank (the “Bank”), its wholly owned subsidiary, and Crescent Financial Services, Inc., a wholly owned subsidiary of the Bank. All significant intercompany items have been eliminated in the consolidated statements. Certain amounts have been reclassified to conform to current year presentation.

Management Opinion

The accompanying consolidated financial statements have been prepared in accordance with generally accepted accounting principles for interim financial information and with the instructions for Form 10-Q. Accordingly they do not contain all the information and footnotes required by accounting principles generally accepted in the United States of America for complete financial statements. The financial statements in this report are unaudited. In the opinion of management, all adjustments necessary to present a fair statement of the results for the interim period have been made. Such adjustments are of a normal and recurring nature. The results of operations for any interim period are not necessarily indicative of the results to be expected for an entire year. These interim financial statements should be read in conjunction with the annual financial statements and notes thereto contained in the 2010 Annual Report on Form 10-K.

Note 2. Earnings per Share

Financial Accounting Standards Board (FASB”) Accounting Standards Codification (“ASC”) 260, "Earnings per Share," requires that the Company present basic and diluted net income (loss) per common share. The assumed conversion of stock options creates the difference between basic and diluted net income per share. Income per share is calculated by dividing net income by the weighted average number of common shares outstanding for each period presented. The weighted average number of common shares outstanding for basic and diluted net loss per common share for the three month period ended March 31, 2011 was 2,210,769 shares. Outstanding options were excluded from the loss per share calculation because they are anti-dilutive as of March 31, 2011 and 2010. The calculation of earnings per share for the first three months of 2010 includes the effect of the 5% stock dividend declared on April 13, 2010 as if it had been declared on January 1, 2010.

Note 3. Stock Based Compensation

As described in Notes 1 and 18 to the financial statements in the Company’s Annual Report on Form 10-K for the year ended December 31, 2010, the Company has a stock-based employee and director compensation plan, which was approved by shareholders in 2003 (the “2003 Plan”).

There have been no options granted in 2011 under the 2003 Plan. Refer to the notes to the financial statements in the Company’s Annual Report on Form 10-K for the year ended December 31, 2010 for further information.

For the three months ended March 31, 2011, the Company expensed $ 12,675 related to options granted in previous years. The expense is included in salaries and employee benefits in the accompanying consolidated statements of income.

Note 4. Estimates

The preparation of consolidated financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of interest and noninterest income and expenses during the reporting period. Actual results could differ from those estimates. The primary significant estimate in the accompanying consolidated financial statements is the allowance for loan losses. A discussion of the significant factors involved in estimating the allowance for loan losses is included in this Form 10-Q in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in the section titled “Results of Operations” and in the Company’s 2010 Form 10-K. The provision for income taxes and the valuation of other real estate owned are also considered significant estimates.

Note 5. Concentrations of credit risk

The Bank makes loans to individuals and small businesses located primarily in upstate South Carolina for various personal and commercial purposes. The Bank monitors the portfolio for concentrations of credit on a quarterly basis using North American Industry Codes, (“NAIC”) and using definitions required by regulatory agencies. The Bank has loans in three NAIC categories of which each represents more than 10% of the portfolio. The NAIC concentrations are 12.8% in Residential Building Construction, 12.2% in Accommodation and Food services, and 21.7% in Real Estate Rental and Leasing. The portfolio also has loans representing 19 other NAIC categories.

The Bank has concentrations in loans collateralized by real estate according to the regulatory definition. Included in this segment of the portfolio is the category for construction and development loans. While the Bank does have a concentration of loans in this category, the Bank’s business is managed in a manner intended to help reduce the risks normally associated with construction lending. Management requires lending personnel to visit job sites, maintain frequent contact with borrowers and perform or commission inspections of completed work prior to issuing additional construction loan draws. Under current policy, loans are limited to 80% of cost of construction projects, and borrowers are required to meet minimum net worth requirements and debt service coverage ratios. Projects for construction of single family homes are generally limited to those projects with contracts for sale where the ultimate owner has a significant investment in the contract. These policies may be considered stricter than policies in place when some of the Bank’s currently outstanding loans were originated. However, as loans mature or as new loans are made, the current guidelines described above would be used to underwrite construction loans.

The Bank does not make long term (more than 15 years) mortgage loans to be held in its portfolio, does not offer loans with negative amortization features or long-term interest only features, or loans with loan to collateral value ratios in excess of 100% at the time the loan is made. The Bank does offer loan products with features that can increase credit risk during periods of declining economic conditions, such as adjustable rate loans, short-term interest-only loans, and loans with amortization periods that differ from the maturity date (i.e., balloon payment loans). However, the Bank evaluates each customer’s creditworthiness based on the customer’s individual circumstances, and current and expected economic conditions, and underwrites and monitors each loan for associated risks. Loans made with exceptions to internal loan guidelines and those with loan-to-value ratios in excess of regulatory loan-to-value guidelines are monitored and reported to the Board of Directors on a monthly basis. The regulatory loan-to-value guidelines permit exceptions to the guidelines up to a maximum of 30% of total capital for commercial loans and exceptions for all types of real estate loans up to a maximum of 100% of total capital. As of March 31, 2011, the Bank had $5.7 million of loans which exceeded the regulatory loan to value guidelines. This amount is within the maximum allowable exceptions to the guidelines. Of the $5.7 million of loans with exceptions to the regulatory loan to value guidelines, $3.8 million or 66.9% were not exceptions at the time the loans were made, but became exceptions upon reappraisal. Management routinely reappraises real estate collateral based on specific criteria and circumstances. If additional collateral is available, the Bank may require the borrower to commit additional collateral to the loan or take other actions to mitigate the Bank’s risk.

Note 6. Income taxes

The Company accounts for income taxes using a method whereby certain items of income and expense (principally provision for loan losses, depreciation, and prepaid expenses) are included in one reporting period for financial accounting purposes and another for income tax purposes. Refer to the notes to the Company’s consolidated financial statements for the year ended December 31, 2010 for more information. To date in 2011, the Company recorded no net income tax expense or benefit. The Company has chosen to effectively reserve any tax benefit that would have accrued until the economic uncertainty in our market areas has subsided or declined. Management has evaluated the net deferred tax asset and determined that the current net deferred tax asset will more-likely-than-not be realized by the Company. The Company also believes that its income tax filing positions taken or expected to be taken in its tax returns will more likely than not be sustained upon audit by the taxing authorities, and does not anticipate any adjustments that will result in a material adverse impact on the Company’s financial condition, results of operations, or cash flows. Therefore, no reserves for uncertain income tax positions have been recorded pursuant to ASC 740, “Income Taxes”.

Note 7. Fair Value Accounting

ASC 820 defines fair value as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. The standard also establishes a fair value hierarchy which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. The standard describes three levels of inputs that may be used to measure fair value:

Level 1-Quoted prices in active markets for identical assets or liabilities. Level 1 assets and liabilities include debt and equity securities and derivative contracts that are traded in an active exchange market, as well as U.S. Treasuries and money market funds.

Level 2-Observable inputs other than Level 1 prices such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities. Level 2 assets and liabilities include debt with quoted prices that are traded less frequently than exchange-traded instruments, mortgage-backed securities, municipal bonds, corporate debt securities, and derivative contracts whose value is determined using a pricing model with inputs that are observable in the market or can be derived principally from or corroborated by observable market data. This category generally includes certain derivative contracts and impaired loans.

Level 3-Unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities. Level 3 assets and liabilities include financial instruments whose value is determined using pricing models, discounted cash flow methodologies, or similar techniques, as well as instruments for which the determination of fair value requires significant management judgment or estimation. For example, this category generally includes certain private equity investments, retained residual interests in securitizations, residential mortgage servicing rights, and highly-structured or long-term derivative contracts.

During the quarter ended March 31, 2011, there were no significant transfers of assets between categories.

Note 8. Cumulative Perpetual Preferred Stock (8%)

During the third quarter of 2010, the Company offered up to $2,500,000 of 8% Series A Cumulative Perpetual Preferred Stock (“the Preferred”) to accredited investors and up to 35 non-accredited investors. The Preferred was offered by the Company’s directors and executive officers, and no selling agents or underwriters were used. 1,038 shares of the Preferred were sold. Proceeds of the offering, net of offering expenses totaled $998,538. The Preferred is scheduled to pay a dividend quarterly. However, the Federal Reserve has declined to approve the dividends scheduled for payment to date. Dividends that have accumulated but have not been declared or accrued total $50,635 as of March 31, 2011.

Note 9. Evaluation of subsequent events

In accordance with the accounting standard regarding subsequent events, management performed an evaluation to determine whether or not there have been any subsequent events since the balance sheet date that would be required to be included in these financial statements and concluded that there were none.

Note 10. Recently issued accounting standards

The following is a summary of recent authoritative pronouncements that may affect accounting, reporting, and disclosure of financial information by the Company:

In July 2010, the Receivables topic of the ASC was amended by Accounting Standards Update (“ASU”) 2010-20 to require expanded disclosures related to a company’s allowance for credit losses and the credit quality of its financing receivables. The amendments require the allowance disclosures to be provided on a disaggregated basis. The Company is required to include these disclosures in their interim and annual financial statements. See “Balance Sheet Review- Loans” for additional information.

Disclosures about Troubled Debt Restructurings (“TDRs”) required by ASU 2010-20 were deferred by the FASB in ASU 2011-01 issued in January 2011. In April 2011, FASB issued ASU 2011-02 to assist creditors with their determination of when a restructuring is a TDR. The determination is based on both whether the restructuring constitutes a concession and whether the debtor is experiencing financial difficulties. Disclosures related to TDRs under ASU 2010-20 will be effective for reporting periods beginning after June 15, 2011.

Accounting standards that have been issued or proposed by the FASB that do not require adoption until a future date are not expected to have a material impact on the consolidated financial statements upon adoption.

CAUTIONARY NOTICE WITH RESPECT TO FORWARD LOOKING STATEMENTS

Statements included in this report which are not historical in nature are intended to be, and are hereby identified as “forward looking statements” for purposes of the safe harbor provided by Section 21E of the Securities Exchange Act of 1934, as amended. Words such as “estimate,” “project,” “intend,” “expect,” “believe,” “anticipate,” “plan,” “may,” “will,” “should,” “could,” “would,” “assume,” “indicate,” “contemplate,” “seek,” “target,” “potential,” and similar expressions identify forward-looking statements. The Company cautions readers that forward looking statements including without limitation, those relating to the Company’s new offices, future business prospects, revenues, working capital, adequacy of the allowance for loan losses, liquidity, capital needs, interest costs, and income, are subject to certain risks and uncertainties that could cause actual results to differ from those indicated in the forward looking statements, due to several important factors identified in this report, among others, and other risks and factors identified from time to time in the Company’s other reports filed with the Securities and Exchange Commission.

These forward-looking statements are based on our current expectations, estimates and projections about our industry, management's beliefs, and assumptions made by management. Such information includes, without limitation, discussions as to estimates, expectations, beliefs, plans, strategies, and objectives concerning the Company’s future financial and operating performance. These statements are not guarantees of future performance and are subject to risks, uncertainties and assumptions that are difficult to predict, particularly in light of the fact that the Company is a relatively new company with limited operating history. Therefore, actual results may differ materially from those expressed or forecasted in such forward-looking statements. The risks and uncertainties include, but are not limited to:

·	future economic and business conditions;

·	the Company’s growth and ability to maintain growth;

·	governmental monetary and fiscal policies;

·	legislative and regulatory changes;

·	actions taken by regulatory authorities;

·	the effect of interest rate changes on our level, costs and composition of deposits, loan demand, and the values of our loan collateral, securities, and interest sensitive assets and liabilities;

·	the effects of competition from a wide variety of local, regional, national and other providers of financial, investment and insurance services, as well as competitors that offer banking products and services by mail, telephone, computer, and/or the Internet;

·	the effect of agreements with regulatory authorities, which restrict various activities and impose additional administrative requirements without commensurate benefits;

·	credit risks;

·	higher than anticipated levels of defaults on loans;

·	perceptions by depositors about the safety of deposits;

·	failure of our customers to repay loans;

·	failure of assumptions underlying the establishment of the allowance for loan losses, including the value of collateral securing loans;

·	the risks of opening new offices, including, without limitation, the related costs and time of building customer relationships and integrating operations, and the risk of failure to achieve expected gains, revenue growth and/or expense savings;

·	changes in accounting policies, rules, and practices;

·	cost and difficulty of implementing changes in technology or products;

·	loss of consumer confidence and economic disruptions resulting from terrorist activities;

·	ability to continue to weather the current economic downturn;

·	loss of consumer or investor confidence; and

·	other factors and information described in this report and in any of the other reports we file with the Securities and Exchange Commission under the Securities Act of 1934.

All forward-looking statements are expressly qualified in their entirety by this cautionary notice. The Company undertakes no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise. In light of these risks, uncertainties, and assumptions, the forward-looking events discussed in this report might not occur.

Website References

References to the Bank’s website included in, or incorporated by reference into, this report are for information purposes only, and are not intended to incorporate the website by reference into this report.

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operation

General

Cornerstone Bancorp, (the “Company”) is a bank holding company and has no operations other than those carried on by its wholly owned subsidiary, Cornerstone National Bank (the “Bank”). The Bank commenced business in 1999, and conducts a general banking business from three offices in the Easley area of Pickens County, in the Berea area of Greenville County, and in the Powdersville area of Anderson County, South Carolina. In 2004, the Bank established a wholly owned subsidiary, Crescent Financial Services, Inc. (“Crescent”), which is an insurance agency that has not yet engaged in any significant operations.

Effect of Economic Trends

Problems in the economy over the last three years have adversely impacted the ability of some borrowers to repay their loans. Although the Company’s market area has not experienced the negative effects of the recession and declines in real estate markets to the same extent as some other markets in the country, these factors have had a significant effect on our operations as evidenced by the increases in our potential problem loans, charge-offs, nonaccrual loans and real estate owned. The majority of problem loans in 2010 were real estate loans. These loans were often collateralized by newly constructed homes or undeveloped land and were foreclosed on after real estate sales in the Company’s market area decreased significantly beginning in the summer of 2008. Borrowers were generally builders and developers who did not have the cash flow required to support the level of inventory financed with area banks. The process of foreclosure in South Carolina is lengthy and expensive. The impact of foregone interest on nonaccruing loans in the process of foreclosure, combined with attorneys’ fees, property taxes, and costs to sell repossessed property negatively impacted the Company’s income in 2010 and 2011. The residential market for single family homes in South Carolina has approximately twelve and one half months of inventory. This inventory will take time for the market to absorb and the Company expects to continue through 2011 and into 2012 with elevated other real estate owned balances. As of April 30, 2011, the Company has $2.6 million of other real estate under contract for sale, and expects such contracts to close before June 30, 2011. The real estate and construction industries have been significant employers in the past in South Carolina, but these industries are not expected to return to pre-2008 levels in the foreseeable future. South Carolina is currently looking to other industries to provide job creation and economic prosperity in the State. The current outlook for the national economy in the United States (“U.S.”) is cautiously optimistic. Throughout 2010, the economy showed mixed signs of recovery, though high unemployment levels persist. The Company expects slow improvement in 2011 in its market areas.

Dodd-Frank Wall Street Reform and Consumer Protection Act

On July 21, 2010, the President signed into law the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”), which significantly changes the regulation of financial institutions and the financial services industry. The Dodd-Frank Act will have extensive effects on all financial institutions, and includes provisions that will affect how community banks, thrifts, and small bank and thrift holding companies will be regulated in the future. Among other things, these provisions abolish the Office of Thrift Supervision and transfer its functions to the other federal banking agencies, relax rules regarding interstate branching, allow financial institutions to pay interest on business checking accounts, change the scope of federal deposit insurance coverage, and impose new capital requirements on bank and thrift holding companies. The Dodd-Frank Act also establishes the Bureau of Consumer Financial Protection as an independent entity within the Federal Reserve, which will be given the authority to promulgate consumer protection regulations applicable to all entities offering consumer financial services or products, including banks. Additionally, the Dodd-Frank Act includes a series of provisions covering mortgage loan origination standards affecting originator compensation, minimum repayment standards, and pre-payments.

The Dodd-Frank Act requires regulatory agencies to implement new regulations that will establish the parameters of the new regulatory framework and provide a clearer understanding of the legislation’s effect on banks. We are in the process of evaluating this new legislation and determining the impact it will have on our current and future operations. However, the manner and degree to which it affects our business will be significantly impacted by the implementing regulations that are ultimately adopted. Accordingly, at the present time we cannot fully assess the impact that the act will have on us, though we are confident it will increase our cost of doing business and the time spent by management on regulatory compliance matters.

Legislative Proposals

Proposed legislation, which could significantly affect the business of banking, is introduced in Congress and the South Carolina Legislature from time to time. For example, numerous bills are pending in Congress and the South Carolina Legislature to provide various forms of relief to homeowners from foreclosure of mortgages as a result of publicity surrounding economic problems resulting from subprime mortgage lending and the economic adjustments in national real estate markets. Broader problems in the financial sector of the economy, which became apparent in 2008, have led to numerous calls for, and legislative and regulatory proposals relating to, restructuring of the regulation of financial institutions. Management of the Company cannot predict the future course of such legislative proposals or their impact on the Company and the Bank should they be adopted.

Fiscal and Monetary Policy

Banking is a business that depends largely on interest rate differentials. In general, the difference between the interest paid by a bank on its deposits and its other borrowings, and the interest received by a bank on its loans and securities holdings, constitutes the major portion of a bank’s earnings. Thus, the earnings and growth of the Company and the Bank are subject to the influence of economic conditions generally, both domestic and foreign, and also to the monetary and fiscal policies of the United States and its agencies, particularly the Federal Reserve. The Federal Reserve regulates the supply of money through various means, including open-market dealings in United States government securities, the discount rate at which banks may borrow from the Federal Reserve, and the reserve requirements on deposits. The nature and timing of any changes in such policies and their impact on the Company and the Bank cannot be predicted.

Results of Operations for the Three Months Ended March 31, 2011 and 2010

Summary

The Company recorded a loss of $16,236 during the first quarter of 2011 or $(.02) per common share compared to a loss of $240,575 during the first quarter of 2010 or $(.11) per share, after giving effect to the five percent stock dividend (recorded as a stock split) declared in 2010. The primary reason for the improvement was a decrease in the quarterly provision for loan losses. The Bank experienced a net increase in noninterest expense for the quarter in 2011 compared to 2010 that partially offset the gain in income from the lower loan loss provision. The increase was related to expenses and write-downs associated with other real estate owned. Although the Company decreased its expenditures for salaries and benefits, and premises and equipment expenses, it had increased expenses for professional and regulatory fees.

Net Interest Income

Net interest income is the primary driver of net income for the Company. Net interest income is equal to the difference between interest income earned on the Company’s interest earning assets and the interest paid on its interest bearing liabilities. The Company’s net interest margin increased to 3.62% in the first quarter of 2011 from 3.13% in the first quarter of 2010. The primary reason for the increase in the net interest margin was a decrease in the average rate paid on interest bearing liabilities. For the quarter ended March 31, 2011 the Bank paid an average of 1.47% on interest bearing liabilities, compared with an average of 1.95% on interest bearing liabilities in the 2010 quarter. The decrease was primarily attributable to the replacement of maturing higher rate deposits with lower rate deposits.

The table below illustrates the average balances of interest earning assets and interest bearing liabilities and the resulting annualized yields and costs for the three month periods ended March 31, 2011 and 2010.

	March 31, 2011							March 31, 2010
	Average Balance		Interest		Average Yield/ Cost			Average Balance		Interest		Average Yield/ Cost
Investments	$	24,401,353	$	188,691		3.14	%	$	28,789,515	$	268,242		3.78	%
Federal funds sold and other interest-earning deposits		9,377,963		3,507		.15	%		8,698,977		2,380		.11	%
Loans, excluding nonaccruals		108,761,645		1,592,064		5.94	%		127,442,354		1,769,282		5.63	%


Total interest earning assets		142,540,961		1,784,262		5.08	%		164,930,846		2,039,904		5.02	%

Interest bearing transaction accounts		12,818,962		13,692		.43	%		12,823,905		15,092		.48	%
Savings and money market		49,810,542		127,506		1.04	%		49,075,728		214,027		1.77	%
Time deposits		67,191,421		291,190		1.76	%		80,464,063		422,886		2.13	%
Total interest bearing deposits		129,820,925		432,388		1.35	%		142,363,696		652,005		1.86	%

Customer repurchase agreements		2,888,748		7,582		1.06	%		3,081,333		12,662		1.67	%
Borrowings from FHLB Atlanta		3,151,996		26,878		3.46	%		9,459,051		59,678		2.56	%
Broker repurchase agreements		5,000,000		43,550		3.53	%		5,000,000		44,034		3.57	%
Total interest bearing liabilities	$	140,861,669		510,398		1.47	%	$	159,904,080		768,379		1.95	%

Net interest income			$	1,273,864						$	1,271,525
Interest rate spread						3.61	%						3.07	%
Interest margin						3.62	%						3.13	%

The Bank, which accounts for all of the Company’s sensitivity to changes in interest rates, measures interest sensitivity using various methods. Using a static GAP measurement, which compares the amount of interest sensitive assets repricing within a one year time period as compared to the amount of interest sensitive liabilities repricing within the same time frame, the Bank’s sensitivity to changes in interest rates can be analyzed. This method does not take into account loan prepayments and other non-contractual changes in balances and the applicable interest rates, but it does give some information as to possible changes in net interest income that could be expected simply as a result of changes in interest rates. As of March 31, 2011, the Bank’s cumulative static GAP ratio was .60 through 12 months assuming all non-maturing deposits reprice immediately and that all securities reprice in the year of their maturity, without regard to calls or principal reductions on mortgage-backed securities. This indicates a liability-sensitive position as of March 31, 2011. However, this measurement is based on assumptions about the repricing of various accounts, which may not occur as they have been modeled. Assuming some non-maturing deposits reprice in periods other than the first twelve months, and accounting for principal reductions on mortgage-backed securities, the Bank’s cumulative static GAP ratio is .99 through 12 months.

Based on a static GAP measurement, in a period of rising interest rates, asset-sensitive balance sheets would normally be expected to experience a widening of the net interest margin, while liability-sensitive balance sheets such as the Bank’s would normally be expected to experience pressure on the net interest margin. In a period of decreasing interest rates, liability-sensitive balance sheets would normally be expected to experience a widening of the net interest margin and asset-sensitive balance sheets would normally be expected to experience the opposite effect. Various market factors can, however, affect the net interest margin and cause it to react differently to changes in interest rates than would normally be expected under the static GAP model.

Provision for loan losses

For the quarter ended March 31, 2011, the Company expensed $150,000 to the provision for loan losses. The Bank sets the allowance for loan loss levels in response to trends in the portfolio and the level of potential problem loans. During the quarter, charge-offs totaled $231,121 and recoveries totaled $5,000.

Management has sought to provide the amount estimated to be necessary to maintain an allowance for loan losses that is adequate to cover the level of loss that management believes to be inherent in the portfolio as a whole, taking into account the Company’s experience, economic conditions and information about borrowers available at the time of the analysis. However, management believes further deterioration of economic conditions in the Company's market areas in the short-term is possible, especially with respect to real estate related activities and real property values. Consequently, management expects that further increases in provisions for loan losses could be needed in the future. See “Balance Sheet Review- Loans” for additional information on the Company’s loan portfolio and allowance for loan losses.

Noninterest income

The primary recurring drivers of noninterest income for the Company and the Bank are service charges on deposit accounts. For the three months ended March 31, 2011, the Company earned $113,035 in service charges on deposit accounts compared to $126,404 for the same period in 2010. The decrease is primarily related to a decrease in insufficient funds charges. Other noninterest income was relatively unchanged in the first quarter of 2011 at $42,931 compared to $45,799 for the first quarter of 2010.

Noninterest expense

Noninterest expense totaled $1.3 million for the three months ended March 31, 2011 and $1.2 million for the three months ended March 31, 2010. Expense related to other real estate owned increased to $139,156 in the first quarter of 2011 compared to $118,990 in the first quarter of 2010, mainly due to write downs of value based on new appraisals. Professional and regulatory fees increased $21,571 as a result of increases in FDIC insurance premiums. Premises and equipment expenses decreased by 6.8% due to lower repair and maintenance costs.

Balance Sheet Review

Investments

At March 31, 2011, the Bank held available for sale securities with a fair value of $24.3 million and other investments with an amortized cost of $1.1 million. Available for sale securities include government sponsored enterprise bonds, mortgage-backed securities, and municipal bonds. The fair values of the Company’s available for sale investments, other than municipal bonds, are measured on a recurring basis using quoted market prices in active markets for identical assets and liabilities (“Level 1 inputs” under FASB ASC 820). Due to the lower level of trading activity in municipal bonds, the fair market values of these investments are measured based on other inputs such as inputs that are observable or can be corroborated by observable market data for similar assets with substantially the same terms (“Level 2 inputs” under FASB ASC 820). We obtain our fair value information via our bond accounting vendor. This vendor obtains municipal bond market pricing from Interactive Data, a provider of third-party financial market data. The Company does not adjust market pricing received from this vendor, but we do request that a qualified analyst review each municipal bond in the portfolio to determine if any other information is available that would call into question the market values used.

Other investments include stock in the Federal Home Loan Bank of Atlanta and the Federal Reserve Bank. These stocks are held at amortized cost because they have no quoted market value and have historically been redeemed at par value. However, there can be no assurance that these stocks will, in fact, be redeemed at cost in the future.

As of March 31, 2011, investments available for sale had a net unrealized gain of $87,678. As of March 31, 2011, the Company held thirteen investments in an unrealized loss position, but none of the investments had been in an unrealized loss position for 12 months or more. Based on its other-than-temporary impairment analysis at March 31, 2011, the company concluded that gross unrealized losses were not other-than-temporary.

Loans

The following table summarizes the composition of our loan portfolio.

	March 31, 2011						December 31, 2010

	Amount			% of Loans			Amount			% of Loans
Commercial and industrial	$	11,854,650			10.3	%	$	12,580,841			10.5	%
Real Estate – construction		38,196,154			33.3			41,855,338			34.9
Real Estate – mortgage
1-4 family residential		19,676,118			17.2			19,604,943			16.3
Nonfarm, nonresidential		42,343,187			37.0			43,080,225			36.0
Multifamily residential		1,772,888			1.6			1,793,400			1.5
Consumer installment		742,890			.6			999,453			.8
Total Loans	$	114,585,887			100.0	%	$	119,914,200			100.0	%
Less allowance for loan losses		(2,627,309	)					(2,703,430	)
Net Loans	$	111,958,578					$	117,210,770

Allowance for loan losses

Portfolio Segmentation Methodology

The provision for loan losses charged to operating expenses reflects the amount deemed appropriate by management to establish an adequate reserve to meet the probable loan losses incurred in the current loan portfolio. Management’s judgment is based on periodic and regular evaluation of individual loans, the overall risk characteristics of the various portfolio segments, past experience with losses, delinquency trends, and prevailing economic conditions. To estimate the amount of allowance necessary the Company separates the portfolio into segments. The portfolio is first separated into groups according to the internal loan rating assigned by management. Loans rated “Other Assets Especially Mentioned” (“OAEM”), “Substandard” “Doubtful” or “Loss,” as defined in the Bank’s loan policy, are evaluated individually for impairment. The Company uses regulatory call report codes to stratify the remaining portfolio and tracks the Bank’s own charge-offs and those of peer banks using FDIC Call Report data. The Bank’s own charge-off ratios by call report code are used to project potential loan losses in the future on loans that are rated “Satisfactory” or better. Charge-off ratios may be increased or decreased based on other environmental factors which may need to be considered, such as unemployment rates and volatility of real estate values. While management uses the best information available to it to make evaluations, future adjustments to the allowance may be necessary if economic conditions differ substantially from the assumptions used in making the evaluations. The allowance for loan losses is also subject to periodic evaluation by various regulatory authorities and may be subject to adjustment upon their examination.

Credit Quality Indicators

Loans evaluated individually for impairment (including loans rated OAEM, Substandard, Doubtful or Loss as defined in the Bank’s loan policy) totaled approximately $20.5 million as of March 31, 2011 and $20.6 million as of December 31, 2010. The majority of loans evaluated are rated Substandard. The Substandard rating is defined as applicable to loans having a well-defined weakness in the liquidity or net worth of the borrower or the collateral that could jeopardize the liquidation of the debt. Well-defined weaknesses could include deterioration in the borrower’s financial condition or cash flows, significant changes in the value of underlying collateral, and other indicators.

Delinquent loans and loans on non-accrual are presented by call report category in the table below.

	March 31, 2011				December 31, 2010
	Past due 30-89 Days		Nonaccrual or Past due over 90 Days		Past due 30-89 Days		Nonaccrual or Past due over 90 Days

Loans secured by real estate – construction	$	2,468,819	$	4,591,977	$	891,035	$	7,218,012
Loans secured by real estate – single family		1,553,662		1,921,343		1,977,519		1,522,290
Loans secured by real estate –nonfarm, nonresidential		-		248,595		-		-
Commercial and industrial loans		76,248		992,027		-		992,027
Loans to consumers		435		-		-		-
Total	$	4,099,164	$	7,753,942	$	2,868,554	$	9,732,329

Management closely monitors delinquent loans. The increase in loans past due 30 to 89 days as of March 31, 2011 in comparison to December 31, 2010 is primarily due to one relationship. Management has evaluated that relationship and believes that sufficient collateral exists to cover the Company’s investment in the loan.

Impaired loans by portfolio segment, the majority of which are included in the table above, as of the dates indicated, were as follows:

	March 31, 2011						December 31, 2010

	Impaired Loans			% of Total			Impaired Loans			% of Total
Commercial and industrial	$	1,125,096			12.9	%	$	1,129,662			10.6	%
Real Estate – construction		4,885,143			56.1			7,218,013			67.8
Real Estate – mortgage
1-4 family residential		1,976,961			22.7			2,137,335			20.1
Nonfarm, nonresidential		724,779			8.3			152,310			1.4
Consumer installment		1,675			-			1,869			-

Total impaired loans (1)		8,713,654			100.0	%		10,639,189			100.0	%
Less related allowance for loan losses		(368,062	)					(348,436	)
Net nonperforming loans	$	8,345,592					$	10,290,753

(1)	Includes loans on nonaccrual.

The Bank accounts for impaired loans in accordance with a financial accounting standard that requires all lenders to value a loan at the loan’s fair value if it is probable that the lender will be unable to collect all amounts due according to the terms of the loan agreement. Factors considered by management in determining impairment include payment status, collateral value, and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Management determines the significance of payment delays and payment shortfalls on a case-by-case basis taking into consideration all the circumstances of the loan and the borrower, including the length of the delay, reasons for the delay, the borrower’s payment record and the amount of the shortfall in relation to the principal and interest owed. The fair value of an impaired loan may be determined based upon the present value of expected cash flows, market price of the loan, if available, or value of the underlying collateral. Expected cash flows are required to be discounted at the loan’s effective interest rate. The Bank’s loan portfolio is largely dependent on collateral for repayment if the borrower’s financial position deteriorates. Therefore, the most common type of valuation is to determine collateral value less disposal costs in order to determine carrying values for loans deemed impaired.

Loans which management identifies as impaired generally will be nonperforming loans or restructured loans. Nonperforming loans include nonaccrual loans or loans which are 90 days or more delinquent as to principal or interest payments. As of March 31, 2011, the Bank had nonaccrual loans of $7.75 million representing 25 loans, a decrease of $2.0 million from December 31, 2010. With the exception of one loan in the amount of $1.0 million, these loans are secured by real estate. In addition to loans on nonaccrual, as of March 31, 2011, management considers another $959,712 of loans impaired. These additional impaired loans are generally restructured loans defined as “troubled debt restructurings” (“TDR’s”). Management routinely assesses the collateral and other circumstances associated with impaired loans in an effort to determine the amount of potential impairment. These loans are currently being carried at management’s best estimate of net realizable value, although no assurance can be given that no further losses will be incurred on these loans until the collateral has been acquired and liquidated or other arrangements can be made. The foreclosure process is lengthy (generally a minimum of six months and often much longer), so loans may be on nonaccrual status for a significant time period prior to moving to other real estate owned and sold. As soon as the amount of impairment is estimable, the amount of principal impairment is generally charged against the allowance for loan losses. However, until losses and selling costs can be estimated via appraisal or other means, a portion of the allowance may be allocated to specific impaired loans. The timing of the appraisal varies from loan to loan depending on the Bank’s ability to access the property. As of March 31, 2011 the allowance for loan losses included approximately $368,062 of reserves specifically related to impaired loans.

Management’s estimates of net realizable value or fair value of real estate collateral are obtained (on a nonrecurring basis) using independent appraisals, less estimated selling costs. Estimates of net realizable value for equipment and other types of personal property collateral are estimated based on input from equipment dealers and other professionals. If an appraisal is not available or management determines that fair value of the collateral is further impaired below the appraised value and there is no observable market price, the Company records the impaired loan as determined by Level 3 inputs as defined by FASB ASC 820, “Fair Value Measurements and Disclosures”.

Management identifies and maintains a list of potential problem loans. These are loans that are not included in nonaccrual status or impaired loans. A loan is added to the potential problem list when management becomes aware of information about possible credit problems of borrowers that causes serious doubts as to the ability of such borrowers to comply with the current loan repayment terms. These loans are designated as such in order to be monitored more closely than other credits in the Bank’s portfolio. There were loans in the amount of $1.2 million that have been determined by management to be potential problem loans at March 31, 2011. These loans are generally secured by real estate, and in many cases have been reappraised. Should potential problem loans become impaired, management will charge-off any impairment amount as soon as the amount of impairment can be determined.

Activity in the allowance for loan losses for the first three months of 2011 and 2010 is presented below.

	Three months ended March 31, 2011		Three months ended March 31, 2010
Allowance for loan losses, beginning of year	$	2,703,430	$	2,695,337
Provision for losses		150,000		620,000
Charge-offs
Real estate- construction		231,121		177,967
Real estate- 1-4 family residential		-		92,002
Total charge-offs		231,121		269,969
Recoveries
Commercial and industrial		5,000		-
Total recoveries		5,000		-
Net charge-offs		226,121		269,969
Allowance for loan losses, end of period	$	2,627,309	$	3,045,368

Nonaccruing loans to gross loans at end of period	6.77	%	5.98	%
Net charge-offs to average loans outstanding	(.19	%)	(.20	%)
Net charge-offs to loans at end of period	(.20	%)	(.20	%)
Allowance for loan losses to average loans	2.24	%	2.24	%
Allowance for loan losses to loans at end of period	2.29	%	2.28	%
Net charge-offs to allowance for loan losses	(8.61	%)	(8.87	%)
Net charge-offs to provision for loan losses	(150.7	%)	(43.5	%)

Other real estate owned

As of March 31, 2011 the Company held other real estate owned as a result of foreclosures totaling $12.8 million representing 46 properties. Of the total recorded amount, $6.9 million relates to collateral formerly securing construction and land development loans, $4.5 million relates to properties formerly securing single family residential loans, and $1.4 million relates to collateral securing former nonfarm-nonresidential mortgage loans. If, at the time of foreclosure, the fair value is determined to be lower than the Company’s recorded investment, a charge-off is recorded at that time. If an appraisal is available, the appraisal will be used to estimate fair value. If an appraisal is not available or management determines that fair value of the collateral is further impaired below the appraised value and there is not an observable market price, the Company records the asset as determined by Level 3 inputs as defined by FASB ASC 820. If the property has been held for longer than one year, the Company’s policy is to arrange for an updated appraisal, unless the circumstances of the property indicate that an appraisal is not necessary. If a property is determined to be over-valued upon appraisal, the excess is charged to expense. At March 31, 2011, approximately $1.2 million of other real estate was under contract for sale. At April 30, 2011, approximately $2.6 million was under contract for sale and expected to close before June 30, 2011.

The Company has acquired a significant number of real estate properties in settlement of loans. A summary of the activity in other real estate owned follows:

	March 31,
	2011			2010

Beginning balance	$	10,278,599		$	6,712,948
Additions from foreclosures and capitalized improvements		3,095,938			2,443,612
Write downs of value		(36,312	)		-
Sales		(507,570	)		(1,902,172	)
Ending other real estate owned	$	12,830,655		$	7,254,388

Other assets

As of March 31, 2011 other assets included accrued interest receivable on loans and investment securities available for sale totaling over $585,000, a deferred tax asset of approximately $856,000, prepaid expenses of approximately $719,000 and several miscellaneous items. Prepaid expenses include $563,000 of FDIC premiums for the remainder of 2011 and 2012 that were required to be prepaid to the FDIC in December 2009. The Company also has an income tax receivable of approximately $260,500 as of March 31, 2011. See Note 6 to the unaudited consolidated financial statements above for additional information related to income taxes.

Deposits

The following table shows the average balance amounts and the average rates we paid on deposits for the three months ended March 31, 2011 and 2010.

	Average Deposits
	Three months ended March 31, 2011					Three months ended March 31, 2010
	Amount		Rate			Amount		Rate


Noninterest bearing demand	$	11,116,209		-	%	$	11,226,243		-	%
Interest bearing transaction accounts		12,818,962		.43	%		12,823,905		.48	%
Savings and money market		49,810,542		1.04	%		49,075,728		1.77	%
Time deposits		67,191,421		1.76	%		80,464,063		2.13	%
Total average deposits	$	140,937,134				$	153,589,939

Included in total deposits as of March 31, 2011 were $15.6 million of deposits considered to be brokered deposits based on regulatory definitions. These deposits come from a variety of sources, and are generally fully insured by FDIC. The Company uses brokered deposits to fund various maturities that may not be attractive to customers in the local market area or to supplement local time deposits when interest rates offered locally are higher than interest rates on similar products in other markets. Pursuant to a formal agreement the Bank entered into with the Office of the Comptroller of the Currency (“OCC”) on May 12, 2010, the Bank is currently required to obtain a determination of no supervisory objection from the OCC prior to accepting or renewing brokered deposits.

Borrowings

The Bank’s outstanding borrowings are described in the following table. The amounts listed as broker repurchase agreements are collateralized borrowings from other institutions. Retail repurchase agreements with the Bank’s customers are not included in the table below.

Borrowings at or for the three months ended March 31, 2011

	Ending Balance		Period- End Rate			Maximum Month-end Balance		Average Balance		Weighted Average Rate Paid
Federal Home Loan Bank advances	$	2,554,630		3.78	%	$	2,579,769	$	3,151,996		3.46	%
Broker repurchase agreements	$	5,000,000		3.48	%	$	5,000,000	$	5,000,000		3.55	%

Of the $2.55 million of FHLB advances outstanding, $554,630 are principal reducing credits with final maturities in 2013 through 2015. The remaining $2.0 million is a convertible advance with a final maturity in 2018.

Of the $5.0 million of broker repurchase agreements outstanding, $2.0 million has a final maturity in January, 2013 and $3.0 million has a final maturity in January, 2015. Both are callable, quarterly, beginning on January 10, 2010 and January 15, 2012, respectively.

Estimated Fair Value of Financial Instruments

The estimated fair values of the Company's financial instruments were as follows:

	March 31, 2011				December 31, 2010
		Carrying Amount		Fair Value		Carrying Amount		Fair Value
Financial Assets
Cash and due from banks	$	6,987,595	$	6,987,595	$	7,043,911	$	7,043,911
Federal funds sold		7,610,000		7,610,000		5,110,000		5,110,000
Investment securities		25,314,178		25,314,178		24,655,686		24,655,686
Loans, gross		114,585,887		114,793,806		119,914,200		120,947,231
Cash surrender value of life insurance policies		1,924,912		1,924,912		1,908,112		1,908,112
Financial Liabilities
Deposits		145,023,014		143,415,535		140,646,392		139,176,006
Customer sweep accounts		667,249		667,249		895,937		895,937
Customer repurchase agreements		2,050,000		2,050,000		2,050,000		2,137,395
Borrowings from FHLB		2,554,630		2,675,364		6,592,338		6,731,378
Broker repurchase agreements		5,000,000		5,278,341		5,000,000		5,212,655

The table below presents the balances of assets measured at fair value on a recurring or nonrecurring basis by level within the hierarchy of inputs that may be used to measure fair value.

	March 31, 2011
	Total		Level 1		Level 2		Level 3
Investment securities, recurring	$	25,314,178	$	15,884,963	$	8,365,865	$	1,063,350
Other real estate owned, nonrecurring	$	12,830,655	$	-	$	-	$	12,830,655
Impaired loans, nonrecurring	$	8,713,654	$	-	$	-	$	8,713,654
	December 31, 2010
Investment securities, recurring	$	24,655,686	$	15,369,729	$	8,222,607	$	1,063,350
Other real estate owned, nonrecurring	$	10,278,599	$	-	$	-	$	10,278,599
Impaired loans, nonrecurring	$	10,639,189	$	-	$	-	$	10,639,189

The table below represents the activity in Level 3 assets that are measured at fair value on a recurring basis for the period January 1, 2011 to March 31, 2011.

	Other Investments
Beginning balance	$	1,063,350
Total realized and unrealized gains or losses:
Included in earnings		-
Included in other comprehensive income		-
Purchases		-
Sales		-
Principal reductions		-
Transfers in and/or out of Level 3		-
Ending balance	$	1,063,350

Liquidity

Liquidity is the ability to meet current and future obligations through liquidation or maturity of existing assets or the acquisition of liabilities. The Company manages both assets and liabilities to achieve appropriate levels of liquidity. Cash and short-term investments are the Company’s primary sources of asset liquidity. These funds provide a cushion against short-term fluctuations in cash flow from both deposits and loans. The investment portfolio is the Company’s principal source of secondary asset liquidity. However, the availability of this source of funds is influenced by market conditions. Individual and commercial deposits and borrowings are the Company’s primary source of funding for credit activities. The Company has a line of credit with the FHLB of Atlanta. The FHLB line is based on the availability of eligible collateral, with a maximum borrowing capacity of 10% of Bank assets. The Bank currently has $2.6 million borrowed under the FHLB line. Approximately $14.8 million is available under the FHLB line, assuming adequate collateral is available for pledging. The Bank also has arrangements in place to borrow from the Federal Reserve Discount Window if necessary. The amount of collateral fluctuates with the borrowing base, which is based on a percentage of the outstanding balance of eligible loan collateral. Management believes that the Company’s liquidity sources are adequate to meet its operating needs.

Off Balance Sheet Risk

Through the operations of the Bank, the Company has contractual commitments to extend credit in the ordinary course of its business activities. These commitments are legally binding agreements to lend money to the Bank’s customers at predetermined interest rates for a specified period of time. Commitments are subject to various conditions which are expected to reduce the credit risk to the Company. The Bank’s management evaluates each customer’s creditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by management upon extension of credit, is based on a credit evaluation of the borrower. Collateral varies but may include accounts receivable, inventory, property, plant and equipment, and commercial or residential real estate. Management manages the credit risk on these commitments by subjecting them to normal underwriting and risk management processes.

At March 31, 2011, the Bank had issued commitments to extend credit of $9.0 million through various types of lending arrangements and overdraft protection arrangements. Of that amount, approximately $3.1 million was undisbursed amounts of closed-end loans, $1.1 million was related to unused overdraft protection, and approximately $4.8 million was related to lines of credit. The Bank also had standby letters of credit outstanding of approximately $635,761 at March 31, 2011. An immaterial amount of fees were collected related to these commitments and letters of credit during the three-month period ended March 31, 2011. Historically many of these commitments and letters of credit expire unused, and the total amount committed as of March 31, 2011 is not necessarily expected to be funded.

The Bank offers an automatic overdraft protection product to checking account customers. Each qualified account with the automatic overdraft protection feature can have up to $500 of paid overdrafts. Unused overdraft protection was $1.1 million as of March 31, 2011, the majority of which is not expected to be utilized. As of March 31, 2011, accounts in overdraft status totaled $14,113.

Capital Resources

The capital base for the Company increased by $135,355 for the first three months of 2011. This was due to stock based compensation activity, and increases in accumulated other comprehensive income, partially offset by a small net loss. Stock based compensation activity includes the impact of accounting requirements on unexercised options. The Company’s ending equity to asset ratio was 10.6% as of March 31, 2011.

The following table details return on average assets (net income divided by average total assets, annualized in 2011), return on average equity (net income divided by average total equity, annualized in 2011), the ratio of average equity to average assets and the Dividend Payout Ratio (dividends paid divided by net income) as of and for the three months ended March 31, 2011 and as of and for the year ended December 31, 2010. The annualized return on assets and return on equity for the first three months of 2011 have improved compared to return on assets and return on equity for the year ended December 31, 2010. However, annualized results for the first three months of 2011 may not be indicative of actual annual results for 2011.

	Three- month period ended March 31, 2011			Year ended December 31, 2010
	(annualized)
Return on average assets		(.04	%)		(.27	%)
Return on average equity		(.35	%)		(2.72	%)
Ratio of average equity to average assets		10.6	%		9.93	%
Dividend payout ratio		-	%		-	%

The FDIC has established guidelines for capital requirements for banks. As of March 31, 2011, the Bank is considered well capitalized based on the capital levels that are required to be maintained according to FDIC guidelines as shown in the following table.

Capital Ratios	Actual					Well Capitalized Requirement Under Prompt Corrective Action Provisions					Adequately Capitalized Requirement
	Amount		Ratio			Amount		Ratio			Amount		Ratio
As of March 31, 2011:	(Dollars in thousands)
Total capital to risk weighted assets	$	19,146		14.0	%	$	13,701		10.0	%	$	10,961		8.0	%
Tier 1 capital to risk weighted assets	$	17,413		12.7	%	$	8,221		6.0	%	$	5,480		4.0	%
Tier 1 capital to average assets	$	17,413		10.2	%	$	8,505		5.0	%	$	6,804		4.0	%

As of December 31, 2010:
Total capital to risk weighted assets	$	19,307		13.8	%	$	14,043		10.0	%	$	11,234		8.0	%
Tier 1 capital to risk weighted assets	$	17,531		12.5	%	$	8,426		6.0	%	$	5,617		4.0	%
Tier 1 capital to average assets	$	17,531		9.8	%	$	8,985		5.0	%	$	7,188		4.0	%

In addition to the FDIC requirements shown above, the Bank is currently required to maintain individual minimum capital ratios by the OCC. Those required ratios are: Total capital to risk weighted assets- 12.0%; Tier 1 capital to risk weighted assets – 11.0%; and Tier 1 capital to average assets- 9.0%. As of March 31, 2011 the Bank exceeded the additional capital requirements required by the OCC.

The Federal Reserve has also established guidelines for capital requirements for bank holding companies that are similar to the FDIC’s guidelines for banks. At March 31, 2011 the Company exceeded all of the minimum requirements of the Federal Reserve guidelines.

Regulatory Actions

The Company has entered into a memorandum of understanding with the Federal Reserve Bank of Richmond (“FRB”). The memorandum of understanding requires the Company to seek permission from the FRB before it takes certain actions such as payment of cash dividends, redemption of outstanding stock, etc. The Company believes it is in compliance with the memorandum of understanding with the FRB as of March 31, 2011.

On May 12, 2010, the Bank entered into a formal agreement with the OCC for the Bank to take various actions with respect to the operation of the Bank. The actions include creation of a committee of the Bank's board of directors to monitor compliance with the agreement and make quarterly reports to the board of directors and the OCC; assessment and evaluation of management and members of the board; development, implementation and adherence to a written program to improve the bank's loan portfolio management; protection of its interest in its criticized assets, implementation of a program that identifies and manages concentrations of credit risk; extension of the Bank’s strategic plan; extension of the Bank’s capital program and profit plan; additional plans for ensuring that the level of liquidity at the Bank is sufficient to sustain the current operations and withstand any anticipated or extraordinary demand; and a requirement for obtaining a determination of no supervisory objection from the OCC before accepting brokered deposits. The substantive actions called for by the agreement should strengthen the Bank and make it more efficient in the long-term. The Bank believes it is in compliance with the requirements included in the formal agreement at March 31, 2011.

Impact of Inflation

Unlike most industrial companies, the assets and liabilities of financial institutions such as the Company are primarily monetary in nature. Therefore, interest rates have a more significant impact on the Company’s performance than do the effects of changes in the general rate of inflation and changes in prices. In addition, interest rates do not necessarily move in the same magnitude as the prices of goods and services. As discussed previously, management seeks to manage the relationships between interest sensitive assets and liabilities in order to protect against wide rate fluctuations, including those resulting from inflation.

Item 3. Quantitative and Qualitative Disclosures about Market Risk

Market risk is the risk of loss from adverse changes in market prices and rates which principally arises from liquidity risk and interest rate risk inherent in the Bank’s lending, deposit gathering, and borrowing activities. Other types of market risks such as foreign currency exchange risk and commodity price risk do not normally arise in the ordinary course of our business. The Funds Management Committee of our Board of Directors, which meets quarterly, monitors and considers methods of managing exposure to liquidity and interest rate risk. Management monitors liquidity and interest rate risk on an on-going basis. Management is responsible for maintaining the level of interest rate sensitivity of our interest sensitive assets and liabilities and managing our liquidity within board-approved limits.

Interest rate sensitivity “GAP” analysis measures the timing and magnitude of the repricing of assets compared with the repricing of liabilities and is an important part of asset/liability management. The objective of interest rate sensitivity management is to generate stable growth in net interest income, and to control the risks associated with interest rate movements. Management constantly reviews interest rate risk exposure and the expected interest rate environment so that adjustments in interest rate sensitivity can be made in a timely manner.

ITEM 4. Controls and Procedures.

Based on the evaluation required by 17 C.F.R. Section 240.13a-15(b) or 240.15d-15(b) of the Company’s disclosure controls and procedures (as defined in 17 C.F.R. Sections 240.13a-15(e) and 240.15d-15(e)), the Company’s chief executive officer and chief financial officer concluded that such controls and procedures, as of the end of the period covered by this report, were effective.

There has been no change in the Company’s internal control over financial reporting during the most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.

Part II - Other Information

ITEM 6. Exhibits

Exhibits:


31-1	Rule 13a-14(a)/ 15d-14(a) Certifications of Chief Executive Officer
31-2	Rule 13a-14(a)/Rule 15d-14(a) Certifications of Chief Financial Officer
32	18 U.S.C. Section 1350 Certifications

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

	Cornerstone Bancorp
	(Registrant)


By:	s/J. Rodger Anthony	Date: May 12, 2011
	J. Rodger Anthony
	Chief Executive Officer



By:	s/Jennifer M. Champagne	Date: May 12, 2011
	Jennifer M. Champagne
	Senior Vice President and Chief Financial Officer
	(Principal Financial Officer)

CORNERSTONE BANCORP/SC - FORM 10-Q - May 12, 2011

Attached files

CORNERSTONE BANCORP/SC Reports