SMARTFINANCIAL INC. - Quarter Report: 2009 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, 2009

¨	TRANSITION REPORT PURSUANT SECTION 13 OR 15(d) OF THE

SECURITIES EXCHANGE ACT OF 1934

For the transition period from __________to .

Commission File Number: 000-30497

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

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

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

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

Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yes x No ¨

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).

Yes ¨ No ¨

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

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

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

Yes ¨ No x

As of November 9, 2009 there were 6,500,396 shares of common stock, $1.00 par value per share, issued and outstanding.

TABLE OF CONTENTS

PART I –FINANCIAL INFORMATION

Item 1. Financial Statements (Unaudited)			4

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations			22

Item 3. Quantitative and Qualitative Disclosures about Market Risk			30

Item 4T.Controls and Procedures			30

PART II – OTHER INFORMATION
Item 1. Legal Proceedings			30

Item 1A. Risk Factors			30

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds			30

Item 3. Defaults Upon Senior Securities			30

Item 4. Submission of Matters to a Vote of Security Holders			30

Item 5. Other Information			30

Item 6. Exhibits			30

FORWARD-LOOKING STATEMENTS

Cornerstone Bancshares, Inc. (“Cornerstone”) may from time to time make written or oral statements, including statements contained in this report which constitute forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934 (the “Exchange Act”). Forward-looking statements are those not based on historical information, but rather related to future operations, strategies, financial results or other developments. Generally, the words “expect,” “anticipate,” “intend,” “consider,” “plan,” “believe,” “seek,” “should,” “estimate,” and similar expressions may be used to identify such forward-looking statements, but other statements may constitute forward-looking statements. These statements are 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 and speak only as of the date made. Cornerstone’s actual results may differ materially from the results anticipated in forward-looking statements due to a variety of factors. Such factors include, without limitation, those specifically described in Item 1A of Part II of this report and in Cornerstone’s Annual Report on Form 10-K for the year ended December 31, 2008, as well as the following: (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 Dalton, Georgia market, (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 Subsidiary

Consolidated Balance Sheets

PART I — FINANCIAL INFORMATION

Item 1. Financial Statements

	Unaudited
	September 30,		December 31,
	2009		2008
ASSETS

Cash and due from banks	$	73,288,166	$	10,872,390
Federal funds sold		-		11,025,000
Cash and cash equivalents		73,288,166		21,897,390

Securities available for sale		59,134,602		44,056,559
Securities held to maturity		141,352		169,284
Federal Home Loan Bank stock, at cost		2,229,200		2,187,500
Loans, net of allowance for loan losses of $7,398,212 at September 30, 2009 and $9,618,265 at December 31, 2008		341,651,523		378,471,619
Bank premises and equipment, net		8,041,869		8,471,955
Accrued interest receivable		1,712,276		1,771,091
Goodwill and amortizable intangibles		2,560,818		2,840,773
Other assets		20,739,556		11,937,004
Total Assets	$	509,499,362	$	471,803,175

LIABILITIES AND STOCKHOLDERS' EQUITY

Deposits:
Noninterest-bearing demand deposits	$	40,795,512	$	40,077,977
Interest-bearing demand deposits		23,919,357		26,908,572
Savings deposits and money market accounts		31,581,290		35,847,667
Time deposits of $100,000 or more		89,529,840		59,056,590
Time deposits of less than $100,000		200,262,309		164,692,417
Total deposits		386,088,308		326,583,223
Federal funds purchased and securities sold under agreements to repurchase		18,136,273		35,790,246
Federal Home Loan Bank advances and line of credit		72,350,000		71,250,000
Accrued interest payable		753,525		469,586
Other liabilities		867,551		1,208,611
Total Liabilities		478,195,657		435,301,666

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; 6,577,646 issued in 2009 and 6,522,718 issued in 2008; 6,372,937 outstanding in 2009 and 6,319,718 outstanding in 2008		6,372,937		6,319,718
Additional paid-in capital		20,741,824		20,311,638
Retained earnings		3,885,474		10,056,680
Accumulated other comprehensive income		303,470		(186,527	)
Total Stockholders' Equity		31,303,705		36,501,509
Total Liabilities and Stockholders' Equity	$	509,499,362	$	471,803,175

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

Cornerstone Bancshares, Inc. and Subsidiary

Consolidated Statements of Income

	Unaudited					Unaudited
	Three months ended					Nine months ended
	September 30,					September 30,
	2009			2008		2009			2008
INTEREST INCOME
Loans, including fees	$	6,018,409		$	6,977,340	$	18,495,619		$	21,730,315
Investment securities		357,677			482,119		1,157,803			1,533,231
Federal funds sold		30,439			3,014		45,085			15,895
Total interest income		6,406,525			7,462,473		19,698,507			23,279,441

INTEREST EXPENSE
Interest bearing demand accounts		20,554			56,513		76,559			180,030
Money market accounts		55,548			151,946		204,836			681,350
Savings accounts		10,721			15,717		30,879			46,903
Time deposits of more than $100,000		476,611			579,186		1,534,269			2,092,277
Time deposits of less than $100,000		1,407,611			1,322,111		4,214,280			4,150,336
Federal funds purchased and securities sold under agreements to repurchase		37,227			157,141		135,157			501,927
Other borrowings		757,682			744,145		2,231,717			2,067,266
Total interest expense		2,765,954			3,026,759		8,427,697			9,720,089

Net interest income before provision for loan losses		3,640,571			4,435,714		11,270,810			13,559,352
Provision for loan losses		3,390,000			440,000		10,748,898			927,000
Net interest income after the provision for loan losses		250,571			3,995,714		521,912			12,632,352

NONINTEREST INCOME
Service charges		416,908			439,664		1,259,646			1,278,485
Net gains / (losses) from sale of loans and other assets		(262,019	)		18,107		(252,323	)		27,638
Other income		29,343			18,962		170,314			89,487
Total noninterest income		184,232			476,733		1,177,637			1,395,610

NONINTEREST EXPENSE
Salaries and employee benefits		1,622,766			1,856,162		5,331,916			5,531,873
Occupancy and equipment expense		382,601			371,943		1,176,735			1,134,996
Other operating expense		1,273,589			922,932		3,836,405			2,796,781
Total noninterest expense		3,278,956			3,151,037		10,345,056			9,463,650

Income / (loss) before provision for income taxes		(2,844,153	)		1,321,410		(8,645,507	)		4,564,312
Provision / (benefit) for income taxes		(1,144,617	)		461,194		(3,431,673	)		1,616,182

NET INCOME / (LOSS)	$	(1,699,536	)	$	860,216	$	(5,213,834	)	$	2,948,130

EARNINGS / (LOSS) PER COMMON SHARE
Basic net income / ( loss) per common share	$	(0.27	)	$	0.14	$	(0.82	)	$	0.46
Diluted net income / (loss) per common share	$	(0.27	)	$	0.13	$	(0.82	)	$	0.45

DIVIDENDS DECLARED PER COMMON SHARE		-		$	0.07	$	0.10		$	0.21

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

Cornerstone Bancshares, Inc. and Subsidiary

Consolidated Statement of Changes in Stockholders' Equity - Unaudited

For the nine months ended September 30, 2009

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

BALANCE, December 31, 2008				$	6,319,718	$	20,311,638	$	10,056,680		$	(186,527	)	$	36,501,509

Employee compensation stock option expense					-		164,094		-			-			164,094

Dividend - $0.10 per share					-		-		(638,061	)		-			(638,061	)

Stock Dividend					53,219		266,092		(319,311	)		-			-

Comprehensive income / (loss):
Net loss	$	(5,213,834	)		-		-		(5,213,834	)		-			(5,213,834	)

Other comprehensive income, net of tax:
Unrealized holding gains (losses) on securities available for sale, net of reclassification adjustment		489,997			-		-		-			489,997			489,997

Total comprehensive loss	$	(4,723,837	)

BALANCE, September 30, 2009				$	6,372,937	$	20,741,824	$	3,885,474		$	303,470		$	31,303,705

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

Cornerstone Bancshares, Inc. and Subsidiary

Consolidated Statements of Cash Flows

	Unaudited
	Nine months ended September 30,
	2009			2008

CASH FLOWS FROM OPERATING ACTIVITIES
Net income / (loss)	$	(5,213,834	)	$	2,948,130
Adjustments to reconcile net income / (loss) to net cash provided by operating activities:
Depreciation and amortization		617,555			422,877
Provision for loan losses		10,748,898			927,000
Stock compensation expense		164,094			209,600
Net (Gains) / Losses on sales of loans and other assets		252,323			(27,638	)
Deferred income taxes		1,100,978			3,202,078
Changes in other operating assets and liabilities:
Net change in loans held for sale		389,700			205,600
Accrued interest receivable		58,815			522,255
Accrued interest payable		283,939			30,776
Other assets and liabilities		(4,012,949	)		(6,850,146	)
Net cash provided by operating activities		4,389,519			1,590,532

CASH FLOWS FROM INVESTING ACTIVITIES
Proceeds from security transactions:
Securities available for sale		29,963,560			21,722,393
Securities held to maturity		27,536			24,087
Purchase of securities available for sale		(44,327,958	)		(28,320,718	)
Purchase of Federal Home Loan Bank stock		(41,700	)		(247,500	)
Loan originations and principal collections, net		17,119,771			(15,947,942	)
Purchase of bank premises and equipment		(144,726	)		(450,096	)
Proceeds from sale of other real estate and other assets		2,548,311			2,142,594
Net cash provided by (used in) investing activities		5,144,794			(21,077,182	)

CASH FLOWS FROM FINANCING ACTIVITIES
Net increase / (decrease)in deposits		59,505,085			(10,434,478	)
Net increase / (decrease) in federal funds purchased and securities sold under agreements to repurchase		(17,653,973	)		1,891,619
Net proceeds from Federal Home Loan Bank advances and other borrowings		1,100,000			25,100,000
Purchase of common stock		-			(503,006	)
Payment of dividends		(1,094,649	)		(1,591,933	)
Net cash provided by financing activities		41,856,463			14,462,202

NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS		51,390,776			(5,024,448	)

CASH AND CASH EQUIVALENTS, beginning of period		21,897,390			14,933,349
CASH AND CASH EQUIVALENTS, end of period	$	73,288,166		$	9,908,901

SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION
Cash paid during the period for interest	$	8,143,758		$	9,689,313
Cash paid during the period for taxes		-			738,886

NONCASH INVESTING AND FINANCING ACTIVITIES
Acquisition of real estate through foreclosure	$	8,638,408		$	2,500,560

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 subsidiary, Cornerstone Community Bank (“Bank”). 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 to further enhance the Bank’s lending markets. The Bank specializes in asset based lending, commercial lending and payment processing. The Bank has a wholly-owned subsidiary, Eagle Financial, Inc. (“Eagle”), which specializes in finance and accounts receivable factoring.

Interim Financial Information (Unaudited)-The financial information in this report for September 30, 2009 and September 30, 2008 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 2008 Annual Report to Shareholders which was furnished to each shareholder of Cornerstone in March of 2009. 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 wholly-owned subsidiary Bank. Substantially all intercompany transactions, profits and balances have been eliminated.

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

Accounting Policies-During interim periods, Cornerstone follows the accounting policies set forth in its Annual Report on Form 10-K for the year ended December 31, 2008 as filed with the Securities and Exchange Commission. Since December 31, 2008, there have been no significant changes in any accounting principles or practices, or in the method of applying any such principles or practices other than those indicated below.

In April 2009, the Financial Accounting Standards Board (“FASB”) issued FSP No. FAS 157-4, Determining Fair Value When the Volume and Level of Activity for the Asset or Liability have Significantly Decreased and Identifying Transactions That Are Not Orderly (“FSP 157-4”) (ASC 820, Fair Value Measurements and Disclosures). FSP 157-4 provides that if an entity determines that either the volume and/or level of activity for an asset or liability has significantly decreased (from normal conditions for that asset or liability) or price quotations or observable inputs are not associated with orderly transactions, increased analysis and management judgment will be required to estimate fair value. FSP 157-4 is effective for interim and annual periods ending after June 15, 2009, with early adoption permitted. FSP 157-4 must be applied prospectively. The provisions of FSP 157-4 became effective for Cornerstone's fiscal quarter ending on June 30, 2009, and its adoption did not have a significant impact on the consolidated financial statements.

In April 2009, the FASB issued FSP No. 107-1 and APB 28-1, Interim Disclosures about Fair Value of Financial Instruments (“FSP 107-1 and APB 28-1”) (ASC 825, Financial Instruments). FSP 107-1 and APB 28-1 amends SFAS 107 to require disclosures about fair value of financial instruments for interim reporting periods of publicly traded companies as well as in annual financial statements. This FSP also amends APB 28, Interim Financial Reporting, to require those disclosures in summarized financial information at interim reporting periods. The provisions of FSP 107-1 and APB 28-1 became effective for the Bank's interim period ending on June 30, 2009 and resulted in the applicable fair value disclosures being included in the June 30, 2009 and September 30, 2009 periods.

CORNERSTONE BANCSHARES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

In April 2009, the FASB issued FSP No. FAS 115-2 and FAS 124-2, Recognition and Presentation of Other-Than-Temporary Impairments (“FSP 115-2 and 124-2”) (ASC 320, Investment – Debt and Equity Securities). FSP 115-2 and 124-2 clarifies the interaction of the factors that should be considered when determining whether a debt security is other-than-temporarily impaired. For debt securities, management must assess whether (a) it has the intent to sell the security and (b) it is more likely than not that it will be required to sell the security prior to its anticipated recovery. These steps are done before assessing whether the entity will recover the cost basis of the investment. This change does not affect the need to forecast recovery of the value of the security through either cash flows or market price. In instances when a determination is made that an other-than-temporary impairment exists but the investor does not intend to sell the debt security and it is not more likely than not that it will be required to sell the debt security prior to its anticipated recovery, FSP 115-2 and 124-2 changes the presentation and amount of the other-than-temporary impairment recognized in the income statement. The other-than-temporary impairment is separated into (a) the amount of the total other-than-temporary impairment related to a decrease in cash flows expected to be collected from the debt security (the credit loss) and (b) the amount of the total other-than-temporary impairment related to all other factors. The amount of the total other-than-temporary impairment related to the credit loss is recognized in earnings. The amount of the total other-than-temporary impairment related to all other factors is recognized in other comprehensive income. FSP 115-2 and 124-2 also requires substantial additional disclosures. The provisions of FSP 115-2 and 124-2 became effective for Cornerstone’s fiscal quarter ended period ending on June 30, 2009, and there was no impact from the adoption on Cornerstone’s financial position, results of operations or cash flows. The expanded disclosures related to FSP 115-2 and 124-2 are included in Note 4.

On May 28, 2009, the FASB issued SFAS No. 165, Subsequent Events (ASC 855, Subsequent Events). Under SFAS 165, companies are required to evaluate events and transactions that occur after the balance sheet date but before the date the financial statements are issued, or available to be issued in the case of non-public entities. SFAS 165 requires entities to recognize in the financial statements the effect of all events or transactions that provide additional evidence of conditions that existed at the balance sheet date, including the estimates inherent in the financial preparation process. Entities shall not recognize the impact of events or transactions that provide evidence about conditions that did not exist at the balance sheet date but arose after that date. SFAS 165 also requires entities to disclose the date through which subsequent events have been evaluated. SFAS 165 was effective for interim and annual reporting periods ending after June 15, 2009. Cornerstone adopted the provisions of SFAS 165 for the quarter ended June 30, 2009, as required, and adoption did not have a material impact on the financial statements taken as a whole. Management has evaluated subsequent events through November 13, 2009, the date these statements were available for release.

On June 30, 2009 the FASB issued SFAS No. 168, The FASB Accounting Standards Codification and the Hierarchy of Generally Accepted Accounting Principles — a Replacement of FASB Statement No. 162 (the “FASB Codification”). The purpose of the FASB Codification was to reorganize all existing U.S. accounting and reporting standards issued by the FASB and other related private-sector standard setters into one authoritative body of literature, which will ease research of accounting literature and reduce the risk of noncompliance. Going forward, all revisions will be made in real time to the FASB Codification. The FASB Codification is effective for all financial statements issued for interim and annual periods ending after September 15, 2009. As a result of the adoption of the FASB Codification, all references in public company financial statements and related notes will be to the classification system set forth in the FASB Codification, rather than to the applicable previously existing literature. Conforming changes will also need to be made throughout a company’s disclosure documents, with changes most likely arising in the Management’s Discussion and Analysis of Financial Condition and Results of Operations and, most particularly, in the discussion of critical accounting policies usually contained in that discussion.

On August 18, 2009 the Securities and Exchange Commission published interpretive guidance titled Commission Guidance Regarding the Financial Accounting Standards Board’s Accounting Standards Codification. In its guidance, the SEC stated that concurrent with the Effective Date, references in the SEC’s rules and SEC staff guidance to specific standards under U.S. generally accepted accounting principles should be understood to mean the corresponding reference in the FASB Codification. The SEC also stated that the FASB Codification does not supersede any SEC rules or regulations, is not the authoritative source for SEC rules or SEC staff guidance, and the inclusion of any SEC rules or SEC staff guidance in the FASB Codification will not affect how such items may be updated in the future by the SEC.

CORNERSTONE BANCSHARES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

In August 2009, the FASB issued Accounting Standards Update No. 2009-05 (ASU 2009-05), Fair Value Measurements and Disclosures (ASC 820, Measuring Liabilities at Fair Value). ASU 2009-05 amends subtopic 820-10, Fair Value Measurements and Disclosures – Overall, and provides clarification for the fair value measurement of liabilities. ASU 2009-05 is effective for the first reporting period including interim period beginning after issuance. Cornerstone does not expect the adoption of ASU 2009-05 to have a material impact on its consolidated financial statements.

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.

The following is a summary of the basic and diluted earnings per share for the three month periods ended September 30, 2009 and 2008.

	Three Months Ended September 30,
	2009			2008
Basic earnings / (loss) per share calculation:
Numerator: Net income / (loss) available to common shareholders	$	(1,699,536	)	$	860,216
Denominator: Weighted avg. common shares outstanding		6,371,202			6,371,202
Effect of dilutive stock options		-			57,375
Diluted shares		6,371,202			6,428,577

Basic earnings / (loss) per share	$	(0.27	)	$	0.14
Diluted earnings / (loss) per share	$	(0.27	)	$	0.13

The following is a summary of the basic and diluted earnings per share for the nine month periods ended September 30, 2009 and 2008.

	Nine Months Ended September 30,
	2009			2008
Basic earnings / (loss) per share calculation:
Numerator: Net income / (loss) available to common shareholders	$	(5,213,834	)	$	2,948,130
Denominator: Weighted avg. common shares outstanding		6,337,066			6,350,272
Effect of dilutive stock options		-			161,459
Diluted shares		6,337,066			6,511,731

Basic earnings / (loss) per share	$	(0.82	)	$	0.46
Diluted earnings / (loss) per share	$	(0.82	)	$	0.45

As of September 30, 2009, Cornerstone had paid a stock dividend totaling 0.8421 percent per share with a record date of June 12, 2009 and a payment date of July 3, 2009. The average number of common shares outstanding and the effect of dilutive stock options for 2008 have been retroactively adjusted to reflect these transactions.

Note 2. Stock Based Compensation

Accounting Policies- Cornerstone, as required by the FASB, applies the fair value recognition provisions of ASC 718, Compensation-Stock Compensation. As a result, for the nine month period ended September 30, 2009, the compensation cost charged to earnings related to the vested incentive stock options was approximately $164,000, which reduced basic earnings per share by $0.03 per share.

CORNERSTONE BANCSHARES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

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 exercise price of the non-qualified stock options may be equal to or more or less than the fair market value of the common stock on the date of the grant. The 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, 2009, the total remaining compensation cost to be recognized on non-vested options was approximately $547,000. A summary of the status of these stock option plans is presented in the following table:

						Weighted-
						Average
				Weighted		Contractual
				Average		Remaining	Aggregate
				Exercisable		Term	Intrinsic
	Number			Price		(in years)	Value
Outstanding at December 31, 2008		755,425		$	6.63	5.0 Years	$	1,634,022
Granted		115,850			3.60
Exercised		-			-
Forfeited		(25,400	)		4.69
Outstanding at September 30, 2009		845,875		$	6.27	5.1 Years	$	505,462
Options exercisable at September 30, 2009		595,378		$	5.46

The weighted average grant-date fair value of stock options granted during the nine months ended September 30, 2009 was $1.13. This was determined using the Black-Scholes option pricing model with the following weighted –average assumptions: Dividend Yield-2.97%, Expected Life-7.0 years, Expected Volatility-38.74%, Risk-free Interest Rate- 2.69%.

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 2009, are 50% on the first and second anniversary of the grant date. At September 30, 2009, the total remaining compensation cost to be recognized on non-vested options was approximately $45,000. 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, 2008		81,800	$	10.73	7.9 Years	$	29,608
Granted		20,500		3.60
Exercised		-		-
Forfeited		-		-
Outstanding at September 30, 2009		102,300	$	9.30	7.5 Years	$	21,523
Options exercisable at September 30, 2009		75,400	$	10.96

The weighted average grant-date fair value of stock options granted during the nine months ended September 30, 2009 was $1.13. This was determined using the Black-Scholes option pricing model with the following weighted –average assumption: Dividend Yield-2.97%, Expected Life-7.0 years, Expected Volatility-38.74%, Risk-free Interest Rate- 2.69%.

CORNERSTONE BANCSHARES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

Note 3. Stockholder’s Equity

During 2009, Cornerstone’s Board of Directors declared the following cash dividends:

Cash Dividend Rate		Declaration Date	Record Date	Payment Date
(per share)
$	0.07	February 25, 2009	March 13, 2009	April 3, 2009
$	0.03	June 2, 2009	June 12, 2009	July 3, 2009

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 September 30, 2009 and December 31, 2008 are summarized as follows:

	September 30, 2009
			Gross		Gross
	Amortized		Unrealized		Unrealized			Market
	Cost		Gains		Losses			Value
Securities Available-for-Sale:
U.S. Government securities	$	8,239,619	$	9,439	$	(56,629	)	$	8,192,429

State and municipal securities		8,049,936		399,502		(3,572	)		8,445,866

Mortgage-backed securities (1)		42,385,245		251,345		(140,283	)		42,496,307

	$	58,674,800	$	660,286	$	(200,484	)	$	59,134,602
Securities Held-to-Maturity:
Mortgage-backed securities (1)	$	141,352	$	1,245	$	(143	)	$	142,454

	December 31, 2008
			Gross		Gross
	Amortized		Unrealized		Unrealized			Market
	Cost		Gains		Losses			Value
Securities Available-for-Sale:
U.S. Government securities	$	7,976,040	$	275,731	$	-		$	8,251,771

State and municipal securities		4,609,632		82,013		(68,830	)		4,622,815

Mortgage-backed securities(1)		31,753,504		160,387		(731,918	)		31,181,973

	$	44,339,176	$	518,131	$	(800,748	)	$	44,056,559
Securities Held-to-Maturity:
Mortgage-backed securities(1)	$	169,284	$	1,158	$	(683	)	$	169,759

(1) With the exception of one private label security with an amortized cost of approximately $250,000 and a market value of approximately $243,000 as of September 30, 2009 the mortgage backed security portfolio is comprised of U.S. Government Agency securities with residential mortgage loans as collateral. As of December 31, 2008 the private label security had an amortized cost of approximately $364,000 and a market value of approximately $297,000.

CORNERSTONE BANCSHARES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

At September 30, 2009, approximately $56 million of Cornerstone’s investment portfolio was pledged to secure public funds, securities sold under agreements to repurchase and serve as collateral for borrowings at the Federal Reserve Discount Window.

The amortized cost and estimated market value of securities at September 30, 2009, by contractual maturity, are shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.

	Securities Available for Sale				Securities Held to Maturity
	Amortized		Market		Amortized		Market
	Cost		Value		Cost		Value
Due in one year or less	$	125,000	$	125,460	$	-	$	-
Due from one year to five years		599,102		630,810		-		-
Due from five years to ten years		2,292,995		2,429,284		-		-
Due after ten years		13,272,458		13,452,741		-		-
		16,289,555		16,638,295		-		-

Mortgage-backed securities		42,385,245		42,496,307		141,352		142,454

	$	58,674,800	$	59,134,602	$	141,352	$	142,454

The following tables present the gross unrealized losses and market value, aggregated by investment category and length of time that individual securities available for sale have been in a continuous unrealized loss position, as of September 30, 2009:

	As of September 30, 2009
	Less than 12 Months					12 Months or Greater					Total
			Gross					Gross					Gross
	Market		Unrealized			Market		Unrealized			Market		Unrealized
	Value		Losses			Value		Losses			Value		Losses
Securities available for sale:
U.S. Governmental Securities	$	5,142,950	$	(56,629	)	$	-	$	-		$	5,142,950	$	(56,629	)

State and municipal securities		-		-			221,247		(3,572	)		221,247		(3,572	)

Mortgage-backed securities		14,918,819		(91,946	)		4,358,623		(48,337	)		19,277,442		(140,283	)

	$	20,061,769	$	(148,575	)	$	4,579,870	$	(51,909	)	$	24,641,639	$	(200,484	)

Securities held to maturity:
Mortgage-backed securities	$	1,771	$	(1	)	$	23,013	$	(142	)	$	24,784	$	(143	)

CORNERSTONE BANCSHARES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

	As of December 31, 2008
	Less than 12 Months					12 Months or Greater					Total
			Gross					Gross					Gross
	Market		Unrealized			Market		Unrealized			Market		Unrealized
	Value		Losses			Value		Losses			Value		Losses
Securities available for sale:
State and municipal securities	$	1,125,144	$	(48,772	)	$	206,650	$	(20,058	)	$	1,331,794	$	(68,830	)

Mortgage-backed securities		19,234,621		(719,051	)		642,457		(12,867	)		19,877,078		(731,918	)

	$	20,359,765	$	(767,823	)	$	849,107	$	(32,925	)	$	21,208,872	$	(800,748	)

Securities held to maturity:
Mortgage-backed securities	$	26,405	$	(289	)	$	30,897	$	(394	)	$	57,302	$	(683	)

Management performs periodic reviews for impairment in accordance with ASC 320, Investment-Debt and Equity Securities.

At September 30, 2009, the 16 (unaudited) securities with unrealized losses have depreciated 0.81 percent (unaudited) from the Bank’s amortized cost basis. Most of these securities are guaranteed by either U.S. government corporations or agencies or had investment grade ratings upon purchase. Further, the issuers of these securities have not established any cause for default. The unrealized losses associated with these investment securities are primarily driven by changes in interest rates and are not due to the credit quality of the securities. These securities will continue to be monitored as a part of Cornerstone’s ongoing impairment analysis, but are expected to perform even if the rating agencies reduce the credit rating of the bond insurers. Management evaluates the financial performance of each issuer on a quarterly basis to determine if it is probable that the issuers can make all contractual principal and interest payments.

ASC 320 requires an entity to assess whether the entity has the intent to sell the debt security or more likely than not will be required to sell the debt security before its anticipated recovery. The Bank does not intend to sell these securities and it is not more likely than not that it will be required to sell the investments before the recovery of its amortized cost bases. In making this determination, management has considered cash flow and liquidity requirements, capital requirements, economic factors, and contractual or regulatory obligations for indication that these securities will be required to be sold before a forecasted recovery occurs. Therefore, in management’s opinion, all securities that have been in a continuous unrealized loss position for the past 12 months or longer as of September 30, 2009 are not other-than-temporarily impaired, and therefore, no impairment charges at September 30, 2009 are warranted.

CORNERSTONE BANCSHARES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

Note 5. Loans and Allowance for Loan Losses

At September 30, 2009 and December 31, 2008, loans are summarized as follows (in thousands):

	September 30, 2009					December 31, 2008
	Amount		Percent			Amount		Percent
Commercial, financial and agricultural	$	60,734		17.4	%	$	83,140		21.4	%
Real estate-construction		57,072		16.4	%		70,456		18.2	%
Real estate-mortgage		70,733		20.3	%		72,737		18.7	%
Real estate-commercial		155,778		44.6	%		155,728		40.1	%
Consumer loans		4,733		1.3	%		6,029		1.6	%
Total loans	$	349,050		100.0	%	$	388,090		100.0	%

A summary of transactions in the allowance for loan losses for the nine months ended September 30, 2009 and year ended December 31, 2008 is as follows (in thousands):

	September 30,			December 31,
	2009			2008
Balance, beginning of period	$	9,618		$	13,710
Loans charged-off		(13,380	)		(7,979	)
Recoveries of loans previously charged-off		411			389
Provision for loan losses		10,749			3,498
Balance, end of period	$	7,398		$	9,618

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.

CORNERSTONE BANCSHARES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

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, 2009 is as follows:

Commitments to extend credit	$ 41.0 million
Standby letters of credit	$ 3.5 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, 2009 will not have a material effect on Cornerstone’s consolidated financial statements.

Note 7. Fair Value Disclosures

Fair Value Measurements:

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

Level 1: Quoted prices (unadjusted) or identical assets or liabilities in active markets that the entity has the ability to access as of the measurement date.

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

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

Cornerstone utilizes fair value measurements to record fair value adjustments to certain assets and determine fair value disclosures. Accordingly, securities available for sale are recorded at fair value on a recurring basis. Additionally, from time to time, Cornerstone may be required to record other assets at fair value on a nonrecurring basis, such as loans held for sale, and impaired loans. These nonrecurring fair value adjustments typically involve application of lower of cost or market accounting or write-downs of individual assets.

Following is a description of valuation methodologies used for assets and liabilities recorded at fair value.

Securities available for sale-Investment securities available for sale are recorded at fair value on a recurring basis. Fair value measurement is based upon quoted prices, if available. If quoted prices are not available, fair values are measured using independent pricing models or other model-based valuation techniques such as the present value of future cash flows, adjusted for the security’s credit rating, prepayment assumptions and other factors such as credit loss assumptions. Level 1 securities include those traded on an active exchange, such as the New York Stock Exchange, U.S. Treasury securities that are traded by dealers or brokers in active over-the-counter markets and money market funds. Level 2 securities include mortgage-backed securities, U.S. Government securities and municipal bonds.

CORNERSTONE BANCSHARES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

Impaired loans-Cornerstone does not record loans at fair value on a recurring basis. However, from time to time, a loan is considered impaired and an allowance for loan losses is established. Loans for which it is probable that payment of interest and principal will not be made in accordance with the contractual terms of the loan agreement are considered impaired. Once a loan is identified as individually impaired, management measures impairment in accordance with ASC 310, Receivables. The fair value of impaired loans is estimated using one of several methods, including collateral value, liquidation value and discounted cash flows. Those impaired loans not requiring an allowance represent loans for which the fair value of the expected repayments or collateral exceed the recorded investments in such loans. In accordance with ASC 820, impaired loans where an allowance is established based on the fair value of collateral require classification in the fair value hierarchy. When the fair value of the collateral is based on an observable market price or a current appraised value, we record the impaired loan as nonrecurring Level 2. When an appraised value is not available or management determines the fair value of the collateral is further impaired below the appraised value and there is no observable market price, we record the impaired loan as nonrecurring Level 3.

Assets and liabilities recorded at fair value on a recurring basis are as follows (amounts in thousands).

	Balance as of September 30, 2009		Quoted Prices In Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)

Securities available for sale	$	59,135	$	-	$	59,135	$	-

Cornerstone has no assets or liabilities whose fair values are measured on a recurring basis using Level 3 inputs.

Assets measured at fair value on a nonrecurring basis are included in the table below (amounts in thousands).

	Balance as of September 30, 2009		Quoted Prices In Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)

Impaired loans	$	21,362	$	-	$	21,362	$	-

Impaired loans, which are measured for impairment using the fair value of the collateral for collateral-dependent loans, had a carrying amount of approximately $24,821,000, with a valuation allowance of approximately $3,459,000 at September 30, 2009. Losses derived from Level 2 inputs were calculated primarily by models utilizing estimated collateral value or the discounted present value of expected cash flows.

Fair Value of Financial Instruments:

Fair value estimates are made at a specific point in time, based on relevant market information about the financial instrument. These estimates do not reflect any premium or discount that could result from offering for sale at one time Cornerstone's entire holdings of a particular financial instrument. Because no market exists for a significant portion of Cornerstone’s financial instruments, fair value estimates are based on judgments regarding future expected loss experience, current economic conditions, risk characteristics of various financial instruments, and other factors. These estimates are subjective in nature; involve uncertainties and matters of judgment; and, therefore, cannot be determined with precision. Changes in assumptions could significantly affect the estimates.

Fair value estimates are based on existing financial instruments without attempting to estimate the value of anticipated future business and the value of assets and liabilities that are not considered financial instruments. The following methods and assumptions were used to estimate the fair value of each class of financial instruments:

CORNERSTONE BANCSHARES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

Cash and cash equivalents:

For cash and cash equivalents, the carrying amount is a reasonable estimate of fair value.

Securities:

The fair value of securities is estimated based on bid prices published in financial newspapers or bid quotations received from securities dealers.

Federal Home Loan Bank stock:

The carrying amount of Federal Home Loan Bank stock approximates fair value based on the stock redemption provisions of the Federal Home Loan Bank.

Loans, net:

The fair value of loans is calculated by discounting scheduled cash flows through the estimated maturity using estimated market discount rates, adjusted for credit risk and servicing costs. The estimate of maturity is based on historical experience with repayments for each loan classification, modified, as required, by an estimate of the effect of current economic and lending conditions.

Deposits:

The fair value of deposits with no stated maturity, such as demand deposits, money market accounts, and savings deposits, is equal to the amount payable on demand. The fair value of time deposits is based on the discounted value of contractual cash flows. The discount rate is estimated using the rates currently offered for deposits of similar remaining maturities.

Federal funds purchased and securities sold under agreements to repurchase:

The fair value of these liabilities, which are extremely short term, approximates their carrying value.

Federal Home Loan Bank advances and line of credit:

The carrying amounts of the FHLB advances and the line of credit approximate their fair value.

Commitments to extend credit:

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

CORNERSTONE BANCSHARES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

The carrying amount and estimated fair value of Cornerstone's financial instruments at September 30, 2009 and December 31, 2008 is follows (in thousands):

	September 30, 2009				December 31, 2008
	Carrying		Estimated		Carrying		Estimated
	Amount		Fair Value		Amount		Fair Value
Assets:
Cash and cash equivalents	$	73,288	$	73,288	$	21,897	$	21,897
Securities		59,276		59,277		44,226		44,226
Federal Home Loan Bank Stock		2,229		2,229		2,188		2,188
Loans, net		341,652		343,271		378,472		380,394

Liabilities:
Noninterest-bearing demand deposits		40,796		40,796		40,078		40,078
Interest-bearing demand deposits		23,919		23,919		26,909		26,909
Savings deposits and money market accounts		31,581		31,581		35,848		35,848
Time deposits		289,792		292,147		223,749		225,882
Federal funds purchased and securities sold under agreements to repurchase		18,136		18,136		35,790		35,790
Federal Home Loan Bank advances and line of credit		72,350		72,350		71,250		71,250

Unrecognized financial instruments (net of contract amount):
Commitments to extend credit		-		-		-		-

Note 8. Other Comprehensive Income

Other comprehensive income consists of unrealized holding gains and losses on securities available for sale. The following is a summary of other comprehensive income for the three month and nine month periods ended September 30, 2009 and 2008.

	Three Months Ended						Nine Months Ended
	September 30,						September 30,
	2009			2008			2009			2008
Net Income	$	(1,699,536	)	$	860,216		$	(5,213,834	)	$	2,948,130
Unrealized holding gains (losses) on securities available for sale, net of reclassification		249,453			(99,349	)		489,997			(163,982	)

Comprehensive income (loss)	$	(1,450,083	)	$	760,867		$	(4,723,837	)	$	2,784,148

CORNERSTONE BANCSHARES, INC.

CONSOLIDATED AVERAGE BALANCE

INTEREST INCOME/EXPENSE AND

YIELD/RATES

Taxable Equivalent Basis	Three months ended
(in thousands)	September 30
	2009								2008
	Average			Income/		Yield/			Average			Income/		Yield/
	Balance			Expense		Rate			Balance			Expense		Rate
Assets

Earning assets:
Loans, net of unearned income	$	354,246		$	6,018		6.74	%	$	381,342		$	6,977		7.26	%
Investment securities		54,335			358		2.61	%		48,508			482		4.06	%
Other earning assets		45,477			31		0.25	%		70			3		2.39	%
Total earning assets		454,058		$	6,407		5.60	%		429,920		$	7,462		6.90	%
Allowance for loan losses		(6,703	)							(7,409	)
Cash and other assets		41,515								26,542
TOTAL ASSETS	$	488,870							$	449,053

Liabilities and Shareholder's Equity

Interest bearing liabilities:
Interest bearing demand deposits	$	25,236		$	21		0.32	%	$	29,581		$	57		0.76	%
Savings deposits		8,317			11		0.51	%		8,313			16		0.75	%
MMDA's		23,246			56		0.95	%		40,683			152		1.48	%
Time deposits of $100,000 or less		207,530			1,408		2.69	%		128,591			1,322		4.08	%
Time deposits of $100,000 or more		64,511			477		2.93	%		57,486			579		4.00	%
Federal funds purchased and securities sold under agreements to repurchase		18,897			37		0.78	%		33,712			157		1.85	%
Other borrowings		72,350			758		4.15	%		72,329			744		4.08	%
Total interest bearing liabilities		420,086			2,766		2.61	%		370,695			3,027		3.24	%
Net interest spread				$	3,641		2.99	%				$	4,436		3.66	%
Noninterest bearing demand deposits		39,490								41,204
Accrued expenses and other liabilities		(3,544	)							(587	)
Shareholder's equity		32,838								37,741
TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY	$	488,870							$	449,053
Net yield on earning assets							3.18	%							4.11	%

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

CORNERSTONE BANCSHARES, INC.

CONSOLIDATED AVERAGE BALANCE

INTEREST INCOME/EXPENSE AND

YIELD/RATES

Taxable Equivalent Basis	Year-to-Date
(in thousands)	September 30
	2009								2008
	Average			Income/		Yield/			Average			Income/		Yield/
	Balance			Expense		Rate			Balance			Expense		Rate
Assets

Earning assets:
Loans, net of unearned income	$	369,394		$	18,496		6.69	%	$	383,966		$	21,730		7.57	%
Investment securities		54,757			1,158		2.83	%		46,439			1,533		4.54	%
Other earning assets		17,169			45		0.27	%		285			16		2.72	%
Total earning assets		441,320		$	19,699		5.97	%		430,690		$	23,279		7.24	%
Allowance for loan losses		(8,379	)							(8,733	)
Cash and other assets		39,984								27,300
TOTAL ASSETS	$	472,925							$	449,257

Liabilities and Shareholder's Equity

Interest bearing liabilities:
Interest bearing demand deposits	$	28,574		$	77		0.36	%	$	31,069		$	179		0.77	%
Savings deposits		8,080			31		0.51	%		7,938			47		0.80	%
MMDA's		28,316			205		0.97	%		46,865			682		1.94	%
Time deposits of $100,000 or less		179,614			4,214		3.14	%		123,277			4,150		4.50	%
Time deposits of $100,000 or more		60,565			1,534		3.39	%		60,240			2,092		4.64	%
Federal funds purchased and securities sold under agreements to repurchase		21,955			135		0.82	%		32,050			502		2.09	%
Other borrowings		72,082			2,232		4.14	%		67,297			2,067		4.11	%
Total interest bearing liabilities		399,186			8,427		2.82	%		368,736			9,720		3.52	%
Net interest spread				$	11,271		3.15	%				$	13,559		3.72	%
Noninterest bearing demand deposits		41,756								42,687
Accrued expenses and other liabilities		(2,539	)							426
Shareholder's equity		34,522								37,408
TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY	$	472,925							$	449,257
Net yield on earning assets							3.41	%							4.22	%

Taxable equivalent adjustment:
Loans					0								0
Investment securities					0								43
Total adjustment					0								43

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, that operates primarily in and around Hamilton County, Tennessee. The Bank has also established a loan production office in Dalton, Georgia and owns Eagle Financial, Inc. (“Eagle”). Eagle generates loans which are secured by accounts receivable. Eagle has a primary focus of lending to temporary staffing companies. The Bank’s business consists primarily of attracting deposits from the general public and, with these and other funds, originating real estate loans, consumer loans, business loans, and residential and commercial construction loans. The principal sources of income for the Bank are interest and fees collected on loans, fees collected on deposit accounts, and interest and dividends collected on other investments. The principal expenses of the Bank are interest paid on deposits, employee compensation and benefits, office expenses, and other overhead expenses.

The following is a discussion of our financial condition at September 30, 2009 and December 31, 2008 and our results of operations for the three and nine months ended September 30, 2009 and 2008. 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, 2009, Cornerstone had total consolidated assets of $509.5 million, total loans of $349.0 million, total deposits of $386.1 million and stockholders’ equity of $31.3 million. Net loss for the three and nine month periods ended September 30, 2009 totaled ($1,699,536) and ($5,213,834), respectively.

Results of Operations

Net loss for the three months ended September 30, 2009 was ($1,699,536) or ($0.27) basic earnings per share, compared to net income of $860,216 or $0.14 basic earnings per share for the same period in 2008. Net loss for the nine months ended September 30, 2009 was ($5,213,834) or ($0.82) basic earnings per share, compared to net income of $2,948,130 or $0.46 basic earnings per share, for the same period of 2008.

The following table presents our results for the three and nine months ended September 30, 2009 and 2008 (amounts in thousands).

						2009-2008											2009-2008
	Three months					Percent			Dollar			Nine months					Percent			Dollar
	ended September 30,					Increase			Amount			ended September 30,					Increase			Amount
	2009			2008		(Decrease)			Change			2009			2008		(Decrease)			Change
Interest income	$	6,407		$	7,462		(14.14	)%	$	(1,055	)	$	19,699		$	23,279		(15.38	)%	$	(3,580	)
Interest expense		2,766			3,026		(8.59	)%		(260	)		8,428			9,720		(13.29	)%		(1,292	)
Net interest income
before provision for loss		3,641			4,436		(17.92	)%		(795	)		11,271			13,559		(16.87	)%		(2,288	)

Provision for loan loss		3,390			440		670.45	%		2,950			10,749			927		1059.55	%		9,822
Net interest income after
Provision for loan loss		251			3,996		(93.72	)%		(3,745	)		522			12,632		(95.87	)%		(12,110	)

Total noninterest income		184			476		(61.34	)%		(292	)		1,178			1,396		(15.62	)%		(218	)
Total noninterest expense		3,279			3,151		4.06	%		128			10,345			9,464		9.31	%		881

Income / (loss) before income taxes		(2,844	)		1,321		(315.29	)%		(4,165	)		(8,645	)		4,564		(289.42	)%		(13,209	)

Provision for income taxes		(1,145	)		461		(348.37	)%		(1,606	)		(3,432	)		1,616		(312.38	)%		(5,048	)

Net income / (loss)	$	(1,699	)	$	860		(297.56	)%	$	(2,559	)	$	(5,213	)	$	2,948		(276.83	)%	$	(8,161	)

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 nine months ended September 30, 2009, net interest income before the provision for loan loss, decreased $(2,288) thousand or (16.87)% over the same period of 2008. 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 3.15% for the nine month period ended September 30, 2009 compared to 3.72% for the same period in 2008. The net interest margin on a tax equivalent basis was 3.41% for the nine month period ended September 30, 2009 compared to 4.22% for the same period in 2008. Significant items related to the changes in net interest income, net interest yields and rates, and net interest margin are presented below:

Future changes in the net interest margin will be impacted due to increased competition for funding. Presently, banks are paying premiums over overnight borrowing rates in order to retain transactional accounts. In addition, certificates of deposit continue to require a premium to investment instruments with similar maturities. Management anticipates that this condition will continue until interest rates rise to a more historic level.

Due to the recent recession, liquidity metrics at the Bank’s usual sources of funding have tightened as community banks asset quality deteriorated across the country. The Bank’s asset quality mirrors this trend. As a result, the Bank has materially increased its asset allocation in securities to provide collateral to these funding sources to guarantee access to these funds as required. The consequence of this action will be a substantial drop in the Bank’s asset yield and net interest margin.

Due to the Bank’s present strategic position and capital position of adequately capitalized, the Bank plans to reduce its loan portfolio by approximately $20 million to regain a well capitalized position. This move will also impact the Bank’s asset allocation and ultimately reduce net interest margin.

The Bank’s loan portfolio yield has declined to 6.74% for the three months ended September 30, 2009 compared to 7.26% for the quarter ended September 30, 2008. The Bank’s loan portfolio yield has declined to 6.69% for the nine months ended September 30, 2009 compared to 7.57% for the nine months ended September 30, 2008. The decrease in loan yields is due primarily to difficult economic conditions in Chattanooga, TN, the increase in the amount of non-accrual and restructured loans in the Bank’s loan portfolio and the prolonged low interest rate environment.

For the three month period ended September 30, 2009, the Bank’s investment portfolio resulted in a yield of 2.61% compared to 4.06% for the same time period in 2008. For the nine month period ended September 30, 2009, the Bank’s investment portfolio resulted in a yield of 2.83% compared to 4.54% for the same time period in 2008. The decline in the investment portfolio yield from September 30, 2008 to September 30, 2009 is primarily attributable to the Bank’s portfolio composition which includes approximately 50% variable rate securities, indexed to the London Interbank Offered Rate or “LIBOR” to account for future increases in interest rates. Presently, the Bank is focusing on liquidity and is retaining unusually large cash balances at the Federal Reserve Bank of Atlanta. This liquidity will be deployed during the fourth quarter of 2009 in zero credit risk fixed rate mortgage backed securities that provide some protection from rate increases in accordance with the Bank’s bar bell strategy.

Management believes the net interest margin is approaching the lowest level for the reasons mentioned above. The Bank’s rationale for this forecast is as follows:

First, while management believes the net interest margin will be negatively impacted as a result of loan revenue declining as the Bank’s average loans outstanding are reduced, however management anticipates that this decline in the net interest margin will be offset by the conversion of the Bank’s excess cash position to higher yielding securities. The net result is expected to be a stable net interest margin for the fourth quarter of 2009.

Second, during 2010, management anticipates that the Bank’s loan portfolio number of non-accrual and restructured loans will decrease and that the portfolio’s yield will recover to more normal levels and will result in a higher net interest margin.

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 $10.7 million for the nine months ended September 30, 2009.

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

The following table presents the components of noninterest income for the three and nine months ended September 30, 2009 and 2008 (dollars in thousands).

						2009-2008								2009-2008
	Three months ended					Percent			Nine months ended					Percent
	September 30,					Increase			September 30,					Increase
	2009			2008		(Decrease)			2009			2008		(Decrease)
Service charges on deposit accounts	$	417		$	440		(5.23	)%	$	1,260		$	1,278		(1.41	)%
Net gains / (losses) on sale of loans and other assets		(262	)		18		(1555.56	)%		(252	)		28		(1000.00	)%
Other fee income		29			18		61.11	%		170			90		88.89	%
Total noninterest income		184			476		(61.34	)%		1,178			1,396		(15.62	)%

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

The Bank realized $724 thousand of loss relating to the disposal of other real estate and repossessed assets during the first nine months of 2009. This amount was partially offset by gains resulting from the sale of investment securities. In the current economic environment, further losses relating to the disposal of other real estate and repossessed assets are possible.

Noninterest Expense-Items reported as noninterest expense include salaries and employee benefits, occupancy and equipment expense and other operating expense.

The following table presents the components of noninterest expense for the three and nine months ended September 30, 2009 and 2008 (dollars in thousands).


	Three months ended				2009-2008			Nine months ended				2009-2008
	September 30,				Percent			September 30,				Percent
	2009		2008		Increase/Decrease			2009		2008		Increase/Decrease
Salaries and employee benefits	$	1,623	$	1,856		(12.55	)%	$	5,332	$	5,532		(3.62	)%
Occupancy and equipment expense		383		372		2.96	%		1,177		1,135		3.70	%
Other operating expense		1,273		923		37.92	%		3,836		2,797		37.15	%
Total noninterest expense		3,279		3,151		4.06	%		10,345		9,464		9.31	%

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

For the nine months ended September 30, 2009, the Bank paid approximately $500,000 in insurance assessments to the Federal Deposit Insurance Corporation (“FDIC”) compared to approximately $189,000 in FDIC insurance assessments for the same period of 2008.

For the nine months ended September 30, 2009, the Bank incurred additional expense related to other real estate. These expenses total approximately $268,000 for the nine months ended September 30, 2009 compared to approximately $94,000 for the same time period in 2008. These expenses include legal, insurance, maintenance, and sales cost. Management expects these costs to continue to increase throughout the remainder of 2009.

Financial Condition

Overview-The following is a summary of Cornerstone’s financial condition as of September 30, 2009 compared to December 31, 2008:

Cornerstone’s consolidated assets totaled $471.8 million as of December 31, 2008. As of September 30, 2009, total consolidated assets had increased $37.7 million or 7.99% to $509.5 million.

The Bank’s loan portfolio totaled $349.0 million as of September 30, 2009, a decrease of $39.0 million or (10.06)% from December 31, 2008.

The Bank’s investment portfolio increased by approximately $15.1 million to a total of $59.3 million as of September 30, 2009 compared to a total of $44.2 million as of December 31, 2008.

Liabilities as of September 30, 2009 and December 31, 2008 totaled approximately $478.2 million and $435.3 million, respectively.

Stockholders’ equity as of September 30, 2009 and December 31, 2008 totaled approximately $31.3 million and $36.5 million, respectively.

Securities-The Bank’s investment portfolio, primarily consisting of Federal Agency, mortgage-backed securities and municipal securities, amounted to $59.3 million as of September 30, 2009 compared to $44.2 million as of December 31, 2008. The primary purpose of the Bank’s investment portfolio is to satisfy pledging requirements, to collateralize the Bank’s repurchase accounts and provide additional liquidity at the Federal Reserve Discount Window.

Loans-The composition of loans at September 30, 2009 and at December 31, 2008 and the percentage (%) of each classification to total loans are summarized in the following table (dollars in thousands):

	September 30, 2009					December 31, 2008
	Amount		Percent			Amount		Percent
Commercial, financial and agricultural	$	60,734		17.4	%	$	83,140		21.4	%
Real estate-construction		57,072		16.4	%		70,456		18.2	%
Real estate-mortgage		70,733		20.3	%		72,737		18.7	%
Real estate-commercial		155,778		44.6	%		155,728		40.1	%
Consumer loans		4,733		1.3	%		6,029		1.6	%
Total loans	$	349,050		100.0	%	$	388,090		100.0	%

For the nine months ended September 30, 2009, the Bank has seen a decrease in total loans of 10.1% when compared to December 31, 2008. One reason for the decrease is the Bank’s emphasis on credit quality and properly pricing loan interest rates based upon the identified risks. Specifically, the decline in real estate construction lending from $70.5 million as of December 31, 2008 compared to $57.1 million as of September 30, 2009 is a result of the Bank’s attempt to minimize its risk given the current real estate market.

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 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 third quarter of 2009, the Bank experienced continued loan quality deterioration. During the quarter, management deemed several large loans to be impaired which resulted in an increase in provision expense. Currently, the Bank believes that it has established an allowance for loan losses that adequately accounts for the Bank’s identified loan impairment. However, additional provision to the loan loss allowance may be needed in future quarters if the Bank’s loan portfolio continues to deteriorate.

The following is a summary of changes in the allowance for loan losses for the nine months ended September 30, 2009 and for the year ended December 31, 2008 and the ratio of the allowance for loan losses to total loans as of the end of each period (dollars in thousands):

	September 30,			December 31,
	2009			2008
Balance, beginning of period	$	9,618		$	13,710
Loans charged-off		(13,380	)		(7,979	)
Recoveries of loans previously charged-off		411			389
Provision for loan losses		10,749			3,498
Balance, end of period	$	7,398		$	9,618

Total loans	$	349,050		$	388,090

Ratio of allowance for loan losses to loans outstanding at the end of the period		2.12	%		2.48	%

Ratio of net charge-offs to total loans outstanding for the period		3.72	%		1.96	%

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 is a summary of changes in Cornerstone’s impaired loans for the nine months ended September 30, 2009 and for the year ended December 31, 2008:

	September 30,		December 31,
	2009		2008
Impaired loans without a valuation allowance	$	4,310,096	$	2,543,320

Impaired loans with a valuation allowance	$	24,820,603	$	17,375,043

Total impaired loans	$	29,130,699	$	19,918,363

Valuation allowance related to impaired loans	$	3,458,663	$	5,872,373

Total non-accrual loans	$	8,138,831	$	4,252,791

Total loans past-due ninety days or more and still accruing	$	-	$	-

	Nine Months		Year Ended
	September 30,		December 31,
	2009		2008
Average investment in impaired loans (1)	$	26,989,776	$	10,891,357

Interest income recognized on impaired loans	$	2,159,010	$	966,011

(1) The average investment in impaired loans is calculated using the following criteria:

(a) Loans with a risk grade of 5 or greater and have been assigned an impairment amount based upon management’s quarterly ASC 310 analysis;

(b) All Loans with a risk grade of 5 or greater that are at least sixty days past due as of the reporting date even if an impairment amount has not been assigned.

Finally, the average investment in impaired loans is calculated using the quarter end balances for the reporting period starting with the fourth quarter of the preceding year.

The Bank’s loan portfolio has experienced a general deterioration in loan quality as the Chattanooga, TN MSA endures the current economic recession. The number and dollar amount of impaired loans decreased slightly during the third quarter of 2009 as the Bank continued to systematically review its loan portfolio to proactively identify possible impaired loans. Management anticipates that its loan asset quality will not improve until the economy recovers from the current economic recession.

The following table summarizes Cornerstone’s non-performing assets at September 30, 2009, June 30, 2009, March 31, 2009 and December 31, 2008 (dollars in thousands):

	September 30,			June 30,			March 31,			December 31,
	2009			2009			2009			2008
Non-accrual loans	$	8,139		$	13,397		$	8,620		$	4,252
Repossessed assets		98			181			256			257
Foreclosed properties		7,695			4,783			2,476			2,459
Total non-performing assets	$	15,932		$	18,361		$	11,352		$	6,968

Total loans outstanding	$	349,050		$	360,615		$	378,993		$	388,090

Allowance for loan losses		7,398			7,383			12,885			9,618

Ratio of non-performing assets to total loans outstanding at the end of the period		4.56	%		5.09	%		3.00	%		1.80	%

Ratio of non-performing assets to total allowance for loan losses at the end of the period		215.36	%		248.69	%		88.09	%		72.45	%

As of September 30, 2009, the Bank’s non-accrual loans decreased from the second to the third quarter of 2009 as impaired loans progressed through the collection process and shifted from non-accrual to other real estate. Furthermore, management estimates a loss of five percent associated with the disposal of these assets. The Bank will continue to place a high priority on the conversion of non-accruing loans to disposable assets, which should result in non-accrual loans decreasing in the future while other real estate increases are projected for the short term until the assets are sold.

Deposits and Other Borrowings-The Bank’s deposits consist of noninterest 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 securities 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.

	September 30, 2009					December 31, 2008
	Amount		Percent			Amount		Percent
Core funding:
Non-interest bearing demand deposits	$	40,796		8.7	%	$	40,078		9.3	%
Interest-bearing demand deposits		23,919		5.1	%		26,909		6.3	%
Savings & money market accounts		31,581		6.7	%		35,848		8.3	%
Time deposits under $100,000		200,262		42.5	%		164,692		38.4	%
Total core funding		296,558		63.0	%		267,527		62.3	%

Non-core funding:
Time deposit accounts greater than $100,000		89,530		19.0	%		59,057		13.8	%
Securities sold under agreements to repurchase		18,136		3.8	%		35,790		8.3	%
Federal Home Loan Bank advances		67,000		14.2	%		67,000		15.6	%
Total non-core funding		174,666		37.0	%		161,847		37.7	%

Total	$	471,224		100.0	%	$	429,374		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 September 30, 2009, the Bank had established $9.0 million in available federal funds lines.

The Federal Reserve Bank of Atlanta encourages the Bank to use its Discount Window to borrow funds on an overnight basis. The Bank presently has availability and collateral in place to fund $15 million in borrowings and plans to increase its borrowing capacity to $20 million by the end of the fourth quarter of 2009.

Federal Home Loan Bank of Cincinnati (“FHLB”) borrowings are secured by certain qualifying residential mortgage loans and, pursuant to a blanket lien, all qualifying commercial mortgage loans. 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, 2009, the Bank had total outstanding of $67 million from FHLB consisting of structured term loans. The Bank is seeking the FHLB’s release of the Bank’s loan portfolio that is pledged as collateral in exchange for a combination of pledged cash and securities. This exchange is sought because of the FHLB’s increased collateral maintenance required on loans pledged by the Bank. The Bank believes the cost associated with this maintenance to be in excess of the revenue and liquidity lost by pledging the securities. Once the exchange is completed the Bank will have only securities pledged against FHLB borrowings and will match the durations of the securities to have sufficient cash flow to payoff the loans as they mature.

Capital Resources-At September 30, 2009 and December 31, 2008, Cornerstone’s stockholders’ equity amounted to $31.3 million and $36.5 million, respectively.

Cornerstone’s stockholders’ equity decreased $5.2 million during the nine months ended September 30, 2009. Factors contributing to the reduction in capital include cash dividends totaling $0.10 per share for the six months ended June 30, 2009, of which $0.03 per share was declared during the second quarter of 2009, and operating losses of $1.7 million during the third quarter of 2009 resulting in a year to date loss of $5.2 million.

As of September 30, 2009, the Bank dipped under the regulatory minimums required to be a well-capitalized institution. The Bank had $32.2 million of Tier 1 capital and $36.9 million of total risk-based capital. Following is a summary of the Bank’s capital ratios as of September 30, 2009:

Tier 1 leverage ratio of 6.71% to average assets.

Tier 1 capital ratio of 8.69% to risk weighted assets.

Total risk based capital ratio of 9.94% to risk weighted assets.

Management anticipates returning to a well-capitalized position by the end of 2009.

Cornerstone had total outstanding borrowings of $5.35 million from Silverton Bank, currently in FDIC receivership, as of September 30, 2009. The $5.35 million is comprised of a $4.35 million term loan amortizing over a five year period and $1.0 million under a revolving line of credit.

On October 15, 2009, Cornerstone notified the FDIC of its decision to withdraw its application for funding under the U.S. Treasury’s Capital Purchase Program.

Market and Liquidity Risk Management

Interest Rate Sensitivity

The Bank’s Asset Liability Management Committee (“ALCO”) is responsible for making decisions regarding liquidity and funding 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 primarily to 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 Annual Report on Form 10-K for the year ended December 31, 2008. No material changes in the assumptions used in preparing, or results obtained from, the model have occurred since December 31, 2008.

Item 4T. Controls and Procedures

Under the supervision and with the participation of management, including Cornerstone’s principal executive officer and principal financial officer, Cornerstone has evaluated the effectiveness of its disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), as of September 30, 2009 (the “Evaluation Date”). Based on such evaluation, such officers have concluded that, as of the Evaluation Date, Cornerstone’s disclosure controls and procedures were 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.

There were no changes in Cornerstone’s internal control over financial reporting during Cornerstone’s fiscal quarter ended September 30, 2009 that have materially affected, or are reasonably likely to materially affect, Cornerstone’s internal control over financial reporting.

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

There have been no material changes to Cornerstone’s risk factors as previously disclosed in Part I, Item 1A of Cornerstone’s Annual Report on Form 10-K for the fiscal year ended December 31, 2008.

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds

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

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.

SIGNATURES

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

	Cornerstone Bancshares, Inc.

Date: November 13, 2009	/s/ Nathaniel F. Hughes
	Nathaniel F. Hughes,
	(Acting) President & Chief Executive Officer
	(principal executive officer)

Date: November 13, 2009	/s/ Gary W. Petty, Jr.
	Gary W. Petty, Jr.
	(Acting) Treasurer
	(principal financial officer)

EXHIBIT INDEX

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.