UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q [ X ] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934 For The Quarterly Period Ended June 30, 2009 OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934 For The Transition Period From _______________ To _________________. Commission File Number 000-51950 CORNERSTONE BANCORP - -------------------------------------------------------------------------------- (Exact name of registrant as specified in its charter) South Carolina 57-1077978 -------------- ---------- (State or other jurisdiction of (I.R.S. Employer Identification Number) incorporation or organization) 1670 East Main Street, Easley, South Carolina 29640 (Address of principal executive offices) (864) 306-1444 (Registrant's telephone number, including Area Code) Not Applicable (Former name, former address, and former fiscal year, if changed 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. [X] Yes [ ] No Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months(or for such shorter period that the registrant was required to submit and post such files). Yes [ ] No [ ] (Not yet applicable to the Registrant) 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 definition of "large accelerated filer," "accelerated filer," and "smaller reporting company" in Rule 12b-2 of the Exchange Act. Large accelerated filer [ ] Accelerated filer [ ] Non-accelerated filer [ ] Smaller reporting company [X] (Do not check if a smaller reporting company) Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). [ ] Yes [X] No Indicate the number of shares outstanding of each of the issuer's classes of common equity, as of the latest practicable date: Common Stock - No Par Value, 2,105,738 shares outstanding on July 1, 2009 PART I FINANCIAL INFORMATION Item 1. Financial Statements CORNERSTONE BANCORP AND SUBSIDIARY CONSOLIDATED BALANCE SHEETS June 30, December 31, 2009 2008 ---- ---- Assets (Unaudited) Cash and due from banks ........................................................................ $ 7,242,337 $ 3,820,227 Federal funds sold ............................................................................. 2,600,000 140,000 ------------ ------------ Cash and cash equivalents ............................................................... 9,842,337 3,960,227 Investment securities Available-for-sale .......................................................................... 19,504,349 19,676,604 Other investments ........................................................................... 999,150 1,114,150 Loans, net ..................................................................................... 138,795,636 129,483,130 Property and equipment, net .................................................................... 5,419,281 5,551,275 Cash surrender value of life insurance policies ................................................ 1,802,663 1,768,520 Other real estate owned ........................................................................ 2,028,364 575,000 Other assets ................................................................................... 2,122,458 1,722,161 ------------ ------------ Total assets ..................................................................... $180,514,238 $163,851,067 ============ ============ Liabilities And Shareholders' Equity Liabilities Deposits Noninterest bearing ....................................................................... $ 11,438,815 $ 10,069,125 Interest bearing .......................................................................... 133,977,170 112,512,449 ------------ ------------ Total deposits ............................................................................ 145,415,985 122,581,574 Federal funds purchased ..................................................................... - 1,810,000 Customer repurchase agreements .............................................................. 3,696,476 4,582,619 Borrowings from Federal Home Loan Bank of Atlanta ........................................... 6,818,588 10,394,005 Broker repurchase agreements ................................................................ 5,000,000 5,000,000 Other liabilities ........................................................................... 573,406 345,922 ------------ ------------ Total liabilities ......................................................................... 161,504,455 144,714,120 Commitments and contingencies Shareholders' equity Preferred stock, 10,000,000 shares authorized, no shares issued ............................. - - Common stock, no par value, 20,000,000 shares authorized, 2,105,738 and 1,991,565 shares issued at June 30, 2009 and December 31, 2008, respectively ...................... 18,763,496 18,323,333 Retained earnings ........................................................................... - 765,906 Accumulated other comprehensive income ...................................................... 246,287 47,708 ------------ ------------ Total shareholders' equity ................................................................ 19,009,783 19,136,947 ------------ ------------ Total liabilities and shareholders' equity ................................................ $180,514,238 $163,851,067 ============ ============ The accompanying notes are an integral part of these consolidated financial statements. 2 CORNERSTONE BANCORP AND SUBSIDIARY CONSOLIDATED STATEMENTS OF INCOME (Unaudited) For the three months ended For the six months ended June 30, June 30, -------- -------- 2009 2008 2009 2008 ---- ---- ---- ---- Interest and Dividend Income Interest and fees on loans ............................. $ 1,770,277 $ 1,972,331 $ 3,508,307 $ 4,039,444 Investment securities .................................. 238,235 313,935 490,023 616,642 Federal funds sold and interest bearing balances ............................................. 4,778 37,173 7,334 61,994 ----------- ----------- ----------- ----------- Total interest income .............................. 2,013,290 2,323,439 4,005,664 4,718,080 ----------- ----------- ----------- ----------- Interest Expense Deposits ............................................... 744,379 826,639 1,515,877 1,750,874 Borrowings ............................................. 118,101 136,825 245,785 281,261 ----------- ----------- ----------- ----------- Total interest expense .............................. 862,480 963,464 1,761,662 2,032,135 ----------- ----------- ----------- ----------- Net Interest Income ...................................... 1,150,810 1,359,975 2,244,002 2,685,945 Provision for Loan Losses ................................ 920,000 120,000 1,080,000 240,000 ----------- ----------- ----------- ----------- Net interest income after provision for loan losses ................................... 230,810 1,239,975 1,164,002 2,445,945 ----------- ----------- ----------- ----------- Noninterest Income Service charges on deposit accounts .................... 137,833 145,598 270,724 287,544 Mortgage loan origination fees ......................... 56,544 99,817 111,062 172,630 Gain on sale of security ............................... - - 52,300 - Other .................................................. 35,725 29,258 48,934 59,193 ----------- ----------- ----------- ----------- Total noninterest income ............................ 230,102 274,673 483,020 519,367 ----------- ----------- ----------- ----------- Noninterest Expense Salaries and employee benefits ......................... 607,596 608,713 1,209,637 1,268,523 Premises and equipment ................................. 150,547 146,557 298,537 299,839 Data processing ........................................ 53,689 64,567 110,875 114,438 Professional and regulatory fees ....................... 192,839 73,050 322,337 147,811 Supplies ............................................... 20,393 20,477 35,356 41,219 Advertising ............................................ 5,297 19,138 18,897 35,630 Other .................................................. 194,270 150,294 379,876 300,655 ----------- ----------- ----------- ----------- Total noninterest expense ........................... 1,224,631 1,082,796 2,375,515 2,208,115 ----------- ----------- ----------- ----------- Net income (loss) before taxes ...................... (763,719) 431,852 (728,493) 757,197 Provision (benefit) for income taxes ..................... (281,563) 148,650 (288,233) 254,101 ----------- ----------- ----------- ----------- Net income (loss) ................................... $ (482,156) $ 283,202 $ (440,260) $ 503,096 =========== =========== =========== =========== Earnings (Loss) Per Share Basic .................................................. $ (.23) $ .14 $ (.21) $ .24 Diluted ................................................ $ (.23) $ .13 $ (.21) $ .24 Weighted Average Shares Outstanding Basic .................................................. 2,105,738 2,091,143 2,100,296 2,087,606 Diluted ................................................ 2,105,738 2,131,533 2,100,296 2,130,104 Earnings per share in 2008 reflect the effect of the 5% stock dividend in 2009. The accompanying notes are an integral part of these consolidated financial statements. 3 CORNERSTONE BANCORP AND SUBSIDIARY CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY AND COMPREHENSIVE INCOME For the six months ended June 30, 2009 and 2008 (Unaudited) Accumulated Common stock other Total ------------ Retained comprehensive shareholders' Shares Amount earnings income (loss) equity ------ ------ -------- ------------- ------ Balance, December 31, 2007 ..................... 1,983,169 $ 18,185,328 $ 1,177,450 $ 218,052 $ 19,580,830 Net income ..................................... - - 503,096 - 503,096 Other comprehensive income, net of income taxes Unrealized loss on investment securities, net ............................. - - - (159,539) (159,539) ------------ Comprehensive income ........................... - - - - 343,557 Stock based compensation ....................... - 28,086 - - 28,086 Options exercised .............................. 8,396 81,833 - - 81,833 Cumulative effect of accounting change ......... - - (39,389) - (39,389) Dividends paid ................................. - - (597,471) - (597,471) --------- ------------ ------------ ------------ ------------ Balance, June 30, 2008 ......................... 1,991,565 $ 18,295,247 $ 1,043,686 $ 58,513 $ 19,397,446 ========= ============ ============ ============ ============ Balance, December 31, 2008 ..................... 1,991,565 $ 18,323,333 $ 765,906 $ 47,708 $ 19,136,947 Net loss ....................................... - - (440,260) - (440,260) Other comprehensive loss, net of income taxes Unrealized gain on investment securities, net ............................. - - - 198,579 198,579 ------------ Comprehensive loss ............................. (241,681) Stock based compensation ....................... - 36,232 - - 36,232 Options exercised .............................. 14,172 80,000 - - 80,000 Stock dividend issued (5%), net of cash paid in lieu of fractional shares .............. 100,001 323,931 (325,646) - (1,715) --------- ------------ ------------ ------------ ------------ Balance, June 30, 2009 ......................... 2,105,738 $ 18,763,496 $ - $ 246,287 $ 19,009,783 ========= ============ ============ ============ ============ The accompanying notes are an integral part of these consolidated financial statements. 4 CORNERSTONE BANCORP AND SUBSIDIARY CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited) For the six months ended June 30, --------------------------------- 2009 2008 ---- ---- Operating Activities Net income (loss) ................................................................. $ (440,260) $ 503,096 Adjustments to reconcile net income (loss) to net cash provided by operating activities Depreciation and amortization .................................................. 153,315 150,595 Provision for loan losses ...................................................... 1,080,000 240,000 Non-cash option expense ........................................................ 36,232 28,086 Gain on sale of property and equipment ............................................ (625) (481) (Gain) loss on sale of property acquired in foreclosure ........................... 24,753 (5,142) Gain on sale of security available for sale ....................................... (52,300) - Changes in operating assets and liabilities Change in interest receivable .................................................. 73,809 104,181 Change in other assets ......................................................... (508,249) (34,370) Change in other liabilities .................................................... 125,187 (77,206) ------------ ------------ Net cash provided by operating activities ................................... 491,862 908,759 ------------ ------------ Investing Activities Proceeds from maturities and principal repayments of available for sale securities ................................................................. 4,561,599 992,237 (Purchase) Redemption of FHLB and Federal Reserve stock ........................... 115,000 (79,150) Purchase of investment securities available for sale .............................. (4,052,041) (6,085,514) Purchase of property and equipment ................................................ (5,448) (22,763) Proceeds from sale of property acquired in foreclosure ............................ 550,247 51,187 Proceeds from sale of property and equipment ...................................... 625 7,495 Net increase in loans to customers ................................................ (12,420,870) (4,430,375) ------------ ------------ Net cash used for investing activities ...................................... (11,250,888) (9,566,883) ------------ ------------ Financing Activities Net increase in demand, savings and time deposits ................................. 22,834,411 5,046,029 Net decrease in customer repurchase agreements .................................... (886,143) (576,059) Dividends paid .................................................................... (1,715) (597,471) Decrease in federal funds purchased ............................................... (1,810,000) - Repayment of FHLB advances ........................................................ (5,075,417) (375,417) Borrowings from FHLB .............................................................. 1,500,000 2,300,000 Proceeds from broker repurchase agreements ........................................ - 5,000,000 Proceeds from exercise of stock options ........................................... 80,000 81,833 ------------ ------------ Net cash provided by financing activities ................................... 16,641,136 10,878,915 ------------ ------------ Net increase in cash and cash equivalents ................................... 5,882,110 2,220,791 Cash and Cash Equivalents, Beginning of Period ......................................... 3,960,227 5,233,777 ------------ ------------ Cash and Cash Equivalents, End of Period ............................................... $ 9,842,337 $ 7,454,568 ============ ============ Supplemental Information Cash paid for interest ............................................................. $ 1,778,923 $ 2,044,959 Cash paid for income taxes ......................................................... $ 60,127 $ 128,048 Non-cash Supplemental information Loans transferred to other real estate owned ....................................... $ 2,028,364 $ 236,644 Loans (charged-off) recovered, net ................................................. $ (590,055) $ 49,106 The accompanying notes are an integral part of these consolidated financial statements. 5 CORNERSTONE BANCORP AND SUBSIDIARY NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS Summary of Significant Accounting Principles A summary of significant accounting policies is included in the Cornerstone Bancorp (the "Company") 2008 Annual Report to Shareholders, which also contains the Company's audited financial statements for 2008 and is also included in the Form 10-K for the year ended December 31, 2008. Principles of Consolidation The consolidated financial statements include the accounts of Cornerstone Bancorp, the parent company, and Cornerstone National Bank (the "Bank"), its wholly owned subsidiary, and Crescent Financial Services, Inc., a wholly owned subsidiary of the Bank. All significant intercompany items have been eliminated in the consolidated statements. Certain amounts have been reclassified to conform to current year presentation. Management Opinion The accompanying financial statements have been prepared in accordance with generally accepted accounting principles for interim financial information and with the instructions for Form 10-Q. Accordingly they do not contain all the information and footnotes required by accounting principles generally accepted in the United States of America for complete financial statements. The statements in this report are unaudited. In the opinion of management, all the adjustments necessary to present a fair statement of the results for the interim period have been made. Such adjustments are of a normal and recurring nature. The results of operations for any interim period are not necessarily indicative of the results to be expected for an entire year. These interim financial statements should be read in conjunction with the annual financial statements and notes thereto contained in the 2008 Annual Report on Form 10-K. Earnings per Share Statement of Financial Accounting Standards ("SFAS") No. 128, "Earnings per Share" requires that the Company present basic and diluted net income (loss) per common share. The assumed conversion of stock options creates the difference between basic and diluted net income per share. Income per share is calculated by dividing net income by the weighted average number of common shares outstanding for each period presented. The weighted average number of common shares outstanding for basic and diluted net loss per common share for the three month period ended June 30, 2009 was 2,105,738 shares. Outstanding options were excluded from the loss per share calculation as they are anti-dilutive as of June 30, 2009. The calculation of earnings per share includes the effect of the 5% stock dividend declared on April 14, 2009 as if it had been declared on January 1, 2009. The weighted average number of common shares outstanding for basic and diluted net loss per common share for the six month period ended June 30, 2009 was 2,100,296. Stock Based Compensation As described in Notes 1 and 17 to the financial statements in the Company's Annual Report on Form 10-K for the year ended December 31, 2008, the Company has a stock-based employee and director compensation plan, which was approved by shareholders in 2003 (the "2003 Plan"). The Company accounts for stock-based compensation under the provisions of SFAS No. 123(R). On January 12, 2009 and January 2, 2008, the Board of Directors awarded options to purchase 15,600 and 19,200 shares, respectively, to executive officers and directors under the 2003 Plan. The options vest over five years and expire ten years from the date of grant. The exercise price for the 2009 grant was $10.00 per share. After giving effect to the 5% stock dividend declared April 14, 2009 and payable on May 29, 2009 to shareholders of record as of May 12, 2009, the number of options granted in 2009 was adjusted to 16,380 with an exercise price of $9.52 per share, in accordance with the terms of the 2003 Plan. Refer to the notes to the financial statements in the Company's Annual Report on Form 10-K for the year ended December 31, 2008 for further information. The fair value of an option is estimated on the date of grant using the Black-Scholes option pricing model. The risk free interest rate used in the calculation was 2.34% for the 2009 grant and 3.91% for the 2008 grant (equal to the U.S. Treasury 10 year constant maturity on the date of grant) and the assumed dividend rate was zero in each case. The expected option life in each case was 10 years. Volatility was estimated at 38.71% for the 2009 grant and 27.5% for the 2008 grant based on a review of stock trades known to management or quoted on the OTC Bulletin Board during the preceding period. Management is aware of only limited trades, which may not represent market value as the stock is not traded on an exchange, though it is quoted on the OTC Bulletin Board. For the six months ended June 30, 2009, the Company expensed $8,146 related to 6 options granted in 2009, $9,826 related to options granted in 2008, $10,348 related to options granted in 2007, and $7,912, related to the options granted in 2006. The expense is included in salaries and employee benefits in the accompanying consolidated statements of income. Prior to adopting the provisions of SFAS No. 123(R) the Company accounted for stock option awards under Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees," and related interpretations. These awards are fully vested, and no compensation expense has been recognized related to these option awards. Options were granted under the 2003 Plan in 2004 and 2005, and have been adjusted to reflect the stock dividends declared since the grant date. Following the 5% stock dividend declared by the Board of Directors on April 14, 2009 and distributable to shareholders of record on May 12, 2009, the adjusted number of options outstanding was approximately 110,143 and the weighted average exercise price was $10.56 per share, all in accordance with the 2003 Plan. The Company awarded options to its Organizers in 1999 (the "Organizers' Options"). Each of the organizing directors was awarded options to purchase 4,000 shares of the Company's common stock at $10.00 per share. The options expire 10 years from the date of grant. Since 1999, 20,000 of the original options have been exercised and 4,000 have been forfeited. As of June 30, 2009, after the effect of stock dividends and exercises, there are 29,759 Organizers' Options outstanding. Each option is currently exercisable at a price of $5.38, following the 5% stock dividend declared by the Board of Directors on April 14, 2009 and distributable to shareholders of record on May 12, 2009 in accordance with the terms of the original grant. These options vested in 2002 and were accounted for under the provisions of APB No. 25. Estimates The preparation of consolidated financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of interest and noninterest income and expenses during the reporting period. Actual results could differ from those estimates. The primary significant estimate in the accompanying consolidated financial statements is the allowance for loan losses. A discussion of the significant factors involved in estimating the allowance for loan losses is included in this Form 10-Q in "Management's Discussion and Analysis of Financial Condition and Results of Operations" in the section titled "Results of Operations" and in the Company's 2008 Form 10-K. The provision for income taxes is also considered a significant estimate. Concentrations of credit risk The Bank makes loans to individuals and small businesses located primarily in upstate South Carolina for various personal and commercial purposes. The Bank has a diversified loan portfolio and borrowers' ability to repay loans is not dependent upon any specific economic sector. The Bank monitors the portfolio for concentrations of credit on a quarterly basis using North American Industry Codes ("NAIC") and using definitions required by regulatory agencies. The Bank has loans in two NAIC categories that each represents more than 10% of the portfolio. The NAIC concentrations are 28.9% in Residential Building Construction and 20.1% in Real Estate and Rental and Leasing. The portfolio also has loans representing 20 other NAIC categories. The Bank has concentrations in loans collateralized by real estate according to the regulatory definition. Included in this segment of the portfolio is the category for construction and development loans. While the Bank does have a concentration of loans in this category, the Bank's business is managed in specific ways with the intention of helping to reduce the risks normally associated with construction lending. Management requires lending personnel to visit job sites, maintain frequent contact with borrowers and perform or commission inspections of completed work prior to issuing additional construction loan draws. In addition, management employs additional procedures for monitoring construction loans, such as engaging an independent appraiser to perform routine reviews of the percentage complete inspection reports for a sample of construction projects. Senior management compares the independent review report to the percentage complete report in the Bank's loan files. Any discrepancy is investigated immediately to help insure that the Bank's investment is protected. The Bank does not make long term (more than 15 years) mortgage loans to be held in its portfolio, does not offer loans with negative amortization features or long-term interest only features, or loans with loan to collateral value ratios in excess of 100% at the time the loan is made. The Bank does offer loan products with features that can increase credit risk during periods of declining economic conditions, such as adjustable rate loans, short-term interest-only loans, and loans with amortization periods that differ from the maturity date 7 (i.e., balloon payment loans). However, the Bank evaluates each customer's creditworthiness based on the customer's individual circumstances, and current and expected economic conditions, and underwrites and monitors each loan for associated risks. Loans made with exceptions to internal loan guidelines and those with loan-to-value ratios in excess of regulatory loan-to-value guidelines are monitored and reported to the Board of Directors on a monthly basis. The regulatory loan-to-value guidelines permit exceptions to the guidelines up to a maximum of 30% of total capital for commercial loans and exceptions for all types of real estate loans up to a maximum of 100% of total capital. As of June 30, 2009, the Bank has $3.6 million of loans which exceed the regulatory loan to value guidelines. This amount is within the maximum allowable exceptions to the guidelines. Of the $3.6 million of loans with exceptions to the regulatory loan to value guidelines, $2.0 million were not exceptions at the time the loan was made, but became exceptions upon reappraisal. Management routinely reappraises real estate collateral based on specific criteria and circumstances. If additional collateral is available, the Bank may require the borrower to commit additional collateral to the loan. Evaluation of subsequent events In accordance with SFAS 165, "Subsequent Events", issued in May 2009 and effective for periods ending after June 15, 2009, management performed an evaluation to determine whether or not there have been any subsequent events since the balance sheet date. The evaluation was performed through August 12, 2009, the date on which the Company's 10-Q was issued as filed with the Securities and Exchange Commission. Recently issued accounting standards The following is a summary of recent authoritative pronouncements that may affect accounting, reporting, and disclosure of financial information by the Company: Effective January 1, 2008, the Company adopted SFAS No. 157, "Fair Value Measurements." SFAS No. 157 defines fair value, establishes a framework for measuring fair value under generally accepted accounting principles, and expands disclosures about fair value measurements. SFAS No. 157 defines fair value as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. SFAS No. 157 also establishes a 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. The standard describes three levels of inputs that may be used to measure fair value: Level 1-Quoted prices in active markets for identical assets or liabilities. Level 1 assets and liabilities include debt and equity securities and derivative contracts that are traded in an active exchange market, as well as U.S. Treasuries and money market funds. Level 2-Observable inputs other than Level 1 prices such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities. Level 2 assets and liabilities include debt with quoted prices that are traded less frequently than exchange-traded instruments, mortgage-backed securities, municipal bonds, corporate debt securities, and derivative contracts whose value is determined using a pricing model with inputs that are observable in the market or can be derived principally from or corroborated by observable market data. This category generally includes certain derivative contracts and impaired loans. Level 3-Unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities. Level 3 assets and liabilities include financial instruments whose value is determined using pricing models, discounted cash flow methodologies, or similar techniques, as well as instruments for which the determination of fair value requires significant management judgment or estimation. For example, this category generally includes certain private equity investments, retained residual interests in securitizations, residential mortgage servicing rights, and highly-structured or long-term derivative contracts. Adoption of SFAS No. 157 did not have any impact on the Company's financial position, results of operations, or cash flows. In May, 2008, the FASB issued SFAS No. 162, "The Hierarchy of Generally Accepted Accounting Principles." SFAS No. 162 identifies the sources of accounting principles and the framework for selecting the principles used in the preparation of financial statements of nongovernmental entities that are presented in conformity with GAAP. SFAS NO. 162 was effective November 15, 2008. The FASB has stated that it does not expect SFAS No. 162 will result in a change in current practice. The application of SFAS No. 162 had no effect on the Company's financial position, results of operations or cash flows. 8 FSP EITF 99-20-1, "Amendments to the Impairment Guidance of EITF Issue No. 99-20," ("FSP EITF 99-20-1") was issued in January 2009. Prior to the Staff Position, other-than-temporary impairment was determined by using either EITF Issue No. 99-20, "Recognition of Interest Income and Impairment on Purchased Beneficial Interests and Beneficial Interests that Continue to be Held by a Transferor in Securitized Financial Assets," ("EITF 99-20") or SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities," depending on the type of security. EITF 99-20 required the use of market participant assumptions regarding future cash flows regarding the probability of collecting all cash flows previously projected. SFAS 115 determined impairment to be other than temporary if it was probable that the holder would be unable to collect all amounts due according to the contractual terms. To achieve a more consistent determination of other-than-temporary impairment, the Staff Position amends EITF 99-20 to determine any other-than-temporary impairment based on the guidance in SFAS No. 115, allowing management to use more judgment in determining any other-than-temporary impairment. The Staff Position was effective for the Company as of December 31, 2008. Management has reviewed and evaluated the Company's security portfolio for any other-than-temporary impairments. The SEC's Office of the Chief Accountant and the staff of the FASB issued press release 2008-234 on September 30, 2008 ("Press Release") to provide clarifications on fair value accounting. The Press Release includes guidance on the use of management's internal assumptions and the use of "market" quotes. It also reiterates the factors in SEC Staff Accounting Bulletin ("SAB") Topic 5M that should be considered when determining other-than-temporary impairment: the length of time and extent to which the market value has been less than cost; financial condition and near-term prospects of the issuer; and the intent and ability of the holder to retain its investment for a period of time sufficient to allow for any anticipated recovery in market value. On October 10, 2008, the FASB issued FSP SFAS 157-3, "Determining the Fair Value of a Financial Asset When the Market for That Asset Is Not Active" ("FSP SFAS 157-3"). This Staff Position clarifies the application of SFAS No. 157 in a market that is not active, and provides an example to illustrate key considerations in determining the fair value of a financial asset when the market for that asset is not active. The FSP is effective upon issuance, including prior periods for which financial statements have not been issued. For the Company, this FSP was effective for the quarter ended September 30, 2008. The Company considered the guidance in the Press Release and in FSP SFAS 157-3 when conducting its review for other-than-temporary impairment as of the balance sheet date. On April 9, 2009, the FASB issued three staff positions related to fair value which are discussed below. FSP SFAS 115-2 and SFAS 124-2, "Recognition and Presentation of Other-Than-Temporary Impairments," ("FSP SFAS 115-2 and SFAS 124-2") categorizes losses on debt securities available-for-sale or held-to-maturity determined by management to be other-than-temporarily impaired into losses due to credit issues and losses related to all other factors. Other-than-temporary impairment (OTTI) exists when it is more likely than not that the security will mature or be sold before its amortized cost basis can be recovered. An OTTI related to credit losses should be recognized through earnings. An OTTI related to other factors should be recognized in other comprehensive income. The FSP does not amend existing recognition and measurement guidance related to other-than-temporary impairments of equity securities. Annual disclosures required in SFAS 115 and FSP SFAS 115-1 and SFAS 124-1 are also required for interim periods (including the aging of securities with unrealized losses). FSP SFAS 157-4, "Determining Fair Value When the Volume and Level of Activity for the Asset or Liability Have Significantly Decreased and Identifying Transactions That are Not Orderly" recognizes that quoted prices may not be determinative of fair value when the volume and level of trading activity has significantly decreased. The evaluation of certain factors may necessitate that fair value be determined using a different valuation technique. Fair value should be the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction, not a forced liquidation or distressed sale. If a transaction is considered to not be orderly, little, if any, weight should be placed on the transaction price. If there is not sufficient information to conclude as to whether or not the transaction is orderly, the transaction price should be considered when estimating fair value. An entity's intention to hold an asset or liability is not relevant in determining fair value. Quoted prices provided by pricing services may still be used when estimating fair value in accordance with SFAS 157; however, the entity should evaluate whether the quoted prices are based on current information and orderly transactions. Inputs and valuation techniques are required to be disclosed in addition to any changes in valuation techniques. FSP SFAS 107-1 and APB 28-1, "Interim Disclosures about Fair Value of Financial Instruments" requires disclosures about the fair value of financial instruments for interim reporting periods of publicly traded companies as well as in annual 9 financial statements and also requires those disclosures in summarized financial information at interim reporting periods A publicly traded company includes any company whose securities trade in a public market on either a stock exchange or in the over-the-counter market, or any company that is a conduit bond obligor. Additionally, when a company makes a filing with a regulatory agency in preparation for sale of its securities in a public market it is considered a publicly traded company for this purpose. The three staff positions are effective for periods ending after June 15, 2009, with early adoption permitted for periods ending after March 15, 2009, in which case all three must be adopted. The Company will adopt the staff positions for its second quarter 10-Q but does not expect the staff positions to have a material impact on the consolidated financial statements. Also on April 1, 2009, the FASB issued FSP SFAS 141(R)-1, "Accounting for Assets Acquired and Liabilities Assumed in a Business Combination That Arise from Contingencies." The FSP requires that assets acquired and liabilities assumed in a business combination that arise from a contingency be recognized at fair value. If fair value cannot be determined during the measurement period as determined in SFAS 141 (R), the asset or liability can still be recognized if it can be determined that it is probable that the asset existed or the liability had been incurred as of the measurement date and if the amount of the asset or liability can be reasonably estimated. If it is not determined to be probable that the asset/liability existed/was incurred or no reasonable amount can be determined, no asset or liability is recognized. The entity should determine a rational basis for subsequently measuring the acquired assets and assumed liabilities. Contingent consideration agreements should be recognized initially at fair value and subsequently reevaluated in accordance with guidance found in paragraph 65 of SFAS 141 (R). The FSP is effective for business combinations with an acquisition date on or after the beginning of the Company's first annual reporting period beginning on or after December 15, 2008. The Company will assess the impact of the FSP if and when a future acquisition occurs. The Securities and Exchange Commission ("SEC") issued Staff Accounting Bulletin ("SAB") No. 111 on April 9, 2009 to amend Topic 5.M., "Other Than Temporary Impairment of Certain Investments in Debt and Equity Securities" and to supplement FSP SFAS 115-2 and SFAS 124-2. SAB 111 maintains the staff's previous views related to equity securities; however debt securities are excluded from its scope. The SAB provides that "other-than-temporary" impairment is not necessarily the same as "permanent" impairment and unless evidence exists to support a value equal to or greater than the carrying value of the equity security investment, a write-down to fair value should be recorded and accounted for as a realized loss. The SAB was effective upon issuance and had no impact on the Company's financial position. SFAS 165 "Subsequent Events," ("SFAS 165") was issued in May 2009 and provides guidance on when a subsequent event should be recognized in the financial statements. Subsequent events that provide additional evidence about conditions that existed at the date of the balance sheet should be recognized at the balance sheet date. Subsequent events that provide evidence about conditions that arose after the balance sheet date but before financial statements are issued, or are available to be issued, are not required to be recognized. The date through which subsequent events have been evaluated must be disclosed as well as whether it is the date the financial statements were issued or the date the financial statements were available to be issued. For non-recognized subsequent events which should be disclosed to keep the financial statements from being misleading, the nature of the event and an estimate of its financial effect, or a statement that such an estimate cannot be made, should be disclosed. The standard is effective for interim or annual periods ending after June 15, 2009. See Note 1 for Management's evaluation of subsequent events. In June 2009, the FASB issued SFAS 168 "The FASB Accounting Standards Codification TM and the Hierarchy of Generally Accepted Accounting Principles - a replacement of FASB Statement No. 162," ("SFAS 168"). SFAS 168 establishes the FASB Accounting Standards Codification TM ("Codification") as the source of authoritative generally accepted accounting principles for nongovernmental entities. SFAS 168 is effective for interim and annual periods ending after September 15, 2009 and is not expected to have any impact on the Company's financial position. Accounting standards that have been issued or proposed by the FASB that do not require adoption until a future date are not expected to have a material impact on the consolidated financial statements upon adoption. CAUTIONARY NOTICE WITH RESPECT TO FORWARD LOOKING STATEMENTS Statements included in this report which are not historical in nature are intended to be, and are hereby identified as "forward looking statements" for 10 purposes of the safe harbor provided by Section 21E of the Securities Exchange Act of 1934, as amended. Words such as "estimate," "project," "intend," "expect," "believe," "anticipate," "plan," "may," "will," "should," "could," "would," "assume," "indicate," "contemplate," "seek," "target," "potential," and similar expressions identify forward-looking statements. The Company cautions readers that forward looking statements including without limitation, those relating to the Company's new offices, future business prospects, revenues, working capital, adequacy of the allowance for loan losses, liquidity, capital needs, interest costs, and income, are subject to certain risks and uncertainties that could cause actual results to differ from those indicated in the forward looking statements, due to several important factors identified in this report, among others, and other risks and factors identified from time to time in the Company's other reports filed with the Securities and Exchange Commission. These forward-looking statements are based on our current expectations, estimates and projections about our industry, management's beliefs, and assumptions made by management. Such information includes, without limitation, discussions as to estimates, expectations, beliefs, plans, strategies, and objectives concerning the Company's future financial and operating performance. These statements are not guarantees of future performance and are subject to risks, uncertainties and assumptions that are difficult to predict, particularly in light of the fact that the Company is a relatively new company with limited operating history. Therefore, actual results may differ materially from those expressed or forecasted in such forward-looking statements. The risks and uncertainties include, but are not limited to: o future economic and business conditions; o the Company's growth and ability to maintain growth; o governmental monetary and fiscal policies; o legislative and regulatory changes; o the effect of interest rate changes on our level, costs and composition of deposits, loan demand, and the values of our loan collateral, securities, and interest sensitive assets and liabilities; o the indirect effects on demand for the Company's mortgage loan products arising from effects on the overall market of the subprime mortgage loan situation and government programs; o the effects of competition from a wide variety of local, regional, national and other providers of financial, investment and insurance services, as well as competitors that offer banking products and services by mail, telephone, computer, and/or the Internet; o credit risks; o higher than anticipated levels of defaults on loans; o perceptions by depositors about the safety of deposits; o failure of our customers to repay loans; o failure of assumptions underlying the establishment of the allowance for loan losses, including the value of collateral securing loans; o the risks of opening new offices, including, without limitation, the related costs and time of building customer relationships and integrating operations, and the risk of failure to achieve expected gains, revenue growth and/or expense savings; o changes in accounting policies, rules, and practices; o cost and difficulty of implementing changes in technology or products; o loss of consumer confidence and economic disruptions resulting from terrorist activities; o ability to weather the current economic downturn; o loss of consumer or investor confidence; and o other factors and information described in this report and in any of the other reports we file with the Securities and Exchange Commission under the Securities Act of 1934. All forward-looking statements are expressly qualified in their entirety by this cautionary notice. The Company undertakes no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise. In light of these risks, uncertainties, and assumptions, the forward-looking events discussed in this report might not occur. 11 Website References References to the Bank's website included in, or incorporated by reference into, this report are for information purposes only, and are not intended to incorporate the website by reference into this report. Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operation General Cornerstone Bancorp, (the "Company") is a bank holding company and has no operations other than those carried on by its wholly owned subsidiary, Cornerstone National Bank (the "Bank"). The Bank commenced business in 1999, and conducts a general banking business from three offices in the Easley area of Pickens County, in the Berea area of Greenville County, and in the Powdersville area of Anderson County, South Carolina. In 2004, the Bank established a wholly owned subsidiary, Crescent Financial Services, Inc. ("Crescent"), which is an insurance agency that has not yet engaged in any significant operations. Effect of Economic Trends During the fourth quarter of 2008 and continuing into the first half of 2009, the FDIC, the Federal Reserve, the Department of the Treasury and Congress took a number of actions designed to alleviate or correct mounting problems in the financial services industry. A number of these initiatives were directly applicable to community banks. Congress enacted the Emergency Economic Stabilization Act of 2008 which, among other things, temporarily increased the maximum amount of FDIC deposit insurance from $100,000 to $250,000 and created a Troubled Assets Relief Program ("TARP") administered by Treasury. In October, 2008, Treasury announced a Capital Purchase Program ("CPP") under TARP to increase the capital of healthy banks. Under the CPP, Treasury would purchase preferred stock with warrants from qualified banks and bank holding companies in an amount up to 3% of the seller's risk-weighted assets as of September 30, 2008. Institutions wishing to participate in the CPP were required to file an application with their principal federal regulators. The Company filed such an application and received preliminary approval to sell preferred stock to the Treasury, but ultimately elected not to participate in the CPP because of (i) the cost of the preferred stock, (ii) the open-ended administrative burdens associated with the preferred stock, including having to agree to allow Treasury to amend unilaterally the stock purchase agreement to comply with subsequent changes in applicable federal statutes, (iii) the fact that the Company and the Bank were already well capitalized under regulatory guidelines and expected to continue to be so, and (iv) management's belief that other sources of capital were, and would continue to be, available should additional capital be needed. The FDIC also implemented in October, 2008, a Temporary Liquidity Guarantee Program consisting of a deposit insurance component pursuant to which it undertook to provide deposit insurance in an unlimited amount for non-interest bearing transaction accounts, and a debt guarantee component pursuant to which it undertook to fully guarantee senior, unsecured debt issued by banks or bank holding companies. Coverage of both components was automatic until December 5, 2008, at which time covered institutions could opt out of one or both of the components. Institutions not opting out would be charged fees for their participation in the components. The Bank did not opt out of either component. An unfortunate consequence of the difficulties that have beset the banking industry in the last year has been a large increase in bank failures, which has led to substantial claims being made against the FDIC's Deposit Insurance Fund. In order to increase the amount in the Deposit Insurance Fund to reflect the increased risk of additional bank failures and insurance claims, the FDIC has raised its assessments on banks for 2009, and has also leveled a special one-time assessment of five cents per $100 of a bank's assessable base, which has been defined as total assets less Tier one capital as of June 30, 2009, to be paid in September, 2009. The Bank included $53,000 in professional and regulatory fees during the quarter related to the special assessment and $88,375 for the six months ended June 30, 2009 related to the special assessment. These assessments are in addition to $102,000 expensed for recurring FDIC insurance premiums. There can be no assurance that additional assessments will not be required in the future as the FDIC's Deposit Insurance Fund absorbs losses resulting from failed institutions. Additional governmental efforts to ameliorate the problems afflicting the banking industry have been adopted or proposed, or are being considered by Congress and various governmental entities. On June 17, 2009, the Obama Administration unveiled its plans for reorganizing the regulatory system for financial institutions. The proposal raises many issues for banks and savings associations. The Company is presently unable to predict the impact of any such 12 changes, although it appears that they are likely to increase operating expenses in the near term without creating completely offsetting benefits. The current outlook for the national economy in the United States remains negative. Management expects that unfavorable economic conditions will persist through 2009. We will continue to monitor both the local and national economic conditions in an effort to minimize any negative impact on the Company. Throughout 2008 and into the third quarter of 2009, the Federal Open Market Committee of the Federal Reserve ("FOMC") has held its target short-term interest rates at very low levels by historical standards. The FOMC has done this as part of its response to the economic turmoil currently dominating the U.S. economy. As a result of the decreases in short-term interest rates, interest rates applicable to many of the Bank's loans, which are tied to the prime rate, have also remained very low. However, interest rates on the Bank's interest bearing liabilities have not decreased by the same magnitude, tightening the Bank's net interest margin. In addition, the ability of many borrowers to obtain mortgage financing has decreased, impacting one source of non-interest income for the Bank. Both of these trends have negatively impacted the Company's profitability in 2009. Additionally, problems in the economy have adversely affected the ability of some borrowers to repay their loans. Although the Company's market area has not experienced the negative effects of the slowing economy and real estate markets and the decline in real estate values to as great a degree as many other parts of the country, these factors have had a significant effect on the local markets, as evidenced by the increases in our potential problem loans, charge-offs, and nonaccrual loans. Results of Operations Results of Operations for the Three Months Ended June 30, 2009 and 2008 Summary The Company recorded a loss of $482,156 during the second quarter of 2009 or $.23 per basic and diluted share compared to income of $283,202 during the second quarter of 2008 or $.14 per basic and $.13 per diluted share, after giving effect to the five percent stock dividend declared in 2009. Reasons for the decline in earnings include a decrease in the net interest margin, an increase in the provision for loan losses, and a decrease in mortgage loan origination fees and increases in FDIC insurance premiums and foreclosure-related costs. These were partially offset by a gain on the sale of an available-for-sale security in 2009. The decrease in the net interest margin is due to changes in market interest rates as described above. The decrease in mortgage loan origination fees is also related to trends in the national market for mortgage loan products. The increase in the provision for loan losses is a result of an increase in potential problem loans related to the current economic environment. Net Interest Income Net interest income is the primary driver of net income for the Company. Net interest income is equal to the difference between interest income earned on the Company's interest earning assets and the interest paid on its interest bearing liabilities. Throughout 2008 and continuing into 2009, we have experienced pressure on our interest rate margin as a result of market conditions. The Bank's balance sheet is sensitive to changes in market interest rates because approximately 61% of the Bank's loans are tied to the Prime Rate, which responds immediately to changes in market interest rates. Some of these loans include provisions for interest rate floors, but due to competitive pressures at the time the loans were made, many do not. Although many of the Bank's interest-bearing liabilities are also short-term in nature, even when those rates can be changed, liquidity needs of other institutions may put pressure on the Bank to keep deposit account interest rates high in order to retain deposits. In addition, the current economic climate is requiring banks to keep more liquidity on their balance sheets. Liquid assets are generally lower-earning assets than loans, further impacting our net interest margin. As mentioned above, a result of maintenance of very low target interest rates by the FOMC from September 2007 through June of 2009 is that earning rates on over half of the Bank's loan portfolio adjusted downward and remain low. While the average balance of loans outstanding grew 17.3% in the second quarter of 2009 as compared to the second quarter of 2008, decreases in rates earned on the portfolio had a greater impact on interest income than the increases in volume. Average rates earned on the loan portfolio decreased 170 basis points in the second quarter of 2009 compared to the second quarter of 2008, exclusive of nonaccrual loans. In contrast, average rates paid on interest bearing liabilities decreased only 82 basis points year over year. In comparison to the first quarter of 2009, the second quarter of 2009 has shown some improvement in the net interest margin. The net interest margin for the 13 quarter ended March 31, 2009 was 2.76% compared to the net interest margin for the quarter ended June 30, 2009 of 2.83%. Management continues to seek improvements to the net interest margin without taking on undue risk. The table below illustrates the average balances of interest earning assets and interest bearing liabilities and the resulting annualized yields and costs for the three month periods ended June 30, 2009 and 2008. June 30, 2009 June 30, 2008 ------------- ------------- Average Average Average Average Balance Interest Yield/ Cost Balance Interest Yield/ Cost ------- -------- ----------- ------- -------- ----------- Investments ................................. $ 20,955,984 $ 238,235 4.56% $ 24,336,773 $ 313,935 5.17% Federal Funds Sold .......................... 10,221,759 4,778 .19% 7,366,872 37,173 2.02% Loans ....................................... 131,883,108 1,770,277 5.38% 112,430,243 1,972,331 7.04% ------------ ---------- ------------ ---------- Total interest earning assets ............ 163,060,851 2,013,290 4.95% 144,133,888 2,323,439 6.47% ============ ---------- ============ ---------- Interest bearing transaction accounts ....... 13,265,338 21,638 .65% 14,088,428 34,261 .98% Savings and money market .................... 29,808,994 137,828 1.85% 12,587,551 48,436 1.54% Time deposits ............................... 89,006,245 584,913 2.64% 79,707,204 743,941 3.74% ------------ ---------- ------------ ---------- Total interest bearing deposits .......... 132,080,577 744,379 2.26% 106,383,183 826,638 3.12% Customer repurchase agreements and Federal Funds purchased ................. 3,741,231 18,780 2.01% 5,228,625 43,667 3.35% Borrowings from FHLB Atlanta ................ 6,838,378 55,288 3.24% 5,488,946 49,609 3.63% Broker repurchase agreements ................ 5,000,000 44,033 3.53% 5,000,000 43,550 3.49% ------------ ---------- ------------ ---------- Total interest bearing liabilities ....... $147,660,186 862,480 2.34% $122,100,754 963,464 3.16% ============ ---------- ============ ---------- Net interest income ......................... $1,150,810 $1,359,975 ========== ========== Interest rate spread ........................ 2.61% 3.31% Interest margin ............................. 2.83% 3.78% The Bank, which accounts for all of the Company's sensitivity to changes in interest rates, measures interest sensitivity using various measures. Using a static GAP measurement, which compares the amount of interest sensitive assets repricing within a one year time period as compared to the amount of interest sensitive liabilities repricing within the same time frame, the Bank's sensitivity to changes in interest rates can be analyzed. This method does not take into account loan prepayments and other non-contractual changes in balances and the applicable interest rates, but it does give some information as to possible changes in net interest income that could be expected simply as a result of changes in interest rates. As of June 30, 2009, the Bank's cumulative Gap ratio was .84 through 12 months. This indicates a liability-sensitive position as of June 30, 2009. Based on a static GAP measurement, in a period of rising interest rates, asset-sensitive balance sheets would be normally expected to experience a widening of the net interest margin, while liability-sensitive balance sheets would normally be expected to experience pressure on the net interest margin. In a period of decreasing interest rates, liability-sensitive balance sheets would normally be expected to experience a widening of the net interest margin and asset-sensitive balance sheets would normally be expected to experience the opposite effect. Various market factors can, however, affect the net interest margin and cause it to react differently to changes in interest rates than would normally be expected under the static GAP model. For example, although the Bank has the contractual right to decrease rates on its liabilities as the Federal Reserve lowers rates, in the past twelve months, the Bank has experienced difficulty in lowering rates on its liabilities because it has been competing for funds with many other entities, some of which have faced significant liquidity needs. This competition for funds has resulted in an increase in rates or a lack of decreases in rates by many of the sources the Bank ordinarily uses for funding. This illustrates the difficulty in predicting changes in interest income using various analytical tools such as the static GAP measurement. Provision for loan losses For the quarter ended June 30, 2009, the Company expensed $920,000 to the provision for loan losses. The Bank sets allowance for loan loss levels in response to trends in the portfolio and the level of potential problem loans. During the quarter, charge-offs totaled $432,649 and recoveries totaled $500. A majority (77%) of the charge-offs during the quarter related to one equipment loan. 14 Management has sought to provide the amount estimated to be necessary to maintain an allowance for loan losses that is adequate to cover the level of loss that management believed to be inherent in the portfolio as a whole, taking into account the Company's experience, economic conditions and information about borrowers available at the time of the analysis. However, management expects further deterioration of economic conditions in the Company's market areas is possible in the short-term, especially with respect to real estate related activities and real property values. Consequently, management expects that further increases in provisions for loan losses could be needed in the future. See "Balance Sheet Review- Loans" for additional information on the Company's loan portfolio and allowance for loan losses. Noninterest income The primary recurring drivers of noninterest income for the Company and the Bank are service charges on deposit accounts and mortgage loan origination fees. For the three months ended June 30, 2009, the Company earned $137,833 in service charges on deposit accounts compared to $145,598 for the same period in 2008. The decrease is attributable to a decrease in charges for insufficient funds. Mortgage loan origination fees in the first quarter of 2009 have decreased by $43,273 or 43% compared to the first quarter of 2008. The decrease is directly related to problems that borrowers are facing as they try to purchase or refinance homes. National mortgage lenders have changed or deleted programs and tightened credit standards, and the appraisal process is becoming increasingly difficult. Some credit worthy borrowers are not making refinancing or purchase decisions until they can determine that interest rates have probably reached their lowest level for this economic cycle. Noninterest expense Noninterest expense totaled $1.22 million for the three months ended June 30, 2009 and $1.08 million for the three months ended June 30, 2008. Professional and regulatory fees increased 164.0%. This dramatic increase primarily relates to premiums for FDIC insurance. On May 22, 2009, the FDIC adopted a final rule imposing a 5 basis point special assessment on each insured depository institution's assets minus Tier 1 capital as of June 30, 2009. The special assessment will be collected on September 30, 2009, but was required to be fully included in the accompanying consolidated income statement as of June 30, 2009. According to the FDIC "an additional special assessment of up to 5 basis points later in 2009 is probable, but the amount is uncertain." Total FDIC insurance premium expense for the quarter ended June 30, 2009 was $125,000 compared to $18,630 for the quarter ended June 30, 2008. Other expense increased $43,976 or 29.3% in 2009 over 2008 levels. Other expense in 2009 includes approximately $33,879 of additional loan-related expenses. These expenses are primarily associated with the foreclosure process. Results of Operations for the Six Months Ended June 30, 2009 and 2008 Summary The Company's net loss for the six months ended June 30, 2009 was $440,260 or $.21 per share, compared to income of $503,096 or $.24 per basic and diluted share for the six months ended June 30, 2008 (including the effect of the five percent stock dividend declared in 2009). The decrease in net income is due to changes in interest rates and the mortgage brokerage business and an increase in the provision for loan losses. Net Interest Income Net interest income was $2.2 million in the first six months of 2009 compared to $2.7 million for the six months ended June 30, 2008. The decrease was the result of previously mentioned changes in the Bank's net interest margin. The Bank's interest earning assets increased $21.7 million over June 30, 2008 levels, but decreases in rates earned on those assets had a greater impact on net interest income than the increases in volume. The average rate earned for the six months ended June 30, 2009 was 4.99% compared to 6.79% for the six months ended June 30, 2008. Rates paid on interest bearing liabilities did not decrease by the same margin, dropping 100 basis points to 2.43% from 3.43%. 15 The table below illustrates the average balances of interest earning assets and interest bearing liabilities and the resulting annualized yields and costs for the six month periods ended June 30, 2009 and 2008. June 30, 2009 June 30, 2008 ------------- ------------- Average Interest Average Average Interest Average Balance Earned Yield/Cost Balance Earned Yield/Cost ------- ------ ---------- ------- ------ ---------- Investments ................................... $ 21,056,282 490,023 4.69% $ 23,746,240 $ 616,642 5.24% Federal Funds Sold ............................ 9,683,202 7,334 .15% 5,361,147 61,994 2.33% Loans ......................................... 131,235,298 3,508,307 5.39% 111,099,449 4,039,444 7.33% ------------ ---------- ------------ ---------- Total interest earning assets .............. 161,974,782 4,005,664 4.99% 140,206,836 4,718,080 6.79% ============ ---------- ============ ---------- Interest bearing transaction accounts ......... 13,032,613 42,967 .66% 13,728,006 71,192 1.05% Savings and money market accounts ............. 27,236,142 256,788 1.90% 11,727,528 102,133 1.76% Time deposits ................................. 89,104,751 1,216,122 2.75% 78,364,879 1,577,549 4.06% ------------ ---------- ------------ ---------- Total interest bearing deposits ............ 129,373,506 1,515,877 2.36% 103,820,413 1,750,874 3.40% Customer repurchase agreements ................ 4,105,985 46,168 2.27% 5,528,022 101,355 3.70% Advances from FHLB ............................ 7,464,765 87,584 3.03% 5,346,419 98,185 3.70% Broker repurchase agreements .................. 5,000,000 112,033 3.53% 4,670,330 81,721 3.53% ------------ ---------- ------------ ---------- Total interest bearing liabilities ......... 145,944,256 1,761,662 2.43% $119,365,184 2,032,135 3.43% ============ ---------- ============ ---------- Net interest income ........................... $2,244,002 $2,685,945 ========== ========== Interest rate spread .......................... 2.55% 3.36% Interest margin ............................... 2.79% 3.86% Provision for loan losses The amount of the Company's provision for loan losses for the six months ended June 30, 2009 was $1,080,000 compared to $240,000 for the six months ended June 30, 2008. In each period, management has sought to provide the amount estimated to be necessary to maintain an allowance for loan losses that is adequate to cover the level of loss that management believed to be inherent in the portfolio as a whole, taking into account the Company's experience, economic conditions and information about borrowers available at the time of the analysis. Charge-offs totaled $590,555 during the first half of 2009 compared to $226,493 for the first six months of 2008. Recoveries totaled $500 in 2009 and $275,599 in 2008. See "Balance Sheet Review- Loans" for additional information on the Company's loan portfolio and allowance for loan losses. Noninterest income Noninterest income for the six months ended June 30, 2009 was $483,020 compared to $519,367 for the six months ended June 30, 2008. Service charges on deposit accounts decreased primarily due to lower charges for insufficient funds. Mortgage loan origination fees also declined year over year. Mortgage origination fees decreased to $111,062 in 2009 from $172,630 in 2008 for the same reasons as discussed above for the three month period. The decreases in noninterest income in 2009 compared to 2008 were partially offset by a gain on the sale of an available for sale security in the amount of $52,300 in 2009. Noninterest expense Total noninterest expense for the six months ended June 30, 2009 was $2.4 million versus $2.2 million for the six months ended June 30, 2008. Salaries decreased $58,886 or 4.6% in 2009 over 2008 levels. The decrease reflects the decrease in commissions paid to mortgage loan officers as well as retirements, partially offset by annual salary increases and increases in the cost of providing benefits, including stock option expenses. Professional and regulatory fees increased $174,526 or 118.1% due to significant increases in FDIC insurance premiums. Other expenses include costs of foreclosure of real estate of approximately $70,000, which contributed heavily to the 26.3% increase in other expense. Balance Sheet Review Investments At June 30, 2009, the Bank held available for sale securities with a fair value cost of $19.5 million and other investments with an amortized cost of $1.0 million. Available for sale securities include government sponsored enterprise 16 bonds, mortgage-backed securities, municipal bonds, and preferred stock issued by the Federal National Mortgage Association ("FNMA"), a government sponsored enterprise. The fair values of the Company's available for sale investments, other than municipal bonds, are measured on a recurring basis using quoted market prices in active markets for identical assets and liabilities ("Level 1 inputs" under SFAS 157). Due to the lower level of trading activity in municipal bonds, the fair market values of these investments are measured based on other inputs such as inputs that are observable or can be corroborated by observable market data for similar assets with substantially the same terms ("Level 2 inputs" under SFAS 157). Other investments include stock in the Federal Home Loan Bank of Atlanta and the Federal Reserve Bank. These stocks are held at amortized cost because they have no quoted market value and have historically been redeemed at par value. However, there can be no assurance that these stocks will, in fact, be redeemed at cost in the future. As of June 30, 2009, investments available for sale had a net unrealized gain of $373,162. As of June 30, 2009 we held seven investments that are in an unrealized loss position. Of those seven, only four had been in an unrealized loss position for more than 12 months. The amount of the total unrealized loss in the portfolio is $149,108, with $115,463 related to the four securities in an unrealized loss position for 12 months or more. The Bank has historically had the intent and ability to hold investments until maturity, and expects to be able to continue to do so. One of the investments in a net unrealized loss position at June 30, 2009 is our investment in FNMA Preferred stock. In September 2008 the U.S. Treasury placed FNMA in conservatorship. At that time the Company recognized an other-than-temporary-impairment charge. However, there can be no certainty that we will not incur further losses on the FNMA preferred stock. The amortized cost of our investment in FNMA preferred stock is $87,200 and the fair value is $26,400 at June 30, 2009. The majority of the remaining investments with unrealized losses at June 30, 2009 are issued by various municipal governments. Based on our review of these securities, we do not currently expect that these losses are other than temporary. Loans The following table summarizes the composition of our loan portfolio. June 30, 2009 June 30, 2008 ------------- ------------- % of % of Amount Loans Amount Loans ------ ----- ------ ----- Commercial and industrial ........................ $ 17,225,366 12.2% $ 19,403,083 17.2% Real Estate - construction ....................... 55,684,879 39.5 48,712,185 43.2 Real Estate - mortgage 1-4 family residential .................... 27,052,013 19.2 18,953,498 16.8 Nonfarm, nonresidential ................... 37,095,854 26.3 21,950,442 19.4 Multifamily residential ................... 2,218,309 1.6 1,584,497 1.4 Consumer installment ............................. 1,707,723 1.2 2,282,464 2.0 ------------- ----- ------------- ----- Total Loans .......................... $ 140,984,144 100.0% 112,886,169 100.0% ===== ===== Less allowance for loan losses ............ (2,188,508) (1,582,236) ------------- -------------- Net Loans ............................ $ 138,795,636 $ 111,303,933 ============= ============== Activity in the allowance for loan losses for the first six months of 2009 and 2008 is presented below. Six months ended Six months ended June 30, 2009 June 30, 2008 ------------- ------------- Allowance for loan losses, beginning of year ................................. $ 1,698,563 $ 1,293,130 Provision for losses ......................................................... 1,080,000 240,000 Charge-offs .................................................................. (590,555) (226,493) Recoveries ................................................................... 500 275,599 ----------- ----------- Allowance for loan losses, end of period ............................... $ 2,188,508 $ 1,582,236 =========== =========== 17 Ratios As of or for the six As of or for the six months ended months ended June 30, 2009 June 30, 2008 ------------- ------------- Nonperforming loans to loans at end of period .................................. 4.9% .63% Net (charge-offs) recoveries to average loans outstanding ...................... .432% .04% Net (charge-offs) recoveries to loans at end of period ......................... .419% .04% Allowance for loan losses to average loans ..................................... 1.60% 1.42% Allowance for loan losses to loans at end of period ............................ 1.55% 1.40% Net (charge-offs) recoveries to allowance for loan losses ...................... 27.0% 3.1% Net (charge-offs) recoveries to provision for loan losses ...................... 54.6% 20.5% Charge-offs totaled $590,555 for the first six months of 2009. These charge-offs primarily related to two loans, one commercial and industrial loan and one commercial construction loan. Loans which management identifies as impaired generally will be nonperforming loans. Nonperforming loans include nonaccrual loans or loans which are 90 days or more delinquent as to principal or interest payments. As of June 30, 2009, the Bank had nonaccrual loans of $6.9 million representing 41 loans. With the exception of one loan, these loans are secured by real estate. In addition to loans on nonaccrual, as of June 30, 2009, Management considers another $2.5 million of loans impaired. Management is currently assessing the collateral associated with these additional impaired loans in an effort to determine the amount of potential impairment. These loans are currently being carried at management's best estimate of net realizable value, although no assurance can be given that no further losses will be incurred on these loans until the collateral has been acquired and liquidated or other arrangements can be made. The foreclosure process is lengthy (generally a minimum of six months), so loans may be on nonaccrual status for a significant time period prior to moving to other real estate owned and sold. As soon as the amount of impairment is estimable, the amount of impairment is generally charged against the allowance for loan losses. However, until losses can be estimated via appraisal or other means, a portion of the allowance may be allocated to specific impaired loans. As of June 30, 2009 the allowance for loan losses included $178,912 of reserves specifically related to impaired loans. Management's estimates of net realizable, or fair value, of real estate collateral are obtained (on a nonrecurring basis) using independent appraisals, less estimated selling costs, which the Company considers to be level 2 inputs as defined by SFAS No. 157. Estimates of net realizable value for equipment and other types of collateral will be estimated based on input from equipment dealers and other professionals (also level 2 inputs). Management identifies and maintains a list of potential problem loans. These are loans that are not included in nonaccrual status or loans that are past due 90 days or more and still accruing interest. A loan is added to the potential problem list when management becomes aware of information about possible credit problems of borrowers that causes serious doubts as to the ability of such borrowers to comply with the current loan repayment terms. These loans are designated as such in order to be monitored more closely than other credits in the Bank's portfolio. There were loans in the amount of $2.1 million that have been determined by management to be potential problem loans at June 30, 2009. These loans are generally secured by real estate, and in many cases have been reappraised. Should potential problem loans become impaired, Management will charge-off any impairment amount as soon as the amount of impairment can be determined. 18 Deposits The following table shows the average balance amounts and the average rates we paid on deposits for the six months ended June 30, 2009 and 2008. Average Deposits ------------------------------------------------------ Six months ended June 30, Six months ended June 30, 2009 2008 ---- ---- Amount Rate Amount Rate ------ ---- ------ ---- Noninterest bearing demand .................................. $ 10,634,071 -% $ 11,370,572 -% Interest bearing transaction accounts ....................... 13,032,613 .66% 13,728,006 1.05% Savings and money market .................................... 27,236,142 1.90% 11,727,528 1.76% Time deposits ............................................... 89,104,751 2.75% 78,364,879 4.06% ------------- ------------- Total average deposits ................................ $ 140,007,577 $ 115,190,985 ============= ============= Borrowings The Bank's outstanding borrowings are described in the following table. The amounts listed as broker repurchase agreements are collateralized borrowings from other institutions. Retail repurchase agreements with the Bank's customers are not included in the table below. Borrowings at or for the six months ended June 30, 2009 Maximum Weighted Period- Month-end Average Ending Balance End Rate Balance Average Balance Rate Paid -------------- -------- ------- --------------- --------- Federal Home Loan Bank advances .................... $6,818,588 3.23% $8,381,435 $7,464,765 3.03% Broker repurchase agreements ....................... $5,000,000 3.53% $5,000,000 $5,000,000 3.53% Liquidity Liquidity is the ability to meet current and future obligations through liquidation or maturity of existing assets or the acquisition of liabilities. The Company manages both assets and liabilities to achieve appropriate levels of liquidity. Cash and short-term investments are the Company's primary sources of asset liquidity. These funds provide a cushion against short-term fluctuations in cash flow from both deposits and loans. The investment portfolio is the Company's principal source of secondary asset liquidity. However, the availability of this source of funds is influenced by market conditions. Individual and commercial deposits and borrowings are the Company's primary source of funding for credit activities. The Company has lines of credit with unrelated banks and with the FHLB of Atlanta. The bank lines total $3.1 million and are available on a one to fourteen day basis for general corporate purposes of the Bank. The FHLB line is based on the availability of eligible collateral, with a maximum borrowing capacity of 10% of Bank assets. The Bank currently has $6.8 million borrowed under the FHLB line. Approximately $11.2 million is available under the FHLB line, assuming adequate collateral is available for pledging. Although many banks have recently experienced substantial pressure on their liquidity, in some cases requiring government intervention, the demands on the Bank's liquidity have been comfortably manageable. Management believes that the Company's liquidity sources are adequate to meet its operating needs. 19 Estimated Fair Value of Financial Instruments The Company adopted SFAS 157 on January 1, 2008. Refer to Note 1 for more information regarding SFAS 157 and the levels of inputs used in determining fair value of the Company's available for sale securities. The table below presents the balances of assets measured at fair value on a recurring basis by level within the hierarchy of inputs that may be used to measure fair value. June 30, 2009 ------------- Carrying Fair Amount Value ------ ----- Financial Assets Cash and due from banks .................................................... $ 7,242,337 $ 7,242,337 Federal funds sold ......................................................... 2,600,000 2,600,000 Investment securities ...................................................... 20,503,499 20,503,499 Loans, gross ............................................................... 140,984,144 142,828,724 Cash surrender value of life insurance policies ............................. 1,802,663 1,802,663 Financial Liabilities Deposits ................................................................... $145,415,985 $145,129,589 Customer repurchase agreements ............................................. 3,696,476 3,701,733 Borrowings from FHLB ....................................................... 6,818,588 6,919,024 Broker repurchase agreements ............................................... 5,000,000 5,294,374 Off Balance Sheet Risk Through the operations of the Bank, the Company has contractual commitments to extend credit in the ordinary course of its business activities. These commitments are legally binding agreements to lend money to the Bank's customers at predetermined interest rates for a specified period of time. Commitments are subject to various conditions which are expected to reduce the credit risk to the Company. The Bank's management evaluates each customer's creditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by management upon extension of credit, is based on a credit evaluation of the borrower. Collateral varies but may include accounts receivable, inventory, property, plant and equipment, and commercial or residential real estate. Management manages the credit risk on these commitments by subjecting them to normal underwriting and risk management processes. At June 30, 2009, the Bank had issued commitments to extend credit of $23.8 million through various types of lending arrangements and overdraft protection arrangements. Of that amount, approximately $17.1 million was undisbursed amounts of closed-end loans, including $1.3 million related to unused overdraft protection, and approximately $6.8 million was related to lines of credit. The Bank also had standby letters of credit outstanding of approximately $455,000 at June 30, 2009. An immaterial amount of fees were collected related to these commitments and letters of credit during the six month period ended June 30, 2009. Historically many of these commitments and letters of credit expire unused, and the total amount committed as of June 30, 2009 is not necessarily expected to be funded. The Bank offers an automatic overdraft protection product to checking account customers. Each qualified account with the automatic overdraft protection feature can have up to $500 of paid overdrafts. Unused overdraft protection was $1.3 million as of June 30, 2009, the majority of which is not expected to be utilized. As of June 30, 2009, accounts in overdraft status totaled $21,701. Capital Resources The capital base for the Company decreased by approximately $127,164 for the first six months of 2009, due to net losses, offset by stock option activity and increases in accumulated other comprehensive income. Stock option activity includes the impact of both stock options exercised and accounting requirements for stock-based compensation on unexercised options. The Company's equity to asset ratio was 10.5% as of June 30, 2009. The Company expects to continue to leverage its capital as the Bank grows. 20 The following table details return on average assets (net income divided by average total assets, annualized if necessary), return on average equity (net income divided by average total equity, annualized if necessary), the ratio of average equity to average assets and the Dividend Payout Ratio (dividends paid divided by net income) as of and for the six months ended June 30, 2009 and as of and for the year ended December 31, 2008. Return on Assets and Return on Equity for the first six months of 2009 have decreased compared to Return on Assets and Return on Equity for the year ended December 31, 2008 due to pressure on our net interest margin and the effect of an increased provision for loan losses. Six- month period ended Year ended June 30, 2009 December 31, 2008 ------------- ----------------- (annualized) Return on average assets .................... (.50)% .15% Return on average equity .................... (4.59)% 1.16% Ratio of average equity to average assets ... 10.96% 12.68% Dividend payout ratio* ...................... -% 265% * In May 2008 the Company declared a cash dividend which was less than the Company's reported net income for the first two quarters of 2008. Following the placement of FNMA in conservatorship in September 2008, the Company recognized an Other-than-temporary-impairment charge of $918,264, which reduced the Company's net income for 2008 to an amount less than the amount of the dividend declared in May 2008. The Company may or may not decide to pay cash dividends in the future. The FDIC has established guidelines for capital requirements for banks. As of March 31, 2008, the Bank is considered well capitalized based on the capital levels that are required to be maintained according to FDIC guidelines as shown in the following table. Capital Ratios Adequately Well Capitalized Capitalized Actual Requirement Requirement ------ ----------- ----------- Amount Ratio Amount Ratio Amount Ratio ------ ----- ------ ----- ------ ----- Total capital to risk weighted assets .............. $ 20,522 13.3% $ 15,439 10.0% $ 12,352 8.0% Tier 1 capital to risk weighted assets ............. $ 18,589 12.0% $ 9 ,264 6.0% $ 6,176 4.0% Tier 1 capital to average assets ................... $ 18,589 10.4% $ 8,940 5.0% $ 7,152 4.0% The Federal Reserve has also established guidelines for capital requirements for bank holding companies that are similar to the FDIC's guidelines for banks. At June 30, 2009 the Company exceeded all of the minimum requirements of the Federal Reserve guidelines. The Company has two stock-based compensation plans. See "Stock based Compensation" in the Notes to Unaudited Consolidated Financial Statements above for more information. Impact of Inflation Unlike most industrial companies, the assets and liabilities of financial institutions such as the Company are primarily monetary in nature. Therefore, interest rates have a more significant impact on the Company's performance than do the effects of changes in the general rate of inflation and changes in prices. In addition, interest rates do not necessarily move in the same magnitude as the prices of goods and services. As discussed previously, management seeks to manage the relationships between interest sensitive assets and liabilities in order to protect against wide rate fluctuations, including those resulting from inflation. Item 3. Quantitative and Qualitative Disclosures about Market Risk Market risk is the risk of loss from adverse changes in market prices and rates, which principally arises from liquidity risk and interest rate risk inherent in 21 the Bank's lending, deposit gathering, and borrowing activities. Other types of market risks such as foreign currency exchange risk and commodity price risk do not normally arise in the ordinary course of our business. The Funds Management Committee of our Board of Directors, which meets quarterly, monitors and considers methods of managing exposure to liquidity and interest rate risk. Our Management monitors liquidity and interest rate risk on an on-going basis. Management is responsible for maintaining the level of interest rate sensitivity of our interest sensitive assets and liabilities and managing our liquidity within board-approved limits. Interest rate sensitivity "GAP" analysis measures the timing and magnitude of the repricing of assets compared with the repricing of liabilities and is an important part of asset/liability management. The objective of interest rate sensitivity management is to generate stable growth in net interest income, and to control the risks associated with interest rate movements. Management constantly reviews interest rate risk exposure and the expected interest rate environment so that adjustments in interest rate sensitivity can be made in a timely manner. ITEM 4T. Controls and Procedures. Based on the evaluation required by 17 C.F.R. Section 240.13a-15(b) or 240.15d-15(b) of the Company's disclosure controls and procedures (as defined in 17 C.F.R. Sections 240.13a-15(e) and 240.15d-15(e)), the Company's chief executive officer and chief financial officer concluded that such controls and procedures, as of the end of the period covered by this report, were effective. There has been no change in the Company's internal control over financial reporting during the most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, the Company's internal control over financial reporting. 22 Part II - Other Information - --------------------------- ITEM 4. Submission of Matters to a Vote of Security Holders The Company held its annual meeting of shareholders on May 12, 2009. At that meeting four directors were elected to serve three year terms and one director (Childress) was elected to serve a one year term. The voting results were as follows: Name For Withhold Broker Non-votes ---- --- -------- ---------------- Elected for three year terms: Joe E. Hooper ................................... 1,081,178 1,771 - Robert R. Spearman .............................. 1,081,178 1,771 - John M. Warren, Jr., M.D. ....................... 1,081,178 1,771 - George I. Wike, Jr. ............................. 1,081,178 1,771 - Elected for a one year term Janice E. Childress ............................. 1,081,178 1,771 - The following directors' terms of office continued after the annual meeting: Jennifer M. Champagne (2011), Susan S. Jolly (2011), J. Bruce Gaston (2011), S. Ervin Hendricks, Jr. (2011), J. Rodger Anthony (2010), and Walter L. Brooks (2010). ITEM 6. Exhibits Exhibits: 31-1 Rule 13a-14(a)/ 15d-14(a) Certifications of Chief Executive Officer 31-2 Rule 13a-14(a)/Rule 15d-14(a) Certifications of Chief Financial Officer 32 18 U.S.C. Section 1350 Certifications SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. Cornerstone Bancorp (Registrant) By: s/J. Rodger Anthony Date: August 12, 2009 ------------------------------------------- J. Rodger Anthony Chief Executive Officer By: s/Jennifer M. Champagne Date: August 12, 2009 ------------------------------------------- Jennifer M. Champagne Senior Vice President and Chief Financial Officer (Principal Financial Officer) 23