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 in Dalton, Georgia to further enhance the Bank’s lending markets.

 

Interim Financial Information (Unaudited)-The financial information in this report for June 30, 2014 and June 30, 2013 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 2013 Annual Report to Shareholders which was furnished to each shareholder of Cornerstone in April of 2014. 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, foreclosed assets and deferred tax assets.

 

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

 

Reclassification-Certain amounts in the prior consolidated financial statements have been reclassified to conform to the current period presentation. The reclassifications had no effect on net income, total assets 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, 2013 as filed with the Securities and Exchange Commission. Since December 31, 2013, there have been no significant changes in any accounting principles or practices, or in the method of applying any such principles or practices.

 

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

   

The following is a summary of the basic and diluted earnings per share for the three and six month periods ended June 30, 2014 and June 30, 2013.

		Three Months Ended June 30,
		2014			2013
Net income available to common shareholders		$	16,638		$	3,186
Weighted average common shares outstanding			6,627,398			6,547,074
Effect of dilutive stock options			179,888			112,416
Diluted shares			6,807,286			6,659,490
Basic earnings per common share		$	0.00		$	0.00
Diluted earnings per common share		$	0.00		$	0.00

 

		Six Months Ended June 30,
		2014			2013
Net income available to common shareholders		$	35,943		$	62,469
Weighted average common shares outstanding			6,601,070			6,547,074
Effect of dilutive stock options			160,068			117,454
Diluted shares			6,761,138			6,664,528
Basic earnings per common share		$	0.01		$	0.01
Diluted earnings per common share		$	0.01		$	0.01

 

For the three and six months ended June 30, 2014, the effects of outstanding antidilutive stock options are excluded from the computation of diluted earnings per common share because the exercise price of such options are higher than the market price. There are 222,435 and 545,075 antidilutive stock options as of June 30, 2014 and 2013, respectively.

 

Accounting Policies- Cornerstone, as required by FASB, applies the fair value recognition provisions of ASC 718, “Compensation –Stock Compensation.” For the six month period ended June 30, 2014, $80,000 in compensation cost was charged to earnings related to the vested incentive stock options.

 

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 percent on the second anniversary of the grant date, 60 percent on the third anniversary of the grant date and 100 percent on the fourth anniversary of the grant date, and the non-qualified stock options vest 50 percent on the first anniversary of the grant date and 100 percent on the second anniversary of the grant date. The options expire ten years from the grant date. At June 30, 2014, the total remaining compensation cost to be recognized on non-vested options is approximately $710,000.

 

A summary of the status of these stock option plans is presented in the following table:

 

								Weighted-
								Average
					Weighted			Contractual
					Average			Remaining			Aggregate
					Exercisable			Term			Intrinsic
		Number			Price			(in years)			Value
Outstanding at December 31, 2013			810,825		$	3.51			6.5 Years		$	257,570
Granted			207,000			2.40			9.9 Years
Exercised			-			-
Forfeited			(73,640)			5.05
Outstanding at June 30, 2014			944,185		$	3.15			7.2 Years		$	382,980
Options exercisable at June 30, 2014			343,085		$	4.92

  

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 common stock. Only non-qualified stock options may be granted under the Plan. In addition, members of the Board of Directors can be issued options under the Cornerstone 2002 Long-Term Incentive Plan to purchase up to 1,200,000 shares of Cornerstone stock. The options available for issuance to Board members under the 2002 Long-Term Incentive Plan are shared with officers and employees of Cornerstone. The exercise price of each option equals the market price of Cornerstone’s stock on the date of grant and the option’s maximum term is ten years, at which point they expire. Vesting for options granted are 50% on each of the first and second anniversary of the grant date with full vesting occurring at the second anniversary date. At June 30, 2014, the total remaining compensation cost to be recognized on non-vested options is approximately $160,000. A summary of the status of this stock option plan is presented in the following table:

 

								Weighted-
								Average
					Weighted			Contractual
					Average			Remaining			Aggregate
					Exercisable			Term			Intrinsic
		Number			Price			(in years)			Value
Outstanding at December 31, 2013			190,250		$	3.07			6.9 Years		$	64,800
Granted			80,000			2.40			9.9 Years
Exercised			-			-
Forfeited			(16,000)			5.44
Outstanding at June 30, 2014			254,250		$	2.71			7.8 Years		$	101,100
Options exercisable at June 30, 2014			151,750		$	2.93

 

The weighted average grant date fair value of all stock options granted during the six months ended June 30, 2014 was $1.30. This was determined using the Black-Scholes option-pricing model with the following weighted-average assumptions:

 

Dividend yield		0.0	%
Expected life		8.5 Years
Expected volatility		45.73	%
Risk-free interest rate		2.32	%

The amortized cost and fair value of securities available-for-sale and held to maturity at June 30, 2014 and December 31, 2013 are summarized as follows:

 

		June 30, 2014
					Gross			Gross
		Amortized			Unrealized			Unrealized			Fair
		Cost			Gains			Losses			Value
Debt securities available-for-sale:
U.S. Government agencies		$	690,436		$	1,202		$	-		$	691,638
State and municipal securities			10,446,393			460,705			(7144)			10,899,954
Mortgage-backed securities:
Residential mortgage guaranteed by GNMA or FNMA			5,148,549			32,338			(1,002)			5,179,885
Collateralized mortgage obligations issued or guaranteed by U.S. Government agencies or sponsored agencies			66,791,823			216,798			(465,491)			66,543,130
		$	83,077,201		$	711,043		$	(473,637)		$	83,314,607
Debt securities held to maturity:
Mortgage-backed securities:
Residential mortgage guaranteed by GNMA or FNMA		$	30,993		$	318		$	(1)		$	31,309

		December 31, 2013
					Gross			Gross
		Amortized			Unrealized			Unrealized			Fair
Debt securities available-for-sale:		Cost			Gains			Losses			Value
U.S. Government agencies		$	3,433,216		$	48,119		$	-		$	3,481,335
State and municipal securities			14,908,761			425,021			(84,544)			15,249,238
Mortgage-backed securities:
Residential mortgage guaranteed by GNMA or FNMA			7,047,076			85,203			-			7,132,279
Collateralized mortgage obligations issued or guaranteed by U.S. Government agencies or sponsored agencies			66,408,975			205,025			(268,180)			66,345,820
		$	91,798,028		$	763,368		$	(352,724)		$	92,208,672
Debt securities held to maturity:
Mortgage-backed securities:
Residential mortgage guaranteed by GNMA or FNMA		$	34,165		$	862		$	-		$	35,027

 

At June 30, 2014, securities with a fair value totaling approximately $ 75 million were pledged to secure public funds, securities sold under agreements to repurchase, as collateral for federal funds purchased from other financial institutions and serve as collateral for borrowings at the Federal Reserve Discount Window and Federal Home Loan Bank.

 

For the six months ended June 30, 2014 and 2013, there were available-for-sale securities sold with proceeds totaling $9,229,167 and $5,328,170, respectively, which resulted in gross gains realized of $402,473 and $424,971, respectively.

 

The amortized cost and estimated market value of securities at June 30, 2014, 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		$	-		$	-		$	-		$	-
Due from one year to five years			900,216			948,320			-			-
Due from five years to ten years			3,077,554			3,244,206			-			-
Due after ten years			7,159,059			7,399,066			-			-
			11,136,829			11,591,592			-			-
Mortgage-backed securities			71,940,372			71,723,015			30,993			31,309
		$	83,077,201		$	83,314,607		$	30,993		$	31,309

 

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 June 30, 2014 and as of December 31, 2013:

 

		As of June 30, 2014
		Less than 12 Months						12 Months or Greater						Total
					Gross						Gross						Gross
		Fair			Unrealized			Fair			Unrealized			Fair			Unrealized
		Value			Losses			Value			Losses			Value			Losses
State and municipal securities		$	358,700		$	(318)		$	555,000		$	(6,826)		$	913,700		$	(7,144)
Residential mortgage guaranteed by GNMA or FNMA			1,409,761			(1,002)			-			-			1,409,761			(1,002)
Collateralized mortgage obligations issued or guaranteed by U.S. Government agencies or     sponsored agencies			17,254,013			(106,428)			22,935,622			(359,063)			40,189,635			(465,491)
		$	19,022,474		$	(107,748)		$	23,490,622		$	(365,889)		$	42,513,096		$	(473,637)

 

		As of December 31, 2013
		Less than 12 Months						12 Months or Greater						Total
					Gross						Gross						Gross
		Fair			Unrealized			Fair			Unrealized			Fair			Unrealized
		Value			Losses			Value			Losses			Value			Losses
State and municipal securities		$	3,025,250		$	(84,544)		$	-		$	-		$	3,025,250		$	(84,544)
Collateralized mortgage obligations issued or guaranteed by U.S. Government agencies or sponsored agencies			27,782,942			(221,827)			8,761,049			(46,353)			36,543,991			(268,180)
		$	30,808,192		$	(306,371)		$	8,761,049		$	(46,353)		$	39,569,241		$	(352,724)

 

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 June 30, 2014 or December 31, 2013.

 

At June 30, 2014 and December 31, 2013, the categories of temporarily impaired securities, and management’s evaluation of those securities, are as follows:

State and municipal securities: At June 30, 2014, two investments in obligations of state and municipal securities had unrealized losses. The Bank believes the unrealized losses on those investments were caused by the interest rate environment and do not relate to the underlying credit quality of the issuers. Because the Bank has the intent and ability to hold those investments for a time necessary to recover their amortized cost bases, which may be until maturity, the Bank does not consider those investments to be other-than-temporarily impaired at June 30, 2014.

 

Mortgage-backed securities: At June 30, 2014, fifteen 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 June 30, 2014.

 

At June 30, 2014 and December 31, 2013, loans are summarized as follows (in thousands):

 

		June 30,			December 31,
		2014			2013
Commercial real estate-mortgage:
Owner-occupied		$	70,808		$	65,747
All other			71,407			64,052
Consumer real estate-mortgage			75,603			76,315
Construction and land development			32,734			41,597
Commercial and industrial			38,973			38,999
Consumer and other			2,844			2,730
Total loans			292,369			289,440
Less: Allowance for loan losses			(3,330)			(3,203)
Loans, net		$	289,039		$	286,237

 

The following describe risk characteristics relevant to each of the portfolio segments:

 

Real estate:

 

As discussed below, Cornerstone offers various types of real estate loan products. All loans within this portfolio segment are particularly sensitive to the valuation of real estate:

 

 

 

 

Commercial and industrial:

 

The commercial and industrial loans include those loans to commercial customers for use in normal business operations to finance working capital needs, equipment purchases, or expansion projects. Loans are repaid by business cash flows. Collection risk in this portfolio is driven by the creditworthiness of the underlying borrower, particularly cash flows from the customers’ business operations.

 

Consumer and other:

 

The consumer loan portfolio segment includes direct consumer installment loans, overdrafts and other revolving credit loans, and educational loans. Loans in this portfolio are sensitive to unemployment and other key consumer economic measures.

 

Cornerstone follows the loan impairment accounting guidance in ASC Topic 310. A loan is considered impaired when, based on current information and events, it is probable that Cornerstone will be unable to collect all amounts due from the borrower in accordance with the contractual terms of the loan. Impaired loans include nonperforming loans and loans modified in troubled debt restructurings where concessions have been granted to borrowers experiencing financial difficulties. These concessions could include a reduction in interest rates, payment extensions, forgiveness of principal, forbearance or other actions intended to maximize collections.

 

The composition of loans by loan classification for impaired and performing loan status at June 30, 2014 and December 31, 2013, is summarized in the tables below (amounts in thousands):

 

June 30, 2014		Commercial			Consumer			Construction			Commercial
		Real Estate-			Real Estate-			and Land			and			Consumer
		Mortgage			Mortgage			Development			Industrial			and Other			Total
Performing loans		$	136,940		$	72,969		$	32,369		$	37,365		$	2,844		$	282,487
Impaired loans			5,275			2,634			365			1,608			-			9,822
Total		$	142,215		$	75,603		$	32,734		$	38,973		$	2,844		$	292,369

 

December 31, 2013		Commercial			Consumer			Construction			Commercial
		Real Estate-			Real Estate-			and Land			and			Consumer
		Mortgage			Mortgage			Development			Industrial			and Other			Total
Performing loans		$	121,817		$	72,868		$	41,228		$	37,007		$	2,730		$	275,650
Impaired loans			7,982			3,447			369			1,992			-			13,790
Total		$	129,799		$	76,315		$	41,597		$	38,999		$	2,730		$	289,440

 

The following tables show the allowance for loan losses allocation by loan classification for impaired and performing loans as of June 30, 2014 and December 31, 2013 (amounts in thousands):

 

June 30, 2014		Commercial			Consumer			Construction			Commercial
		Real Estate-			Real Estate-			and Land			and			Consumer
Allowance related to:		Mortgage			Mortgage			Development			Industrial			and Other			Total
Performing loans		$	1,341		$	1,069		$	262		$	301		$	77		$	3,050
Impaired loans			31			140			-			109			-			280
Total		$	1,372		$	1,209		$	262		$	410		$	77		$	3,330

 

December 31, 2013		Commercial			Consumer			Construction			Commercial
		Real Estate-			Real Estate-			and Land			and			Consumer
Allowance related to:		Mortgage			Mortgage			Development			Industrial			and Other			Total
Performing loans		$	1,051		$	927		$	319		$	297		$	45		$	2,639
Impaired loans			498			11			-			55			-			564
Total		$	1,549		$	938		$	319		$	352		$	45		$	3,203

 

The following tables detail the changes in the allowance for loan losses for the six month period ending June 30, 2014 and year ending December 31, 2013, by loan classification (amounts in thousands):

 

June 30, 2014		Commercial			Consumer			Construction			Commercial
		Real Estate-			Real Estate-			and Land			and			Consumer
		Mortgage			Mortgage			Development			Industrial			and Other			Total
Beginning balance		$	1,549		$	938		$	319		$	352		$	45		$	3,203
Charged-off loans			(427)			(350)			(13)			(53)			(37)			(880)
Recovery of charge-offs			56			42			337			29			28			492
Provision for (reallocation of) loan losses			194			579			(381)			82			41			515
Ending balance		$	1,372		$	1,209		$	262		$	410		$	77		$	3,330

 

December 31, 2013		Commercial			Consumer			Construction			Commercial
		Real Estate-			Real Estate-			and Land			and			Consumer
		Mortgage			Mortgage			Development			Industrial			and Other			Total
Beginning balance		$	2,549		$	1,528		$	1,241		$	809		$	14		$	6,141
Charged-off loans			(1,879)			(842)			(1,193)			(699)			(96)			(4,709)
Recovery of charge-offs			68			241			1,058			99			5			1,471
Provision for (reallocation of) loan losses			811			11			(787)			143			122			300
Ending balance		$	1,549		$	938		$	319		$	352		$	45		$	3,203

 

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, remain properly underwritten and are properly classified by loan grade. This review process is performed by the Bank's management, internal and external loan review, internal auditors, and state and federal regulators.

The Bank’s loan grading process is as follows:

 

 

   

 

 

 

 

If a loan is classified as a problem asset, it will be assigned one of the following loan grades: substandard, 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 or doubtful, a specific allowance for loan losses may be established.

 

The following tables outline the amount of each loan classification and the amount categorized into each risk rating as of June 30, 2014 and December 31, 2013 (amounts in thousands):

 

June 30, 2014		Commercial			Consumer			Construction			Commercial
		Real Estate-			Real Estate-			and Land			and			Consumer
		Mortgage			Mortgage			Development			Industrial			and Other			Total
Pass		$	133,731		$	70,474		$	32,024		$	34,419		$	2,844		$	273,492
Special mention			4,391			1,553			267			2,745			-			8,956
Substandard			4,093			3,576			443			1,809			-			9,921
		$	142,215		$	75,603		$	32,734		$	38,973		$	2,844		$	292,369

 

December 31, 2013		Commercial			Consumer			Construction			Commercial
		Real Estate-			Real Estate-			and Land			and			Consumer
		Mortgage			Mortgage			Development			Industrial			and Other			Total
Pass		$	119,398		$	67,444		$	40,850		$	33,394		$	2,730		$	263,816
Special mention			3,538			3,536			73			3,468			-			10,615
Substandard			6,863			5,335			674			2,137			-			15,009
		$	129,799		$	76,315		$	41,597		$	38,999		$	2,730		$	289,440

  

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 June 30, 2014 and December 31, 2013 (in thousands):

 

											For the quarter ended
		At June 30, 2014									June 30, 2014
					Unpaid						Average			Interest
		Recorded			Principal			Related			Recorded			Income
		Investment			Balance			Allowance			Investment			Recognized
Impaired loans without a valuation allowance:
Commercial real estate – mortgage		$	5,139		$	5,180		$	-		$	5,368		$	126
Consumer real estate – mortgage			1,957			1,972			-			2,052			62
Construction and land development			365			378			-			367			12
Commercial and industrial			1,249			1,292			-			1,390			23
Total		$	8,710		$	8,822		$	-		$	9,177		$	223
Impaired loans with a valuation allowance:
Commercial real estate – mortgage		$	136		$	145		$	31		$	823		$	3
Consumer real estate – mortgage			677			688			140			994			19
Construction and land development			-			-			-			-			-
Commercial and industrial			359			359			109			390			22
Total		$	1,172		$	1,192		$	280		$	2,207		$	44
Total impaired loans		$	9,882		$	10,014		$	280		$	11,384		$	267