SMARTFINANCIAL INC. - Quarter Report: 2009 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, 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 July 28, 2009 there were 6,372,937 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	17

Item 3. Quantitative and Qualitative Disclosures about Market Risk	24

Item 4T.Controls and Procedures	24

PART II – OTHER INFORMATION
Item 1. Legal Proceedings	24

Item 1A. Risk Factors	24

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds	24

Item 3. Defaults Upon Senior Securities	24

Item 4. Submission of Matters to a Vote of Security Holders	24

Item 5. Other Information	25

Item 6. Exhibits	25

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
	June 30,		December 31,
	2009		2008
ASSETS
Cash and due from banks	$	34,306,722	$	10,872,390
Federal funds sold		-		11,025,000
Cash and cash equivalents		34,306,722		21,897,390

Securities available for sale		45,699,449		44,056,559
Securities held to maturity		154,426		169,284
Federal Home Loan Bank stock, at cost		2,229,200		2,187,500
Loans, net of allowance for loan losses of $7,383,314 at June 30, 2009 and $9,618,265 at December 31, 2008		353,231,930		378,471,619
Bank premises and equipment, net		8,104,060		8,471,955
Accrued interest receivable		1,414,384		1,771,091
Goodwill and amortizable intangibles		2,562,760		2,840,773
Other assets		16,795,842		11,937,004
Total Assets	$	464,498,773	$	471,803,175

LIABILITIES AND STOCKHOLDERS' EQUITY
Deposits:
Noninterest-bearing demand deposits	$	42,146,564	$	40,077,977
Interest-bearing demand deposits		30,398,515		26,908,572
Savings deposits and money market accounts		31,639,974		35,847,667
Time deposits of $100,000 or more		65,244,121		59,056,590
Time deposits of less than $100,000		167,610,525		164,692,417
Total deposits		337,039,699		326,583,223
Federal funds purchased and securities sold under agreements to repurchase		20,526,479		35,790,246
Federal Home Loan Bank advances and line of credit		72,350,000		71,250,000
Accrued interest payable		651,368		469,586
Other liabilities		1,232,141		1,208,611
Total Liabilities		431,799,687		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;6,522,718 issued in 2009 and 2008; 6,319,718 outstanding in 2009 and 2008		6,319,718		6,319,718
Additional paid-in capital		20,421,034		20,311,638
Retained earnings		5,904,317		10,056,680
Accumulated other comprehensive income		54,017		(186,527	)
Total Stockholders' Equity		32,699,086		36,501,509
Total Liabilities and Stockholders' Equity	$	464,498,773	$	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					Six months ended
	June 30,					June 30,
	2009			2008		2009			2008
INTEREST INCOME
Loans, including fees	$	6,035,104		$	7,199,680	$	12,477,209		$	14,752,975
Investment securities		386,065			553,103		800,126			1,051,112
Federal funds sold		6,697			4,122		14,646			12,881
Total interest income		6,427,866			7,756,905		13,291,981			15,816,968

INTEREST EXPENSE
Interest bearing demand accounts		29,960			56,570		56,154			123,397
Money market accounts		69,642			191,671		149,288			529,524
Savings accounts		10,247			15,379		20,010			31,186
Time deposits of more than $100,000		480,917			685,347		1,010,094			1,513,092
Time deposits of less than $100,000		1,388,223			1,421,289		2,854,235			2,828,224
Federal funds purchased and securities sold under agreements to repurchase		43,880			170,985		97,929			344,785
Other borrowings		768,199			682,208		1,474,035			1,323,121
Total interest expense		2,791,068			3,223,449		5,661,745			6,693,329

Net interest income before provision for loan losses		3,636,798			4,533,456		7,630,236			9,123,639
Provision for loan losses		1,633,898			170,000		7,358,898			487,000
Net interest income after the provision for loan losses		2,002,900			4,363,456		271,338			8,636,639

NONINTEREST INCOME
Service charges		434,595			433,489		842,738			838,820
Net gains / (losses) from sale of loans and other assets		146,613			61,779		(34,248	)		9,531
Other income		149,083			29,304		184,915			70,526
Total noninterest income		730,291			524,572		993,405			918,877

NONINTEREST EXPENSE
Salaries and employee benefits		1,848,452			1,834,678		3,690,127			3,675,710
Occupancy and equipment expense		387,897			383,173		796,836			763,054
Other operating expense		1,537,010			998,140		2,579,138			1,873,851
Total noninterest expense		3,773,359			3,215,991		7,066,101			6,312,615

Income / (loss) before provision for income taxes		(1,040,168	)		1,672,037		(5,801,358	)		3,242,901
Provision / (benefit) for income taxes		(437,369	)		598,981		(2,287,056	)		1,154,988

NET INCOME / (LOSS)	$	(602,799	)	$	1,073,056	$	(3,514,302	)	$	2,087,913

EARNINGS / (LOSS) PER COMMON SHARE
Basic net income / ( loss) per common share	$	(0.10	)	$	0.17	$	(0.56	)	$	0.33
Diluted net income / (loss) per common share	$	(0.10	)	$	0.17	$	(0.56	)	$	0.32

DIVIDENDS DECLARED PER COMMON SHARE	$	0.03		$	0.07	$	0.10		$	0.14

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 six months ended June 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	$	10056680		$	(186,527	)	$	36,501,509

Employee compensation stock option expense					-		109,396		-			-			109,396

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

Comprehensive income / (loss):
Net loss	$	(3,514,302	)		-		-		(3,514,302	)		-			(3,514,302	)

Other comprehensive income, net of tax: Unrealized holding gains (losses) on securities available for sale, net of reclassification adjustment		240,544			-		-		-			240,544			240,544

Total comprehensive loss	$	(3,273,758	)

BALANCE, June 30, 2009				$	6,319,718	$	20,421,034	$	5,904,317		$	54,017		$	32,699,086

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

Cornerstone Bancshares, Inc. and Subsidiary

Consolidated Statements of Cash Flows

	Unaudited
	Six months ended June 30,
	2009			2008

CASH FLOWS FROM OPERATING ACTIVITIES
Net income / (loss)	$	(3,514,302	)	$	2,087,913
Adjustments to reconcile net income / (loss) to net cash (used in) provided by operating activities:
Depreciation and amortization		500,824			281,590
Provision for loan losses		7,358,898			487,000
Stock compensation expense		109,396			139,800
Net (Gains) / Losses on sales of loans and other assets		34,248			(9,531	)
Deferred income taxes		670,271			3,181,110
Changes in other operating assets and liabilities:
Net change in loans held for sale		(545,700	)		202,900
Accrued interest receivable		356,707			611,987
Accrued interest payable		181,782			77,315
Other assets and liabilities		(3,368,156	)		(7,716,437	)
Net cash provided by (used in) operating activities		1,783,968			(656,353	)

CASH FLOWS FROM INVESTING ACTIVITIES
Proceeds from security transactions:
Securities available for sale		27,916,257			17,222,653
Securities held to maturity		14,603			16,213
Purchase of securities available for sale		(29,228,921	)		(28,320,718	)
Purchase of Federal Home Loan Bank stock		(41,700	)		(187,500	)
Loan originations and principal collections, net		14,950,859			(2,186,712	)
Purchase of bank premises and equipment		(92,128	)		(267,170	)
Proceeds from sale of other real estate and other assets		1,698,445			-
Net cash provided by (used in) investing activities		15,217,415			(13,723,234	)

CASH FLOWS FROM FINANCING ACTIVITIES
Net increase in deposits		10,456,476			756,291
(Decrease) in federal funds purchased and securities sold under agreements to repurchase		(15,263,767	)		(6,230,229	)
Net proceeds from Federal Home Loan Bank advances and other borrowings		1,100,000			19,350,000
Purchase of common stock		-			(503,006	)
Payment of dividends		(884,760	)		(888,260	)
Net cash (used in) provided by financing activities		(4,592,051	)		12,484,796

NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS		12,409,332			(1,894,791	)

CASH AND CASH EQUIVALENTS, beginning of period		21,897,390			14,933,349
CASH AND CASH EQUIVALENTS, end of period	$	34,306,722		$	13,038,558

SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION
Cash paid during the period for interest	$	5,479,963		$	6,616,014
Cash paid during the period for taxes		-			582,500

NONCASH INVESTING AND FINANCING ACTIVITIES
Acquisition of real estate through foreclosure	$	3,594,574		$	-

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 June 30, 2009 and June 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.

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, 2009 and 2008.

	Three Months Ended June 30,
Basic earnings / (loss) per share calculation:	2009			2008
Numerator: Net income / (loss) available to common shareholders	$	(602,799	)	$	1,073,056
Denominator: Weighted avg. common shares outstanding		6,319,718			6,319,718
Effect of dilutive stock options		-			168,579
Diluted shares		6,319,718			6,488,297

Basic earnings / (loss) per share	$	(0.10	)	$	0.17
Diluted earnings / (loss) per share	$	(0.10	)	$	0.17

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

	Six Months Ended June 30,
Basic earnings / (loss) per share calculation:	2009			2008
Numerator: Net income / (loss) available to common shareholders	$	(3,514,302	)	$	2,087,913
Denominator: Weighted avg. common shares outstanding		6,319,718			6,328,234
Effect of dilutive stock options		-			199,288
Diluted shares		6,319,718			6,527,522

Basic earnings / (loss) per share	$	(0.56	)	$	0.33
Diluted earnings / (loss) per share	$	(0.56	)	$	0.32

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 six month period ended June 30, 2009, the compensation cost charged to earnings related to the vested incentive stock options was approximately $109,000, 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 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 June 30, 2009, the total remaining compensation cost to be recognized on non-vested options was approximately $592,000. 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 June 30, 2009		845,875		$	6.27	5.3 Years	$	681,619
Options exercisable at June 30, 2009		595,378		$	5.46

CORNERSTONE BANCSHARES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

The weighted average grant-date fair value of stock options granted during the six months ended June 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 June 30, 2009, the total remaining compensation cost to be recognized on non-vested options was approximately $52,000. 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 June 30, 2009		102,300	$	9.30	7.8 Years	$	29,487
Options exercisable at June 30, 2009		75,400	$	10.96

The weighted average grant-date fair value of stock options granted during the six months ended June 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%.

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.

CORNERSTONE BANCSHARES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

Note 4. Securities

The amortized cost and fair value of securities available-for-sale and held-to-maturity at June 30, 2009 and December 31, 2008 are summarized as follows:

	June 30, 2009
			Gross		Gross
	Amortized		Unrealized		Unrealized			Market
Securities Available-for-Sale:	Cost		Gains		Losses			Value
U.S. Government securities	$	8,292,245	$	-	$	(66,997	)	$	8,225,248

State and municipal securities		6,380,664		163,914		(42,116	)		6,502,462

Mortgage-backed securities		30,944,696		191,104		(164,061	)		30,971,739

	$	45,617,605	$	355,018	$	(273,174	)	$	45,699,449
Securities Held-to-Maturity:
Mortgage-backed securities	$	154,426	$	1,189	$	(131	)	$	155,484

	December 31, 2008
			Gross		Gross
	Amortized		Unrealized		Unrealized			Market
Securities Available-for-Sale:	Cost		Gains		Losses			Value
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		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	$	169,284	$	1,158	$	(683	)	$	169,759

At June 30, 2009, approximately $44 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.

CORNERSTONE BANCSHARES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

Note 5. Loans and Allowance for Loan Losses

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

	June 30, 2009					December 31, 2008
	Amount		Percent			Amount		Percent
Commercial, financial and agricultural	$	66,994		18.6	%	$	83,140		21.4	%
Real estate-construction		61,553		17.1	%		70,456		18.2	%
Real estate-mortgage		72,141		20.0	%		72,737		18.7	%
Real estate-commercial		155,148		43.0	%		155,728		40.1	%
Consumer loans		4,779		1.3	%		6,029		1.6	%
Total loans	$	360,615		100.0	%	$	388,090		100.0	%

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

	June 30,			December 31,
	2009			2008
Balance, beginning of period	$	9,618		$	13,710
Loans charged-off		(9,783	)		(7,979	)
Recoveries of loans previously charged-off		189			389
Provision for loan losses		7,359			3,498
Balance, end of period	$	7,383		$	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 June 30, 2009 is as follows:

Commitments to extend credit	$	49.1 million
Standby letters of credit	$	3.4 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, 2009 will not have a material effect on Cornerstone’s consolidated financial statements.

Note 7. Fair Value Disclosures

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:

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.

CORNERSTONE BANCSHARES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

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.

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

	June 30, 2009
	Carrying		Estimated
	Amount		Fair Value
Assets:
Cash and cash equivalents	$	34,307	$	34,307
Securities		45,854		45,855
Federal Home Loan Bank Stock		2,229		2,229
Loans, net		353,232		355,740

Liabilities:
Noninterest –bearing demand deposits		42,147		42,147
Interest-bearing demand deposits		30,399		30,399
Savings deposits and money market accounts		31,640		31,640
Time deposits		232,855		236,044
Federal funds purchased and securities
sold under agreements to repurchase		20,526		20,526
Federal Home Loan Bank advances
And line of credit		72,350		72,350

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

CORNERSTONE BANCSHARES, INC.

CONSOLIDATED AVERAGE BALANCE

INTEREST INCOME/EXPENSE AND

YIELD/RATES

Taxable Equivalent Basis	Three months ended
(in thousands)	June 30

Assets	2009								2008
	Average			Income/		Yield/			Average			Income/		Yield/
Earning assets:	Balance			Expense		Rate			Balance			Expense		Rate
Loans, net of unearned income	$	370,524		$	6,035		6.53	%	$	384,487		$	7,200		7.51	%
Investment securities		56,849			386		2.91	%		48,549			553		4.69	%
Other earning assets		11,089			7		0.24	%		592			4		2.79	%
Total earning assets		438,461		$	6,428		5.90	%		433,628		$	7,757		7.19	%
Allowance for loan losses		(9,326	)							(7,515	)
Cash and other assets		30,509								26,132
TOTAL ASSETS	$	459,645							$	452,245

Liabilities and Shareholders' Equity

Interest bearing liabilities:
Interest bearing demand deposits	$	31,702		$	30		0.38	%	$	31,434		$	56		0.72	%
Savings deposits		8,101			10		0.51	%		7,857			16		0.79	%
MMDA's		28,754			70		0.97	%		46,391			192		1.66	%
Time deposits of $100,000 or less		165,234			1,388		3.37	%		124,024			1,421		4.60	%
Time deposits of $100,000 or more		57,502			481		3.36	%		57,895			685		4.75	%
Federal funds purchased and securities sold under agreements to repurchase		22,479			44		0.78	%		35,817			169		1.89	%
Other borrowings		72,454			768		4.25	%		69,475			684		3.95	%
Total interest bearing liabilities		386,226			2,791		2.90	%		372,893			3,223		3.47	%
Net interest spread				$	3,637		3.01	%				$	4,533		3.72	%
Noninterest bearing demand deposits		42,752								42,375
Accrued expenses and other liabilities		(3,190	)							(372	)
Shareholders' equity		33,857								37,350
TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY	$	459,645							$	452,245
Net yield on earning assets							3.35	%							4.21	%

Taxable equivalent adjustment:
Loans					0								0
Investment securities					26								14
Total adjustment				$	26							$	14

CORNERSTONE BANCSHARES, INC.

CONSOLIDATED AVERAGE BALANCE

INTEREST INCOME/EXPENSE AND

YIELD/RATES

Taxable Equivalent Basis	Six Months Ended
(in thousands)	June 30

Assets	2009								2008
	Average			Income/		Yield/			Average			Income/		Yield/
Earning assets:	Balance			Expense		Rate			Balance			Expense		Rate
Loans, net of unearned income	$	377,095		$	12,477		6.67	%	$	385,294		$	14,753		7.72	%
Investment securities		54,976			800		3.12	%		45,392			1,051		4.82	%
Other earning assets		12,517			15		0.24	%		394			13		6.60	%
Total earning assets		444,588		$	13,292		6.05	%		431,080		$	15,817		7.42	%
Allowance for loan losses		(9,232	)							(9,403	)
Cash and other assets		29,469								27,682
TOTAL ASSETS	$	464,825							$	449,359

Liabilities and Shareholders' Equity

Interest bearing liabilities:
Interest bearing demand deposits	$	30,270		$	56		0.37	%	$	31,821		$	123		0.78	%
Savings deposits		7,960			20		0.51	%		7,749			31		0.82	%
MMDA's		30,893			149		0.97	%		49,989			530		2.14	%
Time deposits of $100,000 or less		165,425			2,854		3.48	%		120,590			2,828		4.73	%
Time deposits of $100,000 or more		58,559			1,010		3.48	%		61,632			1,513		4.95	%
Federal funds purchased and securities sold under agreements to repurchase		23,509			98		0.84	%		31,209			345		2.23	%
Other borrowings		71,946			1,474		4.13	%		64,754			1,323		4.12	%
Total interest bearing liabilities		388,562			5,661		2.94	%		367,744			6,693		3.67	%
Net interest spread				$	7,631		3.11	%				$	9,124		3.74	%
Noninterest bearing demand deposits		42,907								43,438
Accrued expenses and other liabilities		(2,028	)							939
Shareholders' equity		35,384								37,238
TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY	$	464,825							$	449,359
Net yield on earning assets							3.48	%							4.28	%

Taxable equivalent adjustment:
Loans					0								0
Investment securities					50								34
Total adjustment				$	50							$	34

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. 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 Financial Inc. a wholly owned subsidiary of Cornerstone Bancshares Inc., was sold to Cornerstone Community Bank, effective June 30, 2009, for $958 thousand and will be operated as a wholly owned subsidiary of the Bank to take advantage of economies of scale and operational synergies. Eagle Financial will retain its brand and continue to operate as a factoring company.

The following is a discussion of our financial condition at June 30, 2009 and December 31, 2008 and our results of operations for the three and six months ended June 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 June 30, 2009, Cornerstone had total consolidated assets of $464.5 million, total loans of $360.6 million, total deposits of $337.0 million and stockholders’ equity of $32.7 million. Net loss for the three and six month periods ended June 30, 2009 totaled ($602,799) and ($3,514,302), respectively.

Results of Operations

Net loss for the three months ended June 30, 2009 was ($602,799) or ($0.10) basic earnings per share, compared to net income of $1,073,056 or $0.17 basic earnings per share for the same period in 2008. Net loss for the six months ended June 30, 2009 was ($3,514,302) or ($0.56) basic earnings per share, compared to net income of $2,087,913 or $0.33 basic earnings per share, for the same period of 2008.

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

						2009-2008											2009-2008
	Three months					Percent			Dollar			Six months					Percent			Dollar
	ended June 30,					Increase			Amount			ended June 30,					Increase			Amount
	2009			2008		(Decrease)			Change			2009			2008		(Decrease)			Change
Interest income	$	6,428		$	7,757		(17.13	)%	$	(1,329	)	$	13,292		$	15,817		(15.96	)%	$	(2,525	)
Interest expense		2,791			3,223		(13.40	)%		(432	)		5,662			6,693		(15.40	)%		(1,031	)
Net interest income
before provision for loss		3,637			4,533		(19.77	)%		(896	)		7,630			9,124		(16.37	)%		(1,494	)

Provision for loan loss		1,634			170		861.18	%		1,464			7,359			487		1,411.09	%		6,872
Net interest income after
provision for loan loss		2,003			4,363		(54.09	)%		(2,360	)		271			8,637		(96.86	)%		(8,366	)

Total noninterest income		730			525		39.05	%		205			994			919		8.16	%		75
Total noninterest expense		3,773			3,216		17.32	%		557			7,066			6,313		11.93	%		753

Income / (loss) before income taxes		(1,040	)		1,672		(162.20	)%		(2,712	)		(5,801	)		3,243		(278.88	)%		(9,044	)

Provision for income taxes		(437	)		599		(172.95	)%		(1,036	)		(2,287	)		1,155		(298.01	)%		(3,442	)

Net income / (loss)	$	(603	)	$	1,073		(156.20	)%	$	(1,676	)	$	(3,514	)	$	2,088		(268.30	)%	$	(5,602	)

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 six months ended June 30, 2009, net interest income before the provision for loan loss, decreased $(1,494) thousand or (16.37)% 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 3.11% for the six month period ended June 30, 2009 compared to 3.74% for the same period in 2008. The net interest margin on a tax equivalent basis was 3.48% for the six month period ended June 30, 2009 compared to 4.28% 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.

The Bank’s loan portfolio yield has declined to 6.53% for the three months ended June 30, 2009 compared to 7.51% for the quarter ended June 30, 2008. The Bank’s loan portfolio yield has declined to 6.67% for the six months ended June 30, 2009 compared to 7.72% for the six months ended June 30, 2008. The decrease in loan yields is due primarily to difficult economic conditions in Chattanooga, TN and the increase in the amount of non-accrual and restructured loans in the Bank’s loan portfolio. Management believes the net interest margin is approaching the lowest level and expects the net interest margin to remain at this level during the third quarter of 2009 and increase slightly during the forth quarter of 2009 due to the continued repricing of the Bank’s certificate of deposit portfolio and the eventual decrease in non-performing assets.

For the three month period ended June 30, 2009, the Bank’s investment portfolio resulted in a yield of 2.91% compared to 4.69% for the same time period in 2008. For the six month period ended June 30, 2009, the Bank’s investment portfolio resulted in a yield of 3.12% compared to 4.82% for the same time period in 2008. The decline in the investment portfolio yield from June 30, 2008 to June 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. This liquidity will be deployed during the third 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.

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 $7.4 million for the six months ended June 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 six months ended June 30, 2009 and 2008 (dollars in thousands).

					2009- 2008								2009- 2008
	Three months ended				Percent			Six months ended					Percent
	June 30,				Increase			June 30,					Increase
	2009		2008		(Decrease)			2009			2008		(Decrease)
Service charges on deposit accounts	$	435	$	434		0.23	%	$	843		$	838		0.60	%
Net gains / (losses) on sale of loans and other assets		147		62		137.10	%		(34	)		10		(440.00	)%
Other fee income		149		29		413.79	%		185			71		160.56	%
Total noninterest income	$	731	$	525		39.24	%	$	994		$	919		8.16	%

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

The Bank realized $428 thousand of loss relating to the disposal of other real estate and repossessed assets during the first half of 2009. This amount was offset by gains resulting from the sale of investment securities. The Bank expects further losses relating to the disposal of other real estate and repossessed assets.

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 six months ended June 30, 2009 and 2008 (dollars in thousands).

	Three months ended				2009-2008			Six months ended				2009-2008
	June 30,				Percent			June 30,				Percent
	2009		2008		Increase			2009		2008		Increase
Salaries and employee benefits	$	1,848	$	1,835		0.71	%	$	3,690	$	3,676		0.38	%
Occupancy and equipment expense		388		383		1.31	%		797		763		4.46	%
Other operating expense		1,537		998		54.01	%		2,579		1,874		37.62	%
Total noninterest expense	$	3,773	$	3,216		17.32	%	$	7,066	$	6,313		11.93	%

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

During the six months ended June 30, 2009, the Bank paid approximately $280,000 in insurance assessments to the Federal Deposit Insurance Corporation (“FDIC”) compared to approximately $125,000 in FDIC insurance assessments for the same period of 2008.

During the first half of 2009, Cornerstone incurred additional expense related to other real estate. These expenses total approximately $183,000 for the six months ended June 30, 2009 compared to approximately $53,000 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-Cornerstone’s consolidated assets totaled $471.8 million as of December 31, 2008. As of June 30, 2009, total consolidated assets had decreased $7.3 million or (1.55)% to $464.5 million. The Bank’s loan portfolio totaled $360.6 million as of June 30, 2009, a decrease of $27.5 million or (7.08)% from December 31, 2008. The Bank’s investment portfolio increased by approximately $1.6 million to a total of $45.9 million as of June 30, 2009 compared to a total of $44.2 million as of December 31, 2008. Liabilities as of June 30, 2009 and December 31, 2008 totaled approximately $431.8 million and $435.3 million, respectively. Stockholders’ equity as of June 30, 2009 and December 31, 2008 totaled approximately $32.7 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 $45.9 million as of June 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.

Loans-The composition of loans at June 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):

	June 30, 2009					December 31, 2008
	Amount		Percent			Amount		Percent
Commercial, financial and agricultural	$	66,994		18.6	%	$	83,140		21.4	%
Real estate-construction		61,553		17.1	%		70,456		18.2	%
Real estate-mortgage		72,141		20.0	%		72,737		18.7	%
Real estate-commercial		155,148		43.0	%		155,728		40.1	%
Consumer loans		4,779		1.3	%		6,029		1.6	%
Total loans	$	360,615		100.0	%	$	388,090		100.0	%

For the six months ended June 30, 2009 the Bank has seen a decrease in total loans of 7.08% 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 $61.6 million as of June 30, 2009 is a result of the Bank’s attempt to minimize its risk given the current real estate inventory.

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 second 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 six months ended June 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):

	June 30,			December 31,
	2009			2008
Balance, beginning of period	$	9,618		$	13,710
Loans charged-off		(9,783	)		(7,979	)
Recoveries of loans previously charged-off		189			389
Provision for loan losses		7,359			3,498
Balance, end of period	$	7,383		$	9,618

Total loans	$	360,615		$	388,090

Ratio of allowance for loan losses to loans outstanding at the end of the period		2.05	%		2.48	%

Ratio of net charge-offs to total loans outstanding for the period		2.66	%		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 six months ended June 30, 2009 and for the year ended December 31, 2008:

	June 30,		December 31,
	2009		2008
Impaired loans without a valuation allowance	$	4,929,462	$	2,543,320

Impaired loans with a valuation allowance	$	24,802,323	$	17,375,043

Total impaired loans	$	29,731,785	$	19,918,363

Valuation allowance related to impaired loans	$	4,111,300	$	5,872,373

Total non-accrual loans	$	13,396,656	$	4,252,791

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

	Six Months		Year Ended
	June 30,		December 31,
	2009		2008
Average investment in impaired loans (1)	$	27,779,536	$	10,891,357

Interest income recognized on impaired loans	$	1,116,067	$	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 FASB 114 analysis. (b) Loans with a risk grade of 5 or greater that have not been assigned an impairment amount however, the loan, as of the reporting date, is at least sixty days past due. The average investment in impaired loans is then 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 increased during the second 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 for the six months ended June 30, 2009 and for the year ended December 31, 2008 (dollars in thousands):

	June 30,			December 31,
	2009			2008
Non-accrual loans	$	13,397		$	4,252
Repossessed assets		181			257
Foreclosed properties		4,783			2,459
Total non-performing assets	$	18,361		$	6,968

Total loans outstanding	$	360,615		$	388,090

Allowance for loan losses		7,383			9,618

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

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

As of June 30, 2009, the Bank’s non-accrual loans surged as impaired loans progressed through the collection process and shifted from past due and impaired to non-accrual. Management expects the collateral associated with these loans to be in other real estate or disposed of by the fourth quarter of 2009. Furthermore, management anticipates a minimal loss associated with the disposal of these assets. The Bank has also placed a high priority regarding 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.

	June 30, 2009					December 31, 2008
Core funding:	Amount		Percent			Amount		Percent
Noninterest bearing demand deposits	$	42,147		9.9	%	$	40,078		9.3	%
Interest bearing demand deposits		30,399		7.2	%		26,909		6.3	%
Savings & money market accounts		31,640		7.5	%		35,848		8.3	%
Time deposits under $100,000		167,611		39.4	%		164,692		38.4	%
Total core funding		271,797		64.0	%		267,527		62.3	%

Non-core funding:
Time deposit accounts greater than $100,000		65,244		15.4	%		59,057		13.8	%
Securities sold under agreements to repurchase		20,526		4.8	%		35,790		8.3	%
Federal Home Loan Bank advances		67,000		15.8	%		67,000		15.6	%
Total non-core funding		152,770		36.0	%		161,847		37.7	%

Total	$	424,567		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 June 30, 2009, the Bank had established $20.5 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 $1.5 million in borrowings and plans to increase its borrowing capacity to $10 million by the end of the third 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 June 30, 2009, the Bank had borrowed a total of $67 million from FHLB consisting of structured term loans. During the second quarter of 2009 the Bank received notification from the FHLB that additional collateral totaling approximately, $15 million, would be needed by the end of the third quarter of 2009. The additional collateral is needed given the Bank’s reduction in loan portfolio and the FHLB collateral assessment. Currently, the Bank is purchasing additional securities to pledge at the FHLB to cure the deficiency.

Capital Resources-At June 30, 2009 and December 31, 2008, Cornerstone’s stockholders’ equity amounted to $32.7 million and $36.5 million, respectively.

Cornerstone’s stockholders’ equity decreased $3.8 million during the six months ended June 30, 2009. Factors contributing to the reduction in capital include cash dividends totaling $0.10 for the six months ended June 30, 2009 of which $0.03 was declared during the second quarter 2009. A second factor was the operating losses of $603 thousand during the second quarter 2009 resulting in a year to date loss of $3.5 million.

As of June 30, 2009, the Bank exceeded the regulatory minimums and qualified as a well-capitalized institution under the regulations. The Bank had Tier 1 capital of $34.5 or 9.2% of risk weighted assets as of June 30, 2009. The Bank had total risk based capital of $39.2 or 10.5% of risk weighted assets as of June 30, 2009.

Cornerstone’s had total outstanding borrowings of $5.35 million from Silverton Bank, currently in FDIC receivership, as of June 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. Cornerstone is actively seeking other correspondent relationships and anticipates moving the relationship during 2009.

Cornerstone has applied for $12 million of funding under the U.S. Treasury’s Capital Purchase Program and is currently waiting for approval.

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.

The Bank has identified a material interest rate risk in the Bank’s balance sheet. The risk has been created by the activation of interest rate floors on the majority of the Bank’s variable rate loans. Given the present interest rate levels, the Bank could see its interest sensitive deposits increase 200 basis points without a corresponding movement in the majority of its variable rate loans. Management is discussing possible on-balance sheet strategies to protect against the interest rate exposure presented in this scenario.

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 June 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 June 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

Cornerstone’s annual shareholder meeting was held on April 23, 2009. At the meeting, the individuals whose names appear below were elected to Cornerstone’s board of directors. Shareholders’ also ratified the appointment of Hazlett, Lewis & Bieter, PLLC as its independent auditors for the fiscal year ending December 31, 2009. Finally, shareholders’ voted on Chief Executive Officer compensation. The shareholders’ votes were cast as follows with 5,422,073 or 82.1% of the total shares voting:

Election of Directors	For			Against			Abstain
B. Kenneth Driver		99.9	%		0.0	%		0.1	%
Karl Fillauer		99.9	%		0.0	%		0.1	%
David G. Fussell		99.8	%		0.0	%		0.2	%
Nathaniel F. Hughes		99.8	%		0.0	%		0.2	%
Gregory B. Jones		99.9	%		0.0	%		0.1	%
Jerry D. Lee		99.9	%		0.0	%		0.1	%
Lawrence D. Levine		99.8	%		0.0	%		0.2	%
Frank S. McDonald		100.0	%		0.0	%		0.0	%
Doyce G. Payne		99.8	%		0.0	%		0.2	%
Wesley W. Welborn		100.0	%		0.0	%		0.0	%
Kim H. White		100.0	%		0.0	%		0.0	%
Billy O. Wiggins		99.8	%		0.0	%		0.2	%
Marsha Yessick		95.3	%		0.0	%		4.7	%

Ratification of Appointment of Hazlett, Lewis & Bieter, PLLC.		99.8	%		0.2	%		0.0	%

Non-Binding Vote on CEO Compensation		91.0	%		5.5	%		3.5	%

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: August 13, 2009	/s/ Gregory B. Jones
	Gregory B. Jones,
	Chairman and Chief Executive Officer
	(principal executive officer)

Date: August 13, 2009	/s/ Nathaniel F. Hughes
	Nathaniel F. Hughes
	President and 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.