SMARTFINANCIAL INC. - Quarter Report: 2008 June (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 June 30, 2008

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

For the transition period from __________ to __________

Commission File Number: 000-30497

(Exact name of small business issuer as specified in its charter)

Tennessee		62-1173944
(State or other jurisdiction of incorporation or organization)		(I.R.S. Employer Identification No.)

835 Georgia Avenue Chattanooga, Tennessee		37402
(Address of principal executive offices)		(Zip Code)

423-385-3000		Not Applicable .
(Registrant’s telephone number, including area code)		(Former name, former address and former fiscal
		year, if changes since last report)

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

Yes x No o

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

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

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

Yes o No x

As of June 30, 2008 there were 6,319,718 shares of common stock, $1.00 par value per share, issued and outstanding.

TABLE OF CONTENTS

PART I – CONSOLIDATED FINANCIAL INFORMATION

Item 1. Consolidated Financial Statements and Notes (Unaudited)	2

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 – OTHER INFORMATION

Item 1. Legal Proceedings	19

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	23

Item 6. Exhibits and Reports on Form 8-K	23

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.

PART I. CONSOLIDATED FINANCIAL INFORMATION

CORNERSTONE BANCSHARES, INC. & SUBSIDIARIES

ITEM 1. CONSOLIDATED FINANCIAL STATEMENTS AND NOTES

CONSOLIDATED BALANCE SHEETS

	Unaudited
	June 30,		December 31,
	2008		2007
ASSETS
Cash and due from banks	$	13,038,558	$	14,933,349
Federal funds sold		-		-
Cash and cash equivalents		13,038,558		14,933,349

Securities available for sale		45,764,498		34,751,985
Securities held to maturity		184,010		200,037
Federal Home Loan Bank stock, at cost		2,099,100		1,911,600
Loans, net of allowance for loan losses of $7,386,768 at June 30, 2008 and $13,710,109 at December 31, 2007		371,068,474		369,883,009
Bank premises and equipment, net		6,498,866		6,470,893
Accrued interest receivable		1,795,990		2,407,977
Goodwill and amortizable intangibles		2,899,405		2,941,798
Other assets		10,851,758		10,920,605
Total Assets	$	454,200,659	$	444,421,253

LIABILITIES AND STOCKHOLDERS' EQUITY

Deposits:
Noninterest-bearing demand deposits	$	41,698,204	$	45,284,518
Interest-bearing demand deposits		28,483,315		31,984,590
Savings deposits and money market accounts		45,850,966		49,970,489
Time deposits of $100,000 or more		61,423,622		71,505,272
Time deposits of less than $100,000		136,549,909		114,504,856
Total deposits		314,006,016		313,249,725
Federal funds purchased and securites sold under agreements to repurchase		35,330,126		41,560,355
Federal Home Loan Bank advances and line of credit		66,450,000		47,100,000
Accrued interest payable		293,401		216,086
Other liabilities		1,021,952		5,967,737
Total Liabilities		417,101,495		408,093,903

Stockholders' Equity
Preferred stock - no par value; 2,000,000 shares authorized; no shares issued		-		-
Common stock - $l.00 par value; 10,000,000 shares authorized; 6,522,718 and 6,522,718 issued in 2008 and 2007; 6,319,718 and 6,369,718 outstanding in 2008 and 2007		6,319,718		6,369,718
Additional paid-in capital		20,219,581		20,532,787
Retained earnings		10,517,531		9,317,878
Accumulated other comprehensive income		42,334		106,967
Total Stockholders' Equity		37,099,164		36,327,350
Total Liabilities and Stockholders' Equity	$	454,200,659	$	444,421,253

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

CORNERSTONE BANCSHARES, INC. & SUBSIDIARIES

ITEM 1. CONSOLIDATED FINANCIAL STATEMENTS AND NOTES (continued)

CONSOLIDATED STATEMENTS OF INCOME

	Unaudited				Unaudited
	Three Months Ended				Six Months Ended
	June 30,				June 30,
	2008		2007		2008		2007
INTEREST INCOME
Loans, including fees	$	7,199,680	$	8,292,225	$	14,752,975	$	15,952,120
Investment securities		553,103		420,665		1,051,112		835,427
Federal funds sold		2,230		4,460		4,084		5,091
Other earning assets		1,892		25,737		8,797		57,737
Total interest income		7,756,905		8,743,087		15,816,968		16,850,375

INTEREST EXPENSE
Interest bearing demand accounts		56,570		134,961		123,397		262,811
Money market accounts		191,671		460,901		529,524		936,146
Savings accounts		15,379		19,112		31,186		37,869
Time deposits of more than $100,000		685,347		748,957		1,513,092		1,353,267
Time deposits of less than $100,000		1,421,289		1,277,793		2,828,224		2,495,863
Federal funds purchased and securities sold under agreements to repurchase		170,985		255,124		344,785		493,558
Other borrowings		682,208		572,459		1,323,121		1,022,858
Total interest expense		3,223,449		3,469,307		6,693,329		6,602,372

Net interest income before provision for loan losses		4,533,456		5,273,780		9,123,639		10,248,003
Provision for loan losses		170,000		235,000		487,000		237,000
Net interest income after the provision for loan losses		4,363,456		5,038,780		8,636,639		10,011,003

NONINTEREST INCOME
Service charges and fees		433,489		342,334		838,820		676,802
Net gains / (losses) from sale of loans and other assets		61,779		58,343		9,531		74,055
Other income		29,304		38,727		70,526		80,111
Total noninterest income		524,572		439,404		918,877		830,968

NONINTEREST EXPENSE
Salaries and employee benefits		1,834,678		1,824,901		3,675,710		3,554,991
Occupancy and equipment expense		383,173		365,803		763,054		686,711
Other operating expense		998,140		821,004		1,873,851		1,533,595
Total noninterest expense		3,215,991		3,011,708		6,312,615		5,775,297

Income before provision for income taxes		1,672,037		2,466,476		3,242,901		5,066,674
Provision for income taxes		598,981		902,289		1,154,988		1,850,711

NET INCOME	$	1,073,056	$	1,564,187	$	2,087,913	$	3,215,963

EARNINGS PER COMMON SHARE
Basic net income per common share	$	0.17	$	0.24	$	0.33	$	0.49
Diluted net income per common share	$	0.17	$	0.23	$	0.32	$	0.47

DIVIDENDS DECLARED PER COMMON SHARE	$	0.07	$	0.05	$	0.14	$	0.10

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

CORNERSTONE BANCSHARES, INC. & SUBSIDIARIES

ITEM 1. CONSOLIDATED FINANCIAL STATEMENTS AND NOTES (continued)

CONSOLIDATED STATEMENTS OF CASH FLOWS

	Unaudited
	Six Months Ended June 30,
	2008				2007

CASH FLOWS FROM OPERATING ACTIVITIES
Net income	$	2,087,913		$	3,215,963
Adjustments to reconcile net income to net cash (used in) provided by operating activities:
Depreciation and amortization		281,590			166,882
Provision for loan losses		487,000			237,000
Stock compensation expense		139,800			110,008
Net (Gains) / Losses on sales of loans and other assets		(9,531	)		(73,886	)
Changes in other operating assets and liabilities:
Net change in loans held for sale		202,900			(269,250	)
Accrued interest receivable		611,987			(143,601	)
Deferred income taxes		3,181,110			411,725
Accrued interest payable		77,315			(39,903	)
Other assets and liabilities		(7,716,437	)		(194,426	)
Net cash (used in) provided by operating activities		(656,353	)		3,420,512


CASH FLOWS FROM INVESTING ACTIVITIES
Proceeds from security transactions:
Securities available for sale		17,222,653			3,899,961
Securities held to maturity		16,213			16,103
Purchase of securities available for sale		(28,320,718	)		(4,636,650	)
Purchase of Federal Home Loan Bank stock		(187,500	)		(579,500	)
Loan originations and principal collections, net		(2,186,712	)		(48,102,690	)
Purchase of bank premises and equipment		(267,170	)		(537,105	)
Proceeds from sale of other real estate and other assets		-			1,021,191
Net cash used in investing activities		(13,723,234	)		(48,918,690	)


CASH FLOWS FROM FINANCING ACTIVITIES
Net increase in deposits		756,291			21,796,139
(Decrease) / Increase in federal funds purchased and securities sold under agreements to repurchase		(6,230,229	)		12,013,052
Net proceeds from Federal Home Loan Bank advances and other borrowings		19,350,000			13,500,000
Purchase of common stock		(503,006	)		(30,450	)
Issuance of common stock		-			72,925
Payment of dividends		(888,260	)		(651,888	)
Net cash provided by financing activities		12,484,796			46,699,778

NET (DECREASE) / INCREASE IN CASH AND CASH EQUIVALENTS		(1,894,791	)		1,201,600

CASH AND CASH EQUIVALENTS, beginning of period		14,933,349			17,635,956
CASH AND CASH EQUIVALENTS, end of period	$	13,038,558		$	18,837,556


SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION
Cash paid during the period for interest	$	6,616,014		$	6,642,275
Cash paid during the period for taxes		582,500			1,575,600

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

CORNERSTONE BANCSHARES, INC. & SUBSIDIARIES

ITEM 1. CONSOLIDATED FINANCIAL STATEMENTS AND NOTES (continued)

CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS' EQUITY - Unaudited

For the Six Months Ended June 30, 2008

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

BALANCE, December 31, 2007				$	6,369,718		$	20,532,787		$	9,317,878		$	106,967		$	36,327,350

Issuance of common stock under Director's compensation option plan					-			-			-			-			-

Issuance of common stock under employee compensation option plan					-			-			-			-			-

Employee compensation stock option expense					-			139,800			-			-			139,800

Dividend - $0.14 per share					-			-			(888,260	)		-			(888,260	)

Purchase of common stock					(50,000	)		(453,006	)		-			-			(503,006	)

Comprehensive income:
Net income	$	2,087,913			-			-			2,087,913			-			2,087,913

Other comprehensive income, net of tax:
Unrealized holding gains (losses) on securities available for sale, net of reclassification adjustment		(64,633	)		-			-			-			(64,633	)		(64,633	)

Total comprehensive income	$	2,023,280

BALANCE, June 30, 2008				$	6,319,718		$	20,219,581		$	10,517,531		$	42,334		$	37,099,164

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

Interim Financial Information (Unaudited)-The financial information in this report for June 30, 2008 and June 30, 2007 has not been audited. The information included herein should be read in conjunction with the annual consolidated financial statements and footnotes thereto included in the 2007 Annual Report to Shareholders which was furnished to each shareholder of Cornerstone in March of 2008. The consolidated financial statements presented herein conform to generally accepted accounting principles and to general industry practices. In the opinion of Cornerstone’s management, the accompanying interim financial statements contain all material adjustments, consisting only of normal recurring adjustments necessary to present fairly the financial condition, the results of operations, and cash flows for the interim period. Results for interim periods are not necessarily indicative of the results to be expected for a full year.

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

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

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

Accounting Policies-During interim periods, Cornerstone follows the accounting policies set forth in its 10-K for the year ended December 31, 2007 as filed with the Securities and Exchange Commission. Except as discussed in Note 7, since December 31, 2007 there have been no significant changes in any accounting principles or practices, or in the method of applying any such principles or practices.

Earnings per Common Share- Basic earnings per share (“EPS”) is computed by dividing income available to common shareholders (numerator) by the weighted average number of common shares outstanding during the period (denominator). Diluted EPS is computed by dividing income available to common shareholders (numerator) by the adjusted weighted average number of shares outstanding (denominator). The adjusted weighted average number of shares outstanding reflects the potential dilution occurring if securities or other contracts to issue common stock were exercised or converted into common stock resulting in the issuance of common stock that share in the earnings of the entity.

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 June 30, 2008 and 2007.

	Three Months Ended June 30,
Basic earnings per share calculation:	2008		2007
Numerator: Net income available to common shareholders	$	1,073,056	$	1,564,187

Denominator: Weighted avg. common shares outstanding		6,319,718		6,519,213
Effect of dilutive stock options		168,579		371,871
Diluted Shares		6,488,297		6,891,084

Basic Earnings per share	$	0.17	$	0.24
Diluted Earnings per share	$	0.17	$	0.23

The following is a summary of the basic and diluted earnings per share for the six month periods ended June 30, 2008 and 2007.

	Six Months Ended June 30,
Basic earnings per share calculation:	2008		2007
Numerator: Net income available to common shareholders	$	2,087,913	$	3,215,963

Denominator: Weighted avg. common shares outstanding		6,328,234		6,516,806
Effect of dilutive stock options		199,288		379,463
Diluted Shares		6,527,522		6,896,269

Basic Earnings per share	$	0.33	$	0.49
Diluted Earnings per share	$	0.32	$	0.47

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 June 30, 2008, the compensation cost charged to earnings related to the vested incentive stock options was approximately $140,000, which reduced basic earnings per share by $0.02 per share.

Officer and Employee Plans-Cornerstone has two stock option plans under which officers and employees can be granted incentive stock options or non-qualified stock options to purchase a total of up to 1,420,000 shares of Cornerstone’s common stock. The option price for incentive stock options shall be not less than 100 percent of the fair market value of the common stock on the date of the grant. The non-qualified stock options may be equal to or more or less than the fair market value of the common stock on the date of the grant. The stock options vest at 30 percent on the second and third anniversaries of the grant date and 40 percent on the fourth anniversary. The options expire ten years from the grant date. At June 30, 2008, the total remaining compensation cost to be recognized on non-vested options is approximately $675,000. 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, 2007		715,075		$	6.52		5.5 Years	$	5,177,118
Granted		71,500			7.99
Exercised		-			-
Forfeited		(7,000	)		14.11
Outstanding at June 30, 2008		779,575		$	6.52		5.9 Years	$	2,414,338
Options exercisable at June 30, 2008		571,810		$	4.72

The weighted average grant-date fair value of share options granted during the six months ended June 30, 2008 was $2.23. This was determined using the Black-Scholes option pricing model with the following weighted -average assumptions. Dividend Yield: 1.470%, Expected Life: 8.0 years, Expected Volatility: 20.27%, Risk-free Interest Rate: 4.220%

Board of Directors Plan-Cornerstone has a stock option plan under which members of the Board of Directors, at the formation of the Bank, were granted options to purchase a total of up to 600,000 shares of the Bank's common stock. On October 15, 1997, the Bank stock options were converted to Cornerstone stock options. Only non-qualified stock options may be granted under the Plan. The exercise price of each option equals the market price of Cornerstone’s stock on the date of grant and the option’s maximum term is ten years. Vesting for options granted during 2008, are 50% on the first and second anniversary of the grant date. At June 30, 2008, the total remaining compensation cost to be recognized on non-vested options is approximately $81,000. 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, 2007		69,000	$	11.23		7.7 Years	$	164,214
Granted		12,800		7.99
Exercised		-		-
Forfeited		-		- .
Outstanding at June 30, 2008		81,800	$	10.73		8.4 Years	$	59,875
Options exercisable at June 30, 2008		64,500	$	10.95

Note 3. Stockholder’s Equity

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

Dividend Rate	Declaration Date	Record Date	Payment Date
(per share)
$0.07	February 29, 2008	March 14, 2008	April 4, 2008
$0.07	May 23, 2008	June 15, 2008	July 3, 2008

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

Note 4. Securities

The amortized cost and fair value of securities available-for-sale and held-to-maturity at June 30, 2008 and December 31, 2007 are summarized as follows:

	June 30, 2008 .
			Gross		Gross
	Amortized		Unrealized		Unrealized			Market
	Cost		Gains		Losses			Value
Securities Available-for-Sale:
U.S. Government agencies	$	12,474,471	$	172,517	$	-		$	12,646,988

State and municipal securities		3,433,717		39,598		(45,430	)		3,427,885

Mortgage-backed securities		29,792,167		42,384		(144,926	)		29,689,625

	$	45,700,355	$	254,499	$	(190,356	)	$	45,764,498

Securities Held-to-Maturity:
Mortgage-backed securities	$	184,010	$	676	$	(320	)	$	184,366

	December 31, 2007
			Gross		Gross
	Amortized		Unrealized		Unrealized			Market
	Cost		Gains		Losses			Value
Securities Available-for-Sale:
U.S. Government agencies	$	27,335,992	$	116,624	$	(38,942	)	$	27,413,674

State and municipal securities		3,436,399		66,369		(3	)		3,502,765

Mortgage-backed securities		3,817,522		20,427		(2,403	)		3,835,546

	$	34,589,913	$	203,420	$	(41,348	)	$	34,751,985

Securities Held-to-Maturity:
Mortgage-backed securities	$	200,037	$	424	$	(783	)	$	199,678

At June 30, 2008 approximately $45 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 June 30, 2008 and December 31, 2007 loans are summarized as follows (in thousands):

	June 30, 2008					December 31, 2007
	Amount		Percent			Amount		Percent .
Commercial, financial and agricultural	$	79,893		21.1	%	$	98,065		25.6	%
Real estate-construction		77,971		20.6	%		76,832		20.0	%
Real estate-mortgage		70,527		18.6	%		64,585		16.8	%
Real estate-commercial		144,626		38.3	%		138,074		36.0	%
Consumer loans		5,438		1.4	%		6,037		1.6	%
Total loans	$	378,455		100.0	%	$	383,593		100.0	%

A summary of transactions in the allowance for loan losses for the six months ended June 30, 2008 and year ended December 31, 2007 is as follows:

	June 30,			December 31,
	2008			2007
Balance, beginning of period	$	13,710		$	4,258
Loans charged-off		(7,030	)		(1,075	)
Recoveries of loans previously charged-off		220			118
Provision for loan losses		487			10,409
Balance, end of period	$	7,387		$	13,710

Note 6. Commitments and Contingent Liabilities

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

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 June 30, 2008 is as follows:

Commitments to extend credit		$	62.3 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 June 30, 2008 will not have a material effect on Cornerstone’s consolidated financial statements.

Note 7. Recent Relevant Accounting Pronouncements

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

Cornerstone adopted FASB Statement No. 159 (SFAS 159), “The Fair Value Option for Financial Assets and Financial Liabilities – Including an Amendment of FASB Statement No. 115” in January 2008. This Statement permits entities to choose to measure many financial instruments and certain other items at fair value. Unrealized gains and losses on items for which the fair value option has been elected will be reported in earnings. The objective is to improve financial reporting by providing entities with the opportunity to mitigate volatility in reported earnings caused by measuring related assets and liabilities differently without having to apply complex hedge accounting provisions. This Statement is expected to expand the use of fair value measurement, which is consistent with the FASB’s long-term measurement objectives for accounting for financial instruments. Cornerstone has not elected the fair value option for any financial assets or liabilities at June 30, 2008.

CORNERSTONE BANCSHARES, INC.

CONSOLIDATED AVERAGE BALANCE

INTEREST INCOME/EXPENSE AND YIELD/RATES

Taxable Equivalent Basis	Three months ended
(in thousands)	June 30
	2008								2007
	Average			Income/		Yield/			Average			Income/		Yield/
	Balance			Expense		Rate			Balance			Expense		Rate
Assets
Earning assets:
Loans, net of unearned income	$	384,487		$	7,200		7.51	%	$	346,802		$	8,292		9.59	%
Investment securities		48,549			553		4.69	%		36,691			421		4.78	%
Other earning assets		592			4		2.79	%		1,993			30		6.04	%
Total earning assets		433,628		$	7,757		7.19	%		385,486		$	8,743		9.11	%
Allowance for loan losses		(7,515	)							(4,066	)
Cash and other assets		26,132								24,557
TOTAL ASSETS	$	452,245							$	405,977

Liabilities and Shareholder's Equity

Interest bearing liabilities:
Interest bearing demand deposits	$	31,434		$	56		0.72	%	$	38,863		$	135		1.39	%
Savings deposits		7,857			16		0.79	%		7,619			19		1.01	%
MMDA's		46,391			192		1.66	%		42,825			461		4.32	%
Time deposits of $100,000 or less		124,024			1,421		4.60	%		102,634			1,278		4.99	%
Time deposits of $100,000 or more		57,895			685		4.75	%		60,871			749		4.94	%
Federal funds purchased and securities sold under agreements to repurchase		35,817			171		1.91	%		21,467			256		4.78	%
Other borrowings		69,475			682		3.94	%		49,588			572		4.63	%
Total interest bearing liabilities		372,893			3,223		3.47	%		323,867			3,470		4.30	%
Net interest spread				$	4,534		3.72	%				$	5,273		4.82	%
Noninterest bearing demand deposits		42,375								38,965
Accrued expenses and other liabilities		(372	)							2,472
Shareholder's equity		37,350								40,674
TOTAL LIABILITIES AND
SHAREHOLDERS' EQUITY	$	452,245							$	405,977
Net yield on earning assets							4.21	%							5.50	%

Taxable equivalent adjustment:
Loans					0								0
Investment securities					14								16
Total adjustment					14								16

CORNERSTONE BANCSHARES, INC.

CONSOLIDATED AVERAGE BALANCE

INTEREST INCOME/EXPENSE AND

YIELD/RATES

Taxable Equivalent Basis	Year-to-Date
(in thousands)	June 30
	2008								2007
	Average			Income/		Yield/			Average			Income/		Yield/
	Balance			Expense		Rate			Balance			Expense		Rate
Assets
Earning assets:
Loans, net of unearned income	$	385,294		$	14,753		7.72	%	$	333,622		$	15,952		9.64	%
Investment securities		45,392			1,051		4.82	%		36,900			835		4.69	%
Other earning assets		394			13		6.60	%		2,072			63		6.13	%
Total earning assets		431,080		$	15,817		7.42	%		372,594		$	16,850		9.13	%
Allowance for loan losses		(9,403	)							(4,131	)
Cash and other assets		27,682								23,675
TOTAL ASSETS	$	449,359							$	392,138

Liabilities and Shareholder's Equity

Interest bearing liabilities:
Interest bearing demand deposits	$	31,821		$	123		0.78	%	$	38,580		$	262		1.37	%
Savings deposits		7,749			31		0.82	%		7,660			38		1.01	%
MMDA's		49,989			530		2.14	%		43,644			936		4.33	%
Time deposits of $100,000 or less		120,590			2,828		4.73	%		101,258			2,496		4.97	%
Time deposits of $100,000 or more		61,632			1,513		4.95	%		54,350			1,353		5.02	%
Federal funds purchased and securities
sold under agreements to repurchase		31,209			345		2.23	%		20,852			494		4.78	%
Other borrowings		64,754			1,323		4.12	%		44,746			1,022		4.61	%
Total interest bearing liabilities		367,744			6,693		3.67	%		311,090			6,602		4.28	%
Net interest spread				$	9,124		3.74	%				$	10,248		4.85	%
Noninterest bearing demand deposits		43,438								38,641
Accrued expenses and other liabilities		939								2,440
Shareholder's equity		37,238								39,967
TOTAL LIABILITIES AND
SHAREHOLDERS' EQUITY	$	449,359							$	392,138
Net yield on earning assets							4.28	%							5.56	%

Taxable equivalent adjustment:
Loans					0								0
Investment securities					34								23
Total adjustment					34								23

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 June 30, 2008 and December 31, 2007 and our results of operations for the three and six months ended June 30, 2008 and 2007. The purpose of this discussion is to focus on information about our financial condition and results of operations which is not otherwise apparent from the consolidated financial statements. The following discussion and analysis should be read along with our consolidated financial statements and the related notes included elsewhere herein.

Review of Financial Performance

As of June 30, 2008 Cornerstone had total consolidated assets of $454.2 million, total loans of $378.5 million, total deposits of $314.0 million and stockholders equity of $37.1 million. Net income for the three and six month period ended June 30, 2008 was $1,073,056 and $2,087,913.

Results of Operations

Net income for the three months ended June 30, 2008 was $1,073,056 or $0.17 basic earnings per share, compared to $1,564,187 or $0.24 basic earnings per share, for the same period in 2007.

The following table presents our results for the three and six months ended June 30, 2008 and 2007 (amounts in thousands).

					2008-2007							2008-2007
	Three months ended				Percent			Six months ended				Percent
	June 30,				Increase			June 30,				Increase
	2008		2007		(Decrease)			2008		2007		(Decrease)
Interest Income	$	7,757	$	8,743		(11.3	)%	$	15,817	$	16,850		(6.1	)%
Interest Expense		3,223		3,469		(7.1	)%		6,693		6,602		1.4	%

Net interest income before provision for loan loss		4,533		5,274		(14.0	)%		9,124		10,248		( 11.0	)%
Provision for Loan Loss		170		235		(27.7	)%		487		237		105.5	%

Net interest income after provision for loan loss		4,363		5,039		(13.4)	%		8,637		10,011		(13.7	)%

Total noninterest income		525		439		19.4	%		919		831		10.6	%
Total noninterest expense		3,216		3,012		6.8	%		6,313		5,775		9.3	%

Income before income taxes		1,672		2,466		(32.2	)%		3,243		5,067		(36.0	)%
Provision for income taxes		599		902		(33.6	)%		1,155		1,851		(37.6	)%

Net Income	$	1,073	$	1,564		(31.4	)%	$	2,088	$	3,216		(35.1	)%

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, 2008, net interest income before the provision for loan loss, decreased $740 thousand or (14.0)% over the same period of 2007. For the six months ended June 30, 2008, net interest income before the provision for loan loss, decreased $1,124 thousand or (11.0)% over the same time of 2007. Cornerstone’s interest rate spread on a tax equivalent basis (which is the difference between the average yield on earning assets and the average rate paid on interest bearing liabilities) was 3.74% for the six month period ended June 30, 2008 compared to 4.85% for the same period in 2007. The net interest margin on a tax equivalent basis was 4.28% for the six month period ended June 30, 2008 compared to 5.56% for the same period in 2007. Management expects that downward pressure will continue to be exerted on the net interest margin for the remainder of 2008. Other matters related to the changes in net interest income, net interest yields and rates, and net interest margin are presented below:

	The Bank’s loan yield declined during the first six months of 2008. The loan yield was 7.72% for the first six months of 2008 compared to 9.64% during the first six months of 2007. The decline in loan yield is primarily attributable to the Federal Reserve Bank’s interest rate reductions that began late 2007.

	For the six month period ended June 30, 2008, the Bank’s investment portfolio resulted in a yield of 4.82% compared to 4.69% for the same time period in 2007. The Bank continues its bias towards loans and is currently purchasing securities primarily for pledging requirements.

	As mentioned previously, the Federal Reserve Bank’s interest rate reductions have impacted the Bank’s loan yield during 2008. The rate reductions have also impacted the Bank’s interest bearing liabilities. Rates on funding sources such as money market and interest checking accounts have been repriced as rate reductions occurred. However, certificate of deposit interest rate adjustments lag behind the repricing of the loan portfolio and are not expected to catch up until the third or fourth quarter of 2008.

Provision for Loan Losses-The provision for loan losses represents a charge to earnings necessary to establish an allowance for loan losses that, in management’s evaluation, should be adequate to provide coverage for the inherent losses on outstanding loans. The provision for loan losses amounted to $487 thousand and $237 thousand for the six months ended June 30, 2008 and 2007, respectively.

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

The following table presents the components of non interest income for the three and six months ended June 30, 2008 and 2007 (dollars in thousands).

					2008-2007							2008-2007
	Three months ended				Percent			Six months ended				Percent
	June 30,				Increase			June 30,				Increase
	2008		2007		(decrease)			2008		2007		(decrease)
Service charges on deposit accounts	$	434	$	342		26.6	%	$	838	$	677		23.9	%
Net gains / (losses) on sale of loans and
Other assets		62		58		5.9	%		10		74		(87.1	)%
Other fee income		29		39		(24.3	)%		71		80		(12.0	)%
Total non interest income	$	525	$	439		19.4	%	$	919	$	831		10.6	%

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

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

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 six months ended June 30, 2008 and 2007 (dollars in thousands).

					2008-2007							2008-2007
	Three months ended				Percent			Six months ended				Percent
	June 30,				Increase			June 30,				Increase
	2008		2007		(decrease)			2008		2007		(decrease)
Salaries and employee benefits	$	1,835	$	1,825		0.5	%	$	3,676	$	3,555		3.4	%
Occupancy and equipment expense		383		366		4.7	%		763		687		11.1	%
Other operating expense		998		821		21.6	%		1,874		1,534		22.2	%
Total non interest expense	$	3,216	$	3,012		6.8	%	$	6,313	$	5,775		9.3	%

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

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

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

Financial Condition

Overview-Cornerstone’s consolidated assets totaled $444.4 million as of December 31, 2007. As of June 30, 2008 total consolidated assets had increased $9.8 million or 2.2% to $454.2 million. The Bank’s loan portfolio was $378.5 million as of June 30, 2008. The minimal growth in the loan portfolio, since December 31, 2007, is attributable to the Bank’s desire to obtain quality loans that are priced appropriately given the risk factors. The Bank’s investment portfolio increased by approximately $11.0 million during the first six months of 2008. The increase in the security portfolio was needed to provide additional liquidity and for pledging requirements. Increases in liabilities are primarily attributable to an increase in Bank and Cornerstone borrowings. The Bank obtained an additional $15 million in Federal Home Loan Bank borrowings at June 30, 2008 when compared to December 31, 2007. Cornerstone increased its outstanding loan with Silverton Bank from $100 thousand at December 31, 2007 to $4.45 million as of June 30, 2008. The Bank also offered a local certificate of deposit special during the second quarter of 2008 to attract additional core funding deposits. As a result of the competitive deposit interest rates and customer service demonstrated by the Bank’s branch personnel, approximately $22.0 million in additional time deposits under $100,000 was obtained during the second quarter of 2008.

Securities-The Bank’s investment portfolio, primarily consisting of Federal Agency, mortgage-backed securities and municipal securities, amounted to $45.9 million as of June 30, 2008 compared to $35.0 million as of December 31, 2007. The primary purpose of the Bank’s investment portfolio is to satisfy pledging requirements to collateralize the Bank’s repurchase accounts.

Loans-The composition of loans at June 30, 2008 and at December 31, 2007 and the percentage (%) of each classification to total loans are summarized in the following table (dollars in thousands):

	June 30, 2008					December 31, 2007
	Amount		Percent			Amount		Percent .
Commercial, financial and agricultural	$	79,893		21.1	%	$	98,065		25.6	%
Real estate-construction		77,971		20.6	%		76,832		20.0	%
Real estate-mortgage		70,527		18.6	%		64,585		16.8	%
Real estate-commercial		144,626		38.3	%		138,074		36.0	%
Consumer loans		5,438		1.4	%		6,037		1.6	%
Total loans	$	378,455		100.0	%	$	383,593		100.0	%

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

	During the first quarter of 2008, the Bank charged off $6 million on one commercial loan relationship. The provision was taken at the end of 2007 as announced in Cornerstone’s Form 10-K, and after an investigation in 2008 the loan was considered a loss. The remaining $1.6 million, of the total $7.6 million relationship, has been paid off with no further loss to the Bank. Management expects minimal recovery from the initial loss recognized.

	The Bank has a loan relationship of $8.0 million with $3.1 million reserved under the Bank’s allowance for loan losses. The borrower is presently operating and current on its debt service obligation. Management believes that the current allocation of loan loss allowance, based on its SFAS 114 estimation, is appropriate.

The following is a summary of changes in the allowance for loan losses for the six months ended June 30, 2008 and for the year ended December 31, 2007 and the ratio of the allowance for loan losses to total loans as of the end of each period (dollars in thousands):

	June 30,			December 31,
	2008			2007
Balance, beginning of period	$	13,710		$	4,258
Loans charged-off		(7,030	)		(1,075	)
Recoveries of loans previously charged-off		220			118
Provision for loan losses		487			10,409
Balance, end of period	$	7,387		$	13,710

Total Loans	$	378,455		$	383,593

Ratio of allowance for loan losses to loans outstanding at the end of the period		1.95	%		3.57	%

Ratio of net charge-offs to total loans outstanding for the period		1.80	%		0.25	%

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

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

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

	June 30,			December 31,
.	2008			2007
Non-accrual loans	$	1,604		$	685
Repossessed assets		13			0
Foreclosed properties		1,374			1,038
Total non-performing assets	$	2,991		$	1,723

Total loans outstanding	$	378,455		$	383,593

Ratio of nonperforming assets to total loans outstanding at the end of the period		0.79	%		0.45	%

Ratio of nonperforming assets to total allowance for loan losses at end of period		40.49	%		12.57	%

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

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

	June 30, 2008					December 31, 2007 .
Core funding:	Amount		Percent			Amount		Percent
Non interest bearing demand deposits	$	41,698		10.1	%	$	45,285		11.3	%
Interest-bearing demand deposits		28,483		6.9	%		31,985		8.0	%
Savings & money market accounts		45,851		11.1	%		49,970		12.4	%
Time deposits under $100,000		136,550		33.2	%		114,505		28.5	%
Total core funding	$	252,582		61.3	%	$	241,745		60.2	%
Non-core funding:
Time deposit accounts greater than $100,000
Public funds	$	0		0.0	%	$	0		0.0	%
Brokered deposits		1,920		0.5	%		13,255		3.3	%
Other time deposits		59,504		14.5	%		58,250		14.5	%
Federal funds purchased		17,345		4.2	%		28,450		7.1	%
Securities sold under agreements to repurchase		17,985		4.4	%		13,110		3.3	%
Federal Home Loan Bank advances		62,000		15.1	%		47,000		11.7	%
Total non-core funding	$	158,754		38.7	%	$	160,065		39.8	%
Total	$	411,336		100.0	%	$	401,810		100.0	%

	Federal funds purchased are lines of credit established with other financial institutions that allow the Bank to meet short term funding requirements. These lines can be used as frequently as daily with large variations in balances depending upon the Bank’s immediate funding requirements. As of June 30, 2008 the Bank had established $44 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 June 30, 2008 the Bank had borrowed a total of $62 million from the FHLB consisting of structured term loans.

Capital Resources-At June 30, 2008 and December 31, 2007 Cornerstone’s stockholders’ equity amounted to $37.1 million and $36.3 million, respectively.

Cornerstone had total outstanding borrowings of $4.45 million from Silverton Bank as of June 30, 2008. The proceeds from the advance were used to repurchase 200 thousand shares of Cornerstone’s stock during 2007 and 2008 and provide for a $2.5 million capital injection into the Bank. This capital injection resulted in a change in the Bank’s regulatory capital classification from an adequately capitalized position to a well capitalized position. Cornerstone’s line of credit with Silverton Bank consists of an $8.5 million line of credit with an interest rate of prime minus one and a half.

Market and Liquidity Risk Management

Interest Rate Sensitivity

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

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

Liquidity Risk Management

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

Item 3. Quantitative and Qualitative Disclosures About Market Risk

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

Item 4. Controls and Procedures

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

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 Proceeds

ISSUER PURCHASES OF EQUITY SECURITIES

(d) Maximum Number of

(a) Total Number of

(b) Average Price

Purchased as Part of

Shares that May Yet be

Period

Shares Purchased

Paid Per Share

Publically Announced Plans

Purchased Under the Plan

Prior to 2008

153,000

11.47

150,000

Jan. 2008

50,000

10.00

50,000

Total

203,000

11.11

200,000

Item 3. Defaults Upon Senior Securities

None

Item 4. Submission of Matters to a Vote of Security Holders

Cornerstone’s annual shareholder meeting was held on April 17, 2008. At the meeting, the individuals whose names appear below were elected to Cornerstone’s board of directors. In addition, the shareholders’ ratified the appointment of Hazlett, Lewis & Bieter, PLLC as its independent auditors for the fiscal year ending December 31, 2008. The shareholders’ votes were cast as follows with 5,038,093 or 77.3% of the total shares voting:

Election of Directors	For	Against	Abstain
B. Kenneth Driver	99.9%	0.0%	0.1%
Karl Fillauer	97.4%	0.0%	2.6%
Nathaniel F. Hughes	99.9%	0.0%	0.1%
Gregory B. Jones	99.8%	0.0%	0.2%
Jerry D. Lee	99.9%	0.0%	0.1%
Lawrence Levine	99.9%	0.0%	0.1%
Frank McDonald	99.9%	0.0%	0.1%
Doyce G. Payne, M.D.	99.7%	0.0%	0.3%
Miller Welborn	99.9%	0.0%	0.1%
Billy O. Wiggins	99.9%	0.0%	0.1%
Marsha Yessick	97.3%	0.0%	2.7%

Ratification of Appointment of
Hazlett, Lewis & Bieter, PLLC.	100.0%	0.0%	0.0%

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 23, 2008 reporting earnings results for the fiscal quarter ended December 31, 2007.

(2) Form 8-K dated February 13, 2008 reporting a revision of unaudited earnings results for the 4^th fiscal quarter and fiscal year-ending December 31, 2007.

(3) Form 8-K dated February 29, 2008 reporting the declaration of a cash dividend.

(4) Form 8-K dated April 18, 2008 reporting earnings results for the fiscal quarter ended March 31, 2008.

(5) Form 8-K dated May 23, 2008 reporting the declaration of a cash dividend.

(6) Form 8-K dated July 22, 2008 reporting earnings results for the fiscal quarter ended June 30, 2008.

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: August 7, 2008	/s/ Gregory B. Jones
	Gregory B. Jones,
	Chairman and Chief Executive Officer


Date: August 7, 2008	/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.