SMARTFINANCIAL INC. - Quarter Report: 2011 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, 2011

¨	TRANSITION REPORT PURSUANT SECTION 13 OR 15(d) OF THE
	SECURITIES EXCHANGE ACT OF 1934
	For the transition period from __________to

Commission File Number: 000-30497

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

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

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

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

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

Yes x No ¨

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

Yes ¨ 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 1, 2011 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	30

Item 3. Quantitative and Qualitative Disclosures about Market Risk	42

Item 4T.Controls and Procedures	42

PART II – OTHER INFORMATION

Item 1. Legal Proceedings	42

Item 1A. Risk Factors	42

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds	42

Item 3. Defaults Upon Senior Securities	42

Item 4. [Removed and Reserved]	42

Item 5. Other Information	42

Item 6. Exhibits	42

FORWARD-LOOKING STATEMENTS

Cornerstone Bancshares, Inc. (“Cornerstone”) may from time to time make written or oral statements, including statements contained in this report (including, without limitation, certain statements in “Management Discussion and Analysis of Financial Condition and Results of Operations” in Item 2), that constitute forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934 (the “Exchange Act”). The words “expect,” “anticipate,” “intend,” “consider,” “plan,” “believe,” “seek,” “should,” “estimate,” and similar expressions are intended to identify such forward-looking statements, but other statements may constitute forward-looking statements. These statements should be considered subject to various risks and uncertainties. Such forward-looking statements are made based upon management’s belief as well as assumptions made by, and information currently available to, management pursuant to “safe harbor” provisions of the Private Securities Litigation Reform Act of 1995. Cornerstone’s actual results may differ materially from the results anticipated in forward-looking statements due to a variety of factors. Such factors include, without limitation, those specifically described in Item 1A of Part I of Cornerstone’s Annual Report on Form 10-K for the year ended December 31, 2010, as well as the following: (i) the ability of Cornerstone Community Bank (the “Bank”) to comply with the requirements of the consent order issued by the Federal Deposit Insurance Corporation on April 2, 2010 or the written agreement entered with the Tennessee Department of Financial Institutions on April 8, 2010 (collectively, the “Action Plans”); (ii) the ability of Cornerstone to raise additional capital necessary to retire certain holding company loans and enable the Bank to achieve and maintain the elevated capital levels required under the Action Plans; (iii) unanticipated deterioration in the financial condition of borrowers resulting in significant increases in loan losses and provisions for those losses; (iv) increased competition with other financial institutions; (v) changes in economic conditions in Cornerstone’s market area; (vi) rapid fluctuations or unanticipated changes in interest rates; (vii) the effect on Cornerstone and the financial institutions and banking industry from difficult market conditions, unprecedented volatility and the soundness of other financial institutions; (viii) the ability of Cornerstone to restructure its loan portfolio to acceptable levels and composition; (ix) the effect of recent legislative and regulatory initiatives; and (x) changes in the legislative and regulatory environment. 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

	Unaudited
	September 30,			December 31,
	2011			2010

ASSETS
Cash and due from banks	$	1,084,209		$	1,490,030
Interest-bearing deposits at other financial institutions		31,850,143			21,491,922
Total cash and cash equivalents		32,934,352			22,981,952

Securities available for sale		93,666,153			108,250,434
Securities held to maturity (fair value approximates of $78,053 and $98,388 at September 30, 2011 and December 31, 2010, respectively)		75,810			95,702
Federal Home Loan Bank stock, at cost		2,322,900			2,322,900
Loans, net of allowance for loan losses of $6,864,196 at September 30, 2011 and $9,132,171 at December 31, 2010		263,536,587			276,114,617
Bank premises and equipment, net		5,676,290			8,047,370
Accrued interest receivable		1,337,407			1,326,480
Foreclosed assets		18,254,741			12,808,838
Other assets		8,560,558			9,551,121
Total Assets	$	426,364,798		$	441,499,414

LIABILITIES AND STOCKHOLDERS' EQUITY

Deposits:
Noninterest-bearing demand deposits	$	40,115,385		$	28,980,043
Interest-bearing demand deposits		22,773,718			24,834,214
Savings deposits and money market accounts		43,477,203			34,041,672
Time deposits		216,185,314			247,591,161
Total deposits		322,551,620			335,447,090
Federal funds purchased and securities sold under agreements to repurchase		26,053,577			24,325,372
Federal Home Loan Bank advances and other borrowings		43,045,000			54,715,000
Accrued interest payable		90,706			176,761
Other liabilities		2,176,468			1,016,038
Total Liabilities		393,917,371			415,680,261

Stockholders' Equity:
Preferred stock - no par value; 2,000,000 shares authorized; 300,060 shares issued and outstanding in 2011 and 114,540 shares issued and outstanding in 2010		7,300,221			2,727,424
Common stock - $l.00 par value; 20,000,000 shares authorized; 6,709,199 issued in 2011 and 2010; 6,500,396 outstanding in 2011 and 2010		6,500,396			6,500,396
Additional paid-in capital		21,296,653			21,237,298
Retained deficit		(3,725,732	)		(4,317,130	)
Accumulated other comprehensive income		1,075,889			(328,835	)
Total Stockholders' Equity		32,447,427			25,819,153
Total Liabilities and Stockholders' Equity	$	426,364,798		$	441,499,414

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

Cornerstone Bancshares, Inc. and Subsidiary

Consolidated Statements of Operations

	Unaudited				Unaudited
	Three months ended				Nine months ended
	September 30,				September 30,
	2011		2010		2011		2010
INTEREST INCOME
Loans, including fees	$	4,531,390	$	5,159,963	$	13,691,565	$	16,602,155
Investment securities		573,699		753,783		1,763,479		3,099,362
Federal funds sold & other earning assets		9,269		19,289		37,597		64,682
Total interest income		5,114,358		5,933,035		15,492,641		19,766,199

INTEREST EXPENSE
Time deposits		899,554		1,385,938		2,963,779		4,689,208
Other deposits		111,985		92,437		304,533		289,766
Federal funds purchased and securities sold under agreements to repurchase		33,135		31,649		97,850		99,206
FHLB advances and other borrowings		465,534		665,961		1,590,605		2,204,961
Total interest expense		1,510,208		2,175,985		4,956,767		7,283,141

Net interest income before provision for loan losses		3,604,150		3,757,050		10,535,874		12,483,058
Provision for loan losses		115,000		681,000		145,000		3,161,000
Net interest income after the provision for loan losses		3,489,150		3,076,050		10,390,874		9,322,058

NONINTEREST INCOME
Customer service fee		216,163		308,579		656,877		992,619
Net gains from sale of securities		59,671		1,058,549		107,413		1,698,136
Net gains from sale of loans and other assets		32,322		34,663		87,866		164,549
Other noninterest income		15,256		14,214		57,066		55,585
Total noninterest income		323,412		1,416,005		909,222		2,910,889

NONINTEREST EXPENSE
Salaries and employee benefits		1,458,951		1,525,311		4,503,489		4,679,871
Net occupancy and equipment expense		361,513		397,461		1,118,127		1,121,150
Depository insurance		233,587		385,722		797,747		915,365
Foreclosed assets, net		306,860		905,504		1,384,935		1,898,022
Other operating expense		715,858		995,082		2,346,493		2,879,029
Total noninterest expense		3,076,769		4,209,080		10,150,791		11,493,437

Income before provision for income taxes		735,793		282,975		1,149,305		739,510
Provision for income taxes		212,125		69,301		232,075		163,903

Net income		523,668		213,674		917,230		575,607

Preferred stock dividend requirements		118,013		-		303,413		-
Accretion on preferred stock discount		13,419		-		22,419		-

Net income available to common shareholders	$	392,236	$	213,674	$	591,398	$	575,607

EARNINGS PER COMMON SHARE
Basic net income per common share	$	0.06	$	0.03	$	0.09	$	0.09
Diluted net income per common share	$	0.06	$	0.03	$	0.09	$	0.09

DIVIDENDS DECLARED PER COMMON SHARE	$	-	$	-	$	-	$	-

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

Cornerstone Bancshares, Inc. and Subsidiary

Consolidated Statement of Changes in Stockholders' Equity - Unaudited

For the nine months ended September 30, 2011

												Accumulated
							Additional					Other			Total
	Comprehensive		Preferred		Common		Paid-in		Retained			Comprehensive			Stockholders'
	Income		Stock		Stock		Capital		Deficit			Income			Equity

BALANCE, December 31, 2010			$	2,727,424	$	6,500,396	$	21,237,298	$	(4,317,130	)	$	(328,835	)	$	25,819,153

Employee compensation stock option expense				-		-		59,355		-			-			59,355

Issuance of Series A Convertible Preferred Stock				4,550,378		-		-		-			-			4,550,378

Preferred stock dividends				-		-		-		(303,413	)		-			(303,413	)

Accrection on preferred stock				22,419		-		-		(22,419	)		-			-

Comprehensive income:
Net income	$	917,230		-		-		-		917,230			-			917,230


Other comprehensive income, net of tax:
Unrealized holding gains on securities available for sale, net of reclassification adjusment		1,404,724		-		-		-		-			1,404,724			1,404,724

Total comprehensive income	$	2,321,954

BALANCE, September 30, 2011			$	7,300,221	$	6,500,396	$	21,296,653	$	(3,725,732	)	$	1,075,889		$	32,447,427

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

Cornerstone Bancshares, Inc. and Subsidiary

Consolidated Statements of Cash Flows

	Unaudited
	Nine months ended September 30,
	2011			2010

CASH FLOWS FROM OPERATING ACTIVITIES
Net income	$	917,230		$	575,607
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization		269,503			342,243
Provision for loan losses		145,000			3,161,000
Stock compensation expense		59,355			55,959
Net (gains) losses on sales of loans and other assets		870,978			(930,513	)
Changes in other operating assets and liabilities:
Net change in loans held for sale		(501,300	)		(574,000	)
Accrued interest receivable		(10,927	)		64,385
Accrued interest payable		(86,055	)		19,562
Other assets and liabilities		1,440,032			6,645,833
Net cash provided by operating activities		3,103,816			9,360,076


CASH FLOWS FROM INVESTING ACTIVITIES
Proceeds from security transactions:
Securities available for sale		34,307,143			105,149,214
Securities held to maturity		19,483			33,438
Purchase of securities available for sale		(17,325,386	)		(86,105,614	)
Purchase of Federal Home Loan Bank stock		-			(93,700	)
Loan originations and principal collections, net		3,205,690			33,136,548
Purchase of bank premises and equipment		-			(859,445	)
Proceeds from sale of bank premises and equipment		88,344			199,664
Proceeds from sale of other real estate and other assets		5,143,610			5,874,665
Net cash provided by investing activities		25,438,884			57,334,770


CASH FLOWS FROM FINANCING ACTIVITIES
Net decrease in deposits		(12,895,470	)		(53,375,285	)
Net increase (decrease) in federal funds purchased and securities sold under agreements to repurchase		1,728,205			10,859,712
Net payments on Federal Home Loan Bank advances and other borrowings		(11,670,000	)		(10,585,000	)
Payment of dividends on preferred stock		(303,413	)		-
Issuance of preferred stock		4,550,378			1,424,173
Net cash used in financing activities		(18,590,300	)		(51,676,400	)

NET INCREASE IN CASH AND CASH EQUIVALENTS		9,952,400			15,018,446

CASH AND CASH EQUIVALENTS, beginning of period		22,981,952			38,202,205

CASH AND CASH EQUIVALENTS, end of period	$	32,934,352		$	53,220,651

SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION
Cash paid during the period for interest	$	5,042,822		$	7,263,579
Cash paid during the period for taxes		-			500,000


NONCASH INVESTING AND FINANCING ACTIVITIES
Acquisition of real estate through foreclosure	$	9,808,944		$	9,648,190

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 is a bank holding company whose primary business is performed by its wholly-owned subsidiary, Cornerstone Community Bank (the “Bank”). The Bank provides a full range of banking services to the Chattanooga, Tennessee market. The Bank has also established a loan production office (“LPO”) in Dalton, Georgia to further enhance the Bank’s lending markets. The Bank specializes in small business and commercial lending. 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, 2011 and September 30, 2010 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 2010 Annual Report to Shareholders which was furnished to each shareholder of Cornerstone in April of 2011. The consolidated financial statements presented herein conform to U.S. generally accepted accounting principles and to general industry practices. In the opinion of Cornerstone’s management, the accompanying interim financial statements contain all material adjustments, consisting only of normal recurring adjustments, necessary to present fairly the financial condition, the results of operations, and cash flows for the interim period. Results for interim periods are not necessarily indicative of the results to be expected for a full year.

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

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

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

Accounting Policies-During interim periods, Cornerstone follows the accounting policies set forth in its Annual Report on Form 10-K for the year ended December 31, 2010 as filed with the Securities and Exchange Commission. Since December 31, 2010, there have been no significant changes in any accounting principles or practices, or in the method of applying any such principles or practices, except for the following:

In January 2011, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) No. 2011-01, Deferral of the Effective Date of Disclosures about Troubled Debt Restructurings in Update No. 2010-20 (ASU 2011-01). The FASB determined that certain provisions relating to troubled debt restructurings (TDRs) should be deferred until additional guidance and clarification on the definition of TDRs is issued.

In April 2011, the FASB issued ASU No. 2011-02, A Creditor’s Determination of Whether a Restructuring Is a Troubled Debt Restructuring (ASU 2011-02). ASU 2011-02 amends Accounting Standards Codification (ASC) Topic 310, Receivables, by clarifying guidance for creditors in determining whether a concession has been granted and whether a debtor is experiencing financial difficulties. The amendments are effective for the first interim or annual period beginning on or after June 15, 2011, and should be applied retrospectively to the beginning of the annual period of adoption. ASU 2011-02 also makes disclosure requirements deferred under ASU 2011-01 effective for interim and annual periods beginning on or after June 15, 2011. The adoption of ASU 2011-01 does not have a significant impact on Cornerstone’s financial statements.

CORNERSTONE BANCSHARES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

In April 2011, the FASB issued ASU No. 2011-03, Transfers and Servicing (Topic 860): Reconsideration of Effective Control for Repurchase Agreements (ASU 2011-03), intended to improve financial reporting of repurchase agreements and refocus the assessment of effective control on a transferor’s contractual rights and obligations rather than practical ability to perform those rights and obligations. The guidance in ASU 2011-03 is effective for the first interim or annual period beginning on or after December 15, 2011. The Company is evaluating the effect, if any, the adoption of ASU 2011-03 will have on its consolidated financial statements.

In May 2011, the FASB issued ASU No. 2011-04, Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs (ASU 2011-04). ASU 2011-04 represents the converged guidance of the FASB and the International Accounting Standards Board (IASB) on fair value measurement. A variety of measures are included in the update intended to either clarify existing fair value measurement requirements, change particular principles requirements for measuring fair value or for disclosing information about fair value measurements. For many of the requirements, the FASB does not intend to change the application of existing requirements under the ASC Topic 820, Fair Value Measurements. ASU 2011-04 is effective for interim and annual periods beginning after December 15, 2011 and early application is not permitted. The Company is evaluating the impact adoption of ASU 2011-04 will have on its financial statements.

In June 2011, the FASB issued ASU No. 2011-05, Presentation of Comprehensive Income (ASU 2011-05), intended to increase the prominence of items reported in other comprehensive income and to facilitate convergence of accounting guidance in this area with that of the IASB. The amendments require that all nonowner changes in stockholders’ equity be presented in a single continuous statement of comprehensive income or in two separate but consecutive statements. Amendments under ASU 2011-05 for public entities should be applied retrospectively for fiscal years, and interim periods within those years, beginning December 15, 2011. The Company is evaluating the impact adoption of ASU 2011-05 will have on its financial statements.

In September 2011, the FASB issued ASU 2011-08, Intangibles – Goodwill and Other (Topic 350) – Testing Goodwill for Impairment (ASU 2011-08). ASU 2011-08 amends Topic 350, Intangibles – Goodwill and Other, to give entities the option to first assess qualitative factors to determine whether the existence of events or circumstances leads to a determination that it is more likely than not that the fair value of a reporting unit is less than its carrying amount. If, after assessing the totality of events or circumstances, an entity determines it is not more likely than not that the fair value of a reporting unit is less than its carrying amount, then performing the two-step impairment test is unnecessary. However, if an entity concludes otherwise, then it is required to perform the first step of the two-step impairment test by calculating the fair value of the reporting unit and comparing the fair value with the carrying amount of the reporting unit. ASU 2011-08 is effective for annual and interim impairment tests beginning after December 15, 2011, and is not expected to have a significant impact on the Company’s financial statements.

Allowance for loan losses — The allowance for loan losses is maintained at a level that management believes to be adequate to absorb probable losses in the loan portfolio. Loan losses are charged against the allowance when they are known. Subsequent recoveries are credited to the allowance. Management’s determination of the adequacy of the allowance is based on an evaluation of the portfolio, current economic conditions, volume, growth, composition of the loan portfolio, homogeneous pools of loans, risk ratings of specific loans, historical loan loss factors, loss experience of various loan segments, identified impaired loans and other factors related to the portfolio. This evaluation is performed at least quarterly and is inherently subjective, as it requires material estimates that are susceptible to significant change including the amounts and timing of future cash flows expected to be received on any impaired loans.

As part of management’s quarterly assessment of the allowance, management divides the loan portfolio into five segments: commercial-real estate mortgage (includes owner-occupied and all other), consumer-real estate mortgage, construction and land development, commercial and industrial and consumer and other. Each segment is then analyzed such that a specific and general allocation of the allowance is estimated for each loan segment.

CORNERSTONE BANCSHARES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

The first general component of Cornerstone’s allowance for loan losses estimate involves the use of a historic loss model to estimate future losses. The model includes each of the five loan portfolio segments and records the incurred losses over the last twelve months. The historic loss percentages derived from this model are then applied to the outstanding non-impaired loan balance for each loan category. The amounts for each loan category are then summed to determine the amount of loan and lease loss allowance required.

The estimated general loan loss allocation for all five loan portfolio segments is then adjusted for management’s estimate of probable losses for several environmental factors. The allocation for environmental factors is particularly subjective. This amount represents estimated probable inherent credit losses which exist, but have not yet been identified, as of the balance sheet date, and is based upon quarterly trend assessments in delinquent and nonaccrual loans, unanticipated charge-offs, credit concentration changes, prevailing economic conditions, changes in lending personnel experience, changes in lending policies or procedures and other influencing factors. These environmental factors are considered for each of the loan segments, and the general allowance allocation, as determined by the processes noted above for each component, is increased or decreased based on the incremental assessment of these various environmental factors. The assessment also includes an unallocated component. Cornerstone believes that the unallocated amount is warranted for inherent factors that cannot be practically assigned to individual loan categories, such as the imprecision in the overall loss allocation measurement process, the volatility of the local economies in the markets the Bank serves and imprecision in the credit risk ratings process.

The final component is the specific reserve for loans classified as impaired. In assessing the adequacy of the allowance, Cornerstone also considers the results of our ongoing independent loan review process. Cornerstone undertakes this process both to ascertain whether there are loans in the portfolio whose credit quality has weakened over time and to assist in the overall evaluation of the risk characteristics of the entire loan portfolio. Cornerstone’s loan review process includes the judgment of management, independent loan reviewers, and reviews that may have been conducted by third-party reviewers. Cornerstone incorporates relevant loan review results in the loan impairment determination. For each impaired loan, management determines the impaired amount and assigns a specific reserve. In addition, regulatory agencies, as an integral part of their examination process, will periodically review Cornerstone’s allowance for loan losses, and may require the company to record adjustments to the allowance based on their judgment about information available to them at the time of their examinations.

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 and nine month periods ended September 30, 2011 and September 30, 2010.

	Three Months Ended September30,
	2011		2010
Basic earnings per common share calculation:
Numerator: Net income available to common shareholders	$	392,236	$	213,674

Denominator: Weighted avg. common shares outstanding		6,500,396		6,500,396
Effect of dilutive stock options		-		-
Diluted shares		6,500,396		6,500,396

Basic earnings per common share	$	0.06	$	0.03
Diluted earnings per common share	$	0.06	$	0.03

	Nine Months Ended September 30,
	2011		2010
Basic earnings per common share calculation:
Numerator: Net income available to common shareholders	$	591,398	$	575,607

Denominator: Weighted avg. common shares outstanding		6,500,396		6,500,396
Effect of dilutive stock options		-		-
Diluted shares		6,500,396		6,500,396

Basic earnings per common share	$	0.09	$	0.09
Diluted earnings per common share	$	0.09	$	0.09

Note 2. Stock Based Compensation

Accounting Policies- Cornerstone, as required by FASB, applies the fair value recognition provisions of ASC 718, Compensation –Stock Compensation. As a result, for the nine month period ended September 30, 2011, the compensation cost charged to earnings related to the vested incentive stock options was approximately $60,000, which had no material impact on earnings 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 exercise price for incentive stock options must be not less than 100 percent of the fair market value of the common stock on the date of the grant. The exercise price of the non-qualified stock options may be equal to or more or less than the fair market value of the common stock on the date of the grant. The incentive stock options vest 30% on the second anniversary of the grant date, 60% on the third anniversary of the grant date and 100% on the fourth anniversary of the grant date, and the non-qualified stock options vest 50% on the first anniversary of the grant date and 100% on the second anniversary of the grant date. The options expire ten years from the grant date. At September 30, 2011, the total remaining compensation cost to be recognized on non-vested options is approximately $330,000. A summary of the status of these stock option plans is presented in the following table:

CORNERSTONE BANCSHARES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

					Weighted-
					Average
			Weighted		Contractual
			Average		Remaining	Aggregate
			Exercisable		Term	Intrinsic
	Number		Price		(in years)	Value
Outstanding at December 31, 2010		520,900	$	5.79	4.0 Years	$	-
Granted		216,000		1.70	9.7 Years		-
Exercised		-		-
Forfeited		149,300		4.59
Outstanding at September 30, 2011		587,600	$	4.63	6.0 Years		-
Options exercisable at September 30, 2011		296,915	$	6.66			-

The weighted average grant date fair value of stock options granted during the nine months ended September 30, 2011 was $0.83. This was determined using the Black-Scholes option pricing model with the following weighted-average assumptions:

Dividend yield		0.0	%
Expected life	7.0 Years
Expected volatility		43.11	%
Risk-free interest rate		2.81	%

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 maximum term is ten years. Vesting is 50% on the first anniversary of the grant date and 100% on the second anniversary of the grant date. At September 30, 2011, there was no remaining compensation cost to be recognized on non-vested options. 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, 2010		100,250	$	9.42	5.7 Years	$	-
Granted		-		-
Exercised		-		-
Forfeited		-		-
Outstanding at September 30, 2011		100,250	$	9.42	5.0 Years	$	-
Options exercisable at September 30, 2011		100,250	$	9.42			-

CORNERSTONE BANCSHARES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

Note 3. Securities

The amortized cost and fair value of securities available-for-sale and held-to-maturity at September 30, 2011 and December 31, 2010 are summarized as follows:

	September 30, 2011
			Gross		Gross
	Amortized		Unrealized		Unrealized			Fair
	Cost		Gains		Losses			Value
Debt securities available-for-sale:
U.S. Government agencies	$	4,249,722	$	14,336	$	-		$	4,264,058

State and municipal securities		20,877,531		1,387,658		-			22,265,189

Mortgage-backed securities:
Residential mortgage guaranteed by GNMA		12,185,652		192,754		-			12,378,406

Collateralized mortgage obligations issued or guaranteed by U.S. Government agencies or sponsored agencies		54,599,710		168,517		(9,727	)		54,758,500

	$	91,912,615	$	1,763,265	$	(9,727	)	$	93,666,153

Debt securities held to maturity:
Mortgage-backed securities:
Residential mortgage guaranteed by GNMA	$	75,810	$	2,243	$	-		$	78,053

CORNERSTONE BANCSHARES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

	December 31, 2010
			Gross		Gross
	Amortized		Unrealized		Unrealized			Fair
	Cost		Gains		Losses			Value
Debt securities available-for-sale:
U.S. Government agencies	$	4,571,444	$	15,635	$	-		$	4,587,079

State and municipal securities		20,868,771		191,429		(323,988	)		20,736,212

Mortgage-backed securities:
Residential mortgage guaranteed by GNMA		18,747,272		130,609		(24,856	)		18,853,025

Collateralized mortgage obligations issued or guaranteed by U.S. Government agencies or sponsored agencies		64,575,092		135,479		(636,453	)		64,074,118

	$	108,762,579	$	473,152	$	(985,297	)	$	108,250,434

Debt securities held to maturity:
Mortgage-backed securities:
Residential mortgage guaranteed by GNMA	$	95,702	$	2,686	$	-		$	98,388

At September 30, 2011, securities with a fair value totaling approximately $91 million were pledged to secure public funds, securities sold under agreements to repurchase, the Federal Home Loan Bank (sometimes referred to herein as “FHLB”) as collateral for the Bank’s borrowings, as collateral for federal funds purchased from other financial institutions and serve as collateral at the Federal Reserve Discount Window.

The amortized cost and estimated market value of securities at September 30, 2011, by contractual maturity, are shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.

	Securities Available-for-Sale				Securities Held to Maturity
	Amortized		Fair		Amortized		Fair
	Cost		Value		Cost		Value
Due in one year or less	$	299,926	$	300,794	$	-	$	-
Due from one year to five years		1,174,796		1,272,488		-		-
Due from five years to ten years		4,405,250		4,787,848		-		-
Due after ten years		19,247,281		20,168,117		-		-
	$	25,127,253	$	26,529,247	$	-	$	-


Mortgage-backed securities		66,785,362		67,136,906		75,810		78,053

	$	91,912,615	$	93,666,153	$	75,810	$	78,053

CORNERSTONE BANCSHARES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

The following tables present the gross unrealized losses and fair value, aggregated by investment category and length of time that individual securities available for sale have been in a continuous unrealized loss position, as of September 30, 2011 and as of December 31, 2010:

	As of September 30, 2011
	Less than 12 Months					12 Months or Greater				Total
			Gross					Gross				Gross
	Fair		Unrealized			Fair		Unrealized		Fair		Unrealized
	Value		Losses			Value		Losses		Value		Losses
Collateralized mortgage obligations issued or guaranteed by U.S. Government agencies or sponsored agencies	$	9,797,761	$	(9,727	)	$	-	$	-	$	9,797,761	$	(9,727	)
	$	9,797,761	$	(9,727	)	$	-	$	-	$	9,797,761	$	(9,727	)

	As of December 31, 2010
	Less than 12 Months					12 Months or Greater					Total
			Gross					Gross					Gross
	Fair		Unrealized			Fair		Unrealized			Fair		Unrealized
	Value		Losses			Value		Losses			Value		Losses
Debt securities available for sale:
State and municipal securities	$	6,110,458	$	(154,802	)	$	6,440,892	$	(169,186	)	$	12,551,350	$	(323,988	)

Mortgage-backed securities:
Residential mortgage guaranteed by GNMA		5,647,347		(24,856	)		-		-			5,647,347		(24,856	)

Collateralized mortgage obligations issued or guaranteed by U.S. Government agencies or sponsored agencies		34,694,782		(636,453	)		-		-			34,694,782		(636,453	)
	$	46,452,587	$	(816,111	)	$	6,440,892	$	(169,186	)	$	52,893,479	$	(985,297	)

Upon acquisition of a security, the Bank determines the appropriate impairment model that is applicable. If the security is a beneficial interest in securitized financial assets, the Bank uses the beneficial interests in securitized financial assets impairment model. If the security is not a beneficial interest in securitized financial assets, the Bank uses the debt and equity securities impairment model. The Bank conducts periodic reviews to evaluate each security to determine whether an other-than-temporary impairment has occurred. The Bank does not have any securities that have been classified as other-than-temporarily-impaired at September 30, 2011 or December 31, 2010.

CORNERSTONE BANCSHARES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

At September 30, 2011 and December 31, 2010, the significant categories of temporarily impaired securities, and management’s evaluation of those securities are as follows:

Mortgage-backed securities: At September 30, 2011, 4 investments in residential mortgage-backed securities had unrealized losses. This impairment is believed to be caused by the current interest rate environment. The contractual cash flows of those investments are guaranteed or issued by an agency of the U.S. Government. Because the decline in market value is attributable to the current interest rate environment and not credit quality, and because the Bank does not intend to sell the investments and it is not more likely than not that the Bank will be required to sell the investments before recovery of their amortized cost bases, which may be maturity, the Bank does not deem those investments to be other-than-temporarily impaired at September 30, 2011.

Note 4. Loans and Allowance for Loan Losses

At September 30, 2011 and December 31, 2010, loans are summarized as follows (amounts in thousands):

	September 30,			December 31,
	2011			2010
Commercial real estate-mortgage:
Owner-occupied	$	63,405		$	64,971
All other		62,009			64,060
Consumer real estate-mortgage		68,466			71,878
Construction and land development		32,808			29,848
Commercial and industrial		40,880			51,160
Consumer and other		2,833			3,330
Total loans		270,401			285,247
Less: Allowance for loan losses		(6,864	)		(9,132	)

Loans, net	$	263,537		$	276,115

The composition of loans by primary loan classification as well as impaired and performing loan status at September 30, 2011 and December 31, 2010 is summarized in the tables below (amounts in thousands):

September 30, 2011	Commercial		Consumer		Construction		Commercial
	Real Estate-		Real Estate-		and Land		and		Consumer
	Mortgage		Mortgage		Development		Industrial		and Other		Total
Performing loans	$	113,077	$	61,561	$	31,131	$	40,075	$	2,833	$	248,677
Impaired loans		12,337		6,905		1,677		805		-		21,724
Total	$	125,414	$	68,466	$	32,808	$	40,880	$	2,833	$	270,401

December 31, 2010	Commercial		Consumer		Construction		Commercial
	Real Estate-		Real Estate-		and Land		and		Consumer
	Mortgage		Mortgage		Development		Industrial		and Other		Total
Performing loans	$	119,084	$	61,455	$	27,774	$	50,492	$	3,279	$	262,084
Impaired loans		9,947		10,423		2,074		668		51		23,163
Total	$	129,031	$	71,878	$	29,848	$	51,160	$	3,330	$	285,247

CORNERSTONE BANCSHARES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

The following tables show the allowance allocation by loan classification for impaired and performing loans as of September 30, 2011 and December 31, 2010 (amounts in thousands):

September 30, 2011	Commercial		Consumer		Construction		Commercial
	Real Estate-		Real Estate-		and Land		and		Consumer
Allowance related to:	Mortgage		Mortgage		Development		Industrial		and Other		Total
Performing loans	$	1,798	$	993	$	467	$	596	$	52	$	3,906
Impaired loans		1,312		1,214		40		392		-		2,958
Total	$	3,110	$	2,207	$	507	$	988	$	52	$	6,864

December 31, 2010	Commercial		Consumer		Construction		Commercial
	Real Estate-		Real Estate-		and Land		and		Consumer
Allowance related to:	Mortgage		Mortgage		Development		Industrial		and Other		Total
Performing loans	$	887	$	691	$	3,178	$	588	$	48	$	5,392
Impaired loans		906		2,420		60		337		17		3,740
Total	$	1,793	$	3,111	$	3,238	$	925	$	65	$	9,132

The following tables detail the changes in the allowance for loan losses for the nine month period ending September 30, 2011 and year ending December 31, 2010 by loan classification (amounts in thousands):

September 30, 2011	Commercial			Consumer			Construction			Commercial
	Real Estate-			Real Estate-			and Land			and			Consumer
	Mortgage			Mortgage			Development			Industrial			and Other			Total
Beginning balance	$	1,793		$	3,111		$	3,238		$	925		$	65		$	9,132
Charged-off loans		(1,221	)		(1,509	)		(73	)		(28	)		(24	)		(2,855	)
Recovery of charge-offs		250			33			58			72			29			442
Provision for loan losses		2,288			572			(2,716	)		19			(18	)		145
Ending balance	$	3,110		$	2,207		$	507		$	988		$	52		$	6,864

December 31, 2010	Commercial			Consumer			Construction			Commercial
	Real Estate-			Real Estate-			and Land			and			Consumer
	Mortgage			Mortgage			Development			Industrial			and Other			Total
Beginning balance	$	1,189		$	719		$	3,179		$	786		$	32		$	5,905
Charged-off loans		(2,309	)		(562	)		(1,260	)		(443	)		(114	)		(4,688	)
Recovery of charge-offs		213			54			19			282			56			624
Provision for loan losses		2,700			2,900			1,300			300			91			7,291
Ending balance	$	1,793		$	3,111		$	3,238		$	925		$	65		$	9,132

Credit quality indicators:

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

CORNERSTONE BANCSHARES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

The Bank’s loan grading process is as follows:

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

Loans greater than or equal to $500 thousand are reviewed by the Bank’s internal loan review department within 90 days of origination.

Loan relationships greater than or equal to $1 million are reviewed annually by the internal loan review department.

The Bank’s internal loan review department samples approximately 25 percent of all other loans less than $1 million on an annual basis for review.

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

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

The Bank also contracts with an independent third party to perform loan reviews. This external party reviews approximately 40 percent of the Bank’s loan portfolio annually.

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

CORNERSTONE BANCSHARES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

The following table outlines the amount of each loan classification and the amount categorized into each risk rating as of September 30, 2011 and December 31, 2010 (amounts in thousands):

September 30, 2011	Commercial		Consumer		Construction		Commercial
	Real Estate-		Real Estate-		and Land		and		Consumer
	Mortgage		Mortgage		Development		Industrial		and Other		Total
Pass	$	101,772	$	52,582	$	28,579	$	34,363	$	2,791	$	220,087
Special mention		10,199		5,146		1,692		5,435		18		22,490
Substandard		1,106		3,833		860		277		24		6,100
Substandard-impaired		9,802		6,905		1,677		805		-		19,189
Doubtful		2,535		-		-		-		-		2,535
	$	125,414	$	68,466	$	32,808	$	40,880	$	2,833	$	270,401

December 31, 2010	Commercial		Consumer		Construction		Commercial
	Real Estate-		Real Estate-		and Land		and		Consumer
	Mortgage		Mortgage		Development		Industrial		and Other		Total
Pass	$	97,692	$	49,974	$	24,401	$	41,963	$	3,215	$	217,245
Special mention		19,289		3,786		2,121		7,405		54		32,655
Substandard		2,103		7,695		1,252		1,124		10		12,184
Substandard-impaired		9,947		10,423		2,074		668		51		23,163
	$	129,031	$	71,878	$	29,848	$	51,160	$	3,330	$	285,247

After the Bank’s independent loan review department completes the loan grade assignment, a loan impairment analysis is performed on loans graded substandard or worse. The following tables present summary information pertaining to impaired loans by loan classification as of September 30, 2011 and December 31, 2010 (amounts in thousands):

							For the nine months ended
	At September 30, 2011						September 30, 2011
			Unpaid				Average		Interest
	Recorded		Principal		Related		Recorded		Income
	Investment		Balance		Allowance		Investment		Recognized
Impaired loans without a valuation allowance:
Commercial real estate – mortgage	$	8,002	$	8,005	$	-	$	4,705	$	434
Consumer real estate – mortgage		2,864		2,996		-		3,758		54
Construction and land development		1,379		1,379		-		1,341		13
Commercial and industrial		282		282		-		552		32
Consumer and other		-		-		-		-
Total	$	12,527	$	12,662	$	-	$	10,356	$	533

Impaired loans with a valuation allowance:
Commercial real estate – mortgage	$	4,335	$	4,347	$	1,312	$	5,573	$	131
Consumer real estate – mortgage		4,041		4,203		1,214		6,141		125
Construction and land development		298		300		40		145		-
Commercial and industrial		523		523		392		807		55
Consumer and other		-		-		-		49		-
Total	$	9,197	$	9,373	$	2,958	$	12,715		311

Total impaired loans	$	21,724	$	22,035	$	2,958	$	23,071	$	844

CORNERSTONE BANCSHARES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

							For the year ended
	At December 31, 2010						December 31, 2010
			Unpaid				Average
	Recorded		Principal		Related		Recorded
	Investment		Balance		Allowance		Investment
Impaired loans without a valuation allowance:
Commercial real estate – mortgage	$	1,663	$	2,163	$	-	$	2,747
Consumer real estate – mortgage		998		998		-		776
Construction and land development		1,793		1,793		-		1,526
Commercial and industrial		70		70		-		782
Consumer and other		2		2		-		1
Total	$	4,526	$	5,026	$	-	$	5,832

Impaired loans with a valuation allowance:
Commercial real estate – mortgage	$	8,284	$	8,284	$	906	$	8,494
Consumer real estate – mortgage		9,425		9,425		2,420		8,968
Construction and land development		281		281		60		2,674
Commercial and industrial		598		598		337		1,060
Consumer and other		49		49		17		178
Total	$	18,637	$	18,637	$	3,740	$	21,374

Total impaired loans	$	23,163	$	23,663	$	3,740	$	27,206

Interest income recognized on impaired loans was approximately $943,000 for the year ending December 31, 2010.

The following tables present an aged analysis of past due loans as of September 30, 2011 and December 31, 2010 (amounts in thousands):

September 30, 2011	30-89 Days		Past Due 90
	Past Due and		Days or More				Total		Current		Total
	Accruing		and Accruing		Nonaccrual		Past Due		Loans		Loans
Commercial real estate:
Owner-occupied	$	124	$	-	$	2,833	$	2,957	$	60,448	$	63,405
All other		99		-		789		888		61,121		62,009
Consumer real estate-mortgage		1,528		-		3,244		4,772		63,694		68,466
Construction and land development		249		-		1,614		1,863		30,945		32,808
Commercial and industrial		67		-		65		132		40,748		40,880
Consumer and other		21		-		15		36		2,797		2,833
Total	$	2,088	$	-	$	8,560	$	10,648	$	259,753	$	270,401

CORNERSTONE BANCSHARES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

December 31, 2010	30-89 Days		Past Due 90
	Past Due and		Days or More				Total		Current		Total
	Accruing		and Accruing		Nonaccrual		Past Due		Loans		Loans
Commercial real estate:
Owner-occupied	$	985	$	-	$	618	$	1,603	$	63,368	$	64,971
All other		203		-		7,808		8,011		56,049		64,060
Consumer real estate-mortgage		631		-		5,114		5,745		66,133		71,878
Construction and land development		317		-		-		317		29,531		29,848
Commercial and industrial		116		-		75		191		50,969		51,160
Consumer and other		54		-		18		72		3,258		3,330
Total	$	2,306	$	-	$	13,633	$	15,939	$	269,308	$	285,247

Impaired loans also include loans that the Bank has elected to formally restructure when, due to the weakening credit status of a borrower, the restructuring may facilitate a repayment plan that seeks to minimize the potential losses that the Bank may have to otherwise incur. If on nonaccruing status as of the date of restructuring, the loans are included in nonperforming loans and are classified as impaired loans. Loans that have been restructured that were performing as of the restructure date are reported as troubled debt restructurings. At September 30, 2011 and December 31, 2010, there were $2.5 million and $948 thousand, respectively, of troubled debt restructurings that were performing as of the restructure date. Troubled commercial loans are restructured by specialists within our Special Asset department and all restructurings are approved by committees and credit officers separate and apart from the normal loan approval process. These specialists are trained to reduce the Bank’s overall risk and exposure to loss in the event of a restructuring through obtaining either or all of the following: improved documentation, additional guaranties, increase in curtailments, reduction in collateral terms, additional collateral or other similar strategies.

As a result of adopting the amendments in Accounting Standards Update No. 2011-02 in the third quarter of 2011, the Bank reassessed all restructurings that occurred on or after January 1, 2011 for identification as troubled debt restructurings. The Bank's reassessment resulted in no additional restructurings than those previously identified.

The following table presents a summary of loans that were modified as troubled debt restructurings during the period as of September 30, 2011 (amounts in thousands):

		Pre-Modification		Post-Modification
		Outstanding Recorded		Outstanding Recorded
	Number of Contracts	Investment		Investment
Troubled Debt Restructurings
Consumer real estate-mortgage	4	$	790	$	789
Construction and land development	2		748		748
Commercial and industrial	1		20		20

The following table presents a summary of loans that were modified as troubled debt restructurings during the past twelve months and for which there was a payment default during the period as of September 30, 2011 (amounts in thousands):

	Number of Contracts	Recorded Investment
Troubled Debt Restructurings
That Subsequently Defaulted
Consumer real estate-mortgage	2	$	92

CORNERSTONE BANCSHARES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

Note 5. Commitments and Contingent Liabilities

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

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

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

The contractual amounts of these commitments are not reflected in the consolidated financial statements and would only be reflected if drawn upon. Since many of the commitments are expected to expire without being drawn upon, the contractual amounts do not necessarily represent future cash requirements. However, should the commitments be drawn upon and should customers default on their resulting obligation, 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, 2011 is as follows:

Commitments to extend credit		$	27.7 million
Standby letters of credit		$	2.6 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, 2011 will not have a material effect on Cornerstone’s consolidated financial statements.

Note 6. Fair Value Disclosures

Fair Value Measurements:

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

CORNERSTONE BANCSHARES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

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

ASC Topic 820 also establishes a three-tier fair value hierarchy which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value, as follows:

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

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

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

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

The following methods and assumptions were used by Cornerstone in estimating fair value disclosures for financial instruments. There have been no changes in the methodologies used at September 30, 2011 and December 31, 2010.

Cash and cash equivalents:

The carrying amounts of cash and cash equivalents approximate fair values based on the short-term nature of the assets.

Securities:

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

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

Loans:

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

Those impaired loans not requiring an allowance represent loans for which the fair value of the expected repayments or collateral exceed the recorded investments in such loans. At September 30, 2011, substantially all of the total impaired loans were evaluated based on the fair value of collateral. In accordance with ASC Topic 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, Cornerstone records the impaired loan as nonrecurring Level 2. When an appraised value is not available or management determines the fair value of the collateral is further impaired below the appraised value and there is no observable market price, Cornerstone records the impaired loan as nonrecurring Level 3.

CORNERSTONE BANCSHARES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

Cash surrender value of life insurance:

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

Foreclosed assets:

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

Deposits:

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

Securities sold under agreements to repurchase:

The estimated fair value of these liabilities approximates their carrying value.

Federal Home Loan Bank advances and other borrowings:

The carrying amounts of FHLB advances and other borrowings approximate their fair value.

Accrued interest:

The carrying amounts of accrued interest approximate fair value.

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

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

CORNERSTONE BANCSHARES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

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

			Quoted Prices in		Significant		Significant
			Active Markets		Other		Other
	Balance as of		for Identical		Observable		Unobservable
	September 30,		Assets		Inputs		Inputs
	2011		(Level 1)		(Level 2)		(Level 3)
Debt securities available for sale:

U.S. Government agencies	$	4,264,058	$	-	$	4,264,058	$	-
State and municipal securities		22,265,189		-		22,265,189		-
Mortgage-backed securities:
Residential mortgage guaranteed by GNMA		12,378,406		-		12,378,406		-
Collateralized mortgage obligations issued or guaranteed by U.S. Government agencies or sponsored agencies		54,758,500		-		54,758,500		-

Total securities available for sale	$	93,666,153	$	-	$	93,666,153	$	-

Cash surrender value of life insurance	$	1,158,537	$	-	$	1,158,537	$	-

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

Certain assets and liabilities are measured at fair value on a nonrecurring basis, which means the assets and liabilities are not measured at fair value on an ongoing basis but are subject to fair value adjustments in certain circumstances (for example, when there is evidence of impairment). The tables below present information about assets and liabilities on the balance sheet at September 30, 2011 for which a nonrecurring change in fair value was recorded (amount in thousands).

			Quoted Prices in		Significant		Significant
			Active Markets		Other		Other
	Balance as of		for Identical		Observable		Unobservable
	September 30,		Assets		Inputs		Inputs
	2011		(Level 1)		(Level 2)		(Level 3)

Impaired loans	$	6,239	$	-	$	6,239	$	-
Foreclosed assets (OREO & Repossessions)		18,255		-		18,255		-

Loans include impaired loans held for investment for which an allowance for loan losses has been calculated based upon the fair value of the loans at September 30, 2011. Losses derived from Level 2 inputs were calculated by models incorporating significant observable market data.

CORNERSTONE BANCSHARES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

The carrying amount and estimated fair value of Cornerstone's financial instruments at September 30, 2011 and December 31, 2010 are as follows (amounts in thousands):

	September 30, 2011				December 31, 2010
	Carrying		Estimated		Carrying		Estimated
	Amount		Fair Value		Amount		Fair Value
Assets:
Cash and cash equivalents	$	32,934	$	32,934	$	22,982	$	22,982
Securities		93,742		93,744		108,346		108,349
Federal Home Loan Bank stock		2,323		2,323		2,323		2,323
Loans, net		263,537		264,515		276,115		277,796
Cash surrender value of life insurance		1,159		1,159		1,114		1,114
Accrued interest receivable		1,337		1,337		1,326		1,326

Liabilities:
Noninterest-bearing demand deposits		40,115		40,115		28,980		28,980
Interest-bearing demand deposits		22,774		22,774		24,834		24,834
Savings deposits and money market accounts		43,477		43,477		34,042		34,042
Time deposits		216,185		218,072		247,591		249,990
Federal funds purchased and securities sold under agreements to repurchase		26,054		26,054		24,325		24,325
Federal Home Loan Bank advances and other borrowings		43,045		43,045		54,715		54,715
Accrued interest payable		91		91		177		177

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

Note 7. 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 and nine months ended September 30, 2011 and 2010.

	Three Months Ended
	September 30,
	2011		2010
Net income	$	523,668	$	213,674
Unrealized holding gains (losses) on securities available for sale, net of reclassification		509,154		(116,539	)

Comprehensive income	$	1,032,822	$	97,135

CORNERSTONE BANCSHARES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

	Nine Months Ended
	September 30,
	2011		2010
Net income	$	917,230	$	575,607
Unrealized holding gains on securities available for sale, net of reclassification		1,404,724		1,071,412

Comprehensive income	$	2,321,954	$	1,647,019

Cornerstone Bancshares, Inc. and Subsidiary

Net Interest Margin Analysis

Taxable Equivalent Basis

	Three months ended
	September 30
(Amounts in thousands)
	2011								2010
	Average			Income/		Yield/			Average			Income/		Yield/
	Balance			Expense		Rate			Balance			Expense		Rate
Assets
Earning assets:
Loans, net of unearned income	$	269,715		$	4,531		6.67	%	$	305,743		$	5,160		6.70	%
Investment securities		108,963			574		2.40	%		116,930			754		2.82	%
Other earning assets		18,193			9		0.20	%		35,540			19		0.22	%
Total earning assets		396,872		$	5,114		5.20	%		458,213		$	5,933		5.20	%
Allowance for loan losses		(6,792	)							(6,655	)
Cash and other assets		33,120								37,213
TOTAL ASSETS	$	423,200							$	488,771

Liabilities and Shareholders' Equity

Interest-bearing liabilities:
Interest-bearing demand deposits	$	24,197		$	20		0.33	%	$	31,858		$	25		0.31	%
Savings deposits		9,772			13		0.51	%		9,547			12		0.50	%
MMDA's		30,975			79		1.01	%		22,961			56		0.97	%
Time deposits		218,622			900		1.63	%		270,204			1,386		2.04	%
Federal funds purchased and securities sold under agreements to repurchase		23,250			33		0.57	%		23,256			32		0.55	%
Federal Home Loan Bank & other borrowings		43,078			465		4.29	%		62,612			665		4.21	%
Total interest-bearing liabilities		349,894			1,510		1.71	%		420,438			2,176		2.05	%
Net interest spread				$	3,604		3.49	%				$	3,757		3.15	%
Noninterest-bearing demand deposits		41,800								36,875
Accrued expenses and other liabilities		(64	)							1,103
Shareholders' equity		31,569								30,355
TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY	$	423,200							$	488,771
Net yield on earning assets							3.69	%							3.32	%

Taxable equivalent adjustment:
Loans					0								0
Investment securities					85								77
Total adjustment					85								77

Cornerstone Bancshares, Inc. and Subsidiary

Net Interest Margin Analysis

Taxable Equivalent Basis

	Nine months ended
	September 30
(Amounts in thousands)
	2011								2010
	Average			Income/		Yield/			Average			Income/		Yield/
	Balance			Expense		Rate			Balance			Expense		Rate
Assets
Earning assets:
Loans, net of unearned income	$	275,267		$	13,692		6.65	%	$	318,985		$	16,602		6.96	%
Investment securities		112,850			1,763		2.38	%		134,262			3,099		3.32	%
Other earning assets		22,496			38		0.22	%		39,634			65		0.22	%
Total earning assets		410,613		$	15,493		5.12	%		492,881		$	19,766		5.42	%
Allowance for loan losses		(7,707	)							(6,484	)
Cash and other assets		32,538								31,015
TOTAL ASSETS	$	435,444							$	517,412

Liabilities and Shareholders' Equity

Interest-bearing liabilities:
Interest-bearing demand deposits	$	26,717		$	65		0.33	%	$	34,125		$	91		0.36	%
Savings deposits		9,737			37		0.51	%		9,124			35		0.51	%
MMDA's		27,137			202		1.00	%		22,875			164		0.96	%
Time deposits		233,079			2,964		1.70	%		292,184			4,689		2.15	%
Federal funds purchased and securities sold under agreements to repurchase		23,391			98		0.56	%		23,565			99		0.56	%
Federal Home Loan Bank & other borrowings		49,329			1,590		4.31	%		68,215			2,205		4.32	%
Total interest-bearing liabilities		369,390			4,957		1.79	%		450,088			7,283		2.16	%
Net interest spread				$	10,536		3.33	%				$	12,483		3.26	%
Noninterest-bearing demand deposits		37,463								41,341
Accrued expenses and other liabilities		(81	)							(3,399	)
Shareholders' equity		28,672								29,382
TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY	$	435,444							$	517,412
Net yield on earning assets							3.51	%							3.45	%

Taxable equivalent adjustment:
Loans					0								0
Investment securities					246								232
Total adjustment					246								232

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

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

The following is a discussion of our financial condition at September 30, 2011 and December 31, 2010 and our results of operations for the three and nine months ended September 30, 2011 and 2010. 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.

Critical Accounting Policies

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

Allowance for Loan Losses

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

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

Estimates of Fair Value

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

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

Changes in fair value could materially impact our financial results. Refer to Note 16, “Fair Value Disclosures,” in the notes to Cornerstone’s consolidated financial statements for a discussion of the methodology in calculating fair value.

Goodwill

Cornerstone’s policy is to assess goodwill for impairment on an annual basis or between annual assessments if an event occurs or circumstances change that would more likely than not reduce the fair value of goodwill below its carrying amount. Impairment is a condition that exists when the carrying amount of goodwill exceeds its implied fair value. As more fully described in Note 7, “Goodwill,” in the notes to Cornerstone’s consolidated financial statements included in the 2010 Annual Report to Shareholders, Cornerstone recorded a full goodwill impairment during 2010.

Income Taxes

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

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

Cornerstone periodically evaluates uncertain tax positions and estimates the appropriate level of tax reserves related to each of these positions. Additionally, Cornerstone evaluates its deferred tax assets for possible valuation allowances based on the amounts expected to be realized. The evaluation of uncertain tax positions and deferred tax assets involves a high degree of judgment and subjectivity. Changes in the results of these evaluations could have a material impact on our financial results. Refer to Note 9, “Income Taxes,” in the notes to Cornerstone’s consolidated financial statements included in the 2010 Annual Report to Shareholders for more information.

Consent Order and Written Agreement

On April 2, 2010, Cornerstone Community Bank (the "Bank"), the wholly owned subsidiary bank of Cornerstone, entered into a Stipulation to the Issuance of a Consent Order (the "Stipulation") with the Federal Deposit Insurance Corporation (the "FDIC"). Pursuant to the Stipulation, the Bank has consented, without admitting or denying any charges of unsafe or unsound banking practices or violations of law or regulations, to the issuance of a Consent Order (the "Order") by the FDIC, also effective as of April 2, 2010. On April 8, 2010, the Bank also executed a written agreement (the "Agreement") with the Tennessee Department of Financial Institutions ("TDFI").

The Order and the Agreement (collectively, the "Action Plans") contain substantially similar terms and are based on the findings of the FDIC and TDFI during their joint examination of the Bank commenced on October 8, 2009 (the "Examination"), as disclosed in the Joint Report of Examination (the "Report"). The Order and the Agreement represent agreements between the Bank, on the one hand, and the FDIC and the TDFI, respectively, on the other hand, as to areas of the Bank's operations that warrant improvement and present plans for making those improvements. The Action Plans impose no fines or penalties on the Bank.

Under the terms of each Action Plan, the Bank cannot declare or pay cash dividends without the prior written consent of certain officials of the FDIC and the TDFI (the "Joint Officials"). In addition, the Bank is restricted from extending additional credit to certain borrowers whose existing credit has been classified as "loss," "doubtful" or "substandard" or has been charged off the books of the Bank and, in each case, is uncollected. The Action Plans further require, at varying times following their respective effective dates, the Bank (or its board of directors, as appropriate) to (i) establish a committee comprised of a majority of non-employee directors to oversee the Bank's compliance with the Action Plans; (ii) prepare and implement a written capital plan to increase the Bank's Tier I Capital and achieve and maintain specified capital ratios, containing a contingency plan (including a plan to sell or merge the Bank) for implementation upon written notice from the Joint Officials in certain events; (iii) retain a bank consultant to develop a written management and staffing plan for implementation by the Bank; (iv) develop and implement specified policies and/or procedures addressing interest rate risk, appraisal weaknesses and credit underwriting and loan administration deficiencies; (v) develop and implement a written plan addressing liquidity and related measures and objectives; (vi) eliminate certain assets classified as "loss" by the FDIC or the TDFI; (vii) formulate and implement certain written plans, including an annual profit plan and budget, a comprehensive strategic plan, a plan to reduce certain impaired assets identified during the Examination, and a plan for the reduction and collection of delinquent loans; (viii) implement a system of monitoring loan documentation exceptions on an ongoing basis and implement procedures designed to reduce their future occurrence; and (ix) eliminate and/or correct the deficiencies and technical exceptions, violations of law and regulation and contraventions of policy noted in the Report. The Agreement would further require the Bank to develop and implement a written plan for the continued administration of its IT risk management practices and controls.

The Bank is required to provide written progress reports to the Joint Officials on a quarterly basis until such time as the requirements of the Action Plans have been accomplished and the FDIC has released the Bank in writing from such obligation. The Order and the Agreement will remain in effect until modified or terminated by the FDIC or the TDFI, respectively.

The Bank is in substantial compliance with the terms of the Action Plans. The Bank has provided quarterly written progress reports to the Joint Officials. The status of the Bank's compliance with the specific actions required by the Action Plans is discussed in further detail below.

The Bank's board of directors established a Consent Order Compliance Committee (the "Committee") comprised of a majority of non-employee directors to oversee the Bank's compliance with the Action Plans. The Committee's first meeting was held in May, 2010. The Committee has met monthly since that time and intends to meet monthly until the Bank's responsibilities and obligations under the Action Plans have been fulfilled.

The Bank has prepared and is implementing a capital plan. In furtherance of such capital plan, Cornerstone commenced a public offering in June, 2010 of Cornerstone’s Series A Convertible Preferred Stock (the "Preferred Shares"). Pursuant to the offering, Cornerstone is selling up to 600,000 Preferred Shares at a price of $25.00 per share.

Cornerstone anticipates that the offering will continue to be effective until December 31, 2011. To date, Cornerstone has raised approximately $7.3 million.

The Bank engaged an outside consultant to perform a management and staffing plan. The consultant submitted its findings and recommendations to the Bank's board of directors, the FDIC and the TDFI. The Bank's board of directors submitted its management plan to the Joint Officials in April 2011. After discussing the management plan with the Joint Officials the Bank began implementing its new management plan. Highlights of the management plan include a reorganization of the Bank’s internal loan review and credit departments. The Bank’s loan review department was assigned to the Bank’s risk management department to achieve greater independence. The Bank also assigned additional responsibilities to the Bank’s new Chief Credit Officer with respect to the credit department and the organization’s underwriting process. Next, the human resources assigned to the Bank’s collection department were reviewed. After the review, management concluded that additional personnel were needed to assist the Bank in collecting and resolving problem loans.

The Bank enhanced its liquidity policy to include additional liquidity measurements and a revised liquidity contingency funding plan. In addition to the policy updates, the Bank engaged an outside consultant to perform quarterly liquidity analysis for the Bank's Asset–Liability Committee's ("ALCO") review. The Bank's board of directors has established liquidity goals and is monitors these levels on a quarterly basis. The June 30, 2011 report was received and reviewed during the August, 2011 ALCO meeting.

The Bank engaged an outside consultant to perform quarterly interest rate risk modeling for the Bank's ALCO committee's review. The Bank's board of directors has established interest rate sensitivity goals and is monitoring these levels on a quarterly basis. The June 30, 2011 report was received and reviewed during the August 2011 ALCO meeting.

The Bank prepared budgets for its 2011 and 2012 fiscal years and submitted the budgets to the FDIC for review.

The Bank prepared a strategic plan and submitted such strategic plan to the FDIC for review. The primary thrust of the strategic plan is to reduce the Bank's assets to approximately $405 million by December 31, 2011. The Bank intends to accomplish the reductions by disposing of securities and cash and reducing Federal Home Loan Bank funding and certificates of deposit. The Bank intends to reduce its loan portfolio to $295 million during this same period. The reduction in loans and securities will result in a decrease the Bank’s average assets. A bank’s average assets are included in the calculation of its regulatory capital ratios. A reduction in average assets will improve the regulatory capital ratios in accordance with the Action Plans.

The Bank has prepared a reduction of delinquencies action plan. The Bank has submitted this plan to the Joint Officials. Important aspects of the delinquency action plan include a prohibition against an extension of credit for the payment of interest on delinquent loans, a requirement to establish specific collection procedures to be instituted at various stages of a borrower’s delinquency and specific reporting requirements informing members of management and the board of directors about existing past due levels.

In addition, the Bank has charged off all loans classified by the Joint Officials as "loss." The Bank maintains a tracking report that it submits to the Joint Officials periodically. Finally, the Bank's board of directors has created a Loan Review Committee to review the asset quality, concentrations and problem credits within the Bank's loan portfolio.

The Bank has addressed all violations and contraventions of policy and has either corrected or is in the process of correcting each such violation or contravention.

The Bank has implemented a technical exception tracking system in order to monitor technical exceptions. In addition, the Bank has drafted and implemented new procedures aimed at reducing technical exceptions noted by regulators during their examinations of the Bank.

The Bank has not paid dividends since the inception of the Action Plans. Cornerstone declared a dividend of $0.625 per share with respect to the Preferred Shares. The dividend was paid on May 25, 2011 following the Federal Reserve Bank of Atlanta's (the “FRBA”) approval of the dividend on May 23, 2011. Cornerstone also declared and paid a second dividend in 2011 in the amount of $0.625 per share with respect to the Preferred Shares. The dividend was approved by the FRBA and had a record date of March 31, 2011 and a payment date of September 28, 2011.

The Bank is actively monitoring and is not aware of any new extensions of credit to prohibited classified borrowers as of September 30, 2011.

Management and the Board have carefully considered the impact of the Action Plans on the Bank’s current and future operations. Areas that have received additional attention as a result of the Action Plans include the Bank’s liquidity position, overall balance sheet structure, capital and earnings. The Bank has considered the impact of deposit interest rate restrictions that may impair the Bank’s ability to raise local certificates of deposit. Management has placed an emphasis on increasing local deposits, reducing its non-core liabilities and establishing a liquidity contingency plan to address potential problems. The Bank’s overall balance sheet structure has also been considered. The reduction in assets has impacted the Bank’s earning assets and therefore the Bank’s net interest income. To offset this reduction the Bank has reduced its cost of funds as well as its non-interest expense over the last two years. One of the primary impacts of the Order and the Agreement is the need for additional capital. Cornerstone has incurred additional time and expense to generate its Preferred Stock offering. The Preferred Stock has an annual ten percent return which will require additional earnings from the Bank to meet the annual dividend requirement. The Bank’s earnings have been impacted negatively due to the recent regulatory criticism. One example of the negative impact on earnings is the increased FDIC insurance premiums have been incurred and will continue to be at an elevated level until the Bank’s overall condition improves.

Noncompliance with the Action Plans could subject the Bank to an array of penalties, ranging from civil money penalties to a termination of the Bank's deposit insurance for more egregious violations of applicable bank rules and regulations.

Federal Reserve Bank of Atlanta (FRBA) Letter

Cornerstone received a letter dated March 30, 2010 from its primary banking regulator, the FRBA. The letter directs Cornerstone to obtain the FRBA's written approval before Cornerstone (i) incurs any indebtedness; (ii) declares or pays any dividends; (iii) redeems any corporate stock; or (iv) makes any other payment representing a reduction in its capital, except for the payment of normal and routine operating expenses. As noted above, Cornerstone has received FRBA's approval for dividends with respect to the Preferred Shares. The letter notes that the condition of the Bank has caused Cornerstone to be in "troubled condition" under Regulation Y. As a result, notice to the FRBA is required before Cornerstone undertakes any changes in senior executive management or directorships, and approval of the FRBA (with the written concurrence of the FDIC) must be obtained before Cornerstone grants or enters into any agreement to provide a golden parachute or severance payment. To date, Cornerstone is in compliance with the requirements of the FRBA letter.

To date the most significant impact of the FRBA’s letter relates to the payment of dividends on the Preferred Shares. However, Cornerstone has been able to consistently raise additional capital and the company has generated positive earnings during 2011. These two elements coupled with the Bank’s stabilization of asset quality have, in Cornerstone’s estimation, led to the approval of the Preferred Shares dividend payments.

Review of Financial Performance

As of September 30, 2011, Cornerstone had total consolidated assets of $426.4 million, total loans of $270.4 million, total securities of $93.7 million, total deposits of $322.6 million and stockholders’ equity of $32.4 million. Net income for the three and nine month periods ended September 30, 2011 totaled $523,668 and $917,230, respectively.

Results of Operations

Net income for the three months ended September 30, 2011 was $523,668 or $0.06 basic earnings per common share, compared to a net income of $213,674 or $0.03 basic earnings per common share, for the same period in 2010. Net income for the nine months ended September 30, 2011 was $917,230 or $0.09 basic earnings per common share, compared to a net income of $575,607 or $0.09 basic earnings per common share, for the same period in 2010.

The following table presents our results for the three and nine months ended September 30, 2011 compared to the three and nine months ended September 30, 2010 (amounts in thousands).

					2011-2010										2011-2010
	Three months				Percent			Dollar			Nine months				Percent			Dollar
	ended September 30,				Increase			Amount			ended September 30,				Increase			Amount
	2011		2010		(Decrease)			Change				2011		2010	(Decrease)			Change
Interest income	$	5,114	$	5,933		(13.80	)%	$	(819	)	$	15,493	$	19,766		(21.62	)%	$	(4,273	)
Interest expense		1,510		2,176		(30.61	)%		(666	)		4,957		7,283		(31.94	)%		(2,326	)
Net interest income
before provision for loss		3,604		3,757		(4.07	)%		(153	)		10,536		12,483		(15.60	)%		(1,947	)

Provision for loan loss		115		681		(83.11	)%		(566	)		145		3,161		(95.41	)%		(3,016	)
Net interest income after
provision for loan loss		3,489		3,076		13.43	%		413			10,391		9,322		11.47	%		1,069

Total noninterest income		323		1,416		(77.19	)%		(1,093	)		909		2,911		(68.77	)%		(2,002	)
Total noninterest expense		3,076		4,209		(26.92	)%		(1,133	)		10,151		11,493		(11.68	)%		(1,342	)

Income before income taxes		736		283		160.07	%		453			1,149		740		55.27	%		409

Provision for income taxes		212		69		207.25	%		143			232		164		41.46	%		68

Net income	$	524	$	214		144.86	%		310		$	917	$	576		59.20	%		341

Net Interest Income-Net interest income represents the amount by which interest earned on various earning assets exceeds interest paid on deposits and other interest-bearing liabilities. Net interest income is also the most significant component of our earnings. For the three months ended September 30, 2011, net interest income before the provision for loan loss, decreased $153 thousand or 4.07 percent over the same period of 2010. For the nine months ended September 30, 2011, net interest income before the provision for loan loss, decreased $1.9 million or 15.60 percent.

Cornerstone’s interest rate spread on a tax equivalent basis (which is the difference between the average yield on earning assets and the average rate paid on interest bearing liabilities) was 3.49 percent compared to 3.15 percent for the three month periods ended September 30, 2011 and 2010, respectively. Cornerstone’s interest rate spread for the nine month period ended September 30, 2011 was 3.33 percent compared to 3.26 percent for the same time period in 2010.

The net interest margin on a tax equivalent basis was 3.69 percent and 3.32 percent for the three month periods ended September 30, 2011 and 2010, respectively. Cornerstone’s net interest margin for the nine month period ended September 30, 2011 was 3.51 percent compared to 3.45 percent for the same period in 2010.

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

Cornerstone’s net interest income has been negatively impacted by a reduction in the Bank’s earning assets. For the three months ended September 30, 2011, Cornerstone had approximately $397 million in average earning assets. The decrease is approximately $61 million or 13.3 percent. As a direct result, Cornerstone’s net interest income decreased approximately $153 thousand or 4.1 percent. Cornerstone was, however, able to improve its net interest margin from 3.32 percent in the third quarter of 2010 to 3.69 for the third quarter of 2011 primarily by reducing its most expensive liabilities.

As of September 30, 2011, the Bank’s total loans equaled approximately $270.4 million compared to approximately $285.2 million as of December 31, 2010. The reduction in loans is a result of increased loan competition in the Bank’s local market resulting in refinances and loans that have been transferred into the Bank’s other real estate owned asset category as a result of foreclosure. In response to the decrease in loans, the Bank’s Asset-Liability Committee is proactively managing the Bank’s interest-bearing liabilities which enabled the Bank to reduce its interest expense during the third quarter by approximately $666 thousand or 30.61% when comparing the three months ended September 30, 2011 to September 30, 2010. For the nine months ended September 30, 2011, the Bank was able to reduce its interest expense by approximately $2.3 million or 31.94 percent compared to the nine months ended September 30, 2010. Currently, the Bank is attempting to increase its loan portfolio and thereby improve its net interest income.

For the nine month period ended September 30, 2011, the Bank’s investment portfolio yielded 2.38 percent compared to 3.32 percent for the same time period in 2010. The Bank decreased the amount of its average investment portfolio from approximately $134 million as of September 30, 2010 to approximately $113 million as of September 30, 2011. The reduction in investments is due in part to a decrease in pledging requirements as the Bank has repaid $27 million in Federal Home Loan Bank advances since March 31, 2010. The Bank currently is invested in GNMA securities and municipal general obligations. Further, the Bank intends to increase its loan portfolio over the remainder of 2011 and 2012 and plans to fund the loan growth with cash and the liquidation of floating rate securities.

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 $115 thousand for the three months ended September 30, 2011 and $145 thousand for the nine months ended September 30, 2011.

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, 2011 and 2010 (amounts in thousands):

					2011-2010							2011-2010
	Three months ended				Percent			Nine months ended				Percent
	September 30,				Increase			September 30,				Increase
	2011		2010		(Decrease)				2011		2010	(Decrease)
Service charges on deposit accounts	$	216	$	309		(30.10	)%	$	657	$	993		(33.84	)%
Realized gains on sale of securities		60		1,059		(94.33	)%		107		1,698		(93.70	)%
Net gains / (losses) on sale of loans and other assets		32		34		(5.88	)%		88		165		(46.67	)%
Other noninterest income		15		14		7.14	%		57		55		3.64	%
Total noninterest income	$	323	$	1,416		(77.19	)%	$	909	$	2,911		(68.77	)%

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

The Bank has experienced a decrease in its service charges on deposit accounts during 2011 due to a continued reduction in customer overdraft charges.

The Bank exited the ACH payroll processing business during 2010 due to increased regulatory requirements and expects service charges on deposit accounts to drop approximately $20 thousand a month as a result.

The Bank expects to originate Small Business Administration (“SBA”) qualifying loans and sell the SBA qualified portion of the loans to third parties. The origination and sale of these loans would increase the Bank’s net gain on sale of loans and other assets.

During 2010, the Bank elected to convert a significant amount of its security portfolio from a fixed interest rate position to a variable interest rate position. This change negatively impacted the Bank’s investment yield in the short-term. For example, the yield on investment securities for the three months ended September 30, 2011 was 2.38 percent compared to a nine month yield of 3.32 percent as of September 30, 2010. The Bank’s Investment Committee and Asset-Liability Committees elected to make this adjustment to provide an interest rate hedge in anticipation of interest rates increasing in the future. The adjustment of the portfolio also allowed the Bank to realize approximately $1.7 million in gains on the sale of securities during the first nine months of 2010. The Bank’s Investment Committee has elected to sell a small number of securities in 2011 resulting in a gain of approximately $107 thousand.

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

The following table presents the components of noninterest expense for the three and nine months ended September 30, 2011 and 2010 (amounts in thousands).

					2011-2010							2011-2010
	Three months ended				Percent			Nine months ended				Percent
	September 30,				Increase /			September 30,				Increase /
	2011		2010		(Decrease)				2011		2010	(Decrease)
Salaries and employee benefits	$	1,459	$	1,525		(4.33	)%	$	4,504	$	4,680		(3.78	)%
Occupancy and equipment expense		362		397		(8.82	)%		1,118		1,121		(0.27	)%
Foreclosed asset expense, net		307		906		(66.11	)%		1,385		1,898		(27.03	)%
FDIC depository insurance		234		386		(39.38	)%		798		915		(12.79	)%
Other operating expense		715		995		(28.14	)%		2,346		2,879		(18.51	)%
Total noninterest expense	$	3,077	$	4,209		(26.89	)%	$	10,151	$	11,493		(11.69	)%

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

Cornerstone reduced its employee expense by controlling cost of living adjustment raises over the last three years and through an overall reduction in employees. The Bank anticipates employee expense will increase slightly as Cornerstone adds additional talent to handle the increasing regulatory requirements. The Bank expects employee expense to continue to climb into 2012 as employee benefits are resumed as the Bank’s performance improves.

As of September 30, 2011, the Bank had incurred approximately $1.2 million in write-down of other real estate and repossessed assets. The write-downs were the result of required annual appraisal updates. The largest write-down involved a Chattanooga, Tennessee subdivision which declined in value by approximately 25% from the previous appraisal performed in 2010. The Bank anticipates additional other real estate write-downs during the remainder of 2011 and into 2012 due to a declining trend in real estate values. Finally, during the second quarter, and continuing into the third quarter of 2011, the Bank was able to increase its revenue from its other real estate owned to fully cover the non-write-down expense of the properties.

Depository insurance during the third quarter decreased from approximately $386 thousand as of September 30, 2010 to approximately $234 thousand as of September 30, 2011. The decrease in insurance assessment was the result of a revision in the FDIC’s assessment methodology.

Financial Condition

Overview-Cornerstone’s consolidated assets totaled approximately $426.4 million as of September 30, 2011 compared to $441.5 million as of December 31, 2010.

Liabilities as of September 30, 2011 and December 31, 2010 totaled approximately $393.9 million and $415.7 million, respectively.

Stockholders’ equity as of September 30, 2011 and December 31, 2010 totaled approximately $32.4 million and $25.8 million, respectively.

Securities-The Bank’s investment portfolio, primarily consisting of Ginnie Mae Agency, mortgage-backed securities and municipal securities, amounted to approximately $93.7 million as of September 30, 2011 compared to approximately $108.3 million as of December 31, 2010. The primary purposes of the Bank’s investment portfolio are to provide liquidity, satisfy pledging requirements, collateralize the Bank’s repurchase accounts and secure the Bank’s FHLB borrowings.

Loans-The composition of loans at September 30, 2011 and at December 31, 2010 and the percentage (%) of each classification to total loans are summarized in the following table (amounts in thousands):

	September 30, 2011						December 31, 2010
	Amount			Percent			Amount			Percent
Commercial real estate-mortgage
Owner-occupied	$	63,405			23.45	%	$	64,971			22.78	%
All other		62,009			22.93	%		64,060			22.46	%
Consumer real estate-mortgage		68,466			25.32	%		71,878			25.20	%
Construction and land development		32,808			12.13	%		29,848			10.46	%
Commercial and industrial		40,880			15.12	%		51,160			17.94	%
Consumer and other		2,833			1.05	%		3,330			1.16	%
Total loans		270,401			100.00	%		285,247			100.00	%
Less: Allowance for loan losses		(6,864	)					(9,132	)

Loans, net	$	263,537					$	276,115

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 2011, the Bank added minimal provision to the loan loss allowance. Management 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 as the Bank works its problem assets through the collection cycle.

The following is a summary of changes in the allowance for loan losses for the nine months ended September 30, 2011 and for the year ended December 31, 2010 and the ratio of the allowance for loan losses to total loans as of the end of each period (amounts in thousands):

	September 30,			December 31,
	2011			2010
Balance, beginning of period	$	9,132		$	5,905
Loans charged-off		(2,855	)		(4,688	)
Recoveries of loans previously charged-off		442			624
Provision for loan losses		145			7,291
Balance, end of period	$	6,864		$	9,132

Total loans	$	270,401		$	285,247

Ratio of allowance for loan losses to loans outstanding at the end of the period		2.54	%		3.20	%

Ratio of net charge-offs to total loans outstanding for the period		0.89	%		1.42	%

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 loans, 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 Bank has experienced a stabilization in its loan quality as the Chattanooga, Tennessee Metropolitan Statistical Area begins to recover from a long economic downturn. The number and dollar amount of impaired loans remained consistent during 2011 as the Bank continued to systematically review its loan portfolio to proactively identify possible impaired loans. Management anticipates that its loan asset quality will improve as the economy recovers from the current economic downturn.

The following table summarizes Cornerstone’s non-performing assets at each quarter end from December 31, 2010 to September 30, 2011 (amounts in thousands):

	September 30,			June 30,			March 31,			December 31,
	2011			2011			2011			2010
Non-accrual loans	$	8,560		$	7,233		$	6,271		$	13,633
Foreclosed assets		18,255			20,058			20,464			12,809
Total non-performing assets	$	26,815		$	27,291		$	26,735		$	26,442

30-89 days past due loans	$	2,088		$	2,046		$	8,438		$	2,306

Total loans outstanding	$	270,401		$	270,171		$	273,750		$	285,247

Allowance for loan losses		6,864			6,814			7,914			9,132

Ratio of non-performing loans to total loans outstanding at the end of the period		3.17	%		2.68	%		2.29	%		4.78	%

Ratio of non-performing assets to total allowance for loan losses at the end of the period		390.66	%		400.51	%		337.82	%		289.55	%

As of September 30, 2011, the Bank continued to experience a reduction in 30-89 days past due loans when compared to the first quarter of 2011. The decrease is primarily attributable to two relationships. One of the relationships has moved to the Bank’s other real estate owned and is producing rental income for the Bank. The second relationship is currently on non-accrual. However, the borrower is in active negotiations to sell the property and is fully cooperating with the Bank.

Non-accrual loans increased during 2011 to approximately $8.6 million as of September 30, 2011. The slight increase was due to the above mentioned relationship which should be resolved prior to year end 2011. The non-accrual loan total has another large relationship of approximately $3 million. The relationship is in bankruptcy and the courts are presently making payments on several income producing parcels of commercial real estate. The two relationships represent approximately 64 percent of the total non-accrual amount.

During the third quarter of 2011, the Bank’s foreclosed assets reduced by approximately $1.8 million, of which approximately $1.5 million resulted from sale proceeds. Management will continue its efforts to liquidate all foreclosed assets, especially non-income producing properties that have a negative impact on earnings.

The Bank is experiencing increasing interest in its properties and expects a decrease in the amount of foreclosed assets. The Bank currently has approximately $500 thousand under contract to sell during the fourth quarter of 2011. Management expects further sales to finalize during the remainder of 2011 as well.

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

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 (amounts in thousands).

	September 30, 2011					December 31, 2010
	Amount		Percent			Amount		Percent
Core funding:
Non-interest bearing demand deposits	$	40,115		10.32	%	$	28,980		7.07	%
Interest-bearing demand deposits		22,774		5.86	%		24,834		6.06	%
Savings & money market accounts		43,477		11.19	%		34,042		8.31	%
Time deposits under $100,000		115,411		29.70	%		133,626		32.61	%
Total core funding		221,777		57.07	%		221,482		54.05	%

Non-core funding:
Time deposit of $100,000 or more	$	100,775		25.93	%	$	113,965		27.81	%
Fed funds purchased and securities sold under agreements to repurchase		26,054		6.70	%		24,325		5.94	%
Federal Home Loan Bank advances		40,000		10.30	%		50,000		12.20	%
Total non-core funding		166,829		42.93	%		188,290		45.95	%

Total	$	388,606		100.00	%	$	409,772		100.00	%

The Bank has seen relative stability in its core deposit base but has purposely reduced its certificates of deposit as the loan portfolio decreased. The Bank will continue to reduce its assets but will see future reduction primarily in cash and security balances. To offset these future reductions the Bank expects continued reductions in certificates of deposit accounts and Federal Home Loan Bank borrowings.

Capital Resources-At September 30, 2011 and December 31, 2010, Cornerstone’s stockholders’ equity amounted to approximately $32.4 million and approximately $25.8 million, respectively.

Cornerstone’s stockholders’ equity increased approximately $6.6 million during the first nine months of 2011. The increase in equity can be attributed to Cornerstone’s 2011 earnings of approximately $917 thousand, additional capital from Cornerstone’s preferred stock offering of approximately $4.6 million and an increase in unrealized gain on securities available for sale of approximately $1.4 million. Following is a summary of the Bank’s capital ratios as of September 30, 2011:

Tier 1 leverage ratio of 6.65% to average assets.

Tier 1 risk-based capital ratio of 9.86% to risk weighted assets.

Total risk-based capital ratio of 11.12% to risk weighted assets.

Cornerstone has requested permission from the Federal Reserve Bank of Atlanta (the “Federal Reserve”) to pay its scheduled second quarter 2011 dividend on its series A convertible preferred stock in the amount of $0.625 per share. Cornerstone is waiting for a final decision from the Federal Reserve authorizing the payment of the dividend.

Cornerstone had total outstanding borrowings of approximately $3 million as of September 30, 2011 with the Federal Deposit Insurance Corporation as Receiver for Silverton Bank, N.A.

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 must consider interest rate sensitivity and liquidity risk management when rendering a decision on funding solutions and loan pricing. To assist in this process the Bank has contracted with an independent third party to prepare quarterly reports that summarize several key asset-liability measurements. In addition, the third party will also provide recommendations to the Bank’s ALCO regarding future balance sheet structure, earnings and liquidity strategies. The following is a brief discussion of the primary tools used by the ALCO to perform its responsibilities:

Earnings at Risk Model

The Bank uses an earnings at risk model to analyze interest rate risk. Forecasted levels of earning assets, interest-bearing liabilities, and off-balance sheet financial instruments are combined with ALCO forecasts of interest rates for the next 12 months and are combined with other factors in order to produce various earnings simulations.

Economic Value of Equity

The Bank’s economic value of equity model measures the extent that estimated economic values of the Bank’s assets and liabilities will change as a result of interest rate changes. Economic values are determined by discounting expected cash flows from assets and liabilities, which establishes a base case economic value of equity.

Liquidity Analysis

The Bank uses a liquidity analysis model to examine the current liquidity position and analyze the potential sources of coverage in the event of a liquidity crisis. The following is a brief description of the key measurements contained in the analysis:

Regular Liquidity Position-This is a measurement used to capture the ability of an institution to cover its current debt obligations.

Basic Surplus-The basic surplus ratio is used to determine the number of times non-obligated assets could be used to meet immediate liquidity needs.

Dependency Ratio-The dependency ratio determines the reliance on short-term liabilities.

Leverage Analysis

The leverage analysis examines the potential of the institution to absorb additional debt. The key measurements included in this analysis are the Bank’s tier 1 capital, leverage and total capital ratios.

Balance Sheet Analytics

Balance sheet analytics involve an in depth examination of the balance sheet structure, including diversification of structure and most recent pricing practices. This review uses trend analysis to compare previous balance sheet positions. The analysis enables the ALCO to review significant changes in the Bank’s loan and security portfolios as well as the Bank’s deposit composition.

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 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, 2010. No material changes in the assumptions used in preparing, or results obtained from, the model have occurred since December 31, 2010.

Item 4T. Controls and Procedures

Under the supervision and with the participation of management, including Cornerstone’s Chief Executive Officer and Chief 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, 2011 (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 subsidiary) 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, 2011 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

Cornerstone, as a smaller reporting company, is not required to provide the information required by this Item.

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

None

Item 3. Defaults Upon Senior Securities

None

Item 4. [Removed and Reserved]

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 10, 2011	/s/ Nathaniel F. Hughes
	Nathaniel F. Hughes,
	President
	(principal executive officer)

Date: November 10, 2011	/s/ Gary W. Petty, Jr.
	Gary W. Petty, Jr.
	Senior Vice President and Chief Financial Officer
	(principal financial officer and accounting 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.