SMARTFINANCIAL INC. - Quarter Report: 2007 September (Form 10-Q)

Unassociated Document

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 September 30, 2007

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

For the transition period from __________ to __________.

Commission File Number: 000-30497

(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
(Registrant’s telephone number, including area code)

Not Applicable
(Former name, former address and formal fiscal year, if changes since last report)

Check whether the issuer (1) filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act during the past 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yes x No o

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

Large Accelerated Filer o Accelerated Filer o Non-accelerated Filer x

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

Yes oNo x

As of September 30, 2007 there were 6,519,718 shares of common stock, $1.00 par value per share, issued and outstanding.

CORNERSTONE BANCSHARES, INC.

REPORT ON FORM 10-Q

September 30, 2007

TABLE OF CONTENTS

PART I:
Item 1. Consolidated Financial Statements and Notes (Unaudited)		3
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations		14
Item 3. Quantitative and Qualitative Disclosures about Market Risk		19
Item 4. Evaluation of Controls and Procedures		19

Part II:
Item 1. Legal Proceedings		20
Item 1A. Risk Factors		20
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds		22
Item 3. Defaults Upon Senior Securities		22
Item 4. Submission of Matters to a Vote of Security Holders		22
Item 5. Other Information		22
Item 6. Exhibits and Reports on Form 8-K		22

Signatures		23
Ex-31.1 Section 302 Certification
Ex-31.2 Section 302 Certification
Ex. 32.1 Section 906 Certification
Ex. 32.2 Section 906 Certification

FORWARD-LOOKING STATEMENTS

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

Cornerstone Bancshares, Inc. and Subsidiaries
Consolidated Balance Sheets

PART I — FINANCIAL INFORMATION

Item 1.Financial Statements

	September 30,		December 31,
	2007		2006
	Unaudited
ASSETS
Cash and due from banks	$	13,651,878	$	17,635,956
Federal funds sold		-		-
Cash and cash equivalents		13,651,878		17,635,956

Securities available for sale		33,648,512		32,353,380
Securities held to maturity		209,153		236,169
Federal Home Loan Bank stock, at cost		1,911,600		1,332,100
Loans, net of allowance for loan losses of
$6,780,506 at September 30, 2007
and $4,258,352 at December 31, 2006		367,780,695		305,879,013
Bank premises and equipment, net		6,464,125		6,134,009
Accrued interest receivable		2,433,842		2,120,778
Goodwill and amortizable intangibles		2,969,816		3,046,287
Other assets		6,232,073		6,204,541
Total Assets	$	435,301,694	$	374,942,233

LIABILITIES AND STOCKHOLDERS' EQUITY

Deposits:
Noninterest-bearing demand deposits	$	47,117,210	$	41,722,570
Interest-bearing demand deposits		33,968,360		38,159,718
Savings deposits and money market accounts		63,483,713		56,913,225
Time deposits of $100,000 or more		69,172,011		44,544,335
Time deposits of less than $100,000		120,885,816		94,476,685
Total deposits		334,627,110		275,816,533
Federal funds purchased and securites sold under
agreements to repurchase		15,918,552		19,249,701
Federal Home Loan Bank advances and line of credit		42,000,000		39,500,000
Accrued interest payable		482,371		308,392
Other liabilities		999,967		1,884,342
Total Liabilities		394,028,000		336,758,968

Stockholders' Equity
Preferred stock - no par value; 2,000,000 shares
authorized; no shares issued		-		-
Common stock - $l.00 par value; 10,000,000 shares authorized;
6,522,718 and 6,511,848 issued in 2007 and 2006;
6,519,718 and 6,511,848 outstanding in 2007 and 2006		6,519,718		6,511,848
Additional paid-in capital		22,036,374		21,849,006
Retained earnings		12,678,465		9,881,029
Accumulated other comprehensive income		39,137		(58,618	)
Total Stockholders' Equity		41,273,694		38,183,265
Total Liabilities and Stockholders' Equity	$	435,301,694	$	374,942,233

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

Cornerstone Bancshares, Inc. and Subsidiaries

Consolidated Statements of Income

	Three months ended September 30					Nine months ended September 30
	2007			2006		2007		2006
	Unaudited					Unaudited
INTEREST INCOME
Loans, including fees	$	8,609,851		$	7,022,051	$	24,558,156	$	19,929,219
Investment securities		468,044			418,497		1,303,471		1,170,239
Federal funds sold		29,681			77,953		34,771		104,733
Other earning assets		2,248			15,300		9,645		24,818
Total interest income		9,109,824			7,533,801		25,906,043		21,229,009

INTEREST EXPENSE
Interest bearing demand accounts		122,197			113,932		385,008		311,174
Money market accounts		523,818			575,757		1,459,964		1,517,266
Savings accounts		19,409			18,102		57,278		57,060
Time deposits of less than $100,000		1,351,423			1,055,168		3,847,285		2,774,423
Time deposits of more than $100,000		884,019			528,067		2,237,285		1,417,879
Federal funds purchased		103,629			15,555		507,383		224,619
Securities sold under agreements to repurchase		77,493			36,531		167,297		86,134
Other borrowings		703,215			438,243		1,726,075		986,315
Total interest expense		3,785,203			2,781,355		10,387,575		7,374,870

Net interest income before provision for loan losses		5,324,621			4,752,446		15,518,468		13,854,139
Provision for loan losses		2,963,500			204,800		3,200,500		1,057,800
Net interest income after the provision for loan losses		2,361,121			4,547,646		12,317,968		12,796,339

NONINTEREST INCOME
Service charges		368,771			228,441		1,045,572		635,094
Other income		11,462			189,661		188,231		900,386
Total noninterest income		380,233			418,102		1,233,803		1,535,480

NONINTEREST EXPENSE
Salaries and employee benefits		1,356,769			1,465,236		4,911,759		4,430,732
Occupancy and equipment expense		309,020			281,483		995,731		772,293
Other operating expense		705,200			675,515		2,207,242		2,018,735
Total noninterest expense		2,370,989			2,422,234		8,114,732		7,221,760

Income before provision for income taxes		370,365			2,543,514		5,437,039		7,110,059
Provision for income taxes		(188,971	)		997,065		1,661,740		2,745,323

NET INCOME	$	559,336		$	1,546,449	$	3,775,299	$	4,364,736

EARNINGS PER COMMON SHARE
Basic net income per common share	$	0.09		$	0.24	$	0.58	$	0.68
Diluted net income per common share	$	0.08		$	0.23	$	0.55	$	0.64

DIVIDENDS DECLARED PER COMMON SHARE	$	0.05		$	0.03	$	0.15	$	0.09

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

Cornerstone Bancshares, Inc. and Subsidiaries

Consolidated Statements of Cash Flows

	Nine months ended September 30,
	2007			2006
	Unaudited
CASH FLOWS FROM OPERATING ACTIVITIES
Net income	$	3,775,299		$	4,364,736
Adjustments to reconcile net income
to net cash provided by operating actvities:
Provision for loan losses		3,200,500			1,057,800
Depreciation and amortization		323,783			422,590
Loss / (Gain) on sale of loans held for sale and other assets		111,693			(343,869	)
Changes in other operating assets and liabilities:
Accrued interest receivable		(313,064	)		(343,399	)
Accrued interest payable		173,979			105,838
Other assets and liabilities		(992,322	)		(2,600,752	)
Net cash provided by operating activities		6,279,868			2,662,944


CASH FLOWS FROM INVESTING ACTIVITIES
Purchase of equity investment		-			(3,000,000	)
Purchase of investment securities: AFS		(7,134,291	)		(3,977,766	)
Proceeds from security transactions: AFS		6,093,544			1,602,824
Proceeds from security transactions: HTM		27,001			66,999
Purchase of FHLB Stock		(579,500	)		(279,200	)
Loan originations and principal collections, net		(66,040,065	)		(22,022,147	)
Proceeds from sale of bank equipment		-			1,950,435
Proceeds from sale of other real estate		1,021,191			806,906
Purchase of bank premises and equipment		(683,456	)		(479,587	)
Net cash used in investing activities		(67,295,576	)		(25,331,536	)


CASH FLOWS FROM FINANCING ACTIVITIES
Net increase in deposits		58,810,577			25,933,656
Net decrease in securities sold under agreements to repurchase		(3,331,149	)		(1,809,937	)
Net proceeds from Federal Home Loan Bank advances and other borrowings		2,500,000			11,000,000
Dividends paid on common stock		(978,024	)		(387,974	)
Purchase of common stock		(42,699	)		(62,273	)
Issuance of common stock		72,925			333,429
Net cash provided by financing activities		57,031,630			35,006,901

NET (DECREASE) INCREASE IN CASH AND CASH EQUIVALENTS		(3,984,078	)		12,338,309
CASH AND CASH EQUIVALENTS, beginning of period		17,635,956			14,590,499
CASH AND CASH EQUIVALENETS, end of period	$	13,651,878		$	26,928,808


SUPPLEMENTAL DISCLOSURES OF CASH
FLOW INFORMATION
Cash paid during the period for interest	$	10,213,596		$	7,269,032
Cash paid during the period for taxes		2,041,300			2,353,663

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

Cornerstone Bancshares, Inc. and Subsidiaries

Consolidated Statement of Changes in Stockholders' Equity - Unaudited

For the nine months ended September 30, 2007

						Additional						Other			Total
	Comprehensive		Common			Paid-in			Retained			Comprehensive			Stockholders'
	Income		Stock			Capital			Earnings			Income			Equity

BALANCE, December 31, 2006			$	6,511,848		$	21,849,006		$	9,881,029		$	(58,618	)	$	38,183,265

Issuance of common stock				10,870			62,055			-			-			72,925
under employee compensation
option plan

Employee compensation stock				-			165,012			-			-			165,012
option expense

Dividend - $0.15 per share				-			-			(977,863	)		-			(977,863	)

Purchase of common stock				(3,000	)		(39,699	)		-			-			(42,699	)

Comprehensive income:

Net income	$	3,775,299		-			-			3,775,299			-			3,775,299

Other comprehensive income, net of tax:
Unrealized holding gains (losses) on
securities available for sale, net of
reclassification adjustment		97,755		-			-			-			97,755			97,755

Total comprehensive income	$	3,873,054

BALANCE, September 30, 2007			$	6,519,718		$	22,036,374		$	12,678,465		$	39,137		$	41,273,694

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

CORNERSTONE BANCSHARES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

Note 1. Presentation of Financial Information

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

Interim Financial Information (Unaudited)-The financial information in this report for September 30, 2007 and September 30, 2006 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 2006 Annual Report to Shareholders which was furnished to each shareholder of Cornerstone in March of 2007. The consolidated financial statements presented herein conform to generally accepted accounting principles and to general industry practices. In the opinion of Cornerstone’s management, the accompanying interim financial statements contain all material adjustments, consisting only of normal recurring adjustments necessary to present fairly the financial condition, the results of operations, and cash flows for the interim period. Results for interim periods are not necessarily indicative of the results to be expected for a full year.

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

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

Accounting Policies-During interim periods, Cornerstone follows the accounting policies set forth in its 10-K for the year ended December 31, 2006 as filed with the Securities and Exchange Commission. Since December 31, 2006 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.

CORNERSTONE BANCSHARES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

The following is a summary of the basic and diluted earnings per share for the three month periods ended September 30, 2007 and 2006.

	Three Months Ended September 30,
	2007		2006
Basic earnings per share calculation:
Numerator: Net income available to common shareholders	$	559,336	$	1,546,449

Denominator: Weighted avg. common shares outstanding		6,520,081		6,501,630
Effect of dilutive stock options		305,627		323,930
Diluted Shares		6,825,708		6,825,560

Basic Earnings per share	$	0.09	$	0.24
Diluted Earnings per share	$	0.08	$	0.23

The following is a summary of the basic and diluted earnings per share for the nine month periods ended September 30, 2007 and 2006.

	Nine Months Ended September 30,
	2007		2006
Basic earnings per share calculation:
Numerator: Net income available to common shareholders	$	3,775,299	$	4,364,736

Denominator: Weighted avg. common shares outstanding		6,517,236		6,471,364
Effect of dilutive stock options		357,971		334,868
Diluted Shares		6,875,207		6,806,232

Basic Earnings per share	$	0.58	$	0.68
Diluted Earnings per share	$	0.55	$	0.64

Note 2. Stock Based Compensation

Accounting Policies- Cornerstone, as required by FASB, applies the fair value recognition provisions of SFAS No. 123(R) Share-Based Payment. As a result, for the period ended September 30, 2007, the compensation cost charged to earnings related to the vested incentive stock options was approximately $165,000, which reduced basic earnings per share by $0.03 per share.

Officer and Employee Plans-The Company 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 the Company’s common stock. The option price for incentive stock options shall be not less than 100 percent of the fair market value of the common stock on the date of the grant. The non-qualified stock options may be equal to or more or less than the fair market value of the common stock on the date of the grant. The stock options vest at 30 percent on the second and third anniversaries of the grant date and 40 percent on the fourth anniversary. The options expire ten years from the grant date. At September 30, 2007, the total remaining compensation cost to be recognized on non-vested options is approximately $674,000. A summary of the status of this stock option plan is presented in the following table:

	Number			Weighted- Average Exercisable Price		Weighted- Average Contractual Remaining Term (in years)		Aggregate Intrinsic Value (000’s)
Outstanding at December 31, 2006		669,120		$	5.79		6.1 Years	$	7,169,515
Granted		53,800		$	15.24
Exercised		(5,870	)	$	3.77
Forfeited		(1,650	)	$	14.03
Outstanding at September 30, 2007		715,400		$	6.45		5.5 Years	$	5,688,888
Options exercisable at September 30, 2007		470,990		$	4.06

CORNERSTONE BANCSHARES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

The weighted average grant-date fair value of share options granted during the nine months ended September 30, 2007 was $3.33. This was determined using the Black-Scholes option pricing model with the following weighted -average assumptions. Dividend Yield: 1.330%, Expected Life: 7.0 years, Expected Volatility: 12.22%, Risk-free Interest Rate: 4.510%

Board of Directors Plan-The Company has a stock option plan under which members of the Board of Directors, at the formation of the Bank, were granted options to purchase a total of up to 600,000 shares of the Bank's common stock. On October 15, 1997, the Bank stock options were converted to Company stock options. Only non-qualified stock options may be granted under the Plan. The exercise price of each option equals the market price of the Corporation’s stock on the date of grant and the option’s maximum term is ten years. Vesting for options granted during 2007, are 50% on the first and second anniversary of the grant date. At September 30, 2007, the total remaining compensation cost to be recognized on non-vested options is approximately $109,000. A summary of the status of this stock option plan is presented in the following table:

						Weighted-
						Average
				Weighted-		Contractual		Aggregate
				Average		Remaining		Intrinsic
				Exercisable		Term		Value
	Number			Price		(in years)		(000’s)
Outstanding at December 31, 2006		67,000		$	10.61		8.5 Years	$	394,555
Granted		9,000		$	15.24
Exercised		(5,000	)	$	9.32
Forfeited		(2,000	)	$	13.25
Outstanding at September 30, 2007		69,000		$	11.23		7.9 Years	$	211,422
Options exercisable at September 30, 2007		42,000		$	9.45

Note 3. Stockholder’s Equity

During 2007, Cornerstone’s Board of Director declared the following dividends:

Dividend Rate (per share)	Declaration Date	Record Date	Payment Date
$0.05	February 28, 2007	March 16, 2007	April 9, 2007
$0.05	May 29, 2007	June 18, 2007	July 6, 2007
$0.05	August 24, 2007	September 18, 2007	October 5, 2007

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

CORNERSTONE BANCSHARES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

Note 4. Securities

The amortized cost and fair value of securities available-for-sale and held-to-maturity at September 30, 2007 and December 31, 2006 are summarized as follows:

	September 30, 2007
			Gross		Gross
	Amortized		Unrealized		Unrealized			Market
	Cost		Gains		Losses			Value
Securities Available-for-Sale:
U.S. Government agencies	$	26,622,248	$	63,505	$	(95,742	)	$	26,590,011

State and municipal securities		2,914,438		50,805		(11,846	)		2,953,397

Mortgage-backed securities		4,052,516		52,608		(20	)		4,105,104

	$	33,589,202	$	166,918	$	(107,608	)	$	33,648,512

Securities Held-to-Maturity:
Mortgage-backed securities	$	209,153	$	112	$	(493	)	$	208,772

	December 31, 2006
			Gross		Gross
	Amortized		Unrealized		Unrealized			Market
	Cost		Gains		Losses			Value
Securities Available-for-Sale:
U.S. Government agencies	$	26,631,431	$	81,949	$	(243,160	)	$	26,470,220

State and municipal securities		3,209,905		51,952		(12,479	)		3,249,378

Mortgage-backed securities		2,600,860		32,922		-			2,633,782

	$	32,442,196	$	166,823	$	(255,639	)	$	32,353,380

Securities Held-to-Maturity:
Mortgage-backed securities	$	236,169	$	475	$	(455	)	$	236,189

At September 30, 2007 approximately $30 million of Cornerstone’s investment portfolio was pledged to secure public funds and other deposits and securities sold under agreements to repurchase.

Note 5. Loans and Allowance for Loan Losses

At September 30, 2007 and December 31, 2006 loans are summarized as follows (in thousands):

	September 30, 2007					December 31, 2006
	Amount		Percent			Amount		Percent .
Commercial, financial and agricultural	$	101,981		27.2	%	$	98,542		31.8	%
Real estate-construction		73,494		19.6	%		57,606		18.6	%
Real estate-mortgage		59,783		16.0	%		48,700		15.7	%
Real estate-commercial		133,256		35.6	%		99,197		32.0	%
Consumer loans		6,047		1.6	%		6,092		1.9	%
Total loans	$	374,561		100.0	%	$	310,137		100.0	%

CORNERSTONE BANCSHARES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

A summary of transactions in the allowance for loan losses for the periods ended September 30, 2007 and December 31, 2006 is as follows:

	2007			2006
Balance, beginning of period	$	4,258		$	3,545
Loans charged-off		(789	)		(470	)
Recoveries of loans previously charged-off		111			77
Provision for loan losses		3,201			1,106
Balance, end of period	$	6,781		$	4,258

Note 6. Commitments and Contingent Liabilities

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

Standby letters of credit are generally issued on behalf of an applicant (our customer) to a specifically named beneficiary and are the result of a particular business arrangement that exists between the applicant and the beneficiary. Standby letters of credit have fixed expiration dates and are usually for terms of two years or less unless terminated beforehand due to criteria specified in the standby letter of credit. A typical arrangement involves the applicant routinely being indebted to the beneficiary for such items as inventory purchases, insurance, utilities, lease guarantees or other third party commercial transactions. The standby letter of credit would permit the beneficiary to obtain payment from the Bank under certain prescribed circumstances. Subsequently, the Bank would then seek reimbursement from the applicant pursuant to the terms of the standby letter of credit.

The Bank follows the same credit policies and underwriting practices when making these commitments as it does for on-balance sheet instruments. Each customer’s creditworthiness is evaluated on a case-by-case basis, and the amount of collateral obtained, if any, is based on management’s credit evaluation of the customer. Collateral held varies but may include cash, real estate and improvements, marketable securities, accounts receivable, inventory, equipment, and personal property.

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

A summary of the Bank’s total contractual amount for all off-balance sheet commitments at September 30, 2007 is as follows:

Commitments to extend credit		$	80.4 million
Standby letters of credit		$	5.0 million

Various legal claims also arise from time to time in the normal course of business. In the opinion of management, the resolution of claims outstanding at September 30, 2007 will not have a material effect on Cornerstone’s consolidated financial statements.

CORNERSTONE BANCSHARES, INC.
CONSOLIDATED AVERAGE BALANCE
INTEREST INCOME/EXPENSE AND
YIELD/RATES

Taxable Equivalent Basis	Three months ended
(in thousands)	September 30
	2007								2006
	Average			Income/		Yield/			Average			Income/		Yield/
Earning assets:	Balance			Expense		Rate			Balance			Expense		Rate
Assets
Loans, net of unearned income		367,056		$	8,610		9.31	%		287,354		$	7,022		9.70	%
Investment securities		39,390			468		4.83	%		37,078			418		4.64	%
Other earning assets		2,372			32		5.34	%		6,408			94		5.82	%
Total earning assets		408,818		$	9,110		8.85	%		330,840		$	7,534		9.05	%
Allowance for loan losses		(4,916	)							(4,328	)
Cash and other assets		28,317								22,996
TOTAL ASSETS	$	432,218							$	349,508

Liabilities and Shareholder's Equity

Interest bearing liabilities:
Interest bearing demand deposits	$	36,530		$	122		1.33	%	$	33,974		$	114		1.33	%
Savings deposits		7,635			20		1.02	%		7,141			18		1.00	%
MMDA's		49,814			524		4.17	%		50,910			576		4.49	%
Time deposits of $100,000 or less		106,377			1,351		5.04	%		92,220			1,055		4.54	%
Time deposits of $100,000 or more		67,396			884		5.20	%		43,945			528		4.77	%
Federal funds purchased and securities sold under agreements to repurchase		16,294			181		4.41	%		5,708			53		3.68	%
Other borrowings		59,331			703		4.70	%		41,000			437		4.23	%
Total interest bearing liabilities		343,377			3,785		4.37	%		274,898			2,781		4.01	%
Net interest spread				$	5,325		4.48	%				$	4,753		5.04	%
Noninterest bearing demand deposits		44,873								35,752
Accrued expenses and other liabilities		2,239								2,499
Shareholder's equity		41,729								36,359
TOTAL LIABILITIES AND
SHAREHOLDERS' EQUITY	$	432,218							$	349,508
Net yield on earning assets							5.18	%							5.72	%

Taxable equivalent adjustment:
Loans					0								0
Investment securities					11								15
Total adjustment					11								15

CORNERSTONE BANCSHARES, INC.
CONSOLIDATED AVERAGE BALANCE
INTEREST INCOME/EXPENSE AND
YIELD/RATES

Taxable Equivalent Basis	Year-to-Date
(in thousands)	September 30
	2007								2006
	Average			Income/		Yield/			Average			Income/		Yield/
Earning assets:	Balance			Expense		Rate			Balance			Expense		Rate
Assets
Loans, net of unearned income	$	344,890		$	24,558		9.52	%	$	280,166		$	19,929		9.51	%
Investment securities		37,739			1,303		4.74	%		35,936			1,170		4.50	%
Other earning assets		914			44		6.49	%		2,881			129		5.99	%
Total earning assets		383,543		$	25,906		9.04	%		318,983		$	21,228		8.91	%
Allowance for loan losses		(4,396	)							(4,003	)
Cash and other assets		26,498								23,922
TOTAL ASSETS	$	405,645							$	338,902

Liabilities and Shareholder's Equity

Interest bearing liabilities:
Interest bearing demand deposits	$	37,889		$	385		1.36	%	$	34,889		$	311		1.19	%
Savings deposits		7,651			58		1.01	%		7,594			57		1.00	%
MMDA's		45,723			1,460		4.27	%		49,487			1,517		4.10	%
Time deposits of $100,000 or less		102,983			3,847		4.99	%		87,106			2,774		4.26	%
Time deposits of $100,000 or more		58,747			2,237		5.09	%		42,799			1,418		4.43	%
Federal funds purchased and securities sold under agreements to repurchase		19,316			675		4.67	%		9,745			311		4.27	%
Other borrowings		49,661			1,726		4.65	%		33,971			986		3.88	%
Total interest bearing liabilities		321,970			10,388		4.31	%		265,591			7,374		3.71	%
Net interest spread				$	15,518		4.73	%				$	13,854		5.20	%
Noninterest bearing demand deposits		40,741								36,139
Accrued expenses and other liabilities		2,373								2,255
Shareholder's equity		40,561								34,917
TOTAL LIABILITIES AND
SHAREHOLDERS' EQUITY	$	405,645							$	338,902
Net yield on earning assets							5.42	%							5.82	%

Taxable equivalent adjustment:
Loans					0								0
Investment securities					35								38
Total adjustment					35								38

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

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

The following is a discussion of our financial condition at September 30, 2007 and December 31, 2006 and our results of operations for the three and nine months ended September 30, 2007 and 2006. The purpose of this discussion is to focus on information about our financial condition and results of operations which is not otherwise apparent from the consolidated financial statements. The following discussion and analysis should be read along with our consolidated financial statements and the related notes included elsewhere herein.

Review of Financial Performance

As of September 30, 2007 Cornerstone had total consolidated assets of $435.3 million, total loans of $367.7 million, total deposits of $334.6 million and stockholders equity of $41.2 million. Net income for the three and nine month period ended September 30, 2007 was $559,336 and $3,775,299, respectively.

Results of Operations

Net income for the three months ended September 30, 2007 was $559,336 or $0.09 basic earnings per share, compared to $1,546,449 or $0.24 basic earnings per share, for the same period in 2006. The earnings during the three months ended September 30, 2007 represents a 63.9% decrease compared to the three months ended September 30, 2006. Net income for the nine months ended September 30, 2007 was $3,775,299 or $0.58 basic earnings per share, compared to $4,364,736 or $0.68 basic earnings per share, for the same period in 2006. The earnings during the nine months ended September 30, 2007 represents a 13.5% decrease compared to the nine months ended September 30, 2006.

The following table presents our results for the three and nine months ended September 30, 2007 and 2006.

	Three months ended September 30,					2007-2006 Increase Percent			Nine months ended September 30,				2007-2006 Percent Increase
	2007			2006		(Decrease)			2007		2006		(Decrease)
Interest Income	$	9,110		$	7,534		20.9	%	$	25,906	$	21,229		22.0	%
Interest Expense		3,785			2,781		36.1	%		10,388		7,375		40.9	%

Net interest income before
provision for loan loss		5,325			4,753		12.0	%		15,518		13,854		12.0	%
Provision for Loan Loss		2,964			205		1345.9	%		3,200		1,058		202.5	%

Net interest income after
provision for loan loss		2,361			4,548		(48.1	%)		12,318		12,796		(3.7	%)

Total noninterest income		380			418		(9.1	%)		1,234		1,535		(19.6	%)
Total noninterest expense		2,371			2,422		(2.1	%)		8,115		7,222		12.4	%

Income before income taxes		370			2,544		(85.5	%)		5,437		7,109		(23.5	%)
Provision for income taxes		(189	)		997		(119.0	%)		1,662		2,745		(39.5	%)

Net Income	$	559		$	1,547		(63.9	%)	$	3,775	$	4,364		(13.5	%)

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 September 30, 2007, net interest income before the provision for loan loss, increased $572 thousand or 12.0% over the same period of 2006. For the nine months ended September 30, 2007, net interest income before the provision for loan loss, increased $1,664 thousand or 12.0% over the same period of 2006. 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 4.73% for the nine month period ended September 30, 2007 compared to 5.20% for the same period in 2006. The net interest margin on a tax equivalent basis was 5.42% for the nine month period ended September 30, 2007 compared to 5.82% for the same period in 2006. Management expects that downward pressure will continue to be exerted on the net interest margin for the remainder of 2007. Other matters related to the changes in net interest income, net interest yields and rates, and net interest margin are presented below:

The Bank’s loan yield remained consistent for the first nine months of 2007. The loan yield was 9.52% for the first nine months of 2007 compared to 9.51% during the first nine months of 2006. The three month loan yield decreased slightly to 9.31% during 2007 as compared to 9.70% during the three month period ended September 30, 2006. While, the Bank’s lending staff continues to be successful in attracting new loans and selling participations to banks outside of the Bank’s market area, additional competition has intensified in the Bank’s local market resulting in a slight decrease in loan yields for the most current three month period. The Federal Reserve Bank’s recent rate decreases totaling 75 basis points is also placing downward pressure on loan rates.

As mentioned previously, the Bank expects continued pressure on the net interest margin due to market conditions such as increased competition in Cornerstone’s primary deposit market. Therefore, the Bank has elected to grow its funding base with a variety of solutions including local market CD specials, brokered deposits and borrowings from the Federal Home Loan Bank (the “FHLB”). As of September 30, 2007 borrowings from FHLB totaled $42 million with an interest cost of 4.63%. The Bank’s Asset Liability Committee continues to monitor and explore new avenues for depository accounts and funding solutions. An example of this is the Bank’s recent expansion of its electronic payroll processing operations.

For the nine month period ended September 30, 2007, the Bank’s investment portfolio resulted in a yield of 4.74% compared to 4.50% for the same time period in 2006. The Bank continues its bias towards loans and is currently purchasing securities primarily for pledging requirements.

Provision for Loan Losses-The provision for loan losses represents a charge to earnings necessary to establish an allowance for loan losses that, in management’s evaluation, should be adequate to provide coverage for the inherent losses on outstanding loans. The provision for loan losses amounted to $2,964 thousand and $205 thousand for the three months ended September 30, 2007 and 2006, respectively. For the nine months ended September 30, 2007 and 2006 the provision for loan losses amounted to $3,201 thousand and $1,058 thousand, respectively. Other matters relating to the changes in provision for loan losses are presented below:

During the second quarter of 2007, the Bank identified a customer relationship in its asset based lending program totaling $5.5 million in which management detected a suspected fraud. The company responsible for this problem loan is still operating under a forbearance agreement with the bank and is current on all credit obligations. The problem arose out of a suspected fraud and the company’s operations are still considered a source of repayment and if properly managed will be able to satisfy the debt obligations. In accordance with FAS 114, management assigned $2.5 million to the loan loss allowance for this specific credit and anticipates that the amount will adequately provide for any probable shortfalls of collateral if the company were to discontinue operations.

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

The following table presents the components of non interest income for the three and nine months ended September 30, 2007 and 2006 (dollars in thousands).

		Three months ended September 30,			2007-2006 Percent Increase			Nine months ended September 30,			2007-2006 Percent Increase
		2007		2006	(decrease)			2007		2006	(decrease)
Service charges on deposit accounts	$	369	$	228	61.8	%	$	1,046	$	635	64.7	%
Other income		11		190	(94.21	%)		188		900	(79.1	%)
Total non interest income	$	380	$	418	(9.1	%)	$	1,234	$	1,535	(19.6	%)

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

·	Service charges on deposits increased as a result of the growth in demand deposits and interest demand deposits.

The Bank created a new line of business during the first six months of 2007. A major service provider for the payroll processor industry recently terminated most of its processors in order to pursue its core bank lines of business. Cornerstone recognized this as an opportunity and has built the program and infrastructure to service this sector of ACH processing. Currently, the Bank has seven payroll processors processing ACH transactions and expects to add approximately ten more during the remainder of 2007 and 2008.This line of business has the ability to produce a material amount of non-interest income with a relatively low amount of credit and transaction risk.

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

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

The following table presents the components of non interest expense for the three and nine months ended September 30, 2007 and 2006 (dollars in thousands).

	Three months ended September 30,				2007-2006 Percent Increase			Nine months ended September 30,				2007-2006 Percent Increase
	2007		2006		(decrease)			2007		2006		(decrease)
Salaries and employee benefits	$	1,357	$	1,465		(7.4	%)	$	4,912	$	4,431		10.9	%
Occupancy and equipment expense		309		281		10.0	%		996		772		29.0	%
Other operating expense		705		676		4.3	%		2,207		2,019		9.3	%
Total non interest expense	$	2,371	$	2,422		(2.1	%)	$	8,115	$	7,222		12.4	%

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

As of December 2006 Cornerstone had 98 full time equivalent employees. By September 2007, the number of full time equivalent employees had increased to 115. The positions filled by these employees included four additional relationship managers and two employees in the Bank’s ACH processing department. The addition of these employees as well as the additional staff hired should have a positive impact on the Bank’s growth and performance as the year progresses.

Occupancy and equipment expense has increased from prior periods in part due to the relocation of the Bank’s downtown branch and Cornerstone’s corporate headquarters. While the relocation has increased expenses, the Bank’s presence in downtown Chattanooga, Tennessee makes it more accessible to existing customers as well as potential new customers. The Bank also opened two loan production offices during the first half of 2007; one in Knoxville, Tennessee and one in Dalton, Georgia.

In the third quarter of 2007, in accordance with Fin No. 48, Cornerstone had a change in judgment that resulted in the change of a tax position; the impact amounted to a $300 thousand decrease to Cornerstone’s provision for income taxes. The majority of the adjustment involved certain state tax credits relating to the Bank’s investment in a New Market tax credit program and tax deductions resulting from the exercise and disposition of qualified stock options.

Financial Condition

Overview-Cornerstone’s consolidated balance sheet reflects significant growth since December 31, 2006. Total assets increased $60 million or 16.1% from $375 million as of December 31, 2006 to $435 million as of September 30, 2007. The primary component of the growth continues to be the Bank’s loan portfolio. Total loans increased $65 million or 20.8% from $310 as of December 31, 2006 to $375 million as of September 30, 2007.

Securities-The Bank’s investment portfolio, primarily consisting of Federal Agency, mortgage-backed securities and municipal securities, amounted to $33.8 million as of September 30, 2007 compared to $32.6 million as of December 31, 2006. The investment portfolio is intended to provide the Bank with a stable and reliable source of income, collateral for pledging and liquidity.

Loans-The composition of loans at September 30, 2007 and at December 31, 2006 and the percentage (%) of each classification to total loans are summarized in the following table (dollars in thousands):

	September 30, 2007					December 31, 2006
	Amount		Percent			Amount		Percent .
Commercial, financial and agricultural	$	101,981		27.2	%	$	98,542		31.8	%
Real estate-construction		73,494		19.6	%		57,606		18.6	%
Real estate-mortgage		59,783		16.0	%		48,700		15.7	%
Real estate-commercial		133,256		35.6	%		99,197		32.0	%
Consumer loans		6,047		1.6	%		6,092		1.9	%
Total loans	$	374,561		100.0	%	$	310,137		100.0	%

Allowance for Loan Losses-The allowance for loan losses represents Cornerstone’s assessment of the risks associated with extending credit and its evaluation of the quality of the loan portfolio. Management analyzes the loan portfolio to determine the adequacy of the allowance for loan losses and the appropriate provisions required to maintain a level considered adequate to absorb anticipated loan losses. During the first quarter of 2007 the Bank adopted the new Federal Financial Institutions Examination Council guidance pertaining to loan loss allowance. The new guidance states that a financial institution should use a risk based approach to calculate the appropriate loan loss allowance given the risk profile of the Bank’s loan portfolio. Although the Bank performs prudent credit underwriting, no assurances can be given, however, that adverse economic circumstances will not result in increased losses in the loan portfolio and require greater provisions for possible loan losses in the future.

The following is a summary of changes in the allowance for loan losses for the nine months ended September 30, 2007 and for the year ended December 31, 2006 and the ratio of the allowance for loan losses to total loans as of the end of each period (dollars in thousands):

	2007			2006 .
Balance, beginning of period	$	4,258		$	3,545
Loans charged-off		(789	)		(470	)
Recoveries of loans previously charged-off		111			77
Provision for loan losses		3,201			1,106
Balance, end of period	$	6,781		$	4,258

Total Loans	$	374,561		$	310,137

Ratio of allowance for loan losses to loans
outstanding at the end of the period		1.81	%		1.37	%

Ratio of net charge-offs to average loans
outstanding for the period		0.18	%		0.13	%

Non-Performing Assets-The specific economic and credit risks associated with the Bank’s loan portfolio include, but are not limited to, a general downturn in the economy which could affect employment rates in our market area, general real estate market deterioration, interest rate fluctuations, deteriorated or non-existent collateral, title defects, inaccurate appraisals, financial deterioration of borrowers, fraud, and violation of laws and regulations.

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

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

	As of Sept. 30,			As of December 31,
	2007			2006
Non-accrual loans	$	1,286		$	1,102
Repossessed assets		29			0
Foreclosed properties		130			380
Total non-performing assets	$	1,445		$	1,482
Total loans outstanding	$	374,561		$	310,137
Ratio of nonperforming assets to total loans outstanding at the end of the period		0.39	%		0.48	%
Ratio of nonperforming assets to total allowance for loan losses at end of period		21.31	%		34.81	%

Deposits and Other Borrowings-The Bank’s deposits consist of non-interest bearing demand deposits, interest bearing demand accounts, savings and money market accounts, and time deposits. The Bank has agreements with some customers to sell certain of its securities under agreements to repurchase the security the following day. The Bank has also obtained advances from the Federal Home Loan Bank.

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

	September 30, 2007					December 31, 2006 .
	Amount		Percent			Amount		Percent
Core funding:
Non interest bearing demand deposits	$	47,117		12.0	%	$	41,723		12.5	%
Interest-bearing demand deposits		33,968		8.7	%		38,160		11.4	%
Savings & money market accounts		63,484		16.2	%		56,913		17.0	%
Time deposits under $100,000		120,886		30.8	%		94,477		28.2	%
Total core funding		265,455		67.7	%	$	231,273		69.1	%
Non-core funding:
Time deposit accounts greater than $100,000
Public funds	$	0		0.0	%	$	0		0.0	%
Brokered deposits		16,005		4.1	%		1,140		0.3	%
Other time deposits		53,167		13.5	%		43,404		13.0	%
Federal funds purchased		7,185		1.8	%		14,645		4.4	%
Securities sold under agreements to repurchase		8,733		2.2	%		4,605		1.4	%
Federal Home Loan Bank advances		42,000		10.7	%		39,500		11.8	%
Total non-core funding	$	127,090		32.3	%	$	103,294		30.9	%
Total	$	392,545		100.0	%	$	334,567		100.0	%

An additional source of funding for the Bank is brokered deposits. These deposits allow the Bank to obtain deposits at lower interest rates than alternative sources. The deposits are generally purchased in sums of at least $1 million with stated terms and maturities. The Bank has increased the amount of brokered deposits since December 31, 2006 to accommodate the increase in loans during the same time period.

Federal funds purchased are lines of credit established with other financial institutions that allow the Bank to meet short term funding requirements. These lines can be used as frequently as daily with large variations in balances depending upon the Bank’s immediate funding requirements. As of September 30, 2007 the Bank had established $40 million in available federal funds lines.

Federal Home Loan Bank of Cincinnati (the “FHLB”) borrowings are secured by certain qualifying residential mortgage loans and, pursuant to a blanket lien, all qualifying commercial mortgage loans as collateral. Management believes that FHLB borrowings provide an additional source of funding at lower interest rates than alternative sources. The borrowings are structured as either term loans with call and put options after a stated conversion date and an overnight borrowing arrangement. As of September 30, 2007 the Bank had borrowed a total of $42 million from the FHLB consisting of structured term loans.

Capital Resources-At September 30, 2007 and December 31, 2006 Cornerstone’s stockholders’ equity amounted to $41.3 million and $38.2, respectively. On August 19, 2007 Cornerstone’s board of directors authorized a stock repurchase program. The program calls for a repurchase up to 150,000 shares of the company’s outstanding stock. Based upon the company’s current outstanding shares of 6.5 million, the repurchase program represents 2.3% of the total shares outstanding and will be funded through internal cash flow and borrowings by Cornerstone. The repurchases will be made from time to time by the company in the open market as conditions allow and the repurchase plan will be open for one year unless terminated or extended by the board of directors. The number, price and timing of the repurchases will be at the company’s sole discretion and the program may be re-evaluated periodically, depending upon market conditions, liquidity and other factors.

Market and Liquidity Risk Management

Interest Rate Sensitivity

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

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

Liquidity Risk Management

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

Item 3. Quantitative and Qualitative Disclosures About Market Risk

A comprehensive qualitative and quantitative analysis regarding market risk was disclosed in Cornerstone’s Form 10-K for the year ended December 31, 2006. No material changes in the assumptions used in preparing, or results obtained from, the model have occurred since December 31, 2006.

Item 4. Evaluation of Controls and Procedures

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

PART II. OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

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

ITEM 1A. RISK FACTORS

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

Cornerstone may also consider and enter into new lines of business or offer new products or services. Acquisitions and mergers involve a number of risks, including;

·	The time and costs associated with identifying and evaluating potential acquisitions and merger partners;

·	Inaccuracies in the estimates and judgments used to evaluate credit, operations, and management and market risks with respect to the target institution;

·	The time and costs of evaluating new markets, hiring experienced local management and opening new offices, and the time lags between these activities and the generation of sufficient assets and deposits to support the costs of the expansion;

·	Cornerstone’s ability to finance an acquisition and possible dilution to its existing shareholders;

·	The diversion of Cornerstone’s management’s attention to the negotiation of a transaction, and the integration of the operations and personnel of the combining businesses;

·	Entry into new markets where Cornerstone lacks experience;

·	The introduction of new products and services into Cornerstone’s business;

·	The incurrence and possible impairment of goodwill associated with an acquisition and possible adverse short- term effects on Cornerstone’s results of operations; and

·	The risk of loss of key employees and customers.

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

Competition-Much of Cornerstone’s recent growth has been focused in the highly competitive Chattanooga metropolitan markets. We compete with commercial banks, credit unions, savings and loan associations, mortgage banking firms, consumer finance companies, securities brokerage firms, insurance companies, money market funds, and other mutual funds, as well as other community banks and super-regional and national financial institutions that operate offices in Cornerstone’s primary market areas. Cornerstone’s continued expansion into this market may be impacted if it is unable to meet customer demands or compete effectively with the financial institutions operating in these markets. Cornerstone’s historical accomplishments may not be indicative of future results. There is no assurance that existing offices or future offices will maintain or achieve deposit levels, loan balances or other operating results necessary to avoid losses or produce profits.

Economic Conditions-Cornerstone’s success significantly depends upon the growth in population, income levels, deposits and housing starts in its market areas. If the communities in which Cornerstone operates do not grow or prevailing economic conditions locally or nationally are unfavorable, Cornerstone’s business may not succeed. Adverse economic conditions in Cornerstone’s specific market areas could reduce its growth rate, affect the ability of its customers to repay their loans to the Bank and generally affect its financial condition and results of operations.

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

Liquidity-Cornerstone relies on dividends from the Bank as its primary source of funds. The Bank’s primary sources of funds are customer deposits and loan repayments. While scheduled loan repayments are a relatively stable source of funds, they are subject to the ability of borrowers to repay the loans. The borrowers’ resources can be adversely affected by changes in economic conditions, adverse trends or events affecting business industry group, reductions in real estate values or markets, natural disasters or international instability. Accordingly, Cornerstone may be required from time to time to rely on secondary sources of liquidity to accommodate any funding needs. Such sources include Federal Home Loan Bank advances and federal funds lines of credit from correspondent banks. While Cornerstone believes that these sources are currently adequate, there can be no assurance they will be sufficient to meet future liquidity demands. Cornerstone may be required to slow or discontinue loan growth, capital expenditures or other investments or liquidate assets should such sources not be adequate.

Credit Risks-The risk of credit losses varies with, among other things, general economic conditions, the type of loan being made, the creditworthiness of the borrower over the term of the loan and, in the case of a collateralized loan, the value and marketability of the collateral for the loan. Management maintains an allowance for credit losses based upon historical experience and regular analysis of the ultimate collectibility of the loan portfolio. Capital could be significantly adversely affected if these assumptions and adjustments in the allowance for loan losses prove to be inadequate to absorb unforeseen losses.

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

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

Interest Rate Fluctuations-Changes in interest rates may affect Cornerstone’s level of interest income, the primary component of its gross revenue, as well as the level of its interest expense. Interest rates are highly sensitive to many factors that are beyond Cornerstone’s control, including general economic conditions and the policies of various governmental and regulatory authorities. Accordingly, changes in interest rates up or down could ultimately affect Cornerstone’s earnings. Changes in the level of interest rates also may negatively affect the Bank’s ability to originate real estate loans and may lower the value of Cornerstone’s assets.

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

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

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

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

Cornerstone cannot predict the effect, if any, that future sales of its common stock in the market, or availability of shares of its common stock for sale in the market, will have on the market price of Cornerstone’s common stock. The market price of Cornerstone’s common stock may fluctuate in the future, and these fluctuations may be unrelated to its performance. General market price declines or overall market volatility in the future could adversely affect the price of our common stock, and the current market price may not be indicative of future market prices. Cornerstone cannot say with any certainty when a more active and liquid trading market for its common stock will develop or be sustained. Because of this, Cornerstone’s shareholders may not be able to sell their shares at the volumes, prices, or times that they desire.

Ability to Pay Dividends-Cornerstone derives its income solely from dividends on the shares of common stock of the Bank. The Bank’s ability to declare and pay dividends is limited by its obligations to maintain sufficient capital and by other general restrictions on its dividends that are applicable to banks that are regulated by the FDIC and the Tennessee Department of Financial Institutions. In addition, the FRB may impose restrictions on Cornerstone’s ability to pay dividends on its common stock. As a result, Cornerstone cannot assure its shareholders that it will declare or pay dividends on shares of its common stock in the future.

ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCCEDS

None

ITEM 3. DEFAULTS UPON SENIOR SECURITIES

None

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

None

ITEM 5. OTHER INFORMATION

None

ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K

(a) Exhibits

Exhibit Number		Description

31		Certifications under Section 302 of the Sarbanes-Oxley Act of 2002.

32		Certifications under Section 906 of the Sarbanes-Oxley Act of 2002.

(b) Reports on Form 8-K

(1)

Form 8-K dated January 12, 2007 reporting earnings results for the fiscal quarter ended December 31, 2006.

(2)

Form 8-K dated February 28, 2007 reporting the declaration of a cash dividend.

(3)

Form 8-K dated April 16, 2007 reporting earnings results for the fiscal quarter ended March 31, 2007.

(4)

Form 8-K dated May 29, 2007 reporting the declaration of a cash dividend.

(5)

Form 8-K dated July 19, 2007 reporting earnings results for the fiscal quarter ended June 30, 2007.

(6)

Form 8-K dated August 24, 2007 reporting the declaration of a cash dividend.

(7)

Form 8-K dated October 18, 2007 reporting earnings results for the fiscal quarter ended September 30, 2007.

(8)

Form 8-K dated October 19, 2007 reporting the registrants stock repurchase program.

SIGNATURES

In accordance with the requirements of the Exchange Act, the registrant caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.


		Cornerstone Bancshares, Inc.

Date: November 13, 2007		/s/ Gregory B. Jones
		Gregory B. Jones, Chairman and Chief Executive Officer

Date: November 13, 2007		/s/ Nathaniel F. Hughes
		Nathaniel F. Hughes President and Treasurer

EXHIBIT INDEX

Exhibit Number		Description

3		First Amendment to Amended and Restated Charter of Cornerstone Bancshares, Inc. (1)

31		Certifications under Section 302 of the Sarbanes-Oxley Act of 2002.

32		Certifications under Section 906 of the Sarbanes-Oxley Act of 2002.

(1)	Incorporated by reference from Exhibit 3 of the registrant’s Form 10-QSB filed on May 14, 2004.