SMBK 10-Q Quarterly Report June 30, 2011

SMARTFINANCIAL INC.

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10-Q 1 v230330_10q.htm Unassociated Document

United States Securities and Exchange Commission

Washington, D.C. 20549

FORM 10-Q

(Mark One)

x	QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended June 30, 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 August 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	26

Item 3. Quantitative and Qualitative Disclosures about Market Risk	33

Item 4T.Controls and Procedures	33

PART II – OTHER INFORMATION

Item 1. Legal Proceedings	34

Item 1A. Risk Factors	34

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds	34

Item 3. Defaults Upon Senior Securities	34

Item 4. [Removed and Reserved]	34

Item 5. Other Information	34

Item 6. Exhibits	34

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 regulatory acceptable levels and composition; (ix) the effect of recent legislative 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
	June 30,			December 31,
ASSETS	2011			2010

Cash and due from banks	$	1,120,436		$	1,490,030
Interest-bearing deposits at other financial institutions		28,783,701			21,491,922
Total cash and cash equivalents		29,904,137			22,981,952

Securities available for sale		109,331,248			108,250,434
Securities held to maturity (fair value approximates of $83,834 and $98,388 at June 30, 2011 and December 31, 2010, respectively)		81,534			95,702
Federal Home Loan Bank stock, at cost		2,322,900			2,322,900
Loans, net of allowance for loan losses of $6,814,385 at June 30, 2011 and $9,132,171 at December 31, 2010		263,356,939			276,114,617
Bank premises and equipment, net		5,790,638			8,047,370
Accrued interest receivable		1,297,606			1,326,480
Foreclosed assets		20,057,587			12,808,838
Other assets		9,067,121			9,551,121
Total Assets	$	441,209,710		$	441,499,414

LIABILITIES AND STOCKHOLDERS' EQUITY

Deposits:
Noninterest-bearing demand deposits	$	42,354,816		$	28,980,043
Interest-bearing demand deposits		26,262,115			24,834,214
Savings deposits and money market accounts		38,425,489			34,041,672
Time deposits		227,878,545			247,591,161
Total deposits		334,920,965			335,447,090

Federal funds purchased and securities sold under agreements to repurchase		27,011,269			24,325,372
Federal Home Loan Bank advances and other borrowings		48,480,000			54,715,000
Accrued interest payable		180,223			176,761
Other liabilities		1,757,631			1,016,038
Total Liabilities		412,350,088			415,680,261

Stockholders' Equity:
Preferred stock - no par value; 2,000,000 shares authorized; 188,820 shares issued and outstanding in 2011 and 114,540 shares issued and outstanding in 2010		4,540,516			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		21,276,868			21,237,298
Retained (deficit)		(4,024,893	)		(4,317,130	)
Accumulated other comprehensive income (loss)		566,735			(328,835	)
Total Stockholders' Equity		28,859,622			25,819,153
Total Liabilities and Stockholders' Equity	$	441,209,710		$	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						Six months ended
	June 30,						June 30,
	2011			2010			2011		2010
INTEREST INCOME
Loans, including fees	$	4,521,370		$	5,493,946		$	9,160,175	$	11,442,192
Investment securities		621,108			1,216,300			1,189,780		2,345,579
Federal funds sold & other earning assets		17,325			21,732			28,328		45,393
Total interest income		5,159,803			6,731,978			10,378,283		13,833,164

INTEREST EXPENSE
Time deposits		1,011,776			1,619,243			2,064,225		3,303,270
Other deposits		99,936			99,606			192,548		197,329
Federal funds purchased and securities sold under agreements to repurchase		33,712			32,142			64,715		67,557
FHLB advances and other borrowings		545,413			759,803			1,125,071		1,539,000
Total interest expense		1,690,837			2,510,794			3,446,559		5,107,156

Net interest income before provision for loan losses		3,468,966			4,221,184			6,931,724		8,726,008
Provision for loan losses		15,000			1,465,000			30,000		2,480,000
Net interest income after the provision for loan losses		3,453,966			2,756,184			6,901,724		6,246,008

NONINTEREST INCOME
Customer service fee		225,263			342,126			440,714		684,040
Net gains from sale of securities		47,742			618,745			47,742		639,587
Net gains from sale of loans and other assets		21,517			109,593			55,544		129,886
Other noninterest income		21,531			20,757			41,810		41,371
Total noninterest income		316,053			1,091,221			585,810		1,494,884

NONINTEREST EXPENSE
Salaries and employee benefits		1,501,836			1,521,216			3,044,538		3,154,560
Net occupancy and equipment expense		350,280			368,506			756,614		723,689
Depository insurance		241,505			259,904			564,160		529,643
Foreclosed assets, net		716,505			796,345			1,078,075		992,518
Other operating expense		847,281			938,388			1,630,635		1,883,947
Total noninterest expense		3,657,407			3,884,359			7,074,022		7,284,357

Income (loss) before provision for income taxes		112,612			(36,954	)		413,512		456,535
Provision (benefit) for income taxes		(28,675	)		(55,099	)		19,950		94,602

Net income		141,287			18,145			393,562		361,933

Preferred stock dividend requirements		93,075			-			185,400		-
Accretion on preferred stock discount		9,000			-			9,000		-

Net income available to common shareholders	$	39,212		$	18,145		$	199,162	$	361,933

EARNINGS PER COMMON SHARE
Basic net income per common share	$	0.01		$	-		$	0.03	$	0.06
Diluted net income per common share	$	0.01		$	-		$	0.03	$	0.06

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 six months ended June 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				-		-		39,570		-			-			39,570

Issuance of Series A Convertible Preferred Stock				1,804,092		-		-		-			-			1,804,092

Preferred stock dividends paid				-		-		-		(92,325	)		-			(92,325	)

Accrection on preferred stock				9,000		-		-		(9,000	)		-			-

Comprehensive income:
Net income	$	393,562		-		-		-		393,562			-			393,562


Other comprehensive income, net of tax:
Unrealized holding gains on securities available for sale, net of reclassification adjusment		895,570		-		-		-		-			895,570			895,570

Total comprehensive income	$	1,289,132

BALANCE, June 30, 2011			$	4,540,516	$	6,500,396	$	21,276,868	$	(4,024,893	)	$	566,735		$	28,859,622

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

Cornerstone Bancshares, Inc. and Subsidiary

Consolidated Statements of Cash Flows

	Unaudited
	Six months ended June 30,
	2011			2010

CASH FLOWS FROM OPERATING ACTIVITIES
Net income	$	393,562		$	361,933
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization		155,415			233,564
Provision for loan losses		30,000			2,480,000
Stock compensation expense		39,570			37,306
Net (gains) losses on sales of loans and other assets		858,143			(386,195	)
Changes in other operating assets and liabilities:
Net change in loans held for sale		(298,500	)		(371,000	)
Accrued interest receivable		28,874			(141,737	)
Accrued interest payable		3,462			23,222
Other assets and liabilities		818,835			26,417
Net cash provided by operating activities		2,029,361			2,263,510


CASH FLOWS FROM INVESTING ACTIVITIES
Proceeds from security transactions:
Securities available for sale		689,587			50,499,955
Securities held to maturity		13,872			20,266
Purchase of securities available for sale		(250,000	)		(53,138,697	)
Purchase of Federal Home Loan Bank stock		-			(93,700	)
Loan originations and principal collections, net		3,235,943			12,633,191
Purchase of bank premises and equipment		92,018			(2,299	)
Proceeds from sale of bank premises and equipment		-			199,664
Proceeds from sale of other real estate and other assets		3,474,865			4,516,827
Net cash provided by investing activities		7,256,285			14,635,207


CASH FLOWS FROM FINANCING ACTIVITIES
Net (decrease) in deposits		(526,125	)		(4,093,656	)
Net increase / (decrease) in federal funds purchased and securities sold under agreements to repurchase		2,685,897			(2,216,720	)
Net payments on Federal Home Loan Bank advances and other borrowings		(6,235,000	)		(5,100,000	)
Payment of dividends on preferred stock		(92,325	)		-
Issuance of preferred stock		1,804,092			-
Net cash used in financing activities		(2,363,461	)		(11,410,376	)

NET INCREASE IN CASH AND CASH EQUIVALENTS		6,922,185			5,488,341

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

CASH AND CASH EQUIVALENTS, end of period	$	29,904,137		$	43,690,546


SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION
Cash paid during the period for interest	$	3,443,097		$	5,083,934
Cash paid during the period for taxes		-			500,000


NONCASH INVESTING AND FINANCING ACTIVITIES
Acquisition of real estate through foreclosure	$	9,838,317		$	4,365,571

The Notes to Consolidated Financial Statements are an intergral 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 June 30, 2011 and June 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 Company is evaluating the effect, if any, the adoption of ASU 2011-02 will have on its consolidated 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.

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 six month periods ended June 30, 2011 and June 30, 2010.

	Three Months Ended June 30,
Basic earnings per common share calculation:	2011		2010
Numerator: Net income available to common shareholders	$	39,212	$	18,145
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	$	0.01	$	-
Diluted earnings per common share	$	0.01	$	-

	Six Months Ended June 30,
Basic earnings per common share calculation:		2011		2010
Numerator: Net income available to common shareholders	$	199,162	$	361,933
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	$	0.03	$	0.06
Diluted earnings per common share	$	0.03	$	0.06

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 six month period ended June 30, 2011, the compensation cost charged to earnings related to the vested incentive stock options was approximately $40,000, 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 June 30, 2011, the total remaining compensation cost to be recognized on non-vested options is approximately $346,000. 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		211,000		1.70	9.9 Years		-
Exercised		-		-
Forfeited		149,300		4.59
Outstanding at June 30, 2011		582,600	$	4.63	6.2 Years	$	-
Options exercisable at June 30, 2011		296,915	$	6.66			-

The weighted average grant date fair value of stock options granted during the six months ended June 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 June 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 June 30, 2011		100,250	$	9.42	5.2 Years	$	-
Options exercisable at June 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 June 30, 2011 and December 31, 2010 are summarized as follows:

	June 30, 2011
			Gross		Gross
	Amortized		Unrealized		Unrealized			Fair
Debt securities available-for-sale:	Cost		Gains		Losses			Value
U.S. Government agencies	$	4,282,294	$	14,836	$	-		$	4,297,130

State and municipal securities		21,108,697		702,072		(37,524	)		21,773,245

Mortgage-backed securities:
Residential mortgage guaranteed by GNMA		15,453,645		252,356		(3,120	)		15,702,881

Collateralized mortgage obligations issued or guaranteed by U.S. Government agencies or sponsored agencies		67,554,290		224,307		(220,605	)		67,557,992

	$	108,398,926	$	1,193,571	$	(261,249	)	$	109,331,248

Debt securities held to maturity:
Mortgage-backed securities:
Residential mortgage guaranteed by GNMA	$	81,534	$	2,300	$	-		$	83,834

CORNERSTONE BANCSHARES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

	December 31, 2010
			Gross		Gross
	Amortized		Unrealized		Unrealized			Fair
Debt securities available-for-sale:	Cost		Gains		Losses			Value
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 June 30, 2011, securities with a fair value totaling approximately $104 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 June 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	$	299,873	$	300,779	$	-	$	-
Due from one year to five years		1,175,214		1,265,987		-		-
Due from five years to ten years		4,407,278		4,596,163		-		-
Due after ten years		19,508,626		19,907,446		-		-
		25,390,991		26,070,375		-		-


Mortgage-backed securities		83,007,935		83,260,873		81,534		83,834

	$	108,398,926	$	109,331,248	$	81,534	$	83,834

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 June 30, 2011 and as of December 31, 2010:

	As of June 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
Debt securities available for sale:
State and municipal securities	$	845,897	$	(37,524	)	$	-	$	-		$	845,897	$	(37,524	)

Mortgage-backed securities:
Residential mortgage guaranteed by GNMA		-		-			2,744,919		(3,120	)		2,744,919		(3,120	)

Collateralized mortgage obligations issued or guaranteed by U.S. Government agencies or sponsored agencies		31,258,737		(220,379	)		1,159,526		(226	)		32,418,263		(220,605	)
	$	32,104,634	$	(257,903	)	$	3,904,445	$	(3,346	)	$	36,009,079	$	(261,249	)

	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 June 30, 2011 or December 31, 2010.

CORNERSTONE BANCSHARES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

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

State and municipal securities: At June 30, 2011, 2 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 does 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 maturity, the Bank does not consider those investments to be other-than-temporarily impaired at June 30, 2011.

Mortgage-backed securities: At June 30, 2011, 7 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, 2011.

Note 4. Loans and Allowance for Loan Losses

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

	June 30,			December 31,
	2011			2010
Commercial real estate-mortgage:
Owner-occupied	$	63,801		$	64,971
All other		62,060			64,060
Consumer real estate-mortgage		68,030			71,878
Construction and land development		29,637			29,848
Commercial and industrial		43,673			51,160
Consumer and other		2,970			3,330
Total loans		270,171			285,247
Less: Allowance for loan losses		(6,814	)		(9,132	)

Loans, net	$	263,357		$	276,115

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

June 30, 2011	Commercial		Consumer		Construction		Commercial
	Real Estate-		Real Estate-		and Land		and		Consumer
	Mortgage		Mortgage		Development		Industrial		and Other		Total
Performing loans	$	114,475	$	59,008	$	28,262	$	41,952	$	2,970	$	246,667
Impaired loans		11,386		9,022		1,375		1,721		-		23,504
Total	$	125,861	$	68,030	$	29,637	$	43,673	$	2,970	$	270,171

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 June 30, 2011 and December 31, 2010 (dollar amounts in thousands):

June 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	$	1,983	$	1,079	$	559	$	678	$	62	$	4,361
Impaired loans		1,192		851		-		410		-		2,453
Total	$	3,175	$	1,930	$	559	$	1,088	$	62	$	6,814

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 six month period ending June 30, 2011 and year ending December 31, 2010 by loan classification (dollars in thousands):

June 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		(1,188	)		(1,429	)		(60	)		(21	)		(9	)		(2,707	)
Recovery of charge-offs		240			12			24			70			13			359
Provision for loan losses		2,330			236			(2,643	)		114			(7	)		30
Ending balance	$	3,175		$	1,930		$	559		$	1,088		$	62		$	6,814

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 us to review and classify our assets on a regular basis. There are three classifications for problem assets: 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 we classify an asset as substandard or doubtful, we may establish a specific allowance for loan losses.

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 June 30, 2011 and December 31, 2010 (amounts in thousands):

June 30, 2011	Commercial		Consumer		Construction		Commercial
	Real estate-		Real Estate-		and Land		and		Consumer
	Mortgage		Mortgage		Development		Industrial		and Other		Total
Pass	$	101,708	$	51,008	$	25,489	$	36,040	$	2,893	$	223,138
Special mention		11,627		3,555		1,825		5,603		27		22,637
Substandard		1,140		4,445		948		309		50		6,892
Substandard-impaired		8,852		9,022		1,375		1,721		-		20,970
Doubtful		2,534		-		-		-		-		2,534
	$	125,861	$	68,030	$	29,637	$	43,673	$	2,970	$	270,171

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 June 30, 2011 and December 31, 2010 (in thousands):

June 30, 2011	Unpaid				Average
	Principal		Related		Recorded
	Balance		Allowance		Investment
Impaired loans with no recorded allowance
Commercial real estate – mortgage	$	5,411	$	-	$	3,591
Consumer real estate – mortgage		5,380		-		4,612
Construction and land development		1,375		-		1,056
Commercial and industrial		1,180		-		938
Consumer and other		-		-		-
Total	$	13,346	$	-	$	10,197

Impaired loans with a recorded allowance
Commercial real estate – mortgage	$	5,975	$	1,192	$	6,001
Consumer real estate – mortgage		3,642		851		6,286
Construction and land development		-		-		365
Commercial and industrial		541		410		604
Consumer and other		-		-		155
Total	$	10,158	$	2,453	$	13,411

Total impaired loans	$	23,504	$	2,453	$	23,608

CORNERSTONE BANCSHARES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

December 31, 2010	Unpaid				Average
	Principal		Related		Recorded
	Balance		Allowance		Investment
Impaired loans with no recorded allowance
Commercial real estate – mortgage	$	1,663	$	-	$	2,747
Consumer real estate – mortgage		998		-		776
Construction and land development		1,793		-		1,526
Commercial and industrial		70		-		782
Consumer and other		2		-		1
Total	$	4,526	$	-	$	5,832

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

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

Interest income recognized on impaired loans was approximately $643,000 and $943,000 for the six month ending June 30, 2011 and the year ending December 31, 2010, respectively. There was no interest income recognized on a cash basis on impaired loans during these periods.

Impaired loans also include loans that the Bank may elect to formally restructure due to the weakening credit status of a borrower such that the restructuring may facilitate a repayment plan that minimizes the potential losses, if any, that the Bank may have to otherwise incur. These loans are classified as impaired loans. At June 30, 2011 and December 31, 2010, there were approximately $1.8 million and $948 thousand, respectively, of accruing restructured loans that remain in a performing status.

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

June 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	$	567	$	-	$	2,727	$	3,394	$	60,507	$	63,801
All other		147		-		843		990		61,070		62,060
Consumer real estate-mortgage		1,010		-		3,122		4,132		63,898		68,030
Construction and land development		140		-		428		568		29,069		29,637
Commercial and industrial		170		-		76		141		43,532		43,673
Consumer and other		12		-		37		49		2,921		2,970
Total	$	2,046	$	-	$	7,233	$	9,174	$	260,997	$	270,171

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

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 June 30, 2011 is as follows:

Commitments to extend credit		$	26.1million
Standby letters of credit		$	3.1 million

Various legal claims also arise from time to time in the normal course of business. In the opinion of management, the resolution of claims outstanding at June 30, 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 June 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 June 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
	June 30,		Assets		Inputs		Inputs
	2011		(Level 1)		(Level 2)		(Level 3)
Debt securities available for sale:

U.S. Government agencies	$	4,297,130	$	-	$	4,297,130	$	-
State and municipal securities		21,773,245		-		21,773,245		-
Mortgage-backed securities:
Residential mortgage guaranteed by GNMA		15,702,881		-		15,702,881		-
Collateralized mortgage obligations issued or guaranteed by U.S. Government agencies or sponsored agencies		67,557,992		-		67,557,992		-

Total securities available for sale	$	109,331,248	$	-	$	109,331,248	$	-

Cash surrender value of life insurance	$	1,150,299	$	-	$	1,150,299	$	-

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 June 30, 2011 for which a nonrecurring change in fair value was recorded.

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

Impaired loans	$	7,705	$	-	$	7,705	$	-
Foreclosed assets (OREO & Repossessions)		20,058		-		20,058		-

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 June 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 June 30, 2011 and December 31, 2010 are as follows (in thousands):

	June 30, 2011				December 31, 2010
	Carrying		Estimated		Carrying		Estimated
	Amount		Fair Value		Amount		Fair Value
Assets:
Cash and cash equivalents	$	29,904	$	29,904	$	22,982	$	22,982
Securities		109,413		109,415		108,346		108,349
Federal Home Loan Bank stock		2,323		2,323		2,323		2,323
Loans, net		263,357		264,989		276,115		277,796
Cash surrender value of life insurance		1,150		1,150		1,114		1,114
Accrued interest receivable		1,298		1,298		1,326		1,326

Liabilities:
Noninterest-bearing demand deposits		42,355		42,355		28,980		28,980
Interest-bearing demand deposits		26,262		26,262		24,834		24,834
Savings deposits and money market accounts		38,425		38,425		34,042		34,042
Time deposits		227,879		229,978		247,591		249,990
Federal funds purchased and securities sold under agreements to repurchase		27,011		27,011		24,325		24,325
Federal Home Loan Bank advances
and other borrowings		48,480		48,480		54,715		54,715
Accrued interest payable		180		180		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 six months ended June 30, 2011 and 2010.

	Three Months Ended
	June 30,
	2011		2010
Net income	$	141,287	$	18,145
Unrealized holding gains on securities available for sale, net of reclassification		548,868		804,973

Comprehensive income	$	690,155	$	823,118

	Six Months Ended
	June 30,
	2011		2010
Net income	$	393,562	$	361,933
Unrealized holding gains on securities available for sale, net of reclassification		895,570		1,187,951

Comprehensive income	$	1,289,132	$	1,549,884

Cornerstone Bancshares, Inc.

Net Interest Margin Analysis

Taxable Equivalent Basis

	Three months ended
	June 30
(Amounts in thousands)
Assets	2011								2010
	Average			Income/		Yield/			Average			Income/		Yield/
Earning assets:	Balance			Expense		Rate			Balance			Expense		Rate
Loans, net of unearned income	$	271,952		$	4,521		6.67	%	$	321,455		$	5,494		6.86	%
Investment securities		119,751			621		2.36	%		151,220			1,216		3.44	%
Other earning assets		24,902			17		0.28	%		33,957			22		0.26	%
Total earning assets		416,605		$	5,159		5.05	%		506,632		$	6,732		5.39	%
Allowance for loan losses		(7,285	)							(6,797	)
Cash and other assets		36,152								29,821
TOTAL ASSETS	$	445,472							$	529,656

Liabilities and Shareholders' Equity

Interest-bearing liabilities:
Interest-bearing demand deposits	$	28,402		$	23		0.33	%	$	42,565		$	36		0.34	%
Savings deposits		9,938			13		0.51	%		9,090			12		0.51	%
MMDA's		25,927			64		0.99	%		21,952			52		0.95	%
Time deposits		236,873			1,012		1.71	%		299,720			1,619		2.17	%
Federal funds purchased and securities
sold under agreements to repurchase		24,288			34		0.56	%		23,807			32		0.54	%
Other borrowings		50,678			545		4.32	%		69,833			760		4.36	%
Total interest-bearing liabilities		376,107			1,691		1.80	%		466,967			2,511		2.16	%
Net interest spread				$	3,468		3.25	%				$	4,221		3.24	%
Noninterest-bearing demand deposits		41,486								39,061
Accrued expenses and other liabilities		167								(5,477	)
Shareholders' equity		27,712								29,105
TOTAL LIABILITIES AND
SHAREHOLDERS' EQUITY	$	445,472							$	529,656
Net yield on earning assets							3.42	%							3.41	%

Taxable equivalent adjustment:
Loans					0								0
Investment securities					85								81
Total adjustment					85								81

Cornerstone Bancshares, Inc.

Net Interest Margin Analysis

Taxable Equivalent Basis

	Six months ended
	June 30
(Amounts in thousands)
Assets	2011								2010
	Average			Income/		Yield/			Average			Income/		Yield/
Earning assets:	Balance			Expense		Rate			Balance			Expense		Rate
Loans, net of unearned income	$	278,090		$	9,160		6.64	%	$	325,715		$	11,442		7.08	%
Investment securities		114,825			1,190		2.39	%		143,072			2,346		3.52	%
Other earning assets		23,959			28		0.24	%		39,927			45		0.23	%
Total earning assets		416,874		$	10,378		5.10	%		508,714		$	13,833		5.55	%
Allowance for loan losses		(8,173	)							(6,397	)
Cash and other assets		32,967								29,653
TOTAL ASSETS	$	441,668							$	531,970

Liabilities and Shareholders' Equity

Interest-bearing liabilities:
Interest-bearing demand deposits	$	27,998		$	45		0.32	%	$	35,277		$	66		0.38	%
Savings deposits		9,720			25		0.51	%		8,910			23		0.51	%
MMDA's		25,186			123		0.99	%		22,830			108		0.96	%
Time deposits		240,427			2,064		1.73	%		303,357			3,303		2.20	%
Federal funds purchased and securities
sold under agreements to repurchase		23,461			65		0.56	%		23,723			68		0.57	%
Other borrowings		52,507			1,125		4.32	%		71,063			1,539		4.37	%
Total interest-bearing liabilities		379,299			3,447		1.83	%		465,160			5,107		2.21	%
Net interest spread				$	6,931		3.27	%				$	8,726		3.33	%
Noninterest-bearing demand deposits		35,259								43,610
Accrued expenses and other liabilities		(91	)							(5,688	)
Shareholders' equity		27,200								28,888
TOTAL LIABILITIES AND
SHAREHOLDERS' EQUITY	$	441,668							$	531,970
Net yield on earning assets							3.44	%							3.52	%

Taxable equivalent adjustment:
Loans					0								0
Investment securities					170								155
Total adjustment					170								155

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 June 30, 2011 and December 31, 2010 and our results of operations for the three and six months ended June 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.

Review of Financial Performance

As of June 30, 2011, Cornerstone had total consolidated assets of $441.2 million, total loans of $270.2 million, total securities of $109.4 million, total deposits of $334.9 million and stockholders’ equity of $28.9 million. Net income for the three and six month period ended June 30, 2011 totaled $141,287 and $393,562, respectively.

Results of Operations

Net income for the three months ended June 30, 2011 was $141,287 or $0.01 basic earnings per common share, compared to a net income of $18,145 or $0.00 basic earnings per common share, for the same period in 2010. Net income for the six months ended June 30, 2011 was $393,562 or $0.03 basic earnings per common share, compared to a net income of $361,933 or $0.06 basic earnings per common share, for the same period in 2010.

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

							2011-2010										2011-2010
	Three months						Percent			Dollar			Six months				Percent			Dollar
	ended June 30,						Increase			Amount			ended June 30,				Increase			Amount
	2011			2010			(Decrease)			Change				2011		2010	(Decrease)			Change
Interest income	$	5,160		$	6,732			(23.35	)%	$	(1,572	)	$	10,378	$	13,833		(24.98	)%	$	(3,455	)
Interest expense		1,691			2,511			(32.66	)%		(820	)		3,446		5,107		(32.52	)%		(1,661	)
Net interest income
before provision for loss		3,469			4,221			(17.82	)%		(752	)		6,932		8,726		(20.56	)%		(1,794	)

Provision for loan loss		15			1,465			(98.98	)%		(1,450	)		30		2,480		(98.79	)%		(2,450	)
Net interest income after
provision for loan loss		3,454			2,756			25.33	%		698			6,902		6,246		10.50	%		656

Total noninterest income		316			1,091			(71.04	)%		(775	)		586		1,494		(60.78	)%		(908	)
Total noninterest expense		3,657			3,884			(5.84	)%		(227	)		7,074		7,284		(2.88	)%		(210	)

Income / (loss) before income taxes		113			(37	)		405.41	%		150			414		456		9.21	%		(42	)

Provision/(benefit)for income taxes		(28	)		(55	)		49.09	%		27			20		94		78.72	%		(74	)

Net income	$	141		$	18			683.33	%	$	123		$	394	$	362		(8.84	)%	$	32

Net Interest Income -Net interest income represents the amount by which interest earned on various earning assets exceeds interest paid on deposits and other interest-bearing liabilities. Net interest income is also the most significant component of our earnings. For the three months ended June 30, 2011, net interest income before the provision for loan loss, decreased $752 thousand or 17.82% over the same period of 2010. For the six months ended June 30, 2011, net interest income before the provision for loan loss, decreased $1.8 million or 20.56%.

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 3.25% compared to 3.24% for the three month periods ended June 30, 2011 and 2010, respectively. Cornerstone’s interest rate spread for the six month period ended June 30, 2011 was 3.27% compared to 3.33% for the same time period in 2010.

The net interest margin on a tax equivalent basis was 3.42% and 3.41% for the three month periods ended June 30, 2011 and 2010, respectively. Cornerstone’s net interest margin for the six month period ended June 30, 2011 was 3.44% compared to 3.52% 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 June 30, 2010, Cornerstone had approximately $507 million in average earning assets. For the second quarter of 2011, Cornerstone’s average earning assets had decreased to approximately $417 million. The decrease is approximately $90 million or 17.75%. As a direct result, Cornerstone’s net interest income decreased 17.82%. Cornerstone was, however, able to maintain its net interest margin by reducing its most expensive liabilities in proportion to the reduction of earning assets.

As of June 30, 2011, the Bank’s total loans equaled approximately $270.2 million compared to approximately $318.8 million as of June 30, 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 second quarter by approximately $820 thousand or 32.66% when comparing the three months ended June 30, 2011 to June 30, 2010. For the six months ended June 30, 2011, the Bank was able to reduce its interest expense by approximately $1,661 or 32.52% compared to the six months ended June 30, 2010. Currently, the Bank is attempting to increase its loan portfolio and thereby improve its net interest income.

For the six month periods ended June 30, 2011, the Bank’s investment portfolio yielded 2.39% compared to 3.52% for the same time period in 2010. The Bank decreased the amount of its investment portfolio from approximately $129.7 million as of June 30, 2010 to approximately $109.4 million as of June 30, 2011. The reduction in investments is due in part to a decrease in pledging requirements as the Bank has repaid $22 million in Federal Home Loan Bank advances since March 31, 2010. Further, the Bank liquidated the majority of its fixed rate mortgage backed securities during 2010. A portion of the proceeds from the securities sold were reinvested into variable rate mortgage backed securities. However, the Bank intends to increase its loan portfolio over the remainder of 2011, instead of reacquiring 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 $15 thousand for the three months ended June 30, 2011 and $30 thousand for the six months ended June 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 six months ended June 30, 2011 and 2010 (dollars in thousands):

					2011-2010							2011-2010
	Three months ended				Percent			Six months ended				Percent
	June 30,				Increase			June 30,				Increase
	2011		2010		(Decrease)				2011		2010	(Decrease)
Service charges on deposit accounts	$	225	$	342		(34.21	)%	$	441	$	684		(35.53	)%
Realized gains on sale of securities		48		618		(92.23	)%		48		640		(92.50	)%
Net gains / (losses) on sale of loans and other assets		21		110		(80.91	)%		55		130		(57.69	)%
Other noninterest income		22		21		2.53	%		42		40		4.53	%
Total noninterest income	$	316	$	1,091		(71.08	)%	$	586	$	1,494		(60.79	)%

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 sale the SBA qualified portion of the loans to third parties during the third and fourth quarters of 2011. 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 June 30, 2011 was 2.36% compared to a three month yield of 3.44% as of June 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 $640 thousand in gains on the sale of securities during the first six 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 $48 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 six months ended June 30, 2011 and 2010 (dollars in thousands ).

					2011-2010							2011-2010
	Three months ended				Percent			Six months ended				Percent
	June 30,				Increase /			June 30,				Increase /
	2011		2010		(Decrease)				2011		2010	(Decrease)
Salaries and employee benefits	$	1,502	$	1,521		(1.25	)%	$	3,045	$	3,155		(3.49	)%
Occupancy and equipment expense		350		369		(5.15	)%		756		723		4.56	%
Foreclosed asset expense, net		717		796		(9.92	)%		1,078		993		8.56	%
FDIC depository insurance		241		260		(7.31	)%		564		529		6.65	%
Other operating expense		847		938		(9.70	)%		1,631		1,884		(13.43	)%
Total noninterest expense	$	3,657	$	3,884		(5.84	)%	$	7,074	$	7,284		(2.88	)%

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 documentation. The Bank expects employee expense to continue to climb into 2012 as employee benefits are resumed as the Bank’s performance improves.

As of June 30, 2011, the Bank had incurred approximately $850 thousand in write-down of other real estate and repossessed assets. The write-down of other real estate totaled approximately $800 thousand as of June 30, 2011. 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 majority of the repossessed asset write-down occurred during the first quarter of 2011 and was centered on a houseboat that the Bank had owned for approximately one year. The Bank has subsequently sold the asset for approximately $100 thousand. 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 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 second quarter decreased from approximately $260 thousand as of June 30, 2010 to approximately $241 thousand as of June 30, 2011. The decrease in insurance assessment was the result of the Bank’s decrease in total deposits.

Financial Condition

Overview- Cornerstone’s consolidated assets totaled approximately $441.5 million as of December 31, 2010. As of June 30, 2011, total consolidated assets totaled approximately $441.2 million.

Liabilities as of June 30, 2011 and December 31, 2010 totaled approximately $412.4 million and $415.7 million, respectively.

Stockholders’ equity as of June 30, 2011 and December 31, 2010 totaled approximately $28.9 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 $109.4 million as of June 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 June 30, 2011 and at December 31, 2010 and the percentage (%) of each classification to total loans are summarized in the following table (dollars in thousands):

	June 30, 2011						December 31, 2010
	Amount			Percent			Amount			Percent
Commercial real estate-mortgage
Owner-occupied	$	63,801			23.62	%	$	64,971			22.78	%
All other		62,060			22.97	%		64,060			22.46	%
Consumer real estate-mortgage		68,030			25.18	%		71,878			25.20	%
Construction and land development		29,637			10.97	%		29,848			10.46	%
Commercial and industrial		43,673			16.16	%		51,160			17.94	%
Consumer and other		2,970			1.10	%		3,330			1.16	%
Total loans		270,171			100.00	%		285,247			100.00	%
Less: Allowance for loan losses		(6,814	)					(9,132	)

Loans, net	$	263,357					$	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 the first and second quarters of 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 six months ended June 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 (dollars in thousands):

	June 30,			December 31,
	2011			2010
Balance, beginning of period	$	9,132		$	5,905
Loans charged-off		(2,707	)		(4,688	)
Recoveries of loans previously charged-off		359			624
Provision for loan losses		30			7,291
Balance, end of period	$	6,814		$	9,132

Total loans	$	270,171		$	285,247

Ratio of allowance for loan losses to loans
outstanding at the end of the period		2.52	%		3.20	%

Ratio of net charge-offs to total loans
outstanding for the period		0.87	%		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 September 30, 2010 to June 30, 2011 (amounts in thousands):

	June 30,			March 31,			December 31,			September 30,
	2011			2011			2010			2010
Non-accrual loans	$	7,233		$	6,271		$	13,633		$	10,532
Foreclosed assets		20,058			20,464			12,809			13,427
Total non-performing assets	$	27,291		$	26,735		$	26,442		$	23,959

30-89 days past due loans	$	2,046		$	8,438		$	2,306		$	1,595

Total loans outstanding	$	270,171		$	273,750		$	285,247		$	292,046

Allowance for loan losses		6,814			7,914			9,132			6,271

Ratio of non-performing loans
to total loans outstanding
at the end of the period		2.68	%		2.29	%		4.78	%		3.61	%

Ratio of non-performing assets
to total allowance for loan losses
at the end of the period		400.51	%		337.82	%		289.55	%		382.06	%

As of June 30, 2011, the Bank has experienced a material decrease 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 from first the quarter of 2011 to approximately $7.2 million as of June 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 one other 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 76 percent of the total non-accrual amount.

The Bank’s foreclosed assets remained consistent compared to March 31, 2011 as the Bank sold approximately $2.4 million and added a similar amount. Management will continue its efforts to liquidate all foreclosed assets, especially non-income producing properties that have a negative impact on earnings. During the third quarter of 2011, the Bank anticipates moving all its income producing properties to its existing subsidiary Eagle Financial, Inc.

The Bank is experiencing increasing interest in its properties and expects a decrease in the amount of foreclosed assets. The Bank currently has approximately $1.3 million under contract to sell during the third 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).

	June 30, 2011					December 31, 2010
Core funding:	Amount		Percent			Amount		Percent
Non-interest bearing demand deposits	$	42,355		10.41	%	$	28,980		7.07	%
Interest-bearing demand deposits		26,262		6.45	%		24,834		6.06	%
Savings & money market accounts		38,425		9.44	%		34,042		8.31	%
Time deposits under $100,000		125,196		30.77	%		133,626		32.61	%
Total core funding		232,238		57.07	%		221,482		54.05	%

Non-core funding:
Time deposit of $100,000 or more	$	102,683		25.23	%	$	113,965		27.81	%
Fed funds purchased and securities sold under agreements to repurchase		27,011		6.64	%		24,325		5.94	%
Federal Home Loan Bank advances		45,000		11.06	%		50,000		12.20	%
Total non-core funding		174,694		42.93	%		188,290		45.95	%

Total	$	406,932		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 June 30, 2011 and December 31, 2010, Cornerstone’s stockholders’ equity amounted to approximately $28.9 million and approximately $25.8 million, respectively.

Cornerstone’s stockholders’ equity increased approximately $3 million during the first six months of 2011. The increase in equity can be attributed to Cornerstone’s 2011 earnings of approximately $394 thousand, additional capital from Cornerstone’s preferred stock offering of approximately $1.8 million and an increase in unrealized gain on securities available for sale of approximately $896 thousand. Following is a summary of the Bank’s capital ratios as of June 30, 2011:

Tier 1 leverage ratio of 6.09% to average assets.

Tier 1 risk-based capital ratio of 9.39% to risk weighted assets.

Total risk-based capital ratio of 10.65% to risk weighted assets.

Cornerstone has requested permission from the Federal Reserve Bank of Atlanta (the “Federal Reserve”) to pay its scheduled May 2011dividend 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 $3.5 million as of June 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, Cornerstone has evaluated the effectiveness of its disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), as of June 30, 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 June 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:	August 8, 2011	/s/ Nathaniel F. Hughes
		Nathaniel F. Hughes, President (principal executive officer)


Date:	August 8, 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.

TABLE OF CONTENTS

Part I Financial Information Item 1. Financial Statements (unaudited) 4 Item 1. Financial Statements (unaudited)Item 2. Management S Discussion and Analysis Of Financial Condition and Results Of Operations 26 Item 2. Management S Discussion and Analysis Of Financial Condition and Results Of Operations Item 3. Quantitative and Qualitative Disclosures About Market Risk 33 Item 3. Quantitative and Qualitative Disclosures About Market Risk Item 4T. Controls and Procedures 33 Item 4T. Controls and Procedures Part II Other Information Item 1. Legal Proceedings 34 Item 1. Legal Proceedings Item 1A. Risk Factors 34 Item 1A. Risk Factors Item 2. Unregistered Sales Of Equity Securities and Use Of Proceeds 34 Item 2. Unregistered Sales Of Equity Securities and Use Of Proceeds Item 3. Defaults Upon Senior Securities 34 Item 3. Defaults Upon Senior Securities Item 4. [removed and Reserved] 34 Item 4. [removed and Reserved]Item 5. Other Information 34 Item 5. Other Information Item 6. Exhibits 34 Item 6. Exhibits Note 1. Presentation Of Financial Information Note 2. Stock Based Compensation Note 3. Securities Note 4. Loans and Allowance For Loan Losses Note 5. Commitments and Contingent Liabilities Note 6. Fair Value Disclosures Note 7. Other Comprehensive Income Item 4T. Controls and Procedures Part II. Other Information

SMBK 10-Q Quarter ended June 30, 2011