Cornerstone is a bank holding company and the parent company of the Bank, a
Tennesseebanking corporation which operates primarily in and around Chattanooga, Tennessee. 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. The following is a discussion of Cornerstone's financial condition at March 31, 2014and December 31, 2013and our results of operations for the three months ended March 31, 2014and 2013. The purpose of this discussion is to focus on information about Cornerstone's 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 Cornerstone's consolidated financial statements and the related notes included elsewhere
herein. Critical Accounting Policies Cornerstone's accounting and reporting policies are in accordance with accounting principles generally accepted in
the United States of Americaand conform to general practices within the banking industry. Our significant accounting policies are described in Note 1, "Presentation of Financial Information," to the consolidated financial statements and are integral to understanding the MD&A. Critical accounting policies include the initial adoption of an accounting policy that has a material impact on our financial presentation as well as accounting estimates reflected in our financial statements that require us to make estimates and assumptions about matters that were highly uncertain at the time. Disclosure about critical estimates is required if different estimates that Cornerstone reasonably could have used in the current period would have a material impact on the presentation of our financial condition, changes in financial condition or results of operations. The following is a description of our critical accounting policies. Allowance for Loan Losses The allowance for loan losses is established and maintained at levels management deems adequate to absorb credit losses inherent in the portfolio as of the balance sheet date. The allowance is increased through the provision for loan losses and reduced through loan charge-offs, net of recoveries. The level of the allowance is based on known and inherent risks in the portfolio, past loan loss experience, underlying estimated values of collateral securing loans, current economic conditions and other factors as well as the level of specific impairments associated with impaired loans. This process involves our analysis of complex internal and external variables and it requires that management exercise judgment to estimate an appropriate allowance. Changes in the financial condition of individual borrowers, economic conditions or changes to our estimated risks could require us to significantly decrease or increase the level of the allowance. Such a change could materially impact Cornerstone's net income as a result of the change in the provision for loan losses. Refer to Note 1 and 4 in the notes to Cornerstone's consolidated financial statements for a discussion of Cornerstone's methodology of establishing the allowance. 27 Estimates of Fair Value
Fair value is used on a recurring basis for certain assets and liabilities in which fair value is the primary basis of accounting. Cornerstone's available-for-sale securities are measured at fair value on a recurring basis. Additionally, fair value is used to measure certain assets and liabilities on a nonrecurring basis. Cornerstone uses fair value on a nonrecurring basis for foreclosed assets and collateral associated with impaired collateral-dependent loans. Fair value is also used in certain impairment valuations, including assessments of goodwill, other intangible assets and long-lived assets. Fair value is the price that could be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants. Estimating fair value in accordance with applicable accounting guidance requires that Cornerstone make a number of significant judgments. Accounting guidance provides three levels of fair value. Level 1 fair value refers to observable market prices for identical assets or liabilities. Level 2 fair value refers to similar assets or liabilities with observable market data. Level 3 fair value refers to assets and liabilities where market prices are unavailable or impracticable to obtain for similar assets or liabilities. Level 3 valuations require modeling techniques, such as discounted cash flow analyses. These modeling techniques incorporate Cornerstone's assessments regarding assumptions that market participants would use in pricing the asset or the liability. Changes in fair value could materially impact our financial results. Refer to Note 6, "Fair Value Disclosures," in the notes to Cornerstone's consolidated financial statements for a discussion of the methodology in calculating fair value. Income Taxes Cornerstone is subject to various taxing jurisdictions where Cornerstone conducts business. Cornerstone estimates income tax expense based on amounts expected to be owed to these jurisdictions. Cornerstone evaluates the reasonableness of our effective tax rate based on a current estimate of annual net income, tax credits, non-taxable income, non-deductible expenses and the applicable statutory tax rates. The estimated income tax expense or benefit is reported in the consolidated statements of income. The accrued tax liability or receivable represents the net estimated amount due or to be received from tax jurisdictions either currently or in the future and are reported in other liabilities or other assets, respectively, in Cornerstone's consolidated balance sheets. Cornerstone assesses the appropriate tax treatment of transactions and filing positions after considering statutes, regulations, judicial precedent and other pertinent information and maintains tax accruals consistent with management's evaluation. Changes in the estimate of accrued taxes occur periodically due to changes in tax rates, interpretations of tax laws, the status of examinations by tax authorities and newly enacted statutory, judicial and regulatory guidance that could impact the relative merits of tax positions. These changes, if or when they occur, could impact accrued taxes and future tax expense and could materially affect our financial results. Cornerstone periodically evaluates uncertain tax positions and estimates the appropriate level of tax reserves related to each of these positions. Additionally, Cornerstone evaluates its deferred tax assets for possible valuation allowances based on the amounts expected to be realized. The evaluation of uncertain tax positions and deferred tax assets involves a high degree of judgment and subjectivity. Changes in the results of these evaluations could have a material impact on our financial results. Refer to Note 8, "Income Taxes," in the notes to Cornerstone's consolidated financial statements set forth in its Annual Report on Form 10-K for the year ended
December 31, 2013for more information.
Review of Financial Performance
March 31, 2014, Cornerstone had total consolidated assets of approximately $429 million, total loans of approximately $293 million, total securities of approximately $89 million, total deposits of approximately $ 342 millionand stockholders' equity of approximately $41 million. Net income for the three month period ended March 31, 2014totaled $412,151. Results of Operations
Net income for the three months ended
March 31, 2014was $412,151or $0.00basic earnings per common shares, compared to a net income of $452,128or $0.01basic earnings per common shares, for the same period in 2013. 28 The following table presents our results for the three months ended March 31, 2014compared to the three months ended March 31, 2013(amounts in thousands). 2014-2013 Three months Percent Dollar ended March 31, Increase Amount 2014 2013 (Decrease) Change Interest income $ 4,533 $ 4,603(1.52 )% $ (70 )Interest expense 723 962 (24.84 )% (239 ) Net interest income
before provision for loan loss 3,810 3,641 4.64 %
169 Provision for loan loss 165 300 (45.00 )% (135 ) Net interest income after provision for loan loss 3,645 3,341 9.10 % 304 Total noninterest income 323 356 (9.27 )% (33 ) Total noninterest expense 3,301 2,976 10.92 % 325 Income before income taxes 667 721 7.49 % (54 ) Provision for income taxes 255 269 (5.20 )% (14 ) Net income
$ 412 $ 452(8.85 )% $ (40 )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 March 31, 2014, net interest income before the provision for loan losses, increased approximately $169 thousandor 4.64 percent over the same period of 2013. 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 3.72 percent compared to 3.62 percent for the three month periods ended March 31, 2014and 2013, respectively. The net interest margin on a tax equivalent basis was 3.90 percent and 3.79 percent for the three month periods ended March 31, 2014and 2013, respectively. Significant items related to the changes in net interest income, net interest yields and rates, and net interest margin are presented below: [[Image Removed: *]]The Bank's net interest income as of March 31, 2014has been positively impacted by a reduction in interest expense of the funding of the Bank. The primary savings have been a reduction in the Federal Home Loan Bankbalances and a migration of funding from certificates of deposit and money market accounts into non-interest bearing deposits accounts. First quarter 2014 interest income remains stable when compared to the first quarter of 2013. While yield on earning assets decreased 0.15 percent, the Bank compensated by increasing the balance of average loans and securities by approximately $25 million. [[Image Removed: *]]The Bank's loan portfolio yield decreased to 5.69 percent for the three months ended March 31, 2014compared to 6.09 percent for the three months ended March 31, 2013. Management believes loan yields will continue to see downward pressure during 2014 as customers continue to refinance existing loans and due to general market conditions. Cornerstone will attempt to increase its outstanding loan balances during 2014 to offset the possible yield reduction. 29 [[Image Removed: *]]For the three month period ended March 31, 2014, the Bank investment portfolio yield decreased to 1.99 percent compared to 2.35 percent for the same time period in 2013. The Bank increased the amount of its overall investment portfolio to an average balance of approximately $96 millionas of March 31, 2014from approximately $87 millionas of March 31, 2013to invest cash that accumulated due to decreased loan demand in previous years and continued prepayment amounts associated with the Bank's mortgage-backed security portfolio. Management believes the present level of investment securities is sufficient to provide for all pledging needs and represents an appropriate amount of the balance sheet to provide liquidity and interest rate protection. [[Image Removed: *]]The Bank's net interest margin increased from March 31, 2013to March 31, 2014by 11 basis points. The majority of the increase is due to reduced interest expense relating to a migration from certificates of deposits and other interest bearing deposits to non-interest bearing deposits, further decreases in deposit rates and a reduction in FHLB borrowings. Management believes that the balance sheet will remain at the present level or increase slightly. Further, management continues to try and adjust the Bank's balance sheet composition by reducing foreclosed assets and increasing the Bank's loan balances. Management anticipates improvement in the Bank's net interest margin is possible with the increase in loans and reduction of FHLB advances, as they mature, in the next 12 months. 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. Cornerstone recorded $165 thousandin provision for loan losses for the three months ended March 31, 2014. Cornerstone recorded $300 thousandin provision for loan losses for the three months ended March 31, 2013. 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 months ended
2014-2013 Three months ended Percent March 31, Increase 2014 2013 (Decrease)
Service charges on deposit accounts
$ 189 $ 1880.53 % Net gains on sale of securities 102 - Net gains on sale of loans and other assets 19 149
(87.25 )% Other noninterest income 13 19 (33.33 )% Total noninterest income
$ 323 $ 356(9.30 )%
Significant matters relating to the changes in noninterest income are presented below:
[[Image Removed: *]]The Bank sold approximately
[[Image Removed: *]]During the first quarter of 2013, the Bank recorded approximately a
Noninterest Expense-Items reported as noninterest expense include salaries and employee benefits, occupancy and equipment expense, net foreclosed assets expense, depository insurance and other operating expense.
The following table presents the components of noninterest expense for the three months ended
2014-2013 Three months ended Percent March 31, Increase 2014 2013 (Decrease)
Salaries and employee benefits
$ 1,827 $ 1,59714.40 % Occupancy and equipment expense 309 338 (8.58
Foreclosed assets expense, net 349 129 170.54 % FDIC depository insurance 155 160 (3.13
Other operating expense 661 752 (12.10
Total noninterest expense
$ 3,301 $ 2,97610.92 %
Significant matters relating to the changes to noninterest expense are presented below:
[[Image Removed: *]]Cornerstone recorded compensation expense in the amount of
$156 thousandfor stock grants issued to the Board of Directors and $40 thousandin stock options compensation expense during the first quarter of March 2014versus none in the first quarter of March 2013. Management does not anticipate additional stock grants to be issued in 2014. Other salaries and employee benefits increased slightly during the first quarter of 2014 as a result of the Bank addressing employee wage increases. The Bank had not provided wage increases in the past three years. [[Image Removed: *]]As of March 31, 2014, the Bank recorded approximately $349 thousandin foreclosed asset expense compared to approximately $129 thousandduring the first quarter of March 31, 2013. The majority of the $349 thousandin foreclosed asset expense was comprised of approximately $244 thousandin appraisal write downs and losses incurred on the disposal of foreclosed assets. The Bank incurred approximately $104 thousandin net carrying cost for its foreclosed assets during the first quarter of 2014. A majority of the incremental expense was due to maintenance and repairs of the existing properties. Management anticipates approximately $1.2 millionof expense and write-downs on its foreclosed assets during 2014. Management nets the expense and write-downs of other real estate owned against the income generated from income producing real estate to calculate net foreclosed asset expense. Financial Condition
Overview-Cornerstone's consolidated assets totaled approximately
Liabilities as of
Stockholders' equity as of
Securities-The Bank'sinvestment portfolio, primarily consisting of Ginnie Mae Agency, mortgage-backed securities and municipal securities, in the amount of approximately $89 millionas of March 31, 2014compared to approximately $92 millionas of December 31, 2013. The primary purposes of the Bank's investment portfolio is to provide liquidity, satisfy pledging requirements, collateralize the Bank's repurchase accounts and secure the Bank's FHLB borrowings. 31 Loans-The composition of loans at March 31, 2014and at December 31, 2013and the percentage (%) of each classification to total loans are summarized in the following table (dollars in thousands): March 31, 2014 December 31, 2013 Amount Percent Amount Percent
Commercial real estate-mortgage
$ 68,65323.43 % $ 65,74722.72 % All other 70,089 23.93 % 64,052 22.13 % Consumer real estate-mortgage 77,767 26.55 % 76,315 26.37 %
Construction and land development 32,752 11.18 % 41,597
14.37 % Commercial and industrial 41,122 14.04 % 38,999 13.47 % Consumer and other 2,569 0.87 % 2,730 0.94 % Total loans 292,952 100.00 % 289,440 100.00 %
Less: Allowance for loan losses (3,011 ) (3,203 )
$ 289,941 $ 286,237Allowance 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 quarterly 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. [[Image Removed: *]]During the first quarter of 2014, the Bank recorded $165 thousandin provision expense to the loan loss allowance. Cornerstone utilizes a ten quarter look-back time frame for its historic loan loss analysis for loan charge-offs and recoveries. Management believes its allowance methodology is consistent with generally accepted accounting principles and interagency policy statements published by the Bank's regulatory agencies. 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 and as the loan portfolio continues to grow. The following is a summary of changes in the allowance for loan losses for the three months ended March 31, 2014and for the year ended December 31, 2013and the ratio of the allowance for loan losses to total loans as of the end of each period (dollars in thousands): March 31, December 31, 2014 2013 Balance, beginning of period $ 3,203 $ 6,141Loans charged-off (486 ) (4,709 ) Recoveries of loans previously charged-off 129 1,471 Provision for loan losses 165 300 Balance, end of period $ 3,011 $ 3,203Total loans $ 292,952 $ 289,440Ratio of allowance for loan losses to loans outstanding at the end of the period 1.03 %
Ratio of net charge-offs to total loans outstanding for the period 0.12 % 1.12 % 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. 32
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, nonaccrual loans, foreclosures and repossessed property as non-performing assets. The Bank's policy is to categorize a loan on nonaccrual status when payment of principal or interest is ninety (90) or more days past due. At the time the loan is categorized as nonaccrual the interest previously accrued but not collected may be reversed and charged against current earnings. [[Image Removed: *]]The Bank has been able to reduce its non-performing assets over the last twelve months. As of
March 31, 2014, the Bank had approximately $17.3 millionin non-performing assets. The majority of this amount is comprised of foreclosed assets. The Bank has attempted to be proactive in its approach of minimizing the time a loan is recorded in nonaccrual status. Management has been able to transition loans from nonaccrual into foreclosed assets or, in some limited instances, upgrade the loan to a performing status. Management anticipates additional loans could transition into foreclosed assets in the future. However, management anticipates the balance of foreclosed and non-performing assets overall will continue to reduce as the Bank continues to allocate both financial and human resources towards this objective.
The following table summarizes Cornerstone's non-performing assets at each quarter end from
March 31, December 31, September 30, June 30, 2014 2013 2013 2013 Nonaccrual loans
$ 4,779 $ 3,566$ 4,096 $ 6,883Foreclosed assets 12,559 12,926 14,924 18,867
Total non-performing assets
$ 17,338 $ 16,492
30-89 days past due loans
$ 2,193 $ 5,816
Total loans outstanding
$ 292,952 $ 289,440
Allowance for loan losses
$ 3,011 $ 3,203
Ratio of non-performing loans to total loans outstanding at the end of the period 1.63 % 1.23 %
1.44 % 2.49 %
Ratio of non-performing assets to total allowance for loan losses at the end of the period 575.82 % 514.89 %
602.09 % 505.40 % [[Image Removed: *]]The Bank's nonaccrual balances decreased during the first quarter of 2014 compared to the first quarter of 2013. Loans 30-89 days past due also declined in the first quarter of 2014 when compared to the first quarter of 2013.
[[Image Removed: *]]Management believes nonaccrual loans will decrease during the remainder of 2014.
[[Image Removed: *]]The Bank's foreclosed assets decreased from approximately
$21 millionas of March 31, 2013to approximately $13 millionas of March 31, 2014. The Bank has seen an improvement in the level of interest in its properties by potential buyers and has provided $1.2 millionfor foreclosed asset expense again in the 2014 budget to decrease foreclosed assets. Management is targeting a net reduction in foreclosed asset levels by approximately $5 millionduring the remainder of 2014. 33 Deposits and Other Borrowings-The Bank'sdeposits 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 securities 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 $100,000or greater. All other funding is classified as non-core (amounts in thousands). March 31, 2014 December 31, 2013 Core funding: Amount Percent Amount Percent
Noninterest-bearing demand deposits
Interest-bearing demand deposits 30,170 7.8 % 24,564 6.3 %
Savings and money market accounts 79,195 20.5 % 86,330 22.2 %
Time deposits under
$100,00070,490 18.3 %
74,080 19.0 % Total core funding 248,563 64.4 % 260,180 66.8 % Non-core funding:
Time deposit of
Fed funds purchased and securities
sold under agreements to repurchase 18,923 4.9 % 22,974 5.9 %
Federal Home Loan Bank advances 25,000 6.5 %
25,000 6.4 % Total non-core funding 137,086 35.6 % 129,208 33.2 % Total
$ 385,649100.0 % $ 389,388100.0 % [[Image Removed: *]] In 2011, the Bank began to address its reliance on non-core funding. Over the last several years, the Bank has been able to increase the amount of local core deposits. Management continues to evaluate different pricing, product and customer service options to further increase the core-funding position. The Bank has seen a decrease in funds as of March 31, 2014 when compared to December 31, 2013. However, the Bank historically, and in 2013 as well, experiences an increase in overall deposits during December of each year. Finally, the Bank, primarily through its Asset Liability Management Committee, will review the structure and nature of additional Federal Home Loan Bank advances as they mature. Over the next twelve months, the Bank will have $15 millionin advances mature. Management anticipates maintaining the level of borrowings from FHLB at approximately $20-$30 millionover this time period. However, the Bank will be able to obtain additional advances or substitute the maturing advances with other forms of liability at a significantly lower interest cost than the current interest rates paid on the existing advances.
The following is a summary of the Bank's capital ratios as of
March 31, 2014: Tier 1 leverage ratio 8.87% Tier 1 risk-based capital ratio 12.13% Total risk-based capital ratio 13.11% [[Image Removed: *]] Cornerstone has received permission from the Federal Reserve Bank of Atlanta(the "Federal Reserve") to pay its scheduled December 31, 2013dividend on its Series A convertible preferred stock in the amount of $0.625per share.
[[Image Removed: *]] Cornerstone had total outstanding borrowings of
$1.7 millionas of March 31, 2014included in Federal Home Loan Bankadvances and other borrowings. 34
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 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:
[[Image Removed: *]] 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.
[[Image Removed: *]] 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.
[[Image Removed: *]] 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.
[[Image Removed: *]] 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.
[[Image Removed: *]] 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.