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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 June 30, 2014
   
¨ 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

 

 

(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)

 

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.

Yes x  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 period that the registrant was required to submit and post such files).

Yes x  No ¨

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer”, “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

 

Large accelerated filer  ¨ Accelerated filer  ¨ Non-accelerated filer ¨ Smaller reporting company  x

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

Yes ¨  No x

 

As of August 1, 2014 there were 6,627,398 shares of common stock, $1.00 par value per share, issued and outstanding.

 

 
 

 

TABLE OF CONTENTS

 

 PART I – FINANCIAL INFORMATION

Item 1.  Financial Statements (Unaudited)  
   
Item 2.  Management’s Discussion and Analysis of Financial Condition and Results of Operations 29
   
Item 3.  Quantitative and Qualitative Disclosures About Market Risk 39
   
Item 4.  Controls and Procedures 39
   
PART II – OTHER INFORMATION  
   
Item 1. Legal Proceedings 39
   
Item 1A. Risk Factors 39
   
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds 39
   
Item 3. Defaults Upon Senior Securities 39
   
Item 4. Mine Safety Disclosures 39
   
Item 5. Other Information 39
   
Item 6. Exhibits 39

 

2
 

 

FORWARD-LOOKING STATEMENTS

 

Cornerstone Bancshares, Inc. (“Cornerstone”) may from time to time make written or oral statements, including statements contained in this report (including, without limitation, certain statements in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in Part I, Item 2), that constitute forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934 (the “Exchange Act”). The words “expect,” “anticipate,” “intend,” “consider,” “plan,” “believe,” “seek,” “should,” “estimate,” and similar expressions are intended to identify such forward-looking statements, but other statements may constitute forward-looking statements. These statements should be considered subject to various risks and uncertainties. Such forward-looking statements are made based upon management’s belief as well as assumptions made by, and information currently available to, management pursuant to “safe harbor” provisions of the Private Securities Litigation Reform Act of 1995. Cornerstone’s actual results may differ materially from the results anticipated in forward-looking statements due to a variety of factors. Such factors include, without limitation, those specifically described in Item 1A of Part I of our Annual Report on Form 10-K for the fiscal year ended December 31, 2013, as well as the following:  (i) the possibility that our asset quality would decline or that we experience greater loan losses than anticipated, (ii) increased levels of other real estate, primarily as a result of foreclosures, (iii) the impact of liquidity needs on our results of operations and financial condition, (iv) competition from financial institutions and other financial service providers, (v) economic conditions in the local markets where we operate, (vi) the impact of obtaining regulatory approval prior to the payment of dividends, (vii) the impact of our Series A Preferred Stock on net income available to holders of our Common Stock and earnings per common share, (viii) the impact of negative developments in the financial industry and U.S. and global capital and credit markets, (ix) the impact of recently enacted legislation on our business, (x) the relatively greater credit risk of residential construction and land development loans in our loan portfolio, (xi) adverse impact on operations and financial condition due to changes in interest rates, (xii) our ability to obtain additional capital and, if obtained, the possible significant dilution to current shareholders, (xiii) the impact of federal and state regulations on our operations and financial performance, (xiv) whether a significant deferred tax asset we have can be fully realized, (xv) our ability to retain the services of key personnel, (xvi) the impact of Tennessee’s anti-takeover statutes and certain charter provisions on potential acquisitions of the holding company, and (xvii) our ability to adapt to technological changes. Many of such factors are beyond Cornerstone’s ability to control or predict, and readers are cautioned not to put undue reliance on such forward-looking statements. Cornerstone does not intend to update or reissue any forward-looking statements contained in this report as a result of new information or other circumstances that may become known to Cornerstone.

 

3
 

 

Cornerstone Bancshares, Inc. and Subsidiary

Consolidated Balance Sheets        

 

   Unaudited     
   June 30,   December 31, 
ASSETS  2014   2013 
           
Cash and due from banks  $2,222,077   $2,149,467 
Interest-bearing deposits at other financial institutions   16,818,780    22,702,270 
Total cash and cash equivalents   19,040,857    24,851,737 
           
Securities available for sale   83,314,607    92,208,672 
Securities held to maturity (fair value $31,309 and $35,027          
at June 30, 2014 and December 31, 2013, respectively)   30,993    34,165 
Federal Home Loan Bank stock, at cost   2,322,900    2,322,900 
Loans, net of allowance for loan losses of $3,329,789 and $3,203,158          
at June 30, 2014 and December 31, 2013, respectively   289,039,362    286,236,578 
Bank premises and equipment, net   4,862,213    4,992,449 
Accrued interest receivable   1,082,522    977,925 
Foreclosed assets   12,996,286    12,925,748 
Other assets   7,221,565    7,673,179 
     Total assets  $419,911,305   $432,223,353 
           
LIABILITIES AND STOCKHOLDERS' EQUITY          
           
Deposits:          
Noninterest-bearing demand deposits  $65,965,561   $75,206,540 
Interest-bearing demand deposits   26,241,666    24,563,987 
Savings deposits and money market accounts   82,268,935    86,329,930 
Time deposits   156,935,842    155,313,920 
Total deposits   331,412,004    341,414,377 
           
Accrued interest payable   80,077    82,320 
Federal funds purchased and securities sold under          
agreements to repurchase   21,913,135    22,974,117 
Federal Home Loan Bank advances and other borrowings   25,000,000    26,740,000 
Other liabilities   1,137,134    878,811 
Total liabilities   379,542,350    392,089,625 
           
Stockholders' equity:          
Preferred stock - no par value; 2,000,000 shares authorized;          
600,000 shares issued and outstanding           
in 2014 and 2013   14,928,618    14,892,927 
Common stock - $1.00 par value; 20,000,000 shares authorized;          
6,709,199 shares issued in 2014 and 2013;          
6,627,398 and 6,547,074 shares outstanding in 2014 and 2013, respectively   6,627,398    6,547,074 
Additional paid-in capital   21,740,560    21,549,883 
Accumulated deficit   (3,063,508)   (3,099,451)
Accumulated other comprehensive income   135,887    243,295 
Total stockholders' equity   40,368,955    40,133,728 
Total liabilities and stockholders' equity  $419,911,305   $432,223,353 

 

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

 

4
 

 

Cornerstone Bancshares, Inc. and Subsidiary

Consolidated Statements of Income

                         

   Unaudited   Unaudited 
   Three Months Ended   Six Months Ended 
   June 30,   June 30, 
   2014   2013   2014   2013 
INTEREST INCOME                
Loans, including fees  $4,225,125   $4,079,369   $8,320,593   $8,221,105 
Securities and interest-bearing deposits at other                    
  financial institutions   346,507    482,117    776,997    922,023 
Federal funds sold   10,112    14,533    17,275    36,005 
Total interest income   4,581,744    4,576,019    9,114,865    9,179,133 
                     
INTEREST EXPENSE                    
Time deposits   365,537    455,340    741,027    920,596 
Other deposits   75,965    131,534    143,039    269,464 
Federal funds purchased and securities                    
    sold under agreements to repurchase   20,621    16,743    39,281    34,823 
Federal Home Loan Bank advances and other borrowings   263,201    315,948    524,611    656,387 
Total interest expense   725,324    919,565    1,447,958    1,881,270 
                     
Net interest income before provision for loan losses   3,856,420    3,656,454    7,666,907    7,297,863 
Provision for loan losses   350,000    -    515,000    300,000 
Net interest income after provision for loan losses   3,506,420    3,656,454    7,151,907    6,997,863 
                     
NONINTEREST INCOME                    
Customer service fees   209,538    201,302    398,449    389,783 
Net gains from sale of securities   300,201    424,971    402,473    424,971 
Net gains from sale of loans and other assets   6,529    52,382    25,443    201,582 
Other noninterest income   18,220    18,650    30,436    36,468 
Total noninterest income   534,488    697,305    856,801    1,052,804 
                     
NONINTEREST EXPENSE                    
Salaries and employee benefits   1,722,503    1,622,501    3,549,487    3,219,792 
Net occupancy and equipment expense   324,086    339,606    632,918    677,485 
Depository insurance   164,167    161,120    318,843    320,964 
Foreclosed assets, net   363,122    798,456    712,492    927,148 
Other operating expenses   801,047    780,045    1,462,234    1,532,219 
Total noninterest expenses   3,374,925    3,701,728    6,675,974    6,677,608 
                     
Income before income tax expense   665,983    652,031    1,332,734    1,373,059 
Income tax expense   256,500    256,000    511,100    524,900 
                     
Net income   409,483    396,031    821,634    848,159 
                     
Preferred stock dividend requirements   375,000    375,000    750,000    750,000 
Accretion on preferred stock discount   17,845    17,845    35,691    35,690 
                     
Net income available to common shareholders  $16,638   $3,186   $35,943   $62,469 
                     
EARNINGS PER COMMON SHARE                    
Basic  $-   $-   $0.01   $0.01 
Diluted  $-   $-   $0.01   $0.01 
                     
DIVIDENDS DECLARED PER COMMON SHARE  $-   $-   $-   $- 

 

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

 

5
 

 

Cornerstone Bancshares, Inc. and Subsidiary

Consolidated Statements of Comprehensive Income        

 

   Unaudited 
   Three Months Ended 
   June 30 
   2014   2013 
Net income  $409,483   $396,031 
           
Other comprehensive income, net of tax:          
     Unrealized holding losses arising during the period, net of tax benefit          
         of $131,726 and $290,725 in 2014 and 2013, respectively   (214,920)   (474,341)
           
     Reclassification adjustment for gains included in net income, net of tax          
         expense of $114,076 and $161,489 in 2014 and 2013, respectively   (186,125)   (263,482)
           
Total other comprehensive loss   (401,045)   (737,823)
           
Comprehensive income (loss)  $8,438   $(341,792)

 

   Unaudited 
   Six Months Ended 
   June 30 
   2014   2013 
Net income  $821,634   $848,159 
           
Other comprehensive income, net of tax:          
     Unrealized holding gains (losses) arising during the period, net of tax (expense)          
        (expense) benefit of $(87,111) and $427,124  in 2014 and 2013, respectively.   142,125    (696,892)
           
     Reclassification adjustment for gains include in net income, net of tax          
         expense of $152,940 and $161,489 in 2014 and 2013, respectively   (249,533)   (263,482)
           
Total other comprehensive loss   (107,408)   (960,374)
           
Comprehensive income (loss)  $714,226   $(112,215)

 

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

 

6
 

 

Cornerstone Bancshares, Inc. and Subsidiary

Consolidated Statement of Changes in Stockholders' Equity - Unaudited

For the Six Months Ended June 30, 2014                        

 

                   Accumulated     
           Additional       Other   Total 
   Preferred   Common   Paid-in   Accumulated   Comprehensive   Stockholders' 
   Stock   Stock   Capital   Deficit   Income   Equity 
                         
BALANCE, December 31, 2013  $14,892,927   $6,547,074   $21,549,883   $(3,099,451)  $243,295   $40,133,728 
                               
   Stock compensation expense   -    -    80,000    -    -    80,000 
                               
   Issuance of common stock, 80,324 shares   -    80,324    110,677    -    -    191,001 
                               
   Preferred stock dividends paid   -    -    -    (750,000)   -    (750,000)
                               
   Accretion on preferred stock   35,691    -    -    (35,691)   -    - 
                               
   Net income   -    -    -    821,634    -    821,634 
                               
Unrealized holding losses on securities available for sale, net of reclassification adjustment   -    -    -    -    (107,408)   (107,408)
                               
BALANCE, June 30, 2014                              
   $14,928,618   $6,627,398   $21,740,560   $(3,063,508)  $135,887   $40,368,955 

 

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

 

7
 

 

Cornerstone Bancshares, Inc. and Subsidiary

Consolidated Statements of Cash Flows          

 

   Unaudited 
   Six Months Ended June 30, 
   2014   2013 
CASH FLOWS FROM OPERATING ACTIVITIES        
Net income  $821,634   $848,159 
Adjustments to reconcile net income to net cash          
   provided by operating activities:          
Depreciation and amortization   246,093    217,661 
Provision for loan losses   515,000    300,000 
Stock compensation expense   80,000    64,528 
Gain on sale of securities   (402,473)   (424,971)
Net gains on sales of loans and other assets   (25,443)   (201,582)
Changes in other operating assets and liabilities:          
    Accrued interest receivable   (104,597)   60,851 
    Accrued interest payable   (2,243)   (27,094)
    Other assets and liabilities   1,240,336    1,096,992 
Net cash provided by operating activities   2,368,307    1,934,544 
           
CASH FLOWS FROM INVESTING ACTIVITIES          
Proceeds from security sales, maturities, and paydowns:          
    Securities available for sale   12,673,540    21,494,189 
    Securities held to maturity   3,182    5,012 
Purchase of securities available for sale   (3,603,228)   (46,297,289)
Loan originations and principal collections, net   (4,152,593)   (1,822,518)
Purchase of bank premises and equipment   (62,878)   (3,254)
Proceeds from the sale of bank premises and equipment          
     and foreclosed assets   325,144    2,398,465 
Net cash provided by (used in) investing activities   5,183,167    (24,225,395)
           
CASH FLOWS FROM FINANCING ACTIVITIES          
Net decrease in deposits   (10,002,373)   (5,681,328)
Net (decrease) increase in federal funds purchased and          
    securities sold under agreements to repurchase   (1,060,982)   3,319,677 
Net payments on Federal Home Loan Bank          
    advances and other borrowings   (1,740,000)   (5,435,000)
Payment of dividends on preferred stock   (750,000)   (683,893)
Issuance of common stock   191,001    77,019 
Net cash used in financing activities   (13,362,354)   (8,403,525)
           
NET DECREASE IN CASH AND CASH EQUIVALENTS   (5,810,880)   (30,694,376)
           
CASH AND CASH EQUIVALENTS,  beginning of period   24,851,737    59,395,238 
           
CASH AND CASH EQUIVALENTS, end of period  $19,040,857   $28,700,862 
           
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION          
      Cash paid during the period for interest  $1,450,201   $1,908,364 
      Cash paid during the period for taxes   80,010    - 
           
NONCASH INVESTING AND FINANCING ACTIVITIES          
      Acquisition of real estate through foreclosure  $1,316,064   $1,604,806 
      Financed sales of foreclosed assets   433,750    1,329,400 

 

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

 

8
 

 

CORNERSTONE BANCSHARES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

 

 

Note 1. Presentation of Financial Information

 

Nature of Business-Cornerstone is a bank holding company whose primary business is performed by its wholly-owned subsidiary, Cornerstone Community Bank (the “Bank”). The Bank provides a full range of banking services to the Chattanooga, Tennessee market. The Bank has also established a loan production office in Dalton, Georgia to further enhance the Bank’s lending markets.

 

Interim Financial Information (Unaudited)-The financial information in this report for June 30, 2014 and June 30, 2013 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 2013 Annual Report to Shareholders which was furnished to each shareholder of Cornerstone in April of 2014. The consolidated financial statements presented herein conform to U.S. 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, foreclosed assets and deferred tax assets.

 

Consolidation-The accompanying consolidated financial statements include the accounts of Cornerstone and the Bank. 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, total assets or stockholders’ equity as previously reported.

 

Accounting Policies-During interim periods, Cornerstone follows the accounting policies set forth in its Annual Report on Form 10-K for the year ended December 31, 2013 as filed with the Securities and Exchange Commission. Since December 31, 2013, 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.

 

9
 

 

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 and six month periods ended June 30, 2014 and June 30, 2013.

 

   Three Months Ended June 30, 
   2014   2013 
Net income available to common shareholders  $16,638   $3,186 
Weighted average common shares outstanding   6,627,398    6,547,074 
Effect of dilutive stock options   179,888    112,416 
Diluted shares   6,807,286    6,659,490 
Basic earnings per common share  $0.00   $0.00 
Diluted earnings per common share  $0.00   $0.00 

 

   Six Months Ended June 30, 
   2014   2013 
Net income available to common shareholders  $35,943   $62,469 
Weighted average common shares outstanding   6,601,070    6,547,074 
Effect of dilutive stock options   160,068    117,454 
Diluted shares   6,761,138    6,664,528 
Basic earnings per common share  $0.01   $0.01 
Diluted earnings per common share  $0.01   $0.01 

 

For the three and six months ended June 30, 2014, the effects of outstanding antidilutive stock options are excluded from the computation of diluted earnings per common share because the exercise price of such options are higher than the market price. There are 222,435 and 545,075 antidilutive stock options as of June 30, 2014 and 2013, respectively.

  

Note 2. Stock Based Compensation

 

Accounting Policies- Cornerstone, as required by FASB, applies the fair value recognition provisions of ASC 718, “Compensation –Stock Compensation.” For the six month period ended June 30, 2014, $80,000 in compensation cost was charged to earnings related to the vested incentive stock options.

 

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 exercise price for incentive stock options must be not less than 100 percent of the fair market value of the common stock on the date of the grant. The exercise price of 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 incentive stock options vest 30 percent on the second anniversary of the grant date, 60 percent on the third anniversary of the grant date and 100 percent on the fourth anniversary of the grant date, and the non-qualified stock options vest 50 percent on the first anniversary of the grant date and 100 percent on the second anniversary of the grant date. The options expire ten years from the grant date. At June 30, 2014, the total remaining compensation cost to be recognized on non-vested options is approximately $710,000.

 

10
 

 

CORNERSTONE BANCSHARES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

 

A summary of the status of these stock option plans is presented in the following table:

 

           Weighted-    
           Average    
       Weighted   Contractual    
       Average   Remaining  Aggregate 
       Exercisable   Term  Intrinsic 
   Number   Price   (in years)  Value 
Outstanding at December 31, 2013   810,825   $3.51    6.5  Years  $257,570 
      Granted   207,000    2.40      9.9  Years     
      Exercised   -    -         
      Forfeited   (73,640)   5.05         
Outstanding at June 30, 2014   944,185   $3.15   7.2  Years  $382,980 
Options exercisable at June 30, 2014   343,085   $4.92         

 

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 common stock. Only non-qualified stock options may be granted under the Plan. In addition, members of the Board of Directors can be issued options under the Cornerstone 2002 Long-Term Incentive Plan to purchase up to 1,200,000 shares of Cornerstone stock. The options available for issuance to Board members under the 2002 Long-Term Incentive Plan are shared with officers and employees of Cornerstone. 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, at which point they expire. Vesting for options granted are 50% on each of the first and second anniversary of the grant date with full vesting occurring at the second anniversary date. At June 30, 2014, the total remaining compensation cost to be recognized on non-vested options is approximately $160,000. A summary of the status of this stock option plan is presented in the following table:

 

           Weighted-    
           Average    
       Weighted   Contractual    
       Average   Remaining  Aggregate 
       Exercisable   Term  Intrinsic 
   Number   Price   (in years)  Value 
Outstanding at December 31, 2013   190,250   $3.07   6.9 Years  $64,800 
    Granted   80,000    2.40   9.9 Years     
    Exercised   -    -         
    Forfeited   (16,000)   5.44         
Outstanding at June 30, 2014   254,250   $2.71   7.8 Years  $101,100 
Options exercisable at June 30, 2014   151,750   $2.93         

 

The weighted average grant date fair value of all stock options granted during the six months ended June 30, 2014 was $1.30. This was determined using the Black-Scholes option-pricing model with the following weighted-average assumptions:

 

Dividend yield  0.0%
Expected life  8.5 Years
Expected volatility  45.73%
Risk-free interest rate  2.32%

 

11
 

  

CORNERSTONE BANCSHARES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

 

 

Note 3. Securities

 

The amortized cost and fair value of securities available-for-sale and held to maturity at June 30, 2014 and December 31, 2013 are summarized as follows:

 

   June 30, 2014 
       Gross   Gross     
   Amortized   Unrealized   Unrealized   Fair 
   Cost   Gains   Losses   Value 
Debt securities available-for-sale:                    
U.S. Government agencies  $690,436   $1,202   $-   $691,638 
                     
State and municipal securities   10,446,393    460,705    (7144)   10,899,954 
                     
Mortgage-backed securities:                    
Residential mortgage guaranteed by GNMA or FNMA   5,148,549    32,338    (1,002)   5,179,885 
                     
Collateralized mortgage obligations issued or guaranteed by U.S. Government agencies or sponsored agencies   66,791,823    216,798    (465,491)   66,543,130 
                     
    $83,077,201   $711,043   $(473,637)  $83,314,607 
                     
Debt securities held to maturity:                    
Mortgage-backed securities:                    
Residential mortgage guaranteed by GNMA or FNMA  $30,993   $318   $(1)  $31,309 

 

12
 

 

CORNERSTONE BANCSHARES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

 

   December 31, 2013 
         Gross    Gross      
    Amortized    Unrealized    Unrealized    Fair 
Debt securities available-for-sale:   Cost    Gains    Losses    Value 
    U.S. Government agencies  $3,433,216   $48,119   $-   $3,481,335 
                     
    State and municipal securities   14,908,761    425,021    (84,544)   15,249,238 
                     
Mortgage-backed securities:                    
Residential mortgage guaranteed by GNMA or FNMA   7,047,076    85,203    -    7,132,279 
                     
Collateralized mortgage obligations issued or guaranteed by U.S. Government agencies or sponsored agencies   66,408,975    205,025    (268,180)   66,345,820 
                     
   $91,798,028   $763,368   $(352,724)  $92,208,672 
                     
Debt securities held to maturity:                    
    Mortgage-backed securities:                    
       Residential mortgage guaranteed by GNMA or FNMA  $34,165   $862   $-   $35,027 

 

At June 30, 2014, securities with a fair value totaling approximately $ 75 million were pledged to secure public funds, securities sold under agreements to repurchase, as collateral for federal funds purchased from other financial institutions and serve as collateral for borrowings at the Federal Reserve Discount Window and Federal Home Loan Bank.

 

For the six months ended June 30, 2014 and 2013, there were available-for-sale securities sold with proceeds totaling $9,229,167 and $5,328,170, respectively, which resulted in gross gains realized of $402,473 and $424,971, respectively.

 

The amortized cost and estimated market value of securities at June 30, 2014, by contractual maturity, are shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.

 

   Securities Available-for-Sale   Securities Held to Maturity 
   Amortized   Fair   Amortized   Fair 
   Cost   Value   Cost   Value 
Due in one year or less  $-   $-   $-   $- 
Due from one year to five years   900,216    948,320    -    - 
Due from five years to ten years   3,077,554    3,244,206    -    - 
Due after ten years   7,159,059    7,399,066    -    - 
    11,136,829    11,591,592    -    - 
                     
                     
Mortgage-backed securities   71,940,372    71,723,015    30,993    31,309 
                     
   $83,077,201   $83,314,607   $30,993   $31,309 

 

13
 

 

CORNERSTONE BANCSHARES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

 

The following tables present the gross unrealized losses and fair value, aggregated by investment category and length of time that individual securities available-for-sale have been in a continuous unrealized loss position, as of June 30, 2014 and as of December 31, 2013:

 

    As of June 30, 2014  
    Less than 12 Months     12 Months or Greater     Total  
          Gross           Gross           Gross  
    Fair     Unrealized     Fair     Unrealized     Fair     Unrealized  
    Value     Losses     Value     Losses     Value     Losses  
                                     
State and municipal securities   $ 358,700     $ (318 )   $ 555,000     $ (6,826 )   $ 913,700     $ (7,144 )
                                                 
Residential mortgage guaranteed by GNMA or FNMA     1,409,761       (1,002 )     -       -       1,409,761       (1,002 )
                                                 
Collateralized mortgage obligations issued or guaranteed by U.S. Government agencies or sponsored agencies     17,254,013       (106,428 )     22,935,622       (359,063 )     40,189,635       (465,491 )
    $ 19,022,474     $ (107,748 )   $ 23,490,622     $ (365,889 )   $ 42,513,096     $ (473,637 )

 

    As of December 31, 2013  
    Less than 12 Months     12 Months or Greater     Total  
          Gross           Gross           Gross  
    Fair     Unrealized     Fair     Unrealized     Fair     Unrealized  
    Value     Losses     Value     Losses     Value     Losses  
                                     
State and municipal securities   $ 3,025,250     $ (84,544 )   $ -     $ -     $ 3,025,250     $ (84,544 )
                                                 
Collateralized mortgage obligations issued or guaranteed by U.S. Government agencies or sponsored agencies     27,782,942       (221,827 )     8,761,049       (46,353 )     36,543,991       (268,180 )
    $ 30,808,192     $ (306,371 )   $ 8,761,049     $ (46,353 )   $ 39,569,241     $ (352,724 )

 

Upon acquisition of a security, the Bank determines the appropriate impairment model that is applicable.  If the security is a beneficial interest in securitized financial assets, the Bank uses the beneficial interests in securitized financial assets impairment model.  If the security is not a beneficial interest in securitized financial assets, the Bank uses the debt and equity securities impairment model.  The Bank conducts periodic reviews to evaluate each security to determine whether an other-than-temporary impairment has occurred.  The Bank does not have any securities that have been classified as other-than-temporarily-impaired at June 30, 2014 or December 31, 2013.

 

At June 30, 2014 and December 31, 2013, the categories of temporarily impaired securities, and management’s evaluation of those securities, are as follows:

 

14
 

 

CORNERSTONE BANCSHARES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

 

State and municipal securities: At June 30, 2014, two investments in obligations of state and municipal securities had unrealized losses. The Bank believes the unrealized losses on those investments were caused by the interest rate environment and do not relate to the underlying credit quality of the issuers. Because the Bank has the intent and ability to hold those investments for a time necessary to recover their amortized cost bases, which may be until maturity, the Bank does not consider those investments to be other-than-temporarily impaired at June 30, 2014.

 

Mortgage-backed securities: At June 30, 2014, fifteen investments in residential mortgage-backed securities had unrealized losses.  This impairment is believed to be caused by the current interest rate environment.  The contractual cash flows of those investments are guaranteed or issued by an agency of the U.S. Government.  Because the decline in market value is attributable to the current interest rate environment and not credit quality, and because the Bank does not intend to sell the investments and it is not more likely than not that the Bank will be required to sell the investments before recovery of their amortized cost bases, which may be maturity, the Bank does not deem those investments to be other-than-temporarily impaired at June 30, 2014.

 

Note 4. Loans and Allowance for Loan Losses

 

At June 30, 2014 and December 31, 2013, loans are summarized as follows (in thousands):

 

   June 30,   December 31, 
   2014   2013 
Commercial real estate-mortgage:        
    Owner-occupied  $70,808   $65,747 
    All other   71,407    64,052 
Consumer real estate-mortgage   75,603    76,315 
Construction and land development   32,734    41,597 
Commercial and industrial   38,973    38,999 
Consumer and other   2,844    2,730 
Total loans   292,369    289,440 
Less: Allowance for loan losses   (3,330)   (3,203)
           
Loans, net  $289,039   $286,237 

 

The following describe risk characteristics relevant to each of the portfolio segments:

 

Real estate:

 

As discussed below, Cornerstone offers various types of real estate loan products. All loans within this portfolio segment are particularly sensitive to the valuation of real estate:

 

·Commercial real estate-mortgage loans include owner-occupied commercial real estate loans and other commercial real estate loans. Owner-occupied commercial real estate loans to operating businesses are long-term financing of land and buildings. Other commercial real estate loans are generally secured by income producing properties.

 

·Consumer real estate-mortgage loans include loans secured by 1-4 family and multifamily residential properties. These loans are repaid by various means such as a borrower’s income, sale of the property, or rental income derived from the property.

 

15
 

 

CORNERSTONE BANCSHARES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

 

·Construction and land development loans include extensions of credit to real estate developers or investors where repayment is dependent on the sale of the real estate or income generated from the real estate collateral. These loans are repaid through cash flow related to the operations, sale or refinance of the underlying property. This portfolio segment also includes owner-occupied construction loans for commercial businesses for the development of land or construction of a building. These loans are repaid by cash flow generated from the business operation. Real estate loans for income-producing properties such as apartment buildings, office and industrial buildings, and retail shopping centers are repaid from rent income derived from the properties.

 

Commercial and industrial:

 

The commercial and industrial loans include those loans to commercial customers for use in normal business operations to finance working capital needs, equipment purchases, or expansion projects. Loans are repaid by business cash flows. Collection risk in this portfolio is driven by the creditworthiness of the underlying borrower, particularly cash flows from the customers’ business operations.

 

Consumer and other:

 

The consumer loan portfolio segment includes direct consumer installment loans, overdrafts and other revolving credit loans, and educational loans. Loans in this portfolio are sensitive to unemployment and other key consumer economic measures.

 

Cornerstone follows the loan impairment accounting guidance in ASC Topic 310. A loan is considered impaired when, based on current information and events, it is probable that Cornerstone will be unable to collect all amounts due from the borrower in accordance with the contractual terms of the loan. Impaired loans include nonperforming loans and loans modified in troubled debt restructurings where concessions have been granted to borrowers experiencing financial difficulties. These concessions could include a reduction in interest rates, payment extensions, forgiveness of principal, forbearance or other actions intended to maximize collections.

 

The composition of loans by loan classification for impaired and performing loan status at June 30, 2014 and December 31, 2013, is summarized in the tables below (amounts in thousands):

 

June 30, 2014  Commercial   Consumer   Construction   Commercial         
   Real Estate-   Real Estate-   and Land   and   Consumer     
   Mortgage   Mortgage   Development   Industrial   and Other   Total 
Performing loans  $136,940   $72,969   $32,369   $37,365   $2,844   $282,487 
Impaired loans   5,275    2,634    365    1,608    -    9,822 
Total  $142,215   $75,603   $32,734   $38,973   $2,844   $292,369 
                               

 

December 31, 2013   Commercial    Consumer    Construction    Commercial           
    Real Estate-    Real Estate-    and Land    and    Consumer      
    Mortgage    Mortgage    Development    Industrial    and Other    Total 
Performing loans  $121,817   $72,868   $41,228   $37,007   $2,730   $275,650 
Impaired loans   7,982    3,447    369    1,992               - .     13,790 
Total  $129,799   $76,315   $41,597   $38,999   $2,730   $289,440 

 

16
 

 

CORNERSTONE BANCSHARES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

 

 

The following tables show the allowance for loan losses allocation by loan classification for impaired and performing loans as of June 30, 2014 and December 31, 2013 (amounts in thousands):

 

June 30, 2014  Commercial   Consumer   Construction   Commercial         
   Real Estate-   Real Estate-   and Land   and   Consumer     
Allowance related to:  Mortgage   Mortgage   Development   Industrial   and Other   Total 
Performing loans  $1,341   $1,069   $262   $301   $77   $3,050 
Impaired loans   31    140    -    109    -    280 
Total  $1,372   $1,209   $262   $410   $77   $3,330 

 

 

December 31, 2013  Commercial   Consumer   Construction   Commercial         
   Real Estate-   Real Estate-   and Land   and   Consumer     
Allowance related to:  Mortgage   Mortgage   Development   Industrial   and Other   Total 
Performing loans  $1,051   $927   $319   $297   $45   $2,639 
Impaired loans   498    11    -    55    -    564 
Total  $1,549   $938   $319   $352   $45   $3,203 

 

The following tables detail the changes in the allowance for loan losses for the six month period ending June 30, 2014 and year ending December 31, 2013, by loan classification (amounts in thousands):

 

June 30, 2014  Commercial   Consumer   Construction   Commercial         
   Real Estate-   Real Estate-   and Land   and   Consumer     
   Mortgage   Mortgage   Development   Industrial   and Other   Total 
Beginning balance  $1,549   $938   $319   $352   $45   $3,203 
   Charged-off loans   (427)   (350)   (13)   (53)   (37)   (880)
   Recovery of charge-offs   56    42    337    29    28    492 
   Provision for (reallocation of) loan losses   194    579    (381)   82    41    515 
Ending balance  $1,372   $1,209   $262   $410   $77   $3,330 

 

December 31, 2013  Commercial   Consumer   Construction   Commercial         
   Real Estate-   Real Estate-   and Land   and   Consumer     
   Mortgage   Mortgage   Development   Industrial   and Other   Total 
Beginning balance  $2,549   $1,528   $1,241   $809   $14   $6,141 
   Charged-off loans   (1,879)   (842)   (1,193)   (699)   (96)   (4,709)
   Recovery of charge-offs   68    241    1,058    99    5    1,471 
   Provision for (reallocation of) loan losses   811    11    (787)   143    122    300 
Ending balance  $1,549   $938   $319   $352   $45   $3,203 

 

Credit quality indicators:

 

Federal regulations require the Bank to review and classify its assets on a regular basis. To fulfill this requirement, the Bank systematically reviews its loan portfolio to ensure the Bank’s large loan relationships are being maintained within its loan policy guidelines, remain properly underwritten and are properly classified by loan grade. This review process is performed by the Bank's management, internal and external loan review, internal auditors, and state and federal regulators.

 

17
 

 

CORNERSTONE BANCSHARES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

 

The Bank’s loan grading process is as follows:

 

·All loans are assigned a loan grade at the time of origination by the relationship manager. Typically, a loan is assigned a loan grade of “pass” at origination.

 

·Loan relationships greater than or equal to $500 thousand are reviewed by the Bank’s external loan review provider on an annual basis.

  

·Additionally, the Bank’s external loan review provider samples other loan relationships between $100 thousand and $500 thousand with an emphasis on commercial and commercial real estate loans and insider loans.

 

·The Bank’s internal loan review department samples approximately 33 percent of all other loan relationships less than $500 thousand on an annual basis for review.

 

·If a loan is delinquent 60 days or more or a pattern of delinquency exists, the loan will be selected for review.

 

·Generally, all loans on the Bank’s internal watchlist are reviewed annually by internal loan review or external loan review providers.

 

If a loan is classified as a problem asset, it will be assigned one of the following loan grades: substandard, doubtful, and loss. “Substandard” assets must have one or more defined weaknesses and are characterized by the distinct possibility that we will sustain some loss if the deficiencies are not corrected. “Doubtful” assets have the weaknesses of substandard assets with the additional characteristic that the weaknesses make collection or liquidation in full on the basis of currently existing facts, conditions and values questionable, and there is a high possibility of loss. An asset classified “loss” is considered uncollectible and of such little value that continuance as an asset of the institution is not warranted. The regulations also provide for a “special mention” category, described as assets which do not currently expose an institution to a sufficient degree of risk to warrant classification but do possess credit deficiencies or potential weaknesses deserving close attention. When the Bank classifies an asset as substandard or doubtful, a specific allowance for loan losses may be established.

 

The following tables outline the amount of each loan classification and the amount categorized into each risk rating as of June 30, 2014 and December 31, 2013 (amounts in thousands):

 

June 30, 2014  Commercial   Consumer   Construction   Commercial         
   Real Estate-   Real Estate-   and Land   and   Consumer     
   Mortgage   Mortgage   Development   Industrial   and Other   Total 
Pass  $133,731   $70,474   $32,024   $34,419   $2,844   $273,492 
Special mention   4,391    1,553    267    2,745    -    8,956 
Substandard   4,093    3,576    443    1,809    -    9,921 
   $142,215   $75,603   $32,734   $38,973   $2,844   $292,369 

 

December 31, 2013  Commercial   Consumer   Construction   Commercial         
   Real Estate-   Real Estate-   and Land   and   Consumer     
   Mortgage   Mortgage   Development   Industrial   and Other   Total 
Pass  $119,398   $67,444   $40,850   $33,394   $2,730   $263,816 
Special mention   3,538    3,536    73    3,468    -    10,615 
Substandard   6,863    5,335    674    2,137    -    15,009 
   $129,799   $76,315   $41,597   $38,999   $2,730   $289,440 

 

18
 

  

CORNERSTONE BANCSHARES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

 

After the Bank’s independent loan review department completes the loan grade assignment, a loan impairment analysis is performed on loans graded substandard or worse. The following tables present summary information pertaining to impaired loans by loan classification as of June 30, 2014 and December 31, 2013 (in thousands):

 

               For the quarter ended 
   At June 30, 2014   June 30, 2014 
       Unpaid       Average   Interest 
   Recorded   Principal   Related   Recorded   Income 
   Investment   Balance   Allowance   Investment   Recognized 
Impaired loans without a valuation allowance:                    
Commercial real estate – mortgage  $5,139   $5,180   $-   $5,368   $126 
Consumer real estate – mortgage   1,957    1,972    -    2,052    62 
Construction and land development   365    378    -    367    12 
Commercial and industrial   1,249    1,292    -    1,390    23 
Total  $8,710   $8,822   $-   $9,177   $223 
                          
Impaired loans with a valuation allowance:                         
Commercial real estate – mortgage  $136   $145   $31   $823   $3 
Consumer real estate – mortgage   677    688    140    994    19 
Construction and land development   -    -    -    -    - 
Commercial and industrial   359    359    109    390    22 
Total  $1,172   $1,192   $280   $2,207   $44 
Total impaired loans  $9,882   $10,014   $280   $11,384   $267 

 

19
 

   

CORNERSTONE BANCSHARES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

 

               For the year ended 
   At December 31, 2013   December 31, 2013 
       Unpaid       Average   Interest 
   Recorded   Principal   Related   Recorded   Income 
   Investment   Balance   Allowance   Investment   Recognized 
Impaired loans without a valuation allowance:                    
Commercial real estate – mortgage  $5,786   $5,854   $-   $4,657   $340 
Consumer real estate – mortgage   2,177    2,202    -    2,669    96 
Construction and land development   369    383    -    358    23 
Commercial and industrial   1,563    1,621    -    1,857    60 
Total  $9,895   $10,060   $-   $9,541   $519 
                          
Impaired loans with a valuation allowance:                         
Commercial real estate – mortgage  $2,196   $2,285   $498   $4,869   $118 
Consumer real estate – mortgage   1,270    1,281    11    1,353    90 
Construction and land development   -    -    -    177    - 
Commercial and industrial   429    430    55    597    53 
Total  $3,895   $3,996   $564   $6,996   $261 
                          
Total impaired loans  $13,790   $14,056   $564   $16,537   $780 

 

The following tables present an aged analysis of past due loans as of June 30, 2014 and December 31, 2013 (amounts in thousands):

 

June 30, 2014  30-89 Days   Past Due 90                 
   Past Due and   Days or More       Total   Current   Total 
   Accruing   and Accruing   Nonaccrual   Past Due   Loans   Loans 
Commercial real estate-mortgage:                              
     Owner-occupied  $342   $-   $319   $661   $70,147   $70,808 
     All other   -    -    179    179    71,228    71,407 
Consumer real estate-mortgage   954    -    926    1,880    73,723    75,603 
Construction and land development   -    -    44    44    32,690    32,734 
Commercial and industrial   337    -    1,384    1,721    37,252    38,973 
Consumer and other   8    -    -    8    2,836    2,844 
Total  $1,641   $-   $2,852   $4,493   $287,876   $292,369 

 

December 31, 2013  30-89 Days   Past Due 90                 
   Past Due and   Days or More       Total   Current   Total 
   Accruing   and Accruing   Nonaccrual   Past Due   Loans   Loans 
Commercial real estate-mortgage:                              
     Owner-occupied  $678   $-   $838   $1,516   $64,231   $65,747 
     All other   867    -    44    911    63,141    64,052 
Consumer real estate-mortgage   419    -    1,006    1,425    74,890    76,315 
Construction and land development   50    -    47    97    41,500    41,597 
Commercial and industrial   201    -    1,631    1,832    37,167    38,999 
Consumer and other   35    -    -    35    2,695    2,730 
Total  $2,250   $-   $3,566   $5,816   $283,624   $289,440 

 

20
 

  

CORNERSTONE BANCSHARES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

  

Impaired loans also include loans that the Bank has elected to formally restructure when, due to the weakening credit status of a borrower, the restructuring may facilitate a repayment plan that seeks to minimize the potential losses that the Bank may have to otherwise incur. At June 30, 2014 and December 31, 2013, the Bank has loans of approximately $5,006,000 and $5,753,000, respectively, that were modified in troubled debt restructurings. Troubled commercial loans are restructured by specialists within our Special Asset department and all restructurings are approved by committees and credit officers separate and apart from the normal loan approval process. These specialists are trained to reduce the Bank’s overall risk and exposure to loss in the event of a restructuring through obtaining either or all of the following: improved documentation, additional guaranties, increase in curtailments, reduction in collateral terms, additional collateral or other similar strategies.

 

There was one commercial real estate-mortgage loan with a pre-modification and post-modification outstanding recorded investment of $480,000 that was modified as a troubled debt restructuring during the six month period ending June 30, 2014.

 

The following table presents a summary of loans that were modified as troubled debt restructurings during the six month period ending June 30, 2013 (amounts in thousands):

 
       Pre-Modification   Post-Modification 
       Outstanding
Recorded
   Outstanding
Recorded
 
June 30, 2013  Number of Contracts   Investment   Investment 
             
  Commercial real estate-mortgage   2   $555   $555 
  Consumer real estate-mortgage   1    66    66 
  Construction and land development   3    898    898 
  Commercial and industrial   3    2,389    2389 

 

There were no loans that were modified as troubled debt restructurings during the past twelve months and for which there was a subsequent payment default.

 

Note 5. Commitments and Contingent Liabilities

 

Off Balance Sheet Arrangements - 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.

 

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

 

21
 

 

CORNERSTONE BANCSHARES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

 

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 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 customers default on their resulting obligation to the Bank the 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 June 30, 2014 is as follows:

 

Commitments to extend credit  $ 45.9 million
Standby letters of credit  $ 452 thousand

 

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 June 30, 2014 will not have a material effect on Cornerstone’s consolidated financial statements.

 

Note 6. Fair Value Disclosures

 

Fair Value Measurements:

 

Cornerstone uses fair value measurements to record fair value adjustments to certain assets and liabilities and to determine fair value disclosures. In accordance with the “Fair Value Measurements and Disclosures” ASC Topic 820, the fair value of a financial instrument is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Fair value is best determined based upon quoted market prices. In cases where quoted market prices are not available, fair values are based on estimates using present value or other valuation techniques. Those techniques are significantly affected by the assumptions used, including the discount rate and estimates of future cash flows. Accordingly, the fair value estimates may not be realized in an immediate settlement of the instrument.

 

ASC Topic 820 provides a consistent definition of fair value, which focuses on exit price in an orderly transaction between market participants at the measurement date under current market conditions. If there has been a significant decrease in the volume and level of activity for the asset or liability, a change in valuation technique or the use of multiple valuation techniques may be appropriate. In such instances, determining the price at which willing market participants would transact at the measurement date under current market conditions depends on the facts and circumstances and requires the use of significant judgment. The fair value is a reasonable point within the range that is most representative of fair value under current market conditions.

 

ASC Topic 820 also establishes a three-tier 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, as follows:

 

22
 

 

CORNERSTONE BANCSHARES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

 

Level 1 - Quoted prices (unadjusted) in active markets for identical assets or liabilities that Cornerstone has the ability to access.

 

Level 2 - Significant other observable inputs other than Level 1 prices, such as quoted prices for similar assets or liabilities in active markets, quoted prices in markets that are not active and other inputs that are observable or can be corroborated by observable market data.

 

Level 3 - Significant unobservable inputs that reflect a company’s own assumptions about the assumptions that market participants would use in pricing an asset or liability.

 

A financial instrument’s categorization within the valuation hierarchy is based upon the lowest level of input that is significant to the fair value measurement.

 

The following methods and assumptions were used by Cornerstone in estimating fair value disclosures for financial instruments. There have been no changes in the methodologies used at June 30, 2014 and December 31, 2013.

 

Cash and cash equivalents:

 

The carrying amounts of cash and cash equivalents approximate fair values based on the short-term nature of the assets. Cash and cash equivalents are classified as Level 1 of the fair value hierarchy.

 

Securities:

 

Fair values are estimated using pricing models and discounted cash flows that consider standard input factors such as observable market data, benchmark yields, interest rate volatilities, broker/dealer quotes, and credit spreads. Securities classified as available-for-sale are reported at fair value utilizing Level 2 inputs.

 

The carrying value of Federal Home Loan Bank stock approximates fair value based on the redemption provisions of the Federal Home Loan Bank. Federal Home Loan Bank stock is classified as Level 3 of the fair value hierarchy.

 

Loans:

 

For variable-rate loans that reprice frequently and with no significant change in credit risk, fair values are based on carrying values. Fair values for fixed-rate loans are estimated using discounted cash flow analysis, using market interest rates for comparable loans. Loans for which it is probable that payment of interest and principal will not be made in accordance with the contractual terms of the loan agreement are considered impaired. Once a loan is identified as individually impaired, management measures impairment in accordance with ASC Topic 310, “Accounting by Creditors for Impairment of a Loan.” The fair value of impaired loans is estimated using several methods including collateral value, liquidation value and discounted cash flows.

 

Those impaired loans not requiring an allowance represent loans for which the fair value of the expected repayments or collateral exceed the recorded investments in such loans. At June 30, 2014, substantially all of the total impaired loans were evaluated based on the fair value of collateral. The remaining impaired loans were evaluated based on a discounted cash flow methodology. In accordance with ASC Topic 820, these impaired loans with a valuation allowance require classification in the fair value hierarchy. When the fair value of the collateral is based on an observable market price or a current appraised value, Cornerstone records the impaired loan as nonrecurring Level 2. When an appraised value is not available or management determines the fair value of the collateral is further impaired below the appraised value or is based on a discounted cash flow methodology and there is no observable market price, Cornerstone records the impaired loan as nonrecurring Level 3. At December 31, 2013, impaired loans were evaluated based on the fair value of collateral and on the discounted cash flow methodology.

 

Cash surrender value of life insurance:

 

The carrying amounts of cash surrender value of life insurance approximate their fair value. The carrying amount is based on information received from the insurance carriers indicating the financial performance of the policies and the amount Cornerstone would receive should the policies be surrendered. Cornerstone reflects these assets within Level 2 of the valuation hierarchy.

 

23
 

 

CORNERSTONE BANCSHARES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

 

Foreclosed assets:

 

Foreclosed assets, consisting of properties obtained through foreclosure or in satisfaction of loans, is initially recorded at fair value, determined on the basis of current appraisals, comparable sales, and other estimates of value obtained principally from independent sources, adjusted for estimated selling costs. At the time of foreclosure, any excess of the loan balance over the fair value of the real estate held as collateral is treated as a charge against the allowance for loan losses. Gains or losses on sale and any subsequent adjustment to the fair value are recorded as a component of foreclosed assets expense. Foreclosed assets are included in Level 2 of the valuation hierarchy.

 

Deposits:

 

The fair value of deposits with no stated maturity, such as noninterest-bearing and interest-bearing demand deposits, savings deposits, and money market accounts, is equal to the amount payable on demand at the reporting date. The carrying amounts of variable-rate, fixed-term certificates of deposit approximate their fair values at the reporting date. Fair values for fixed-rate certificates of deposit are estimated using a discounted cash flow calculation that applies market interest rates on comparable instruments to a schedule of aggregated expected monthly maturities on time deposits. Generally, Level 3 inputs are utilized in this estimate.

 

Securities sold under agreements to repurchase:

 

The carrying amount of these liabilities approximates their estimated fair value. These liabilities are included in Level 3 of the fair value hierarchy.

 

Federal Home Loan Bank advances and other borrowings:

 

The fair value of these fixed rate advances is estimated based on discounted contractual cash flows using current incremental borrowing rates for similar type borrowing arrangements. These liabilities are included in Level 3 of the fair value hierarchy.

 

Accrued interest:

 

The carrying amounts of accrued interest approximate fair value. Accrued interest is included in Level 3 of the fair value hierarchy.

 

Commitments to extend credit, letters of credit and lines of credit:

 

The fair value of commitments is estimated using the fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the present creditworthiness of the counterparties. For fixed-rate loan commitments, fair value also considers the difference between current levels of interest rates and the committed rates.

 

Assets and liabilities recorded at fair value on a recurring basis are as follows.

 

       Quoted Prices in   Significant   Significant 
       Active Markets   Other   Other 
   Balance as of   for Identical   Observable   Unobservable 
   June 30,   Assets   Inputs   Inputs 
   2014   (Level 1)   (Level 2)   (Level 3) 
Debt securities available-for-sale:                    
                     
U.S. Government agencies  $691,638   $-   $691,638   $- 
State and municipal securities   10,899,954    -    10,899,954    - 
Mortgage-backed securities:                    
Residential mortgage guaranteed by GNMA or FNMA   5,179,885    -    5,179,885    - 
Collateralized mortgage obligations issued or guaranteed by U.S.                    
Government agencies or sponsored agencies   66,543,130    -    66,543,130    - 
                     
Total securities available-for-sale  $83,314,607   $-   $83,314,607   $- 

  

24
 

  

CORNERSTONE BANCSHARES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

 

       Quoted Prices in   Significant   Significant 
       Active Markets   Other   Other 
   Balance as of   for Identical   Observable   Unobservable 
   December 31,   Assets   Inputs   Inputs 
   2013   (Level 1)   (Level 2)   (Level 3) 
Debt securities available-for-sale:                    
                     
U.S. Government agencies  $3,481,335   $-   $3,481,335   $- 
State and municipal securities   15,249,238    -    15,249,238    - 
Mortgage-backed securities:                    
Residential mortgage guaranteed by GNMA or FNMA   7,132,279    -    7,132,279    - 
Collateralized mortgage obligations issued or guaranteed by U.S.                    
Government agencies or sponsored agencies   66,345,820    -    66,345,820    - 
                     
Total securities available-for-sale  $92,208,672   $-   $92,208,672   $- 

  

Cornerstone has no assets or liabilities whose fair values are measured on a recurring basis using Level 3 inputs. Additionally, there were no transfers between Level 1 and Level 2 in the fair value hierarchy.

 

Certain assets and liabilities are measured at fair value on a nonrecurring basis, which means the assets and liabilities are not measured at fair value on an ongoing basis but are subject to fair value adjustments in certain circumstances (for example, when there is evidence of impairment). The tables below present information about assets and liabilities on the balance sheet at June 30, 2014 and December 31, 2013 for which a nonrecurring change in fair value was recorded (amounts in thousands).

 

       Quoted Prices in   Significant   Significant 
       Active Markets   Other   Other 
   Balance as of   for Identical   Observable   Unobservable 
   June 30,   Assets   Inputs   Inputs 
   2014   (Level 1)   (Level 2)   (Level 3) 
                 
Impaired loans  $892   $-   $878   $14 
Foreclosed assets   12,996    -    12,996    - 

 

       Quoted Prices in   Significant   Significant 
       Active Markets   Other   Other 
   Balance as of   for Identical   Observable   Unobservable 
   December 31,   Assets   Inputs   Inputs 
   2013   (Level 1)   (Level 2)   (Level 3) 
Impaired loans  $3,331   $-   $891   $2,440 
Foreclosed assets   12,926    -    12,926    - 

 

25
 

  

CORNERSTONE BANCSHARES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

 

Loans include impaired loans held for investment for which an allowance for loan losses has been calculated based upon the fair value of the loans at June 30, 2014 and December 31, 2013.

 

The carrying amount and estimated fair value of Cornerstone's financial instruments at June 30, 2014 and December 31, 2013 are as follows (in thousands):

 

   June 30, 2014   December 31, 2013 
   Carrying   Estimated   Carrying   Estimated 
   Amount   Fair Value   Amount   Fair Value 
Assets:                
    Cash and cash equivalents  $19,041   $19,041   $24,852   $24,852 
    Securities   83,346    83,346    92,243    92,244 
    Federal Home Loan Bank stock   2,323    2,323    2,323    2,323 
    Loans, net   289,039    289,587    286,237    287,411 
    Cash surrender value of life insurance   1,243    1,243    1,233    1,233 
    Accrued interest receivable   1,083    1,083    978    978 
                     
Liabilities:                    
    Noninterest-bearing demand deposits   65,966    65,966    75,207    75,207 
    Interest-bearing demand deposits   26,242    26,242    24,564    24,564 
    Savings deposits and money market accounts   82,269    82,269    86,330    86,330 
    Time deposits   156,936    158,216    155,314    156,698 
    Federal funds purchased and securities                    
        sold under agreements to repurchase   21,913    21,913    22,974    22,974 
    Federal Home Loan Bank advances                    
       and other borrowings   25,000    25,497    26,740    27,449 
    Accrued interest payable   80    80    82    82 
                     
    Unrecognized financial instruments                    
        (net of contract amount):                    
             Commitments to extend credit   -    -    -    - 
             Letters of credit   -    -    -    - 
             Lines of credit   -    -    -    - 

 

26
 

 

Cornerstone Bancshares, Inc. and Subsidiary

Net Interest Margin Analysis

Taxable Equivalent Basis                      

 

   Three months ended 
   June 30 
(Amounts in thousands)                        
Assets      2014           2013     
   Average   Income/   Yield/   Average   Income/   Yield/ 
Earning assets:  Balance   Expense   Rate   Balance   Expense   Rate 
Loans, net of unearned income  $292,039   $4,225    5.80%  $272,718   $4,079    6.00%
Investment securities   93,074    347    1.64%   102,164    482    2.13%
Other earning assets   15,647    10    0.26%   20,635    15    0.28%
  Total earning assets   400,760   $4,582    4.62%   395,517   $4,576    4.70%
Allowance for loan losses   (3,112)             (5,315)          
Cash and other assets   29,303              39,994           
TOTAL ASSETS  $426,951             $430,196           
                               
Liabilities and Shareholders' Equity                              
                               
Interest-bearing liabilities:                              
Interest-bearing demand deposits  $28,462   $11    0.16%  $25,640   $16    0.24%
Savings deposits   15,054    4    0.11%   12,214    8    0.25%
MMDA's   65,740    61    0.37%   77,206    108    0.56%
Time deposits   160,174    366    0.92%   167,078    455    1.09%
Federal funds purchased and securities                              
  sold under agreements to repurchase   22,580    21    0.37%   20,752    17    0.32%
Federal Home Loan Bank and other borrowings   27,776    263    3.80%   31,740    316    3.99%
  Total interest-bearing liabilities   319,786    726    0.91%   334,630    920    1.10%
Net interest spread       $3,856    3.71%       $3,657    3.60%
Noninterest-bearing demand deposits   65,528              52,401           
Accrued expenses and other liabilities   927              2,100           
Shareholders' equity   40,710              41,065           
TOTAL LIABILITIES AND                              
  SHAREHOLDERS' EQUITY  $426,951             $430,196           
Net yield on earning assets             3.89%             3.77%
                               
Taxable equivalent adjustment:                              
  Loans        0              0      
  Investment securities        33              60      
          Total adjustment        33              60      

  

27
 

 

Cornerstone Bancshares, Inc. and Subsidiary

Net Interest Margin Analysis

Taxable Equivalent Basis                      

 

   Six months ended 
   June 30 
(Amounts in thousands)                        
Assets      2014           2013     
   Average   Income/   Yield/   Average   Income/   Yield/ 
Earning assets:  Balance   Expense   Rate   Balance   Expense   Rate 
Loans, net of unearned income  $291,935   $8,321    5.75%  $274,199   $8,221    6.05%
Investment securities   94,513    777    1.81%   94,495    922    2.27%
Other earning assets   13,760    17    0.25%   26,668    36    0.27%
  Total earning assets   400,208   $9,115    4.63%   395,362   $9,179    4.75%
Allowance for loan losses   (3,109)             (5,622)          
Cash and other assets   29,519              38,781           
TOTAL ASSETS  $426,618             $428,521           
                               
Liabilities and Shareholders' Equity                              
                               
Interest-bearing liabilities:                              
Interest-bearing demand deposits  $28,218   $20    0.14%  $27,031   $35    0.26%
Savings deposits   15,216    7    0.09%   11,919    15    0.25%
MMDA's   65,521    116    0.36%   75,719    219    0.58%
Time deposits   160,278    741    0.93%   167,919    921    1.11%
Federal funds purchased and securities                              
  sold under agreements to repurchase   22,074    39    0.36%   20,920    35    0.34%
Federal Home Loan Bank and other borrowings   29,708    525    3.56%   32,224    656    4.11%
  Total interest-bearing liabilities   321,015    1,448    0.91%   335,732    1,881    1.13%
Net interest spread       $7,667    3.72%       $7,298    3.62%
Noninterest-bearing demand deposits   64,310              49,632           
Accrued expenses and other liabilities   714              2,058           
Shareholders' equity   40,579              41,099           
TOTAL LIABILITIES AND                              
  SHAREHOLDERS' EQUITY  $426,618             $428,521           
Net yield on earning assets             3.90%             3.79%
                               
Taxable equivalent adjustment:                              
  Loans        0              0      
  Investment securities        72              142      
          Total adjustment        72              142      

  

28
 

 

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS (MD&A) OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

Cornerstone is a bank holding company and the parent company of the Bank, a Tennessee banking corporation which operates primarily in and around Chattanooga, Tennessee. The Bank has five full-service banking offices located in Hamilton County, Tennessee, and one loan production office located in Dalton, Georgia. The Bank’s business consists primarily of attracting deposits from the general public and, with these and other funds, originating real estate loans, consumer loans, business loans, and residential and commercial construction loans. The principal sources of income for the Bank are interest and fees collected on loans, fees collected on deposit accounts, and interest and dividends collected on other investments. The principal expenses of the Bank are interest paid on deposits, employee compensation and benefits, office expenses, and other overhead expenses.

 

The following is a discussion of Cornerstone’s financial condition at June 30, 2014 and December 31, 2013 and our results of operations for the three months and six months ended June 30, 2014 and 2013. The purpose of this discussion is to focus on information about Cornerstone’s financial condition and results of operations which is not otherwise apparent from the consolidated financial statements. The following discussion and analysis should be read along with Cornerstone’s consolidated financial statements and the related notes included elsewhere herein.

 

Critical Accounting Policies

 

Cornerstone’s accounting and reporting policies are in accordance with accounting principles generally accepted in the United States of America and conform to general practices within the banking industry. Our significant accounting policies are described in Note 1, “Presentation of Financial Information,” to the consolidated financial statements and are integral to understanding the MD&A. Critical accounting policies include the initial adoption of an accounting policy that has a material impact on our financial presentation as well as accounting estimates reflected in our financial statements that require us to make estimates and assumptions about matters that were highly uncertain at the time. Disclosure about critical estimates is required if different estimates that Cornerstone reasonably could have used in the current period would have a material impact on the presentation of our financial condition, changes in financial condition or results of operations. The following is a description of our critical accounting policies.

 

Allowance for Loan Losses

 

The allowance for loan losses is established and maintained at levels management deems adequate to absorb credit losses inherent in the portfolio as of the balance sheet date. The allowance is increased through the provision for loan losses and reduced through loan charge-offs, net of recoveries. The level of the allowance is based on known and inherent risks in the portfolio, past loan loss experience, underlying estimated values of collateral securing loans, current economic conditions and other factors as well as the level of specific impairments associated with impaired loans. This process involves our analysis of complex internal and external variables and it requires that management exercise judgment to estimate an appropriate allowance.

 

Changes in the financial condition of individual borrowers, economic conditions or changes to our estimated risks could require us to significantly decrease or increase the level of the allowance. Such a change could materially impact Cornerstone’s net income as a result of the change in the provision for loan losses. Refer to Note 1 and 4 in the notes to Cornerstone’s consolidated financial statements for a discussion of Cornerstone’s methodology of establishing the allowance.

 

29
 

 

Estimates of Fair Value

 

Fair value is used on a recurring basis for certain assets and liabilities in which fair value is the primary basis of accounting. Cornerstone’s available-for-sale securities are measured at fair value on a recurring basis. Additionally, fair value is used to measure certain assets and liabilities on a nonrecurring basis. Cornerstone uses fair value on a nonrecurring basis for foreclosed assets and collateral associated with impaired collateral-dependent loans. Fair value is also used in certain impairment valuations, including assessments of goodwill, other intangible assets and long-lived assets.

 

Fair value is the price that could be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants. Estimating fair value in accordance with applicable accounting guidance requires that Cornerstone make a number of significant judgments. Accounting guidance provides three levels of fair value. Level 1 fair value refers to observable market prices for identical assets or liabilities. Level 2 fair value refers to similar assets or liabilities with observable market data. Level 3 fair value refers to assets and liabilities where market prices are unavailable or impracticable to obtain for similar assets or liabilities. Level 3 valuations require modeling techniques, such as discounted cash flow analyses. These modeling techniques incorporate Cornerstone’s assessments regarding assumptions that market participants would use in pricing the asset or the liability.

 

Changes in fair value could materially impact our financial results. Refer to Note 6, “Fair Value Disclosures,” in the notes to Cornerstone’s consolidated financial statements for a discussion of the methodology in calculating fair value.

 

Income Taxes

 

Cornerstone is subject to various taxing jurisdictions where Cornerstone conducts business. Cornerstone estimates income tax expense based on amounts expected to be owed to these jurisdictions. Cornerstone evaluates the reasonableness of our effective tax rate based on a current estimate of annual net income, tax credits, non-taxable income, non-deductible expenses and the applicable statutory tax rates. The estimated income tax expense or benefit is reported in the consolidated statements of income.

 

The accrued tax liability or receivable represents the net estimated amount due or to be received from tax jurisdictions either currently or in the future and is reported in other liabilities or other assets, respectively, in Cornerstone’s consolidated balance sheets. Cornerstone assesses the appropriate tax treatment of transactions and filing positions after considering statutes, regulations, judicial precedent and other pertinent information and maintains tax accruals consistent with management’s evaluation. Changes in the estimate of accrued taxes occur periodically due to changes in tax rates, interpretations of tax laws, the status of examinations by tax authorities and newly enacted statutory, judicial and regulatory guidance that could impact the relative merits of tax positions. These changes, if or when they occur, could impact accrued taxes and future tax expense and could materially affect our financial results.

 

Cornerstone periodically evaluates uncertain tax positions and estimates the appropriate level of tax reserves related to each of these positions. Additionally, Cornerstone evaluates its deferred tax assets for possible valuation allowances based on the amounts expected to be realized. The evaluation of uncertain tax positions and deferred tax assets involves a high degree of judgment and subjectivity. Changes in the results of these evaluations could have a material impact on our financial results. Refer to Note 8, “Income Taxes,” to Cornerstone’s consolidated financial statements set forth in its Annual Report on Form 10-K for the year ended December 31, 2013 for more information.

 

Review of Financial Performance

 

As of June 30, 2014, Cornerstone had total consolidated assets of approximately $420 million, total loans of approximately $292 million, total securities of approximately $83 million, total deposits of approximately $ 331 million and stockholders’ equity of approximately $40 million. Net income for the three and six month period ended June 30, 2014 totaled $409,483 and $821,634, respectively.

 

Results of Operations

 

Net income for the three months ended June 30, 2014 was $409,483 or $0.00 basic earnings per common share, compared to a net income of $396,031 or $0.00 basic earnings per common share, for the same period in 2013. Net income for the six months ended June 30, 2014 was $821,634 or $0.01 basic earnings per common share, compared to a net income of $848,159 or $0.01 basic earnings per common share, for the same period in 2013.

 

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The following table presents our results for the three and six months ended June 30, 2014 compared to the three and six months ended June 30, 2013 (amounts in thousands).

 

       2014-2013           2014-2013     
   Three months   Percent   Dollar   Six months   Percent   Dollar 
   ended June 30,   Increase   Amount   ended June 30,   Increase   Amount 
   2014   2013   (Decrease)   Change   2014   2013   (Decrease)   Change 
Interest income   $ 4,582     $ 4,576       0.13 %   $ 6     $ 9,115     $ 9,179       (0.70 )%   $ (64 )
Interest expense     725       919       (21.11 )%     (194 )     1,448       1,881       (23.02 )%     (433 )
Net interest income                                                                
before provision for loan loss     3,857       3,657       5.47 %     200       7,667       7,298       5.06 %     369  
                                                                 
Provision for loan loss     350       -       -       350       515       300       71.67 %     215  
                                                                 
 Net interest income after                                                                
provision for loan loss     3,507       3,657       (4.10 )%     (150 )     7,152       6,998       2.20 %     154  
                                                                 
Total noninterest income     534       697       (23.39 )%     (163 )     857       1,053       (18.61 )%     (196 )
Total noninterest expense     3,375       3,702       (8.83 )%     (327 )     6,676       6,678       (0.03 )%     (2 )
                                                                 
Income before income taxes     666       652       2.15 %     14       1,333       1,373       (2.91 )%     (40 )
                                                                 
Provision for income taxes     257       256       0.39 %     1       511       525       (2.67 )%     (14 )
                                                                 
Net income   $ 409     $ 396       3.28 %   $ 13     $ 822     $ 848       (3.07 )%   $ (26 )

 

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 June 30, 2014, net interest income before provision for loan loss, increased approximately $200 thousand or 5.47 percent over the same period of 2013. For the six months ended June 30, 2014, net interest income before provision for loan loss increased $369 thousand or 5.06 percent.

 

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 3.71 percent compared to 3.60 percent for the three month periods ended June 30, 2014 and 2013, respectively. The interest rate spread on a tax equivalent basis was 3.72 percent compared to 3.62 percent for the six months periods ended June 30, 2014 and 2013, respectively.

 

The net interest margin on a tax equivalent basis was 3.89 percent and 3.77 percent for the three month periods ended June 30, 2014 and 2013, respectively. The net interest margin on a tax equivalent basis was 3.90 percent and 3.79 percent for the six month periods ended June 30, 2014 and 2013, respectively.

 

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

 

* For the six months period ended June 30, 2014, the Bank’s net interest income has been positively impacted by a reduction in interest expense of the funding of the Bank. The primary savings have been a reduction in the Federal Home Loan Bank balances and a decrease in interest rates on deposit accounts.

 

* The Bank’s loan portfolio yield decreased to 5.80 percent for the three months ended June 30, 2014 compared to 6.00 percent for the three months ended June 30, 2013. Management believes loan yields will continue to see downward pressure during 2014 as customers continue to refinance existing loans and general market conditions. Cornerstone will attempt to increase its outstanding loan balances during 2014 to offset the possible yield reduction.

 

* For the three month period ended June 30, 2014, the Bank’s investment portfolio yield decreased to 1.64 percent compared to 2.13 percent for the same time period in 2013. The decrease in the investment portfolio yield was due to the liquidation of approximately $6.8 million in securities during the second quarter of 2014.

 

* The Bank’s net interest margin increased 11 basis points for the six month period ended June 30, 2014 compared to the six month period ended June 30, 2013. The majority of the increase is due to reduced interest expense relating to decreases in deposit rates and a reduction in FHLB borrowing expense. Management continues to try and adjust the Bank’s balance sheet composition by reducing foreclosed assets and increasing the Bank’s loan balances. Management anticipates continued improvement in the Bank’s net interest margin with the increase in loans and reduction of FHLB advance rates, as they mature, in the next 9 months.

 

Provision for Loan Losses-The provision for loan losses represents a charge to earnings necessary to establish an allowance for loan losses that, in management’s evaluation, should be adequate to provide coverage for the inherent losses on outstanding loans. Cornerstone recorded $350 thousand for the three months ended June 30, 2014. There was no provision for loan losses recorded in the three months ended June 30, 2013 due to the amount of loan loss recoveries that were recorded from previous loans that were charged off. For the six months period ended June 30, 2014, the Bank recorded $515 thousand compared to $300 thousand for the same period in 2013.

 

Noninterest Income-Items reported as noninterest income include service charges on checking accounts, insufficient funds charges, automated clearing house (“ACH”) processing fees and the Bank’s secondary mortgage department earnings. Increases in income derived from service charges and ACH fees are primarily a function of the Bank’s growth while fees from the origination of mortgage loans will often reflect market conditions and fluctuate from period to period.

 

The following table presents the components of noninterest income for the three and six months ended June 30, 2014 and 2013 (dollars in thousands):

 

       2014-2013       2014-2013 
   Three months ended   Percent   Six months ended   Percent 
   June 30,   Increase   June 30,   Increase 
   2014   2013   (Decrease)   2014   2013   (Decrease) 
Service charges on deposit accounts  $210   $201    4.48%  $399   $390    2.31%
Net gains on sale of securities   300    425    (29.41)%   403    425    (5.18)%
Net gains on sale of loans and other assets   6    52    (88.46)%   25    202    (87.62)%
Other noninterest income   18    19    (5.26)%   30    36    (16.67)%
Total noninterest income  $534   $697    (23.39)%  $857   $1,053    (18.61)%

 

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

 

* The Bank sold approximately $6.8 million of securities and recorded a gain of approximately $300 thousand during the second quarter of 2014. For the six months ended June 30, 2014, approximately $9.2 million of securities were sold with a recorded gain of approximately $402 thousand. The Bank chose to liquidate the securities to offset foreclosed asset expense.

 

* During the first six months of 2013, the Bank recorded approximately a $100 thousand fee from the sale of a Small Business Administration ( “SBA”) 7A loan and approximately $88 thousand in gains from the sale of mortgage loans while during the first six months of 2014, the Bank did not sell any SBA loans and the gains from the sale of mortgage loans were approximately $48 thousand.

 

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

 

The following table presents the components of noninterest expense for the three and six months ended June 30, 2014 and 2013 (dollars in thousands).

                 
       2014-2013       2014-2013 
   Three months ended   Percent   Six months ended   Percent 
   June 30,   Increase   June 30,   Increase 
   2014   2013   (Decrease)   2014   2013   (Decrease) 
Salaries and employee benefits  $1,723   $1,623    6.16%  $3,549   $3,220    10.22%
Occupancy and equipment expense   324    340    (4.71)%   633    678    (6.64)%
Foreclosed assets expense, net   363    798    (54.51)%   713    927    (23.09)%
FDIC depository insurance   164    161    1.86%   319    321    (0.62)%
Other operating expense   801    780    2.69%   1,462    1,532    (4.57)%
Total noninterest expense  $3,375   $3,702    (8.83)%  $6,676   $6,678    (0.03)%

 

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

 

* Cornerstone’s employee expense increased when comparing both the three and six months ended June 30, 2014 and June 30, 2013. The increase is primarily attributable to the Bank addressing employee wage increases that were not provided for in the past three years. In addition, during the six months ended June 30, 2014, the Bank recorded compensation expense in the amount of $196 thousand for stock grants issued to the Board of Directors and stock options issued to the employees versus none in the first six months of June 2013. Management does not anticipate additional stock grants or stock options to be issued in 2014.

 

* For the six month period ended June 30, 2014, the Bank recorded approximately $713 thousand in foreclosed assets expense compared to approximately $927 thousand during the six months ended June 30, 2013. The decrease in foreclosed asset expense can be attributed to a reduction of approximately $5.9 million in foreclosed assets from June 30, 2013 through June 30, 2014. For the six month period ended June 30, 2014, the majority of the $713 thousand in foreclosed assets expense was comprised of approximately $535 thousand in appraisal write downs and losses incurred on the disposal of foreclosed assets. The Bank incurred approximately $178 thousand in net carrying cost for its foreclosed assets during the six months ended June 30, 2014. A majority of the incremental expense was due to maintenance and repairs of the existing properties. Management anticipates approximately $1.2 million of expense and write-downs on its foreclosed assets during 2014. Management nets the expense and write-downs of other real estate owned against the income generated from income producing real estate to calculate net foreclosed assets expense.

 

Financial Condition

 

Overview-Cornerstone’s consolidated assets totaled approximately $432 million as of December 31, 2013. As of June 30, 2014, total consolidated assets had decreased approximately $12 million or 2.85 percent to approximately $420 million.

 

Liabilities as of June 30, 2014 and December 31, 2013 totaled approximately $380 million and $392 million, respectively.

 

Stockholders’ equity as of June 30, 2014 and December 31, 2013 totaled approximately $40 million.

 

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Securities-The Bank’s investment portfolio, primarily consisting of collateralized mortgage obligations, mortgage backed securities and municipal securities, amounted to approximately $83 million as of June 30, 2014 compared to approximately $92 million as of December 31, 2013. The primary purposes of the Bank’s investment portfolio is to provide liquidity, satisfy pledging requirements, collateralize the Bank’s repurchase accounts and secure the Bank’s FHLB borrowings.

 

Loans-The composition of loans at June 30, 2014 and at December 31, 2013 and the percentage of each classification to total loans are summarized in the following table (dollars in thousands):

 

   June 30, 2014   December 31, 2013 
   Amount   Percent   Amount   Percent 
Commercial real estate-mortgage                
    Owner-occupied  $70,808    24.22%  $65,747    22.72%
    All other   71,407    24.42%   64,052    22.13%
Consumer real estate-mortgage   75,603    25.86%   76,315    26.37%
Construction and land development   32,734    11.20%   41,597    14.37%
Commercial and industrial   38,973    13.33%   38,999    13.47%
Consumer and other   2,844    0.97%   2,730    0.94%
Total loans   292,369    100.00%   289,440    100.00%
Less:  Allowance for loan losses   (3,330)        (3,203)     
                     
Loans, net  $289,039        $286,237      

 

* The Bank’s gross loans increased from approximately $276 million as of June 30, 2013 to approximately $292 million as of June 30, 2014 or 5.9 percent. The primary increase was in commercial real estate loans as the Bank’s relationship managers are marketing business loan products to business owners and the demand for business property continues to increase in the Chattanooga market. Management anticipates continued loan growth for the remainder of 2014.

 

Allowance for Loan Losses-The allowance for loan losses represents Cornerstone’s assessment of the risks associated with extending credit and its evaluation of the quality of the loan portfolio. Management analyzes the loan portfolio quarterly to determine the adequacy of the allowance for loan losses and the appropriate provisions required to maintain a level considered adequate to absorb anticipated loan losses. The Bank uses a risk based approach to calculate the appropriate loan loss allowance in accordance with guidance issued by the Federal Financial Institutions Examination Council. Although the Bank performs prudent credit underwriting, no assurances can be given that adverse economic circumstances will not result in increased losses in the loan portfolio and require greater provisions for possible loan losses in the future.

 

* During the second quarter of 2014, the Bank recorded $350 thousand in provision expense to the loan loss allowance. The Bank’s net loan charge offs decreased from approximately $1.3 million for the six month period ended June 30, 2013 to approximately $388 thousand for the six month period ended June 30, 2014 or approximately 71 percent. The decrease in net loan charge offs is attributed to the decrease in problem loans. Cornerstone utilizes a ten quarter look-back time frame for its historic loan loss analysis