Tableof Contents

 

 

 

**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

# **FORM 10-K**

#  

| **x** | ** ** | **ANNUAL REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
|-------|------------|-----------------------------------------------------------------------------------------------------|

 

**For thefiscal year ended December 31, 2008**

 

**OR**

 
| **o** | ** ** | **TRANSITION REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
|-------|------------|---------------------------------------------------------------------------------------------------------|

 

**For thetransition period from                    to                    **

 

**CommissionFile No.:****  0-28312**

 

**First Federal Bancshares of Arkansas, Inc.**

(Exactname of registrant as specified in its charter)

 

| **Texas**                          | ** ** | **71-0785261**         |
|------------------------------------|------------|------------------------|
| (State or other  jurisdiction      |       | (I.R.S. Employer       |
| of incorporation or  organization) |       | Identification Number) |

 

| **1401  Highway 62-65 North** |       |       |
|-------------------------------|------------|------------|
| **Harrison,  Arkansas**       | ** ** | **72601**  |
| (Address)                     |       | (Zip Code) |

 

Registrant’stelephone number, including area code:**  (870) 741-7641**

 

Securities registered pursuant to Section 12(b) of the Act:

 

| **Common Stock (par value $.01 per share)** | ** ** | **The Nasdaq Stock Market LLC** |
|---------------------------------------------------------------------------|------------|-----------------------------------------------------|
| (Title of Class)                                                          |       | (Exchange on which  registered)                     |

 

Securities registered pursuant to Section 12(g) of the Act

**None**

 

Indicateby check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405of the Securities Act.  Yes  o   No  x

 

Indicateby check mark if the registrant is not required to file reports pursuant to Section13 or Section 15(d) of the Act.  Yes  o   No  x

 

Indicateby check mark whether the Registrant (1) has filed all reports required bySection 13 or 15(d) of the Securities Exchange Act of 1934 during thepreceding 12 months (or for such shorter period that the Registrant wasrequired to file such reports), and (2) has been subject to such filingrequirements for the past 90 days.  Yes  x   No  o

 

Indicateby check mark if disclosure of delinquent filers pursuant to Item 405 ofRegulation S-K ( § 229.405 of this chapter) is not contained herein, and willnot be contained, to the best of Registrant’s knowledge, in definitive proxy orinformation statements incorporated by reference in Part III of this Form 10-Kor any amendment to this Form 10-K. x

 

Indicateby check mark whether the registrant is a large accelerated filer, anaccelerated filer, a non-accelerated filer, or a smaller reportingcompany.  See the definitions of “largeaccelerated filer,” “accelerated filer,” and “smaller reporting company” in Rule 12b-2of the Exchange Act.  (Check one):

 
| Large Accelerated Filer  o |   | Accelerated Filer  o |   | Non-accelerated Filer  o |   | Smaller reporting company  x |
|---------------------------------|--------|---------------------------|--------|-------------------------------|--------|-----------------------------------|

 

Indicateby check mark whether the registrant is a shell company (as defined in Rule 12B-2of the Act).  Yes o   No  x

 

Asof June 30, 2008, the aggregate value of the 4,048,264 shares of CommonStock of the Registrant issued and outstanding on such date, which excludes800,121 shares held by directors and officers of the Registrant as a group, wasapproximately $35.0 million.  This figureis based on the last sales price of $8.65 per share of the Registrant’s CommonStock on June 30, 2008.

 

Numberof shares of Common Stock outstanding as of February 20, 2009:  4,846,785

# ** **

# **DOCUMENTS INCORPORATED BYREFERENCE**

 

List hereunder the following documents incorporated by reference and thePart of the Form 10-K into which the document is incorporated.

 

Portions of the definitive proxy statement for the 2009 Annual Meetingof Stockholders are incorporated into Part III, Items 10 through 14 ofthis Form 10-K.

 

 

 

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**First Federal Bancshares of Arkansas, Inc.**

**Form 10-K**

**For the YearEnded December 31, 2008**

 
| **PART I.**   |   |                                                                                                                |   |   |
|--------------------|--------|---------------------------------------------------------------------------------------------------------------------|--------|--------|
| Item 1.            |   | Business                                                                                                            | 1      |
| Item 1A.           |   | Risk Factors                                                                                                        | 26     |
| Item  1B.          |   | Unresolved  Staff Comments                                                                                          | 29     |
| Item 2.            |   | Properties                                                                                                          |   | 30     |
| Item 3.            |   | Legal  Proceedings                                                                                                  |   | 30     |
| Item  4.           |   | Submission  of Matters to a Vote of Security Holders                                                                |   | 30     |
|               |   |                                                                                                                |   |   |
| **PART II.**  |   |                                                                                                                |   |   |
| Item  5.           |   | Market  for Registrant’s Common Equity, Related Stockholder Matters and Issuer  Purchases of Equity Securities | 31     |
| Item 6.            |   | Selected  Financial Data                                                                                            |   | 32     |
| Item 7.            |   | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                         |   | 34     |
| Item  7A.          |   | Quantitative  and Qualitative Disclosures About Market Risk                                                         |   | 45     |
| Item  8.           |   | Financial  Statements and Supplementary Data                                                                        |   | 47     |
| Item  9.           |   | Changes  in and Disagreements with Accountants on Accounting and Financial Disclosure                               |   | 77     |
| Item  9A.          |   | Controls  and Procedures                                                                                            |   | 77     |
| Item 9B.           |   | Other  Information                                                                                                  |   | 77     |
|               |   |                                                                                                                |   |   |
| **PART III.** |   |                                                                                                                |   |   |
| Item  10.          |   | Directors,  Executive Officers and Corporate Governance                                                             |   | 77     |
| Item  11.          |   | Executive  Compensation                                                                                             |   | 77     |
| Item  12.          |   | Security  Ownership of Certain Beneficial Owners and Management and Related Stockholder  Matters                    |   | 78     |
| Item  13.          |   | Certain  Relationships and Related Transactions, and Director Independence                                          |   | 78     |
| Item  14.          |   | Principal  Accountant Fees and Services                                                                             |   | 78     |
|               |   |                                                                                                                |   |   |
| **PART IV.**  |   |                                                                                                                |   |   |
| Item  15.          |   | Exhibits  and Financial Statement Schedules                                                                         |   | 79     |

 

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**PART I.**

 

**Item 1.  Business**

 

**First Federal Bancshares of Arkansas, Inc. **First Federal Bancshares of Arkansas, Inc. (the “Company”) is aTexas corporation organized in January 1996 by First Federal Bank (“FirstFederal” or the “Bank”) for the purpose of becoming a unitary holding companyof the Bank.  The significant asset ofthe Company is the capital stock of the Bank. The business and management of the Company consists of the business andmanagement of the Bank.  The Company doesnot presently own or lease any property, but instead uses the premises,equipment and furniture of the Bank.  Atthe present time, the Company does not employ any persons other than officersof the Bank, and the Company utilizes the support staff of the Bank from timeto time.  Additional employees will behired as appropriate to the extent the Company expands or changes its businessin the future.  At December 31,2008, the Company had $795.2 million in total assets, $618.0 million in totaldeposits and $73.1 million in stockholders’ equity.

 

TheCompany’s executive office is located at the home office of the Bank at 1401Highway 62-65 North, Harrison, Arkansas 72601, and its telephone number is(870) 741-7641.

 

**First Federal Bank. **The Bank is afederally chartered stock savings and loan association formed in 1934.  First Federal conducts business from its mainoffice and nineteen full service branch offices, all of which are located in asix county area in Northcentral and Northwest Arkansas comprised of Benton,Marion, Washington, Carroll, Baxter and Boone counties.  First Federal’s deposits are insured by theDeposit Insurance Fund (“DIF”), which is administered by the Federal DepositInsurance Corporation (“FDIC”), to the maximum extent permitted by law.

 

TheBank is a community-oriented financial institution offering a wide range ofretail and business deposit accounts, including noninterest bearing andinterest bearing checking, savings and money market accounts, certificates ofdeposit, and individual retirement accounts. Loan products offered by the Bank include residential real estate,consumer, construction, lines of credit, commercial real estate and commercialnon-real estate.  Other financialservices include investment products offered through First Federal InvestmentServices, Inc.; automated teller machines; 24-hour telephone banking;internet banking, including account access, bill payment, e-statements andonline loan applications; Bounce ProtectionTM overdraft service; debit cards; and safedeposit boxes.

 

TheBank is subject to examination and comprehensive regulation by the Office ofThrift Supervision (“OTS”), which is the Bank’s chartering authority andprimary regulator.  The Bank is alsoregulated by the FDIC, the administrator of the DIF.  The Bank is also subject to certain reserverequirements established by the Board of Governors of the Federal ReserveSystem (“FRB”) and is a member of the Federal Home Loan Bank (“FHLB”) of Dallas,which is one of the 12 regional banks comprising the FHLB System.

 

ThisForm 10-K contains certain forward-looking statements and informationrelating to the Company that are based on the beliefs of management as well asassumptions made by and information currently available to management.  In addition, in those and other portions ofthis document, the words “anticipate,” “believe,” “estimate,” “expect,” “intend,”“should” and similar expressions, or the negative thereof, as they relate tothe Company or the Company’s management, are intended to identifyforward-looking statements.  Suchstatements reflect the current views of the Company with respect to futurelooking events and are subject to certain risks, uncertainties and assumptions.  Should one or more of these risks oruncertainties materialize or should underlying assumptions prove incorrect,actual results may vary materially from those described herein as anticipated,believed, estimated, expected or intended. The Company does not intend to update these forward-looking statements.

 

## **Employees**

##  

TheBank had 268 full-time employees and 44 part-time employees at December 31,2008, compared to 279 full-time employees and 50 part-time employees at December 31,2007.   None of these employees is representedby a collective bargaining agent, and the Bank believes that it enjoys goodrelations with its personnel.

 

## **Available Information**

##  

TheCompany makes available free of charge its annual report on Form 10-K,quarterly reports on Form 10-Q, current reports on Form 8-K, and allamendments to such reports filed pursuant to Sections 13(a) or 15(d) ofthe Securities Exchange Act of 1934, as soon as reasonably practicable on orthrough its website located at www.ffbh.com after filing with the United StatesSecurities and Exchange Commission (“SEC”).

##  

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## **Competition**

##  

TheBank faces strong competition both in attracting deposits and makingloans.  Its most direct competition fordeposits has historically come from other savings associations, communitybanks, credit unions and commercial banks, including many large financialinstitutions that have greater financial and marketing resources available tothem.  In addition, the Bank has facedadditional significant competition for investors’ funds from short-term moneymarket securities, mutual funds and other corporate and governmentsecurities.  The ability of the Bank toattract and retain savings and certificates of deposit depends on its abilityto generally provide a rate of return, liquidity and risk comparable to thatoffered by competing investment opportunities. The Bank’s ability to increase checking deposits depends on offeringcompetitive checking accounts and promoting these products through effectivechannels.  Additionally, the Bank offersconvenient hours, locations and online services to maintain and attractcustomers.

 

TheBank experiences strong competition for loans principally from savingsassociations, community banks, commercial banks and mortgage companies.  Banks new to the market, as well as thoseinstitutions who are well-established in the market, such as our bank, continueto open branches in their respective branch networks, albeit at a slower pacethan in previous years. The Bank competes for loans principally through theinterest rates and loan fees it charges and the efficiency and quality ofservices it provides borrowers.

 

Withtwenty offices located in twelve cities and towns in Northwest and NorthcentralArkansas, the Bank is positioned to be a leader in providing financialservices. In our combined market area of Washington, Marion, Carroll, Boone,Benton, and Baxter Counties, we had a 6.87% of the deposit market share at June 30,2008 compared to 5.94% at June 30, 2007. Of the 38 banks in this marketarea, we are the third largest in our combined market area.  We are striving to make gains in market shareat all our locations with our branching operations.

 

**Lending Activities**

 

**General. **At December 31, 2008, the Bank’sportfolio of net loans receivable amounted to $568.1 million or 71.4% of theCompany’s total assets.  The Bank hastraditionally concentrated its lending activities on loans collateralized byreal estate.  Consistent with suchapproach, $541.8 million or 92.5% of the Bank’s total portfolio of loansreceivable (“total loan portfolio”) consisted of loans collateralized by realestate at December 31, 2008.

 

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**Loan Composition.** Thefollowing table sets forth certain data relating to the composition of the Bank’sloan portfolio by type of loan at the dates indicated.

 
| ** **                                             | ** ** | **December 31,**                | ** ** |
|--------------------------------------------------------|------------|--------------------------------------|------------|
| ** **                                             | ** ** | **2008**                             | ** ** | **2007** | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                             | ** ** | **Amount**                           | ** ** | **Percentage  of Loans** | ** ** | **Amount** | ** ** | **Percentage  of Loans** | ** ** | **Amount** | ** ** | **Percentage  of Loans** | ** ** | **Amount** | ** ** | **Percentage  of Loans** | ** ** | **Amount** | ** ** | **Percentage  of Loans** | ** ** |
| ** **                                             | ** ** | **(Dollars in Thousands)** | ** ** |
| Mortgage loans:                                        |       |                                 |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| One-to four-family residences                          |       | $                                    | 243,321    |   | 41.54 | % | $ | 230,005 |   | 35.77 | % | $ | 257,867 |   | 35.05 | % | $ | 280,900 |   | 35.53 | % | $ | 292,228 |   | 41.79 | % |
| Home equity and second mortgage                        |       | 31,712                               |       | 5.41 |   | 34,315 |   | 5.34 |   | 35,192 |   | 4.78 |   | 29,210 |   | 3.69 |   | 27,059 |   | 3.87 |   |
| Multifamily residential                                |       | 24,147                               |       | 4.12 |   | 15,616 |   | 2.43 |   | 12,203 |   | 1.66 |   | 12,900 |   | 1.63 |   | 9,454 |   | 1.35 |   |
| Commercial real estate                                 |       | 115,935                              |       | 19.79 |   | 117,548 |   | 18.29 |   | 134,647 |   | 18.30 |   | 131,181 |   | 16.59 |   | 126,151 |   | 18.04 |   |
| Land loans                                             |       | 49,354                               |       | 8.43 |   | 42,843 |   | 6.66 |   | 47,590 |   | 6.48 |   | 47,585 |   | 6.02 |   | 39,036 |   | 5.58 |   |
| Total permanent loans                                  |       | 464,469                              |       | 79.29 |   | 440,327 |   | 68.49 |   | 487,499 |   | 66.27 |   | 501,776 |   | 63.46 |   | 493,928 |   | 70.63 |   |
| Construction loans                                     |       |                                 |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| One- to four-family residences                         |       | 8,450                                |       | 1.44 |   | 20,815 |   | 3.23 |   | 32,146 |   | 4.37 |   | 51,579 |   | 6.52 |   | 29,006 |   | 4.15 |   |
| Speculative one- to four-family residences             |       | 17,096                               |       | 2.92 |   | 40,893 |   | 6.35 |   | 80,311 |   | 10.92 |   | 104,001 |   | 13.16 |   | 82,709 |   | 11.83 |   |
| Multifamily residential                                |       | 15,016                               |       | 2.56 |   | 18,632 |   | 2.90 |   | 14,120 |   | 1.92 |   | 20,919 |   | 2.65 |   | 21,938 |   | 3.14 |   |
| Commercial real estate                                 |       | 18,297                               |       | 3.12 |   | 31,239 |   | 4.86 |   | 21,896 |   | 2.98 |   | 22,331 |   | 2.83 |   | 11,436 |   | 1.64 |   |
| Land development                                       |       | 18,457                               |       | 3.16 |   | 42,145 |   | 6.56 |   | 47,439 |   | 6.45 |   | 40,232 |   | 5.09 |   | 14,022 |   | 2.01 |   |
| Total construction loans                               |       | 77,316                               |       | 13.20 |   | 153,724 |   | 23.90 |   | 195,912 |   | 26.64 |   | 239,062 |   | 30.25 |   | 159,111 |   | 22.77 |   |
| Total mortgage loans                                   |       | 541,785                              |       | 92.49 |   | 594,051 |   | 92.39 |   | 683,411 |   | 92.91 |   | 740,838 |   | 93.71 |   | 653,039 |   | 93.40 |   |
|                                                   |       |                                 |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Commercial loans                                       |       | 23,078                               |       | 3.94 |   | 24,846 |   | 3.87 |   | 26,281 |   | 3.57 |   | 20,835 |   | 2.64 |   | 16,380 |   | 2.34 |   |
|                                                   |       |                                 |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Consumer loans:                                        |       |                                 |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Automobile                                             |       | 8,631                                |       | 1.47 |   | 9,531 |   | 1.48 |   | 12,086 |   | 1.64 |   | 15,748 |   | 1.99 |   | 19,101 |   | 2.73 |   |
| Other consumer                                         |       | 12,291                               |       | 2.10 |   | 14,537 |   | 2.26 |   | 13,815 |   | 1.88 |   | 13,149 |   | 1.66 |   | 10,685 |   | 1.53 |   |
| Total consumer loans                                   |       | 20,922                               |       | 3.57 |   | 24,068 |   | 3.74 |   | 25,901 |   | 3.52 |   | 28,897 |   | 3.65 |   | 29,786 |   | 4.26 |   |
|                                                   |       |                                 |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Total loans receivable                                 |       | 585,785                              |       | 100.00 | % | 642,965 |   | 100.00 | % | 735,593 |   | 100.00 | % | 790,570 |   | 100.00 | % | 699,205 |   | 100.00 | % |
|                                                   |       |                                 |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Less:                                                  |       |                                 |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Undisbursed loan funds                                 |       | (11,750                              | )          |   |   | (36,868 | ) |   |   | (40,069 | ) |   |   | (69,086 | ) |   |   | (62,661 | ) |   |   |
| Unearned discounts and net deferred loan  costs (fees) |       | 529                                  |       |   |   | 321 |   |   |   | 143 |   |   |   | (156 | ) |   |   | (481 | ) |   |   |
| Allowance for losses                                   |       | (6,441                               | )          |   |   | (5,162 | ) |   |   | (2,572 | ) |   |   | (2,114 | ) |   |   | (1,846 | ) |   |   |
| Total loans receivable, net                            |       | $                                    | 568,123    |   |   |   | $ | 601,256 |   |   |   | $ | 693,095 |   |   |   | $ | 719,214 |   |   |   | $ | 634,217 |   |   |   |

 

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**Loan Maturity and Interest Rates. **The following table sets forth certain information at December 31,2008, regarding the dollar amount of loans maturing in the Bank’s loanportfolio based on their contractual terms to maturity.  Demand loans and loans having no statedschedule of repayments and no stated maturity are reported as due in one yearor less. All other loans are included in the period in which the finalcontractual repayment is due.

 
| ** **                      | ** ** | **Within  One Year** | ** ** | **One Year  Through  Five Years** | ** ** | **After Five  Years** | ** ** | **Total** | ** ** |
|---------------------------------|------------|---------------------------|------------|---------------------------------------------|------------|----------------------------|------------|-----------|------------|
| ** **                      | ** ** | **(In Thousands)**   | ** ** |
| Mortgage loans:                 |       |                      |       |                                        |       |                       |       |      |       |
| One- to four-family residential |       | $                         | 12,117     |                                        | $          | 18,784                     |       | $         | 212,420    |   | $ | 243,321 |   |
| Home equity and second mortgage |       | 14,793                    |       | 14,878                                      |       | 2,041                      |       | 31,712    |       |
| Multifamily residential         |       | 5,350                     |       | 17,569                                      |       | 1,228                      |       | 24,147    |       |
| Commercial real estate          |       | 44,724                    |       | 58,807                                      |       | 12,404                     |       | 115,935   |       |
| Land loans                      |       | 27,260                    |       | 20,673                                      |       | 1,421                      |       | 49,354    |       |
| Construction                    |       | 56,226                    |       | 21,090                                      |       | —                     |       | 77,316    |       |
| Commercial loans                |       | 10,957                    |       | 10,436                                      |       | 1,685                      |       | 23,078    |       |
| Consumer loans                  |       | 5,405                     |       | 14,258                                      |       | 1,259                      |       | 20,922    |       |
| Total(1)                        |       | $                         | 176,832    |                                        | $          | 176,495                    |       | $         | 232,458    |   | $ | 585,785 |   |

 

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(1)     Gross of undisbursed loan funds, unearneddiscounts and net deferred loan fees and the allowance for loan losses.

 

The following table sets forth the dollar amount of the Bank’s loans at December 31,2008, due after one year from such date which have fixed interest rates orwhich have floating or adjustable interest rates.

 
| ** **                      | ** ** | **Fixed Rates**    | ** ** | **Floating or  Adjustable Rates** | ** ** | **Total** | ** ** |
|---------------------------------|------------|-------------------------|------------|---------------------------------------------|------------|-----------|------------|
| ** **                      | ** ** | **(In Thousands)** | ** ** |
| Mortgage loans:                 |       |                    |       |                                        |       |      |       |
| One- to four-family residential |       | $                       | 47,413     |                                        | $          | 183,791   |       | $ | 231,204 |   |
| Home equity and second mortgage |       | 10,554                  |       | 6,365                                       |       | 16,919    |       |
| Multifamily residential         |       | 17,433                  |       | 1,364                                       |       | 18,797    |       |
| Commercial real estate          |       | 67,905                  |       | 3,306                                       |       | 71,211    |       |
| Land loans                      |       | 16,109                  |       | 5,985                                       |       | 22,094    |       |
| Construction                    |       | 4,394                   |       | 16,696                                      |       | 21,090    |       |
| Commercial loans                |       | 10,726                  |       | 1,395                                       |       | 12,121    |       |
| Consumer loans                  |       | 13,238                  |       | 2,279                                       |       | 15,517    |       |
| Total                           |       | $                       | 187,772    |                                        | $          | 221,181   |       | $ | 408,953 |   |

 

Scheduledcontractual maturities of loans do not necessarily reflect the actual term ofthe Bank’s loan portfolio. The average life of mortgage loans is substantiallyless than their average contractual terms because of loan prepayments andrefinancing.  The average life ofmortgage loans tends to increase, however, when current mortgage loan ratessubstantially exceed rates on existing mortgage loans and, conversely, decreasewhen rates on existing mortgage loans substantially exceed current mortgageloan rates.

 

**Origination, Purchase and Sale of Loans.**  Thelending activities of the Bank are subject to the written, non-discriminatoryunderwriting standards and policies established by the Bank’s board ofdirectors and management.  Loanoriginations are obtained from a variety of sources, including realtorreferrals, walk-in customers to the Bank’s branch locations, solicitation byloan officers, radio, television and newspaper advertising, and to a lesserextent, through the Bank’s Internet website. The Bank continually emphasizes its community ties and its practice ofquick and efficient underwriting and loan approval processes, made possible inpart through the use of automated underwriting software.  The Bank believes it provides exceptionalpersonalized service to its customers. The Bank requires hazard insurance, title insurance, and, to the extentapplicable, flood insurance on all secured real property.

 

Applicationsare initially received by loan officers or from the Bank’s secure website.   Applications received over the Bank’swebsite are forwarded to loan officers. All loans exceeding an individual officer’s approval authority aresubject to review by members of the appropriate loan committee. The Bank hasthree loan committees (Senior Loan Committee, Executive Loan Committee, andDirector Loan Committee) that review and make a decision based upon type, size,and classification.

 

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During2008, the Bank purchased a participation in one commercial mortgage loantotaling $2.3 million.  During 2007, theBank purchased participations in four commercial construction loans with atotal commitment amount of $18.7 million as well as a $1.6 millionparticipation in a commercial loan. During 2006, the Bank purchased a commercial construction loan with acommitment amount of $100,000.

 

Tominimize interest rate risk, fixed rate loans with terms of fifteen years orgreater are typically sold to specific investors in the secondary mortgagemarket.  The rights to service such loansare typically sold with the loans. This allows the Bank to provide its customerscompetitive long-term fixed rate mortgage products, which are very popularfinancing products for homebuyers in today’s market, while not exposing theBank to undue interest rate risk.  Theseloans are originated subject to Fannie Mae, Freddie Mac and the specificinvestor’s underwriting guidelines and are typically underwritten and validatedby a third party prior to loan closing. The Secondary Market Department of the Bank typically locks and confirmsthe purchase price of the loan on the day of the loan application, whichprotects the Bank from market price movements and ensures that the Bank willreceive a fair and reasonable price on the sale of the respective loan.  Due to the loans being underwritten by athird party, the underwriter substantially assumes the repurchase riskassociated with these loans. The Bank believes it has minimal risk ofrepurchase of these loans based upon the contracts with the specificinvestors.  This risk typically involvespotential early prepayments of the mortgage or an early default of a loan.  In 2008, 2007, and 2006, the Bank’s secondarymarket loan sales amounted to $25.0 million, $58.1 million, and $69.4 million,respectively.  The Bank is not involvedin loan hedging or other speculative mortgage loan origination activities.

 

Inaddition to sales of loans on the secondary market, the Bank periodically sellslarger commercial loans or participations in such loans in order to comply withthe Bank’s loans to one borrower limit or for credit concentrationpurposes.  In such situations the loansare typically sold with servicing retained. During the years ended December 31, 2008, 2007, and 2006, suchloans sold amounted to approximately $4.0 million, $7.2 million, and $3.4million, respectively.  At December 31,2008, 2007, and 2006, the balances of loans sold with servicing retained wereapproximately $28.5 million, $27.8 million, and $22.2 million,respectively.   Loan servicing fee incomefor the years ended December 31, 2008, 2007, and 2006, was approximately$117,000, $110,000, and $121,000, respectively.

 

Thefollowing table shows the Bank’s originations, sales, purchases, and repaymentsof loans during the periods indicated.

 
| ** **                              | ** ** | **Year Ended December 31,** | ** ** |
|-----------------------------------------|------------|--------------------------------------------|------------|
| ** **                              | ** ** | **2008**                                   | ** ** | **2007** | ** ** | **2006** | ** ** |
| ** **                              | ** ** | **(In Thousands)**                    | ** ** |
|                                    |       |                                       |       |   |   |   |   |
| Loans receivable at beginning of period |       | $                                          | 642,965    |   | $ | 735,593 |   | $ | 790,570 |   |
| Loan originations:                      |       |                                       |       |   |   |   |   |
| Mortgage loans:                         |       |                                       |       |   |   |   |   |
| One- to four-family residential         |       | 91,937                                     |       | 86,814 |   | 119,859 |   |
| Home equity and second mortgage loans   |       | 16,498                                     |       | 20,914 |   | 46,258 |   |
| Multifamily residential                 |       | 6,769                                      |       | 6,427 |   | 3,034 |   |
| Commercial real estate                  |       | 23,969                                     |       | 18,356 |   | 46,370 |   |
| Land loans                              |       | 23,264                                     |       | 5,880 |   | 8,583 |   |
| Construction                            |       | 15,060                                     |       | 39,016 |   | 93,557 |   |
| Commercial loans                        |       | 14,457                                     |       | 12,395 |   | 21,861 |   |
| Consumer:                               |       |                                       |       |   |   |   |   |
| Automobile                              |       | 5,589                                      |       | 5,916 |   | 7,678 |   |
| Other                                   |       | 9,217                                      |       | 13,347 |   | 13,008 |   |
| Total loan originations(2)              |       | 206,760                                    |       | 209,065 |   | 360,208 |   |
| Loan purchases                          |       | 2,333                                      |       | 20,365 |   | 100 |   |
| Repayments                              |       | (208,302                                   | )          | (242,230 | ) | (336,927 | ) |
| Loan sales                              |       | (29,079                                    | )          | (65,287 | ) | (72,857 | ) |
| Transfers to real estate owned          |       | (28,532                                    | )          | (13,037 | ) | (6,284 | ) |
| Other                                   |       | (360                                       | )          | (1,504 | ) | 783 |   |
| Net loan activity                       |       | (57,180                                    | )          | (92,628 | ) | (54,977 | ) |
| Loans receivable at end of period(1)    |       | $                                          | 585,785    |   | $ | 642,965 |   | $ | 735,593 |   |

 

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(1)        Gross of undisbursed loan funds, unearned discounts and net loan feesand the allowance for loan losses.

(2)        Includes internal refinancing loans of $52.0 million, $26.1 million and$43.4 million for each of the years ended December 31, 2008, 2007, and2006, respectively.

 

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**Loans to One Borrower. **A savingsinstitution generally may not make loans to one borrower and related entitiesin an amount which exceeds 15% of its unimpaired capital and surplus, althoughloans in an amount equal to an additional 10% of unimpaired capital and surplusmay be made to a borrower if the loans are fully secured by readily marketablesecurities.  At December 31, 2008,the Bank’s limit on loans to one borrower was approximately $11.1 million.  At December 31, 2008, the Bank’s largestloan or group of loans to one borrower, including persons or entities relatedto the borrower, amounted to $11.0 million, including undisbursed loanfunds.  The Bank’s ten largest loans orgroups of loans to one borrower, including persons or entities related to theborrower, including unfunded commitments, totaled $91.8 million at December 31,2008.  Of the $91.8 million, one $692,000loan is on nonaccrual status at December 31, 2008.  See “Asset Quality.”   This borrower also has one loan of $2.8million that is 90 days past due and still accruing.  See “Potential Problem Loans.”  This borrower has one other loan and it iscurrent at December 31, 2008.

 

**One- to Four-Family Residential Real Estate Loans. **At December 31, 2008, $243.3 million or 41.5% of the Bank’s totalloan portfolio consisted of one- to four-family residential real estateloans.   Of the $243.3 million of suchloans at December 31, 2008, $185.5 million or 76.3% had adjustable ratesof interest (including $31.8 million of seven-year adjustable rate loans) and$57.8 million or 23.7% had fixed rates of interest.

 

TheBank currently originates both fixed rate and adjustable rate one- tofour-family residential mortgage loans. The Bank’s fixed rate loans to be held in portfolio are typicallyoriginated with maximum terms of fifteen years and are typically fullyamortizing with monthly payments sufficient to repay the total amount of theloan with interest by the end of the loan term. The Bank does offer fixed rate loans with terms exceeding fifteen yearsand such loans are typically sold in the secondary market.  The Bank’s one- to four-family loans aretypically originated under terms, conditions and documentation that permit themto be sold to U.S. Government-sponsored agencies such as Fannie Mae or FreddieMac. However, as stated above, such loans with terms of less than fifteen yearsare generally originated for portfolio while substantially all of such loanswith terms of fifteen years or longer are sold in the secondary market.  The Bank’s fixed rate loans typically include“due on sale” clauses.

 

TheBank’s adjustable rate mortgage loans that are held in the portfolio typicallyprovide for an interest rate which adjusts every one, three, five or sevenyears in accordance with a designated index plus a margin.  Such loans are typically based on a 15-, 20-,25- or 30-year amortization schedule. The Bank generally does not offer below market rates, and the amount ofany increase or decrease in the interest rate per one- or three-year period isgenerally limited to 2%, with a limit of 6% over the life of the loan.  The Bank’s five-year adjustable rate loansprovide that any increase or decrease in the interest rate per period islimited to 3%, with a limit of 6% over the life of the loan.  The Bank’s seven-year adjustable rate loansprovide that any increase or decrease in the interest rate per period islimited to 5%, with a limit of 5% over the life of the loan.  The Bank’s adjustable rate loans areassumable (generally without release of the initial borrower), do not containprepayment penalties and do not provide for negative amortization.  The Bank’s adjustable rate mortgage loanstypically include “due on sale” clauses. The Bank generally underwrites itsone- and three-year adjustable rate loans on the basis of the borrowers’ability to pay at the rate after the first interest rate adjustment.  Adjustable rate loans decrease the risksassociated with changes in interest rates but involve other risks, primarilybecause as interest rates rise, the payment by the borrower rises to the extentpermitted by the terms of the loan, thereby increasing the potential fordefault. At the same time, the marketability of the underlying property may beadversely affected by higher interest rates.

 

TheBank’s residential mortgage loans generally do not exceed 80% of the appraisedvalue of the secured property. However, pursuant to the underwriting guidelinesadopted by the board of directors, the Bank may lend up to 100% of theappraised value of the property securing a one- to four-family residential loanwith private mortgage insurance to protect the portion of the loan that exceeds80% of the appraised value.  The Bankmay, on occasion, extend a loan up to 90% of the appraised value of the securedproperty without private mortgage insurance coverage.  However, these exceptions are minimal and areonly approved on loans with exceptional credit scores, sizeable asset reserves,or other compensating factors.  At December 31,2008, the Bank had $8.5 million of nonaccrual one- to four-family residentialloans.  See “Asset Quality.”

 

**Home Equity and Second Mortgage Loans. ** At December 31, 2008, $31.7million or 5.4% of the Bank’s total loan portfolio consisted of home equity andsecond mortgage loans.  At December 31,2008, the unused portion of home equity lines of credit was $10.5 million.  At December 31, 2008, the Bank hadnonaccrual home equity and second mortgage loans totaling $927,000.  See “Asset Quality.”

 

TheBank’s home equity and second mortgage loans are fixed rate loans with fullyamortized terms of up to fifteen years, variable rate interest-only loans withterms up to three years, or home equity lines of credit.  The variable rate loans are typically tied toWall Street Journal Prime, plus a margin commensurate with the risk asdetermined by the borrower’s credit score. Longer-term amortizing loans typically have a balloon feature in five,seven, or ten years.  The home equitylines of credit are typically either fixed rate for a term of no longer thanone year or variable rate with terms typically up to three years.  The Bank generally limits the totalloan-to-value on these mortgages to 90% of the value of the secured property.

 

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**Multifamily Residential Real Estate Loans. **The Bank offers mortgage loans for the acquisition and refinancing ofmultifamily residential properties.  At December 31,2008, $24.1 million or 4.1% of the Bank’s total loan portfolio consisted ofloans collateralized by existing multifamily residential real estateproperties.

 

TheBank currently originates both fixed rate and adjustable rate multifamilyloans.  Fixed rate loans are generallyoriginated with amortization periods not to exceed 30 years, and typically haveballoon periods of three, five or seven years. Adjustable rate loans are typically amortized over terms up to 30 years,with interest rate adjustments every three to seven years.  Loan-to-value ratios on the Bank’smultifamily real estate loans are currently limited to 80%.  It is also the Bank’s general policy toobtain corporate or personal guarantees, as applicable, on its multifamilyresidential real estate loans from the principals of the borrower.

 

Multifamilyreal estate lending entails significant additional risks as compared with one-to four-family residential property lending. Such loans typically involve large loan balances to single borrowers orgroups of related borrowers.  The paymentexperience on such loans is typically dependent on the successful operation ofthe real estate project.  The success ofsuch projects is sensitive to changes in supply and demand conditions in themarket for multifamily real estate as well as regional and economic conditionsgenerally.  At December 31, 2008,the Bank had $441,000 of nonaccrual multifamily real estate loans.  See “Asset Quality.”

 

**Commercial Real Estate Loans. **The Bankoriginates mortgage loans for the acquisition and refinancing of commercialreal estate properties.  At December 31,2008, $115.9 million or 19.8% of the Bank’s total loan portfolio consisted ofloans collateralized by existing commercial real estate properties.

 

Manyof the Bank’s commercial real estate loans are collateralized by propertiessuch as office buildings, convenience stores, service stations, mini-storagefacilities, motels, churches, small shopping malls, and strip centers.  The Bank underwrites commercial real estateloans specifically in relation to the type of property beingcollateralized.  Cash flows and occupancyrates are primary considerations when underwriting loans collateralized by officebuildings, mini-storage facilities and motels. Loans with borrowers that are corporations, limited liability companies,trusts, or other such legal entities are also typically personally guaranteedby the principals of the respective entity. The financial strength of the individuals who are personallyguaranteeing the loan is also a primary underwriting factor.

 

TheBank’s policy requires real estate appraisals of all properties securingcommercial real estate loans by licensed real estate appraisers pursuant tostate licensing requirements.  The Bankconsiders the quality and location of the real estate, the creditworthiness ofthe borrower, the cash flow of the project, and the quality of managementinvolved with the property.  The Bank’scommercial real estate loans are generally originated with amortization periodsnot to exceed 25 years and typically have three-, five-, or seven-year balloonterms.  As part of the criteria forunderwriting multifamily and commercial real estate loans, the Bank generallyestimates a cash flow analysis that includes a vacancy rate projection,expenses for taxes, insurance, maintenance and repair reserves as well as debtcoverage ratios.  This information isalso estimated and included in commercial real estate appraisals.

 

Commercialreal estate lending entails additional risks as compared to the Bank’s one- tofour-family residential property loans. Commercial real estate loans generallyinvolve larger loan balances to single borrowers or groups of relatedborrowers.  The payment experience onsuch loans is typically dependent on the successful operation of the realestate project. The success of such projects is sensitive to changes in supplyand demand conditions in the market for commercial real estate, as well asregional and economic conditions generally. Within the last several years, reports have ranked theNorthwest Arkansas as one of the top performing economic areas in thecountry.   During these periods of economic expansion the Bankfocused on commercial real estate activities within the market in order to takeadvantage of growth. More recently, this economic expansion resulted in anoversupply of residential lots and residential housing.    Theregion is currently in a correction mode but is still an economically viablearea for the future, in the Bank’s opinion.  This region is the home ofthe world’s largest retailer, Wal-Mart; as well as the nation’s largest meatcompany, Tyson Foods; the trucking firm J. B. Hunt; and the University ofArkansas.   Unemployment rates lower than state and national rates,population growth, and job growth add additional support to the Bank’s lendingin the area.  At December 31, 2008,the Bank had $6.7 million of nonaccrual commercial real estate loans. See “AssetQuality.”

 

**Land Loans. **Land loans include loans for the acquisitionor refinancing of land for consumer or commercial purposes.  This segment of the portfolio totaled $49.4million, or 8.4% of the Bank’s total loan portfolio, as of December 31,2008, and included of $10.6 million of developed residential lots, $15.6million of land acquired for future development and $5.4 million of developedcommercial property.  Generally, theseloans are collateralized by properties in the Bank’s market areas.  At December 31, 2008, the Bank had nonaccrualland loans totaling $2.5 million.  See “AssetQuality.”

 

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**Land Development Loans. **The Bank hasalso offered loans for the acquisition and development of land into residentialsubdivisions. At December 31, 2008, $18.5 million or 3.2% of the Bank’stotal loan portfolio consisted of land development loans.  However, no new land development loans havebeen originated since the fourth quarter of 2006 due to local real estatemarket conditions.  This segment of themarket in Northwest Arkansas has been heavily impacted by the housing marketslowdown.  As a result of slowing lotsales, borrowers have been unable to rely on lot sales to repay their loans andhave had to rely on secondary sources of repayment.  For the most part, borrowers have been ableto pay the interest due at maturity and the Bank has extended the loan maturityupon payment of interest.  As long asthese borrowers are willing to work with the Bank on a plan to repay theirloans, the Bank intends to attempt to accommodate borrowers’ workoutplans.  So far, except for the nonaccrualland development loans described in “Asset Quality”, the borrowers in our landdevelopment portfolio have demonstrated a willingness to work with theBank.  However, given the current marketconditions, it is possible at any time for any one of these borrowers todefault on their loans.  At December 31,2008, the Bank had nonaccrual land development loans totaling $2.6 millionrepresenting one subdivision in the Benton county area and land acquired fordevelopment in the Washington county area. See “Asset Quality.”

 

Someof the larger loans in the land development portfolio are described in moredetail below.  None of these loans wasadversely classified at December 31, 2008. The table represents accruing land development loans over $1 million asof December 31, 2008 (dollars in thousands).  These loans represent approximately 73% ofthe accruing land development loans based on commitment amount.

 
| **Origination  Date** | ** ** | **Maturity  Date** | ** ** | **Commitment  Amount** | ** ** | **Funded  Amount** | ** ** | **Accrued  Interest** | ** ** | **Number of  Lots** | ** ** | **Status** | ** ** | **County** | ** ** |
|-----------------------|------------|--------------------|------------|------------------------|------------|--------------------|------------|-----------------------|------------|--------------------------|------------|------------|------------|------------|------------|
| 01/03/2006            |       | 01/03/2010         |       | $                      | 5,845      |               | $          | 5,845                 |       | $                        | 181        |       | 208        |       | (1)        |   | Washington |   |
| 12/28/2006            |       | 06/08/2009         |       | 3,413                  |       | 3,413              |       | 3                     |       | 124                      |       | (2)        |       | Washington |       |
| 08/05/2005            |       | 08/05/2008         |       | 2,372                  |       | 2,372              |       | 316                   |       | 36                       |       | (3)        |       | Washington |       |
| 08/05/2005            |       | 08/05/2013         |       | 2,102                  |       | 2,102              |       | 16                    |       | 48                       |       | Complete   |       | Benton     |       |
|                       |            |                    |            |                        |            |                    |            |                       |            |                          |            |            |            |            |            |  |  |  |

 

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(1)        This loan represents two phases of a 208-lot subdivision containing 116lots nearing completion in phase one and 92 lots in phase two.  The first section of phase one is nearingfinal plat approval.  The lots in thissubdivision were pre-sold to an investor who is now attempting to withdraw fromthe contract.  The contract issuesbetween the investor and our borrower will be going into arbitration.

(2)        This subdivision is not complete. Subdivision is expected to be paid off from the proceeds of a bondissuance in the second quarter of 2009.

(3)        This loan was paid off after December 31, 2008.

 

**Construction Loans. **The Bankoriginates one- to four-family residential, multifamily, and commercial realestate construction loans.  However, theBank’s primary emphasis has been residential construction lending.  The Bank’s construction lending activitiesare typically limited to the Bank’s primary market areas.  At December 31, 2008, constructionloans, including land development loans, amounted to $77.3 million or 13.2% ofthe Bank’s total loan portfolio.  Asdiscussed previously, our market areas of Benton and Washington counties haveexperienced tremendous growth over the past several years and provided the Bankwith increased lending opportunities, which can be demonstrated by the significantgrowth in construction lending over the past five to seven years.  However, beginning in late 2005, the Bankbegan to note an oversupply of homes and lots in the Northwest Arkansas marketand limited its construction loan origination activity accordingly.  Construction loan originations dropped from$195.8 million in 2005 to $93.6 million in 2006 to $39.0 million in 2007 and$15.1 million in 2008.

 

TheBank’s construction loans generally have fixed interest rates or variable ratesthat float with Wall Street Journal Prime and are typically issued for terms ofsix to eighteen months. However, the Bank is permitted to originateconstruction loans with terms up to two years under its loan policy.  This practice is generally limited to largerprojects that cannot be completed in the typical six- to eighteen-monthperiod.  Construction loans are typicallymade with a maximum loan-to-value ratio of 80% on an as-completed basis.

 

TheBank originates construction loans to individual homeowners and local buildersand developers for the purpose of constructing one- to four-familyresidences.  The Bank typically requiresthat permanent financing with the Bank or some other lender be in place priorto closing any non-speculative construction loan.  Interest on construction/permanent loans isdue upon completion of the construction phase of the loan.  At such time, the loan will convert to apermanent loan at the interest rate established at the initial closing of theconstruction/permanent loan.

 

TheBank makes construction loans to local builders for the purpose of constructionof speculative (or unsold) residential properties, and for the construction ofpre-sold one- to four-family homes. These loans are subject to credit review, analysis of personal and, ifapplicable, corporate financial statements, and an appraisal of the property tobe constructed. The Bank also reviews and inspects the project prior to thedisbursement of funds (draws) during the construction term.  Loan proceeds are disbursed after a satisfactoryinspection of the project has been made based upon percentage of 

 

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completion.  Interest on these construction loans is dueupon maturity.  The Bank may extend theterm of a construction loan upon payment of interest accrued if the propertyhas not been sold by the maturity date. During 2006 the Bank began to experience an increase in the incidence ofbuilders who were unable to pay their interest at maturity due to a softeningof the housing market in Northwest Arkansas. Market data indicates an overall decrease in the number of home sales inBenton and Washington counties in 2008 compared to 2007 and 2006.

 

Constructionlending is generally considered to involve a higher level of risk as comparedto one- to four-family residential loans. This is due, in part, to the concentration of principal in a limitednumber of loans and borrowers, and the effects of general economic conditionson developers and builders.  In addition,construction loans to a builder for construction of homes that are not pre-soldpossess a greater potential risk to the Bank than construction loans toindividuals on their personal residences or on houses that are pre-sold priorto the inception of the loan.  The Bankanalyzes each borrower involved in speculative building and limits theprincipal amount and number of unsold speculative homes at any one time withsuch borrower.  At December 31,2008, the Bank’s portfolio of speculative single-family loans consisted of 83loans with an average balance of approximately $206,000.  Fifty-eight percent of the Bank’s $17.1million in speculative single-family loans was concentrated with five borrowerswho had 45 loans totaling $9.9 million. None of the top five borrowers’ loans was adversely classified or onnonaccrual status at December 31, 2008. At December 31, 2008, the Bank had nonaccrual speculative one- tofour-family construction loans totaling $1.5 million.  See “Asset Quality.”

 

**Commercial Loans. **The Bank alsooffers commercial loans, which primarily consist of equipment and inventoryloans that are typically cross-collateralized by commercial real estate.  At December 31, 2008, such loansamounted to $23.1 million or 3.9% of the total loan portfolio.  At December 31, 2008, the Bank hadnonaccrual commercial loans totaling $2.1 million.  See “Asset Quality.”

 

TheBank’s commercial loans are typically originated with fixed interest rates andcall provisions between one and five years. These loans are typically based on a maximum fifteen-year amortizationschedule.  The Bank also originatesinterest-only commercial loans and variable rate commercial loans.  The Bank’s commercial loans do not providefor negative amortization.

 

**Consumer Loans. **The Bank offers consumer loans in order toprovide a full range of financial services to its customers while increasingthe yield on its overall loan portfolio and decreasing its interest rate riskdue to the relatively shorter-term nature of consumer loans. The consumer loansoffered by the Bank primarily include automobile loans, deposit account securedloans, and unsecured loans.  Consumerloans amounted to $20.9 million or 3.6% of the total loan portfolio at December 31,2008, of which $8.6 million and $12.3 million consisted of automobile loans andother consumer loans, respectively.  TheBank intends to continue its emphasis on consumer loans in furtherance of itsrole as a community-oriented financial institution.

 

TheBank’s automobile loans are typically originated for the purchase of new andused cars and trucks.  Such loans aregenerally originated with a maximum term of five years.  The Bank does offer extended terms onautomobile loans to some customers based upon their creditworthiness.

 

Otherconsumer loans consist primarily of deposit account loans and unsecuredloans.  Loans secured by deposit accountsare originated for up to 95% of the deposit account balance, with a hold placedon the account restricting the withdrawal of the deposit account balance.

 

Consumerloans entail greater risk than do residential mortgage loans, particularly inthe case of consumer loans that are unsecured or secured by rapidlydepreciating assets such as automobiles. In such cases, any repossessed collateral for a defaulted consumer loanmay not provide an adequate source of repayment of the outstanding loan balanceas a result of the greater likelihood of damage, loss or depreciation.  In addition, consumer loan collections aredependent on the borrower’s continuing financial stability, and thus are morelikely to be adversely affected by job loss, divorce, illness or personalbankruptcy.  Furthermore, the applicationof various federal and state laws, including federal and state bankruptcy andinsolvency laws, may limit the amount which can be recovered on suchloans.  At December 31, 2008, theBank had $170,000 of nonaccrual consumer loans. See “Asset Quality.”

 

## **Asset Quality**

##  

Generally,when a borrower fails to make a loan payment before the expiration of the loan’sassigned grace period, a late charge is assessed and a late charge notice ismailed. Collection personnel review all delinquent accounts and attempt to curethe delinquency by contacting the borrower. The Bank’s policies and procedures provide for frequent contact with theborrower until the delinquency is cured or until an acceptable repayment planhas been agreed upon.  Contact, by phoneand mail, with delinquent borrowers begins immediately after the expiration ofthe loan’s assigned grace days.  The Bank’scollectors also have weekly phone conferences with loan officers to review therespective officer’s delinquent lists. Generally, when a consumer loan is 60days past due and the borrower has not indicated a willingness to work with theBank to bring the account current within a reasonable period of time, thecollector will mail a letter giving the borrower 10 days to bring the accountcurrent or make acceptable arrangements. If they fail to cure the default, the collateral will be 

 

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repossessed.  We attempt to work with troubled borrowers toreturn their loans to performing status where possible.  The decision on when to proceed withforeclosure action is made on a case-by- case basis.  The Bank recognizes that this will cause thedelinquency rate on the mortgage portfolio to be elevated for an extendedperiod of time.

 

Loansare placed on nonaccrual status when, in the judgment of management, theprobability of collection of interest is deemed to be insufficient to warrantfurther accrual.  When a loan is placedon nonaccrual status, previously accrued but unpaid interest is deducted frominterest income.  The Bank generally doesnot accrue interest on loans past due 90 days or more.  Loans may be reinstated to accrual statuswhen payments are made to bring the loan less than 90 days past due and, in theopinion of management, collection of the remaining balance can be reasonablyexpected.  The Bank may continue toaccrue interest on certain loans that are 90 days past due or more if suchloans are in the process of collection and collection is reasonably assured.

 

Realestate properties acquired through foreclosure are initially recorded at fairvalue less estimated selling costs.  Fair value is typically determined based on the lower of appraised valueor the anticipated listing price of the property. Valuations of real estateowned are performed at least quarterly. Real estate is carried at the lower of carrying amount or fair valueless cost to sell.

 

**Delinquent Loans. **The followingtable sets forth information concerning delinquent loans at December 31,2008 and 2007, in dollar amounts and as a percentage of the Bank’s total loanportfolio.  The amounts presentedrepresent the total outstanding principal balances of the related loans, ratherthan the actual payment amounts that are past due.  The decrease in delinquent loans between 2007and 2008 was primarily due to decreases in the 30-59 day and 60-89 daycategories, partially offset by an increase in loans over 90 days pastdue.  While the trend in 30-59 day and60-89 day past due categories is encouraging and would seem to indicate adownward trend in loans eventually expected to migrate to nonperforming status,there can be no assurance that this will actually be the case.  The state of the broader economy, includingincreasing unemployment and bankruptcy filings, may cause an increase innonperforming loans not indicated by this delinquency trend data.

 
| ** **                      | ** ** | **Loans Delinquent at December 31, 2008** | ** ** |
|---------------------------------|------------|--------------------------------------------------------------------|------------|
| ** **                      | ** ** | **30-59 Days**                                                | ** ** | **60-89 Days** | ** ** | **Over 90 Days** | ** ** | **Total** | ** ** |
| One- to four-family residential |       | $                                                                  | 3,382      |   | $ | 907 |   | $ | 9,744 |   | $ | 14,033 |   |
| Home equity and second mortgage |       | 387                                                                |       | 326 |   | 812 |   | 1,525 |   |
| Multifamily residential         |       | 230                                                                |       | — |   | 211 |   | 441 |   |
| Commercial real estate          |       | 172                                                                |       | 293 |   | 7,879 |   | 8,344 |   |
| Land                            |       | 134                                                                |       | 486 |   | 5,060 |   | 5,680 |   |
| Construction                    |       | —                                                             |       | 717 |   | 6,989 |   | 7,706 |   |
| Commercial                      |       | 145                                                                |       | 42 |   | 1,981 |   | 2,168 |   |
| Consumer                        |       | 122                                                                |       | 71 |   | 138 |   | 331 |   |
| Total                           |       | $                                                                  | 4,572      |   | $ | 2,842 |   | $ | 32,814 |   | $ | 40,228 |   |
| Percentage of total loans       |       | 0.78                                                               | %          | 0.49 | % | 5.60 | % | 6.87 | % |

 
| ** **                      | ** ** | **Loans Delinquent at December 31, 2007** | ** ** |
|---------------------------------|------------|--------------------------------------------------------------------|------------|
| ** **                      | ** ** | **30-59 Days**                                                | ** ** | **60-89 Days** | ** ** | **Over 90 Days** | ** ** | **Total** | ** ** |
| One- to four-family residential |       | $                                                                  | 6,114      |   | $ | 1,351 |   | $ | 5,138 |   | $ | 12,603 |   |
| Home equity and second mortgage |       | 299                                                                |       | 331 |   | 1,376 |   | 2,006 |   |
| Commercial real estate          |       | 4,887                                                              |       | 1,938 |   | 6,993 |   | 13,818 |   |
| Land                            |       | 189                                                                |       | 40 |   | 1,027 |   | 1,256 |   |
| Construction                    |       | 753                                                                |       | 1,683 |   | 13,389 |   | 15,825 |   |
| Commercial                      |       | 229                                                                |       | 366 |   | 799 |   | 1,394 |   |
| Consumer                        |       | 321                                                                |       | 145 |   | 169 |   | 635 |   |
| Total                           |       | $                                                                  | 12,792     |   | $ | 5,854 |   | $ | 28,891 |   | $ | 47,537 |   |
| Percentage of total loans       |       | 1.99                                                               | %          | 0.91 | % | 4.49 | % | 7.39 | % |

 

Interestincome that would have been recorded under the original terms of the Bank’snonaccruing loans for the year ended December 31, 2008, amounted to $1.8million, and the interest recognized during this period amounted to $415,000.

 

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Thefollowing table sets forth the amounts and categories of the Bank’snonperforming assets at the dates indicated.

 
| ** **                                                                                                                   | ** ** | **December 31,**                | ** ** |
|------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------|------------|
| ** **                                                                                                                   | ** ** | **2008**                             | ** ** | **2007** | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                                                                                                   | ** ** | **(Dollars in Thousands)** | ** ** |
| Nonaccrual loans:                                                                                                            |       |                                 |       |   |   |   |   |   |   |   |   |
| One- to four-family residential                                                                                              |       | $                                    | 8,471      |   | $ | 6,800 |   | $ | 3,689 |   | $ | 2,630 |   | $ | 2,619 |   |
| Home equity and second mortgage                                                                                              |       | 927                                  |       | 1,194 |   | 994 |   | 269 |   | 406 |   |
| Multifamily residential                                                                                                      |       | 441                                  |       | — |   | — |   | — |   | — |   |
| Commercial real estate                                                                                                       |       | 6,702                                |       | 6,160 |   | 738 |   | 707 |   | — |   |
| Land                                                                                                                         |       | 2,537                                |       | 1,311 |   | 1,372 |   | — |   | — |   |
| Speculative one- to four-family  construction                                                                                |       | 1,466                                |       | 4,934 |   | 5,417 |   | 1,177 |   | 634 |   |
| Land development                                                                                                             |       | 2,577                                |       | 11,428 |   | 5,324 |   | — |   | — |   |
| Commercial                                                                                                                   |       | 2,128                                |       | 1,234 |   | 1,268 |   | 236 |   | 186 |   |
| Consumer                                                                                                                     |       | 170                                  |       | 268 |   | 213 |   | 287 |   | 317 |   |
| Total nonaccrual loans                                                                                                       |       | 25,419                               |       | 33,329 |   | 19,015 |   | 5,306 |   | 4,162 |   |
|                                                                                                                         |       |                                 |       |   |   |   |   |   |   |   |   |
| Accruing loans 90 days or more past due                                                                                      |       | 8,961                                |       | 2,412 |   | 668 |   | 1,600 |   | — |   |
| Restructured loans                                                                                                           |       | —                               |       | — |   | — |   | 6,264 |   | 3,790 |   |
| Real estate owned                                                                                                            |       | 22,385                               |       | 8,120 |   | 3,858 |   | 892 |   | 563 |   |
|                                                                                                                         |       |                                 |       |   |   |   |   |   |   |   |   |
| Total nonperforming assets                                                                                                   |       | $                                    | 56,765     |   | $ | 43,861 |   | $ | 23,541 |   | $ | 14,062 |   | $ | 8,515 |   |
|                                                                                                                         |       |                                 |       |   |   |   |   |   |   |   |   |
| Total nonaccrual, accruing loans 90 days or  more past due and restructured loans as a percentage of total loans  receivable |       | 5.87                                 | %          | 5.56 | % | 2.68 | % | 1.67 | % | 1.14 | % |
|                                                                                                                         |       |                                 |       |   |   |   |   |   |   |   |   |
| Total nonperforming assets as a percentage of  total assets                                                                  |       | 7.14                                 | %          | 5.54 | % | 2.76 | % | 1.65 | % | 1.13 | % |

 

Thedecrease in nonaccrual loans is primarily related to the transfer of nonaccrualland development and speculative single family construction loans to realestate owned, which was offset somewhat by an increase in nonaccrual one- tofour-family residential, commercial real estate, land, and commercialloans.  The Northwest Arkansas marketcontinues to experience an oversupply of lots and speculative homes. Certain ofthe Bank’s homebuilders are experiencing extended marketing times for the saleof their homes which has resulted in inadequate cash flow to service theinterest carry on their loans.  Thespecific loan loss allowance related to loans to builders and developers wasapproximately $1.6 million at December 31, 2008.

 

Weexpect a significant amount of the nonaccrual real estate loans to eventuallymigrate to real estate owned as $17.4 million of the nonaccrual real estateloans reported above are in some stage of the foreclosure process as of December 31,2008.  Therefore, we expect real estateowned and associated expenses to continue to increase in future periods as suchloans migrate from loans to real estate owned.

 

Thelevel of nonaccrual speculative one- to four-family residential loans,commercial real estate loans, land loans, land development loans and commercialloans is attributable primarily to eight loan relationships totaling $11.2million, or 44.0% of nonaccrual loans. These relationships are described in more detail in the paragraphs thatfollow.

 

Thefirst relationship totaled $2.2 million with a specific loan loss allowance of$981,000 at December 31, 2008, and is comprised of a completed 42 lotsubdivision located in Cave Springs, Arkansas. The borrowers have been attempting to find a buyer for the subdivisionsince it matured in July 2007.  Weare exercising forbearance with this borrower due to their cooperation andmaintenance of the subdivision such as mowing and other upkeep while they tryto find a buyer.  The Bank obtained anupdated valuation on the subdivision using discounted cash flow analysis.  Due to the market conditions and theoversupply of lots in Northwest Arkansas, the valuation indicated lower lotprices and an extended marketing time over that in the original appraisalobtained when the loan was originated. Based on the nature of this loan and the possibility of continuedadverse changes in the market conditions, we may incur losses in the future inexcess of the specific allowance recorded as of December 31, 2008.

 

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Thesecond relationship totaled $2.0 million at December 31, 2008, andconsists of a $1.3 million commercial loan secured by commercial real estate,franchise rights, inventory and equipment, a $650,000 loan on the borrower’sprimary residence, and a $20,000 unsecured loan.  The loans in this relationship are currentlyin foreclosure and a specific loan loss allowance of $579,000 has been recordedas of December 31, 2008.

 

Thethird relationship totaled $2.1 million and represents a single commercial realestate loan secured by a convenience store, car wash, and retail space locatedin Bentonville, Arkansas.  This loan isin foreclosure.  As of December 31,2008, based on the then current estimated fair value of the collateral, theBank estimates it will incur no loss.

 

Thefourth relationship totaled $1.6 million at December 31, 2008, andconsists of a $668,000 commercial real estate loan secured by an officebuilding located in Pea Ridge, Arkansas, five loans totaling $665,000 securedby single family rental properties located in Pea Ridge, Arkansas and Washburn,Missouri, and a $230,000 loan secured by an apartment building located in PeaRidge, Arkansas.  The borrower has filedfor bankruptcy protection.  At December 31,2008, based on the estimated fair value of the collateral, the Bank estimatesit will incur no loss.

 

Thefifth relationship totaled $1.1 million at December 31, 2008 with aspecific loan loss allowance of $59,000. This relationship is comprised of a $773,000 commercial real estate loansecured by a car wash and an eight-plex located in Farmington, Arkansas, twospeculative single family homes totaling $236,000 located in Bella Vista,Arkansas, and land totaling $120,000 located in Fayetteville and Bella Vista,Arkansas.  The loans are all inforeclosure.

 

Thesixth relationship totaled $800,000 at December 31, 2008, and is comprisedof a single commercial real estate loan secured by a car wash.  At December 31, 2008, based on the thencurrent appraised value of the property, the Bank estimates a specific loanloss allowance of $8,000.  This borroweris attempting to cure the delinquency so the Bank is exercising a degree offorbearance.

 

Theseventh relationship consists of a commercial real estate loan totaling$661,000 at December 31, 2008 secured by a restaurant located inFayetteville, Arkansas.  The restaurantis under contract with certain contingent items pending.  Based on the current estimated fair value ofthe collateral at December 31, 2008, the Bank estimates that it will incurno loss.

 

Theeighth relationship totaled $692,000 at December 31, 2008 and consists ofa real estate loan secured by land in Fayetteville, Arkansas.  The borrower is attempting to sell the collateral.  Based on the current estimated fair value ofthe collateral, the Bank estimates it will incur no loss as of December 31,2008.

 

Accruingloans 90 days or more past due at December 31, 2008, consisted of fiverelationships whose past due interest is expected to be paid or was paid after December 31,2008.  See “Potential Problem Loans.”

 

Thefollowing table sets forth the amounts and categories of the Bank’s real estateowned at the dates indicated.

 
| ** **                                       | ** ** | **December 31,  2008**          | ** ** | **December 31,  2007** | ** ** | **Increase** | ** ** | **Percentage  Change** | ** ** |
|--------------------------------------------------|------------|--------------------------------------|------------|-----------------------------|------------|--------------|------------|------------------------|------------|
|                                             |       | **(Dollars in Thousands)** |       |                        |       |         |       |
| Real estate owned                                |       |                                 |       |                        |       |         |       |                   |       |
| One- to four-family residential                  |       | $                                    | 3,436      |                        | $          | 1,566        |       | $                      | 1,870      |   | 119.4 | % |
| Speculative one- to four-family  construction(1) |       | 4,310                                |       | 5,956                       |       | (1,646       | )          | (27.6                  | )          |
| Land(2)                                          |       | 13,314                               |       | 598                         |       | 12,716       |       | 2,126.4                |       |
| Commercial real estate                           |       | 1,325                                |       | —                      |       | 1,325        |       | —                 |       |
| Total real estate owned                          |       | $                                    | 22,385     |                        | $          | 8,120        |       | $                      | 14,265     |   | 175.7 | % |

 

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(1)                      At December 31, 2008, $4.0 million ofthese properties were 100% complete.  Theremainder range from 79% to 84% complete.

(2)                      At December 31, 2008, $10.0 million ofthe land balance represented 273 finished subdivision lots.  The remainder consisted of raw land.

 

Theincrease in real estate owned from December 31, 2007 to December 31,2008 is primarily related to four subdivisions. The first totaled $3.7 million,and represents two phases of the same subdivision located in Lowell, Arkansas,one of which is complete and the other is approximately 10% complete.   Phase one contains 66 lots.  The second subdivision totaled $4.0 millionfor a 110 lot subdivision in Springdale, Arkansas.  The third totaled $3.9 million, andrepresents two phases of a subdivision located in Elm Springs, Arkansas.  The first phase consists of 48 completed lotsand the second phase consists of undeveloped land.  The fourth subdivision totaled $926,000 for35 completed lots located in Pea Ridge, Arkansas.  During 2008, seventeen single familyresidential properties were transferred to REO and fifteen were sold.  

 

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Duringthe same period, eighteen speculative single family properties were transferredto REO and twenty-eight were sold.  At December 31,2008, the Bank owned ten foreclosed one- to four-family residential propertiesand eighteen speculative single family residential properties compared to eightand twenty-eight properties, respectively, at December 31, 2007.

 

TheBank is diligently working to dispose of its REO and has dedicated anexperienced special assets officer who is working full-time to liquidate theBank’s properties in the Northwest Arkansas market. Each property is evaluatedon a case-by-case basis to determine the best course of action with respect toliquidation.  Properties are marketed directly by the Bank or listed withlocal real estate agents utilizing appraisals, market information fromrealtors, market research reports, and our own market evaluations to make pricingand selling decisions.   The Bank’s Chief Lending Officer, loanofficers, credit manager, special assets officer, and team members in thecollections department all work together in this endeavor.   The Bank’sgoal is to liquidate these properties in an orderly and efficient mannerwithout incurring extraordinary losses due to quick sale pricing.  During 2008, the Bank sold real estate ownedtotaling $10.0 million and originated loans to facilitate such sales totaling $6.9million.  The Bank offers attractiverates and financing options to prospective buyers of real estate owned to helpfacilitate sales.

 

**Classified Assets. **Federalregulations require that each insured savings association classify its assetson a regular basis.  In addition, inconnection with examinations of insured institutions, federal examiners haveauthority to identify problem assets and, if appropriate, classify them.  There are three classifications for problemassets: “substandard,” “doubtful” and “loss.” Substandard assets have one or more defined weaknesses and arecharacterized by the distinct possibility that the insured institution willsustain some loss if the deficiencies are not corrected.  Doubtful assets have the weaknesses ofsubstandard assets with the additional characteristic that the weaknesses makecollection or liquidation in full on the basis of currently existing facts,conditions and values questionable, and there is a high possibility ofloss.  An asset classified loss is considereduncollectible and of such little value that continuance as an asset of theinstitution is not warranted.  At December 31,2008, the Bank had $54.4 million of classified assets, $51.5 million of whichwere classified as substandard and $2.9 million of which were classified asloss, consisting of $25.4 million of nonaccrual loans, $22.4 million of realestate owned and $6.6 million of loans 90 days or more past due and stillaccruing.  In addition, at such date, theBank had $34.8 million of assets designated as special mention. Special mentionassets have potential weaknesses that deserve management’s closeattention.  If left uncorrected, thesepotential weaknesses may result in deterioration of the repayment prospects forthe asset or the institution’s credit position at some future date.

 

**Potential Problem Loans.**  Basedon the oversupply of lots in Northwest Arkansas, our land development portfolioposes a higher risk of default.  Theseloans are typically structured with interest due at maturity and lot sales asthe source of repayment.  Since lot salesin the Northwest Arkansas market are significantly slower than when these loanswere originated, our borrowers typically must rely on a secondary source offunds to pay the interest as it becomes due. Due to the relatively large balances of these types of loans, theinterest due at maturity is usually significant.  At December 31, 2008, gross landdevelopment loans totaled $18.5 million with $1.1 million of accruedinterest.  Of this total, $2.6 million ison nonaccrual status with $566,000 in accrued interest, $11.4 million with$200,000 in accrued interest is classified as special mention, and $4.4 millionwith $332,000 in accrued interest is on our watch list.  There was only one matured land developmentloan on accrual status at December 31, 2008 with a principal balance of$2.4 million and accrued interest of $317,000 and it was paid in fullsubsequent to December 31, 2008.

 

AtDecember 31, 2008, the Bank had $9.0 million in loans that were 90 days ormore past due and still accruing.  One ofsuch loans totaling $2.4 million discussed above was paid off subsequent to December 31,2008.  The remaining $6.6 millionconsists of the following loans:

 

A$2.8 million first mortgage loan secured by the Belclaire subdivision locatedin Fayetteville, Arkansas.  Bonds weresold on this property by the Belclaire Improvement District without satisfyingthe first mortgage with our Bank.  Theloan is in default and we have filed foreclosure.  This property is also the subject of variouslitigation.  We believe our firstmortgage will prevail and absent that, believe the guarantors will satisfy theobligation.

 

A$2.0 million portfolio of single family rental properties located inFayetteville, Springdale, and Bethel Heights, Arkansas. The borrower has madeseveral payments on these loans since December 31, 2008.

 

A$1.2 million loan on a church building located in Fayetteville, Arkansas.  The church is attempting to lease thebuilding to another church, which would provide cash flow to service the loan.  Negotiations are ongoing.

 

A$640,000 matured construction loan.  Weexpect the interest to be paid and the construction loan to be rolled over to apermanent loan.

 

Theloans discussed above were maintained on accrual status and not classified orjudged to be impaired at December 31, 2008, based on our assessment offacts and circumstances existing at that time. If any of the facts or circumstances change, our treatment of theseloans might be different in future reporting periods.

 

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**Allowance for Loan Losses.**  Theallowance for loan losses is established as losses are estimated to haveoccurred through a provision for loan losses charged to earnings.  Loan losses are charged against the allowancewhen management believes it is likely that a loan balance isuncollectible.  Subsequent recoveries, ifany, are credited to the allowance.

 

Theallowance for loan losses represents management’s estimate of incurred creditlosses inherent in the Company’s loan portfolio as of the balance sheetdate.  The estimation of the allowance isbased on a variety of factors, including past loan loss experience, the currentcredit profile of the Company’s borrowers, adverse situations that haveoccurred that may affect the borrowers’ ability to repay, the estimated valueof underlying collateral, and general economic conditions.  Losses are recognized when availableinformation indicates that it is probable that a loss has been incurred and theamount of the loss can be reasonably estimated. This evaluation is inherentlysubjective as it requires estimates that are susceptible to significantrevision as more information becomes available or conditions change.

 

Indetermining the allowance for loan losses, the Company allocates a portion ofthe allowance to its various loan categories based on an analysis of individualloans and pools of loans.  However, theentire allowance is available to absorb credit losses inherent in the totalloan portfolio as of the balance sheet date.

 

Aloan is considered impaired when, based on current information and events, itis probable that the Bank will be unable to collect the scheduled payments ofprincipal or interest when due according to the contractual terms of the loanagreement. Factors considered by management in determining impairment includepayment status, collateral value, and the probability of collecting scheduledprincipal and interest payments when due. Loans that experience insignificantpayment delays and payment shortfalls generally are not classified as impaired.Management determines the significance of payment delays and payment shortfallson a case-by-case basis, taking into consideration all of the circumstancessurrounding the loan and the borrower, including the length of the delay, thereasons for the delay, the borrower’s prior payment record, and the amount ofthe short fall in relation to the principal and interest owed. Impairment ismeasured on a loan by loan basis by either the present value of expected futurecash flows discounted at the loan’s effective interest rate, the loan’sobtainable market price, or the fair value of the collateral if the loan iscollateral dependent.  Multifamilyresidential, commercial real estate, land and land development, and commercialloans that are delinquent or where the borrower’s total loan relationshipexceeds $1 million are evaluated on a loan-by-loan basis at least annually.

 

Largegroups of smaller balance homogeneous loans are collectively evaluated forimpairment. Accordingly, the Bank does not separately identify individualconsumer and residential loans for impairment disclosures.  Homogeneous loans are those that areconsidered to have common characteristics that provide for evaluation on anaggregate or pool basis. The Bank considers the characteristics of (1) one-to four-family residential mortgage loans; (2) unsecured consumer loans;and (3) collateralized consumer loans to permit consideration of theappropriateness of the allowance for losses of each group of loans on a poolbasis. The primary methodology used to determine the appropriateness of theallowance for losses includes segregating certain specific, poorly performing loansbased on their performance characteristics from the pools of loans as to type,valuing these loans, and then applying a loss factor to the remaining poolbalance based on several factors including past loss experience, inherentrisks, and economic conditions in the primary market areas.

 

Inestimating the amount of credit losses inherent in our loan portfolio, variousjudgments and assumptions are made.  Forexample, when assessing the condition of the overall economic environment,assumptions are made regarding market conditions and their impact on the loanportfolio.  For impaired loans that arecollateral dependent, the estimated fair value of the collateral may deviatesignificantly from the proceeds received when the collateral is sold in theevent that the Bank has to foreclose or repossess the collateral.

 

Althoughwe consider the allowance for loan losses of approximately $6.4 millionadequate to cover losses inherent in our loan portfolio at December 31,2008, no assurance can be given that we will not sustain loan losses that aresignificantly different from the amount recorded, or that subsequentevaluations of the loan portfolio, in light of factors then prevailing, wouldnot result in a significant change in the allowance for loan losses.

 

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Thefollowing table summarizes changes in the allowance for loan losses and otherselected statistics for the periods indicated.

 
| ** **                                                                             | ** ** | **Year Ended December 31,** | ** ** |
|----------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                             | ** ** | **2008**                                   | ** ** | **2007** | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                                                             | ** ** | **(Dollars in Thousands)**       | ** ** |
|                                                                                   |       |                                       |       |   |   |   |   |   |   |   |   |
| Total loans outstanding at end of period                                               |       | $                                          | 585,785    |   | $ | 642,965 |   | $ | 735,593 |   | $ | 790,570 |   | $ | 699,205 |   |
| Average loans outstanding                                                              |       | $                                          | 583,063    |   | $ | 649,062 |   | $ | 726,642 |   | $ | 687,373 |   | $ | 573,520 |   |
| Allowance at beginning of period                                                       |       | $                                          | 5,162      |   | $ | 2,572 |   | $ | 2,114 |   | $ | 1,846 |   | $ | 1,621 |   |
| Charge-offs:                                                                           |       |                                       |       |   |   |   |   |   |   |   |   |
| One- to four-family residential                                                        |       | (63                                        | )          | (75 | ) | (25 | ) | (74 | ) | (152 | ) |
| Home equity and second mortgage                                                        |       | (392                                       | )          | (175 | ) | (2 | ) | (49 | ) | (3 | ) |
| Multifamily residential                                                                |       | —                                     |       | — |   | — |   | — |   | — |   |
| Commercial real estate                                                                 |       | (316                                       | )          | (18 | ) | — |   | — |   | (71 | ) |
| Land                                                                                   |       | (32                                        | )          | (20 | ) | — |   | — |   | — |   |
| Land development                                                                       |       | (2,396                                     | )          | — |   | — |   | — |   | — |   |
| Construction                                                                           |       | (236                                       | )          | (401 | ) | (239 | ) | (77 | ) | — |   |
| Commercial                                                                             |       | (827                                       | )          | (132 | ) | (234 | ) | (41 | ) | (184 | ) |
| Consumer (1)                                                                           |       | (652                                       | )          | (798 | ) | (695 | ) | (715 | ) | (488 | ) |
| Total charge-offs                                                                      |       | (4,914                                     | )          | (1,619 | ) | (1,195 | ) | (956 | ) | (898 | ) |
| Recoveries:                                                                            |       |                                       |       |   |   |   |   |   |   |   |   |
| One- to four-family residential                                                        |       | —                                     |       | 5 |   | — |   | — |   | 2 |   |
| Home equity and second mortgage                                                        |       | 5                                          |       | — |   | — |   | 2 |   | — |   |
| Multifamily residential                                                                |       | —                                     |       | — |   | — |   | — |   | — |   |
| Commercial real estate                                                                 |       | 88                                         |       | — |   | — |   | 1 |   | 2 |   |
| Land                                                                                   |       | 2                                          |       | — |   | — |   | — |   | — |   |
| Construction                                                                           |       | 231                                        |       | 5 |   | 7 |   | — |   | — |   |
| Commercial                                                                             |       | 2                                          |       | — |   | — |   | — |   | — |   |
| Consumer (1)                                                                           |       | 155                                        |       | 171 |   | 164 |   | 120 |   | 99 |   |
| Total recoveries                                                                       |       | 483                                        |       | 181 |   | 171 |   | 123 |   | 103 |   |
| Net charge-offs                                                                        |       | (4,431                                     | )          | (1,438 | ) | (1,024 | ) | (833 | ) | (795 | ) |
| Total provisions for losses                                                            |       | 5,710                                      |       | 4,028 |   | 1,482 |   | 1,101 |   | 1,020 |   |
| Allowance at end of period                                                             |       | $                                          | 6,441      |   | $ | 5,162 |   | $ | 2,572 |   | $ | 2,114 |   | $ | 1,846 |   |
|                                                                                   |       |                                       |       |   |   |   |   |   |   |   |   |
| Allowance for loan losses as a percentage  of total loans Outstanding at end of period |       | 1.10                                       | %          | 0.80 | % | 0.35 | % | 0.27 | % | 0.26 | % |
|                                                                                   |       |                                       |       |   |   |   |   |   |   |   |   |
| Net loans charged-off as a percentage of  average loans outstanding                    |       | 0.76                                       | %          | 0.22 | % | 0.14 | % | 0.12 | % | 0.14 | % |

 

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(1)        Consumer loan charge-offs include overdraft charge-offs of $480,000,$575,000, $600,000, $522,000, and $323,000, for the years ended December 31,2008, 2007, 2006, 2005, and 2004, respectively. Consumer loan recoveries include recoveries of overdraft charge-offs of$140,000, $162,000, $151,000, $114,000, and $85,000, for the years ended December 31,2008, 2007, 2006, 2005, and 2004, respectively.

 

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The following table presents the allocation of theBank’s allowance for loan losses by the type of loan at each of the datesindicated.

 
|                                              |   | **December 31,**                |       |
|---------------------------------------------------|--------|--------------------------------------|------------|
|                                              |   | **2008**                             | ** ** | **2007** | ** ** | **2006** |   | **2005** |   | **2004** |   |
|                                              |   | **Amount**                           | ** ** | **Percentage  of Loans** | ** ** | **Amount** | ** ** | **Percentage  of Loans** | ** ** | **Amount** | ** ** | **Percentage  of Loans** | ** ** | **Amount** | ** ** | **Percentage  of Loans** | ** ** | **Amount** | ** ** | **Percentage  of Loans** | ** ** |
|                                              |   | **(Dollars in Thousands)** |       |
|                                              |   |                                 |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| One-to-four family residences (1)                 |   | $                                    | 490        |   | 41.54 | % | $ | 221 |   | 35.77 | % | $ | 204 |   | 35.05 | % | $ | 173 |   | 35.53 | % | $ | 301 |   | 41.79 | % |
| Home equity and second mortgage (2)               |   | 350                                  |       | 5.41 |   | 160 |   | 5.34 |   | 222 |   | 4.78 |   | 136 |   | 3.69 |   | 96 |   | 3.87 |   |
| Speculative one- to four-family  construction (3) |   | 153                                  |       | 2.92 |   | 405 |   | 6.35 |   | 589 |   | 10.92 |   | 295 |   | 13.16 |   | — |   | 11.83 |   |
| Multifamily residential                           |   | 29                                   |       | 4.12 |   | 19 |   | 2.43 |   | 15 |   | 1.66 |   | 16 |   | 1.63 |   | 12 |   | 1.35 |   |
| Commercial real estate (4)                        |   | 448                                  |       | 19.79 |   | 309 |   | 18.62 |   | 413 |   | 18.30 |   | 372 |   | 16.59 |   | 356 |   | 18.04 |   |
| Land (5)                                          |   | 869                                  |       | 8.43 |   | 105 |   | 6.66 |   | 48 |   | 6.48 |   | — |   | 6.02 |   | — |   | 5.58 |   |
| Land development (6)                              |   | 1,583                                |       | 3.16 |   | 2,658 |   | 6.56 |   | 211 |   | 6.45 |   | 101 |   | 5.09 |   | 35 |   | 2.01 |   |
| Construction                                      |   | 79                                   |       | 7.12 |   | 118 |   | 10.99 |   | 92 |   | 9.27 |   | 113 |   | 12.00 |   | 73 |   | 8.93 |   |
| Commercial (7)                                    |   | 2,020                                |       | 3.94 |   | 628 |   | 3.54 |   | 452 |   | 3.57 |   | 371 |   | 2.64 |   | 509 |   | 2.34 |   |
| Consumer (8)                                      |   | 420                                  |       | 3.57 |   | 539 |   | 3.74 |   | 326 |   | 3.52 |   | 437 |   | 3.65 |   | 412 |   | 4.26 |   |
| Unallocated                                       |   | —                               |       | — |   | — |   | — |   | — |   | — |   | 100 |   | — |   | 52 |   | — |   |
| Total                                             |   | $                                    | 6,441      |   | 100.00 | % | $ | 5,162 |   | 100.00 | % | $ | 2,572 |   | 100.00 | % | $ | 2,114 |   | 100.00 | % | $ | 1,846 |   | 100.00 | % |

 

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|   | (1) | The increase in the allowance for loan losses for one- to four-family  residential loans from 2007 to 2008 was primarily due to an increase in  specific loan loss allowances as well as an increase in the loss factor  applied to such loans.                                                                                                                                                                                                                                                                                                                                                                                                           |
|--------|-----|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   | (2) | The increase in the allowance for loan losses for home equity and  second mortgage loans from 2007 to 2008 was primarily due to an increase in  the loss factor applied to such loans.                                                                                                                                                                                                                                                                                                                                                                                                                                                                    |
|   | (3) | The decrease in the allowance for loan losses for speculative one- to  four-family construction loans from 2007 to 2008 was primarily due to a  decrease in the related loan balances. The decrease from 2006 to 2007 was  primarily due to a decrease in specific loan loss allowances. The increase from  2005 to 2006 was primarily due to an increase in specific loan loss  allowances as well as an increase in the loss factor applied to such loans.  In 2004, speculative one- to four-family residential construction loans were  pooled with permanent one- to four-family residences for the determination of  the allowance for loan losses. |
|   | (4) | The increase in the allowance for loan losses for commercial real  estate loans from 2007 to 2008 was primarily due to an increase in specific  loan loss allowances. The allowance allocated to commercial real estate loans  decreased between 2006 and 2007 primarily due to a decrease in the related  loan balances.                                                                                                                                                                                                                                                                                                                                 |
|   | (5) | The increase in the allowance for loan losses for land loans from 2007  to 2008 was primarily due to an increase in specific loan loss allowances as  well as an increase in the loss factor applied to such loans.                                                                                                                                                                                                                                                                                                                                                                                                                                       |
|   | (6) | The decrease in the allowance for loan losses for land development  loans from 2007 to 2008 was due to a decrease specific loan loss allowances  and a decrease in the related loan balances, partially offset by an increase  in the loss factor applied to such loans. The allowance allocated to land  development loans increased between 2006 and 2007 primarily due to an  increase in specific loan loss allowances in this category of $2.4 million.                                                                                                                                                                                              |
|   | (7) | The increase in the allowance for loan losses for commercial loans  from 2007 to 2008 was primarily due to an increase in the loss factor applied  to such loans. The allowance allocated to commercial loans increased from  2005 to 2006 and from 2006 to 2007 primarily due to increases in specific  loan loss allowances in this category.                                                                                                                                                                                                                                                                                                           |
|   | (8) | The decrease in the allowance for loan losses for consumer loans from  2007 to 2008 was primarily due to decreases in the related loan balances and  decreases in the loss factors applied to such loans. Consumer loan loss  allowances increased from 2006 to 2007 primarily due to an increase in the  loss factor applied to such loans.                                                                                                                                                                                                                                                                                                              |

 

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## **Investment Activities**

##  

**Investment Securities. **The investmentpolicy of the Bank, as established by the board of directors, is designedprimarily to provide and maintain liquidity, to provide collateral for pledgingrequirements, to complement the Bank’s interest rate risk strategy and togenerate a favorable return on investments. The Bank’s investment policy is currently implemented by the Bank’sChief Executive Officer within the parameters set by the asset/liabilitymanagement committee and the board of directors.  The Bank is authorized to invest inobligations issued or fully guaranteed by the U.S. Government, certain federalagency obligations, certain time deposits, negotiable certificates of depositissued by commercial banks and other insured financial institutions, municipalsecurities, and other specified investments.

 

Investmentsecurities that management has the positive intent and ability to hold to maturityare classified as held to maturity and are reported at amortized cost.  Investment securities classified as availablefor sale are reported at fair value, with unrealized gains and losses excludedfrom earnings and reported net of tax in other comprehensive income.  At December 31, 2008, all of the Bank’sinvestment securities were classified as held to maturity.  At December 31, 2008, approximately$76.4 million of the Bank’s investment securities were pledged as collateralfor certain deposits in excess of $250,000 as well as for advances from FHLB ofDallas and the Federal Reserve Bank.  At December 31,2008, investments in the debt and/or equity securities of any one issuer, otherthan those issued by U.S. Government agencies, did not exceed more than 10% ofthe Company’s stockholders’ equity.

 

Thefollowing table sets forth the amount of investment securities held to maturitythat contractually mature during each of the periods indicated and the weightedaverage yields for each range of maturities at December 31, 2008.  Weighted average yields for municipalobligations have not been adjusted to a tax-equivalent basis.  Expected maturities may differ fromcontractual maturities because issuers may have the right to call or prepay theobligation without prepayment penalties.

 
| ** **                              | ** ** | **Less than One Year** | ** ** | **One to Five  Years** | ** ** | **Five to Ten  Years** | ** ** | **After Ten  Years** | ** ** | **Total**  | ** ** |
|-----------------------------------------|------------|---------------------------------------|------------|----------------------------------|------------|----------------------------------|------------|---------------------------|------------|------------|------------|
| ** **                              | ** ** | **Amount**                            | ** ** | **Yield**                        | ** ** | **Amount**                       | ** ** | **Yield**                 | ** ** | **Amount** | ** ** | **Yield** | ** ** | **Amount** | ** ** | **Yield** | ** ** | **Amount** | ** ** | **Yield** | ** ** |
|                                    |       |                                  |       |                             |       |                             |       |                      |       |       |       |   |   |   |   |   |   |   |   |   |   |
| Municipal securities                    |       | $                                     | 225        |                             | 3.45       | %                                | $          | 2,180                     |       | 4.23       | %          | $ | 6,889 |   | 4.25 | % | $ | 10,271 |   | 4.54 | % | $ | 19,565 |   | 4.39 | % |
| U. S. Government and agency obligations |       | —                                |       | —                           | %          | 1,000                            |       | 4.45                      | %          | 11,000     |       | 5.28 | % | 104,847 |   | 5.55 | % | 116,847 |   | 5.52 | % |
| Total                                   |       | $                                     | 225        |                             | 3.45       | %                                | $          | 3,180                     |       | 4.30       | %          | $ | 17,889 |   | 4.88 | % | $ | 115,118 |   | 5.46 | % | $ | 136,412 |   | 5.36 | % |

 

Asof December 31, 2008, there were approximately $135.8 million ofinvestment securities at an average interest rate of 5.36% with issuer calloptions, of which approximately $124.8 million at an average interest rate of5.44% are callable within one year.

 

Thefollowing table sets forth the carrying value of the Company’s investmentsecurities classified as held to maturity. The Company held no investment securities as available for sale at thedates indicated.

 
| ** **                              | ** ** | **December 31,**   | ** ** |
|-----------------------------------------|------------|-------------------------|------------|
| ** **                              | ** ** | **2008**                | ** ** | **2007** | ** ** | **2006** | ** ** |
| ** **                              | ** ** | **(In Thousands)** | ** ** |
| Investment securities held to maturity: |       |                    |       |   |   |   |   |
| Municipal securities                    |       | $                       | 19,565     |   | $ | 17,089 |   | $ | 16,889 |   |
| U.S. Government and agency obligations  |       | 116,847                 |       | 78,501 |   | 43,857 |   |
| Total                                   |       | $                       | 136,412    |   | $ | 95,590 |   | $ | 60,746 |   |

 

Asa member of the FHLB of Dallas, the Bank is required to maintain an investmentin FHLB stock.  At December 31,2008, the Bank’s investment in FHLB stock amounted to $4.8 million.  No ready market exists for such stock and ithas no quoted market value.

 

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**Sources of Funds**

 

**General. **Deposits are the primary source of the Bank’sfunds for lending and other investment purposes.  In addition to deposits, the Bank derivesfunds from loan principal repayments and prepayments and interest payments,maturities and calls of investment securities, advances from the FHLB ofDallas, and borrowings from the Federal Reserve Bank Discount Window PrimaryCredit Program.  Loan repayments are arelatively stable source of funds, while deposit inflows and outflows aresignificantly influenced by general interest rates and money marketconditions.  Borrowings are used whenfunds from loan and deposit sources are insufficient to meet fundingneeds.  FHLB advances are the primarysource of borrowings.

 

**Deposits. **The Bank’s deposit products include a broadselection of deposit instruments, including checking accounts, money marketaccounts, savings accounts and term certificate accounts.  Deposit account terms vary, with theprincipal differences being the minimum balance required, the time period thefunds must remain on deposit, early withdrawal penalties and the interest rate.

 

TheBank considers its primary market area to be Northcentral and NorthwestArkansas.  The Bank utilizes traditionalmarketing methods to attract new customers and savings deposits.  The Bank does not advertise for depositsoutside of its primary market area and management believes that non-residentsof Arkansas held an insignificant number of deposit accounts at December 31,2008.  Services of deposit brokers havebeen used on a limited basis with less than 1% of certificates of deposit at December 31,2008, obtained through a broker.

 

TheBank has been competitive in the types of accounts and in interest rates it hasoffered on its deposit products but does not necessarily seek to match thehighest rates paid by competing institutions. Although market demand generally dictates which deposit maturities andrates will be accepted by the public, the Bank intends to continue to offerlonger-term deposits to the extent possible and consistent with its asset andliability management goals.

 

Thefollowing table shows the distribution of, and certain other informationrelating to, the Bank’s deposits by type of deposit, as of the dates indicated.

 
| ** **                 | ** ** | **December 31,**                | ** ** |
|----------------------------|------------|--------------------------------------|------------|
| ** **                 | ** ** | **2008**                             | ** ** | **2007** | ** ** | **2006** | ** ** |
| ** **                 | ** ** | **Amount**                           | ** ** | **%** | ** ** | **Amount** | ** ** | **%** | ** ** | **Amount** | ** ** | **%** | ** ** |
| ** **                 | ** ** | **(Dollars in Thousands)** | ** ** |
| Certificate accounts:      |       |                                 |       |   |   |   |   |   |   |   |   |   |   |
| Less than 3.00%            |       | $                                    | 92,625     |   | 15.0 | % | $ | 2,063 |   | 0.3 | % | $ | 4,173 |   | 0.6 | % |
| 3.00% - 3.99%              |       | 213,847                              |       | 34.6 |   | 66,897 |   | 10.6 |   | 98,932 |   | 15.2 |   |
| 4.00% - 5.99%              |       | 77,587                               |       | 12.5 |   | 353,534 |   | 56.1 |   | 327,311 |   | 50.2 |   |
| 6.00% - 7.99%              |       | 2,435                                |       | 0.4 |   | 3,917 |   | 0.6 |   | 3,826 |   | 0.6 |   |
| Total certificate accounts |       | 386,494                              |       | 62.5 |   | 426,411 |   | 67.6 |   | 434,242 |   | 66.6 |   |
|                       |       |                                 |       |   |   |   |   |   |   |   |   |   |   |
| Transaction accounts:      |       |                                 |       |   |   |   |   |   |   |   |   |   |   |
| Savings                    |       | 23,019                               |       | 3.7 |   | 25,088 |   | 4.0 |   | 26,824 |   | 4.1 |   |
| Money market accounts      |       | 45,022                               |       | 7.3 |   | 51,424 |   | 8.2 |   | 51,827 |   | 7.9 |   |
| Checking accounts          |       | 163,468                              |       | 26.5 |   | 127,491 |   | 20.2 |   | 139,372 |   | 21.4 |   |
| Total transaction accounts |       | 231,509                              |       | 37.5 |   | 204,003 |   | 32.4 |   | 218,023 |   | 33.4 |   |
| Total deposits             |       | $                                    | 618,003    |   | 100.0 | % | $ | 630,414 |   | 100.0 | % | $ | 652,265 |   | 100.0 | % |

 

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Thefollowing table presents the average balance of each type of deposit and theaverage rate paid on each type of deposit and/or total deposits for the periodsindicated.

 
| ** **                      | ** ** | **Year Ended December 31,** | ** ** |
|---------------------------------|------------|--------------------------------------------|------------|
| ** **                      | ** ** | **2008**                                   | ** ** | **2007** | ** ** | **2006** | ** ** |
| ** **                      | ** ** | **Average  Balance**                       | ** ** | **Average  Rate  Paid** | ** ** | **Average  Balance** | ** ** | **Average  Rate  Paid** | ** ** | **Average  Balance** | ** ** | **Average  Rate  Paid** | ** ** |
| ** **                      | ** ** | **(Dollars in Thousands)**       | ** ** |
| Savings accounts                |       | $                                          | 24,665     |   | 0.12 | % | $ | 26,512 |   | 0.57 | % | $ | 29,018 |   | 0.59 | % |
| Money market accounts           |       | 48,974                                     |       | 1.84 |   | 51,484 |   | 2.89 |   | 56,984 |   | 2.64 |   |
| Checking accounts with interest |       | 127,627                                    |       | 1.36 |   | 102,406 |   | 1.83 |   | 96,095 |   | 1.47 |   |
| Checking accounts - noninterest |       | 29,286                                     |       | — |   | 33,298 |   | — |   | 36,133 |   | — |   |
| Certificates of deposit         |       | 399,256                                    |       | 4.00 |   | 425,024 |   | 4.81 |   | 412,000 |   | 4.31 |   |
| Total deposits                  |       | $                                          | 629,808    |   | 2.95 | % | $ | 638,724 |   | 3.74 | % | $ | 630,230 |   | 3.28 | % |

 

Thefollowing table presents, by various interest rate categories, certificates ofdeposit at December 31, 2008 and 2007, and the amounts at December 31,2008, which mature during the periods indicated.

 
| ** **                 | ** ** | **December 31,**   | ** ** | **Amounts at December 31, 2008  Maturing in the 12 Months Ending December 31,** | ** ** |
|----------------------------|------------|-------------------------|------------|----------------------------------------------------------------------------------------------------------------------------------------|------------|
| ** **                 | ** ** | **2008**                | ** ** | **2007**                                                                                                                               | ** ** | **2009** | ** ** | **2010** | ** ** | **2011** | ** ** | **Thereafter** | ** ** |
| ** **                 | ** ** | **(In Thousands)** | ** ** |
| Certificate accounts:      |       |                    |       |                                                                                                                                   |       |   |   |   |   |   |   |   |   |
| Less than 3.00%            |       | $                       | 92,625     |                                                                                                                                   | $          | 2,063 |   | $ | 80,467 |   | $ | 11,932 |   | $ | 226 |   | $ | — |   |
| 3.00% - 3.99%              |       | 213,847                 |       | 66,897                                                                                                                                 |       | 169,120 |   | 23,779 |   | 12,603 |   | 8,345 |   |
| 4.00% - 5.99%              |       | 77,587                  |       | 353,534                                                                                                                                |       | 18,133 |   | 20,052 |   | 16,601 |   | 22,801 |   |
| 6.00% - 7.99%              |       | 2,435                   |       | 3,917                                                                                                                                  |       | 2,435 |   | — |   | — |   | — |   |
| Total certificate accounts |       | $                       | 386,494    |                                                                                                                                   | $          | 426,411 |   | $ | 270,155 |   | $ | 55,763 |   | $ | 29,430 |   | $ | 31,146 |   |

 

Thefollowing table sets forth maturities of the Bank’s certificates of deposit of$100,000 or more at December 31, 2008 by time remaining to maturity.

 
| ** **                                                       | ** ** | **Amount**              | ** ** |
|------------------------------------------------------------------|------------|-------------------------|------------|
| ** **                                                       | ** ** | **(In Thousands)** | ** ** |
| Period Ending:                                                   |       |                    |       |
| March 31, 2009                                              |       | $                       | 17,443     |   |
| June 30, 2009                                               |       | 24,586                  |       |
| September 30, 2009                                          |       | 30,788                  |       |
| December 31, 2009                                           |       | 15,333                  |       |
| After December 31, 2009                                     |       | 35,142                  |       |
| Total certificates of deposit with balances  of $100,000 or more |       | $                       | 123,292    |   |

 

**Borrowed funds.**  TheBank utilizes FHLB advances in its normal operating and investingactivities.  The Bank pledges ascollateral for FHLB advances certain qualifying one- to four-family mortgageloans and certain qualifying investment securities.  Pledged collateral is held in the custody ofthe FHLB.  Currently, the Bank may borrowonly short-term FHLB advances with maturities up to thirty days.

 

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Borrowingsfrom the FHLB at December 31, 2008, have maturity dates and weightedaverage rates as follows:

 
| **Year Ending  December 31,** | ** ** | **Weighted  Average Rate** | ** ** | **Amount**                           | ** ** |
|-----------------------------------------|------------|---------------------------------|------------|--------------------------------------|------------|
| ** **                              | ** ** | ** **                      | ** ** | **(Dollars in Thousands)** | ** ** |
| 2009                                    |       | 3.55                            | %          | $                                    | 46,636     |   |
| 2010                                    |       | 3.37                            |       | 17,353                               |       |
| 2011                                    |       | 3.24                            |       | 11,514                               |       |
| 2012                                    |       | 2.36                            |       | 3,570                                |       |
| 2013                                    |       | 0.89                            |       | 2,168                                |       |
| Thereafter                              |       | 4.33                            |       | 941                                  |       |
| Total                                   |       | 3.36                            | %          | $                                    | 82,182     |   |

 

The Bank also utilizes borrowings from the FRB through the DiscountWindow Primary Credit Program which is available for a period of approximatelyone month to generally sound depository institutions.  On March 17, 2008, the Primary CreditProgram was temporarily changed to allow for terms of up to 90 days and thespread of the primary credit rate over the FOMC’s target federal funds rate wasreduced to 25 basis points.  At December 31,2008, the Bank had $10.0 million in overnight borrowings at a rate of 0.50%outstanding with the FRB.

 

The following table sets forth information with respect to the Company’sborrowings at and during the periods indicated.

 
| ** **                      | ** ** | **At or For the Year Ended December 31,** | ** ** |
|---------------------------------|------------|------------------------------------------------------------------------------|------------|
| ** **                      | ** ** | **2008**                                                                     | ** ** | **2007** | ** ** | **2006** | ** ** |
| ** **                      | ** ** | **(Dollars in Thousands)**                                         | ** ** |
| Maximum balance                 |       | $                                                                            | 104,100    |   | $ | 120,305 |   | $ | 171,375 |   |
| Average balance                 |       | 92,544                                                                       |       | 94,481 |   | 154,186 |   |
| Year end balance                |       | 92,212                                                                       |       | 82,087 |   | 120,305 |   |
| Weighted average interest rate: |       |                                                                         |       |   |   |   |   |
| At end of year                  |       | 3.05                                                                         | %          | 4.53 | % | 4.58 | % |
| During the year                 |       | 3.84                                                                         | %          | 4.56 | % | 4.50 | % |
|                                 |            |                                                                              |            |  |  |  |  |  |  |  |

 

## **Subsidiaries**

##  

TheBank is permitted to invest up to 2% of its assets in the capital stock of, orsecured or unsecured loans to, subsidiary corporations, with an additionalinvestment of 1% of assets when such additional investment is utilized primarilyfor community development purposes.  TheBank’s only subsidiary, First Harrison Service Corporation (the “ServiceCorporation”), was formed in 1971.  At December 31,2008, the Service Corporation was inactive.

 

**REGULATION**

 

*Set forth below is a brief description of those lawsand regulations which, together with the descriptions of laws and regulationscontained elsewhere herein, are deemed material to an investor’s understandingof the extent to which the Company and the Bank are regulated.  The description of the laws and regulationshereunder, as well as descriptions of laws and regulations contained elsewhereherein, does not purport to be complete and is qualified in its entirety byreference to applicable laws and regulations.*

 

**The Company**

 

**General.**  The Company, as a savings andloan holding company within the meaning of the Home Owners’ Loan Act (“HOLA”),has registered with the OTS and is subject to OTS regulations, examinations,supervision and reporting requirements. As a subsidiary of a savings and loan holding company, the Bank issubject to certain restrictions in its dealings with the Company and affiliatesthereof.

 

**Holding Company Acquisitions.** Federal law generally prohibits a savings and loan holding company,without prior OTS approval, from acquiring the ownership or control of anyother savings institution or savings and loan holding company, or all, orsubstantially all, of the assets or more than 5% of the voting shares thereofwhich is not a subsidiary.  Theseprovisions also prohibit, among other things, any director or officer of asavings and loan holding company, or any individual who owns or controls morethan 25% of the voting shares of such holding company, from acquiring controlof any savings institution not a subsidiary of such savings and loan holdingcompany, unless the acquisition is approved by the OTS.

 

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**Holding Company Activities.**  Thereare generally no restrictions on the activities of a savings and loan holdingcompany, such as the Company, which controlled only one subsidiary savingsassociation on or before May 4, 1999 (a “grandfathered holding company”).  However, if the Director of the OTSdetermines that there is reasonable cause to believe that the continuation by asavings and loan holding company of an activity constitutes a serious risk tothe financial safety, soundness or stability of its subsidiary savings association,the Director may impose such restrictions as it deems necessary to address suchrisk, including limiting (i) payment of dividends by the savingsassociation; (ii) transactions between the savings association and itsaffiliates; and (iii) any activities of the savings association that mightcreate a serious risk that the liabilities of the holding company and itsaffiliates may be imposed on the savings association.  Notwithstanding the above rules as topermissible business activities of unitary savings and loan holding companies,if the savings association subsidiary of such a holding company fails to meetthe qualified thrift lender (“QTL”) test, then such unitary holding companyalso shall become subject to the activities restrictions applicable to multiplesavings and loan holding companies and, unless the savings associationrequalifies as a QTL within one year thereafter, shall register as, and becomesubject to the restrictions applicable to, a bank holding company.

 

Ifa savings and loan holding company acquires control of a second savingsassociation and holds it as a separate institution, the holding company becomesa multiple savings and loan holding company. As a general rule, multiple savings and loan holding companies aresubject to restrictions on their activities that are not imposed on agrandfathered holding company.  They arerestricted to activities traditionally permitted to multiple savings and loanholding companies and to financial holding companies under provisions of theBank Holding Company Act.  Multiplesavings and loan holding companies may:

 

·                 furnish or perform management services for asavings association subsidiary of a savings and loan holding company;

·                 hold, manage or liquidate assets owned oracquired from a savings association subsidiary of a savings and loan holdingcompany;

·                 hold or manage properties used or occupied bya savings association subsidiary of a savings and loan holding company;

·                 engage in activities determined by the FederalReserve to be closely related to banking and a proper incident thereto; and

·                 engage in services and activities previouslydetermined by the Federal Home Loan Bank Board by regulation to be permissiblefor a multiple savings and loan holding company as of March 5, 1987.

 

Theactivities financial holding companies may engage in include:

 

·                 lending, exchanging, transferring or investingfor others, or safeguarding money or securities;

·                 insuring, guaranteeing or indemnifying others,issuing annuities, and acting as principal, agent or broker for purposes of theforegoing;

·                 providing financial, investment or economicadvisory services, including advising an investment company;

·                 issuing or selling interests in pooled assetsthat a bank could hold directly;

·                 underwriting, dealing in or making a market insecurities; and

·                 merchant banking activities.

 

Everysavings institution subsidiary of a savings and loan holding company isrequired to give the OTS at least 30 days’ advance notice of any proposeddividends to be made on its guaranteed, permanent or other non-withdrawablestock, or else such dividend will be invalid.

 

**Restrictions on Transactions with Affiliates.**  Transactions between a savings institution and its “affiliates” aresubject to quantitative and qualitative restrictions under Sections 23A and 23Bof the Federal Reserve Act and OTS regulations. Affiliates of a savings institution generally include, among otherentities, the savings institution’s holding company and companies that arecontrolled by or under common control with the savings institution.  Generally, Section 23A (i) limitsthe extent to which the savings association or its subsidiaries may engage in “coveredtransactions” with any one affiliate to an amount equal to 10% of suchassociation’s capital stock and surplus, and contain an aggregate limit on allsuch transactions with all affiliates to an amount equal to 20% of such capitalstock and surplus.  Section 23Bapplies to “covered transactions” as well as certain other transactions andrequires that all transactions be on terms substantially the same, or at leastfavorable, to the association or subsidiary as those provided to anon-affiliate.  The term “coveredtransaction” includes the making of loans to, purchase of assets from, issuanceof a guarantee to an affiliate and similar transactions.  Section 23B transactions also apply tothe provision of services and the sale of assets by a savings association to anaffiliate.  In addition to therestrictions imposed by Sections 23A and 23B, Section 11 of the HOLAprohibits a savings association from (i) making a loan or other extensionof credit to an affiliate, except for any affiliate which engages only incertain activities which are permissible for bank holding companies, or (ii) purchasingor investing in any stocks, bonds, debentures, notes or similar obligations ofany affiliate, except for affiliates which are subsidiaries of the savingsassociation.

 

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Inaddition, Sections 22(g) and (h) of the Federal Reserve Act placerestrictions on loans to executive officers, directors and principalstockholders.  Under Section 22(h),loans to a director, an executive officer and to a greater than 10% stockholderof a savings institution (“a principal stockholder”), and certain affiliatedinterests of either, may not exceed, together with all other outstanding loansto such person and affiliated interests, the savings institution’s loans to oneborrower limit (generally equal to 15% of the institution’s unimpaired capitaland surplus).  Section 22(h) alsorequires that loans to directors, executive officers and principal stockholdersbe made on terms substantially the same as offered in comparable transactionsto other persons unless the loans are made pursuant to a benefit orcompensation program that (i) is widely available to employees of theinstitution and (ii) does not give preference to any director, executiveofficer or principal stockholder, or certain affiliated interests of either,over other employees of the savings institution.  Section 22(h) also requires priorboard approval for certain loans.  Inaddition, the aggregate amount of extensions of credit by a savings institutionto all insiders cannot exceed the institution’s unimpaired capital andsurplus.  Furthermore, Section 22(g) placesadditional restrictions on loans to executive officers.  At December 31, 2008, the Bank was incompliance with the above restrictions.

 

**Federal Securities Law.*** *The common stock of the Company is registered with the SEC under theSecurities Exchange Act of 1934, as amended. The Company is subject to theinformation, proxy solicitation, insider trading restrictions and otherrequirements of the SEC under the Securities Exchange Act of 1934.

 

Companystock held by persons who are affiliates of the Company may not be resoldwithout registration unless sold in accordance with certain resalerestrictions. Affiliates are generally considered to be officers, directors andprincipal stockholders. If the Company meets specified current publicinformation requirements, each affiliate of the Company will be able to sell inthe public market, without registration, a limited number of shares in anythree-month period.

 

TheSarbanes-Oxley Act of 2002 (“Sarbanes-Oxley”), which was signed into law in July 2002,impacts all companies with securities registered under the Securities ExchangeAct of 1934, including the Company. Sarbanes-Oxley created new requirements inthe areas of corporate governance and financial disclosure including, amongother things:

 

·                 increased responsibility for Chief ExecutiveOfficers and Chief Financial Officers with respect to the content of filingswith the SEC;

·                 enhanced requirements for audit committees,including independence and disclosure of expertise;

·                 enhanced requirements for auditor independenceand the types of non-audit services that auditors can provide;

·                 enhanced requirements for controls andprocedures;

·                 accelerated filing requirements for SECreports;

·                 disclosure of a code of ethics; and

·                 increased disclosure and reporting obligationsfor companies, their directors and their executive officers.

 

Certificationsof the Chief Executive Officer and the Chief Financial Officer as required bySarbanes-Oxley and the resulting SEC rules can be found in the “Exhibits” sectionof this Form 10-K.

 

## **The Bank**

##  

**General.**  The OTS has extensive authorityover the operations of federally chartered savings institutions.  As part of this authority, savingsinstitutions are required to file periodic reports with the OTS and are subjectto periodic examinations by the OTS and the FDIC.  The last regulatory examination of the Bankby the OTS was completed in July 2008. The Bank was not required to make any material changes to its operationsas a result of such examination.  Federallaws and regulations prescribe the investment and lending authority of savingsinstitutions, and such institutions are prohibited from engaging in anyactivities not permitted by such laws and regulations.

 

TheOTS’ enforcement authority over all savings institutions and their holdingcompanies includes, among other things, the ability to assess civil moneypenalties, to issue cease and desist or removal orders and to initiateinjunctive actions.  In general, theseenforcement actions may be initiated for violations of laws and regulations andunsafe or unsound practices.  Otheractions or inactions may provide the basis for enforcement action, includingmisleading or untimely reports filed with the OTS.

 

**Insurance of Accounts.** Substantially all of the deposits of the Bank are insured up toapplicable limits by the Deposit Insurance Fund (“DIF”) of the FDIC and aresubject to deposit insurance assessments to maintain the DIF. The FDIC utilizesa risk-based assessment system that imposes insurance premiums based upon arisk matrix that takes into account a bank’s capital level and supervisoryrating (“CAMELS rating”).

 

FDICinsurance expense totaled $374,000, $76,000 and $77,000 in 2008, 2007, and2006, respectively. FDIC insurance expense includes deposit insuranceassessments and Financing Corporation (“FICO”) assessments related tooutstanding FICO bonds. The FICO is a mixed-ownership government corporationestablished by the Competitive Equality Banking Act of 1987 whose sole purposewas to function as a financing vehicle for the now defunct Federal Savings &

 

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LoanInsurance Corporation. Under the Federal Deposit Insurance Reform Act of 2005,which became law in 2006, the Bank received a one-time assessment credit of$592,000 to be applied against future deposit insurance assessments, subject tocertain limitations. This credit was utilized to offset $452,000 of depositinsurance assessments during 2007 and $140,000 of assessments during 2008. Theassessment credits were mostly utilized for assessments through June 30,2008.

 

Thedeposits of the Bank are insured to the maximum extent permitted by the DIF,which is administered by the FDIC, and are backed by the full faith and creditof the U.S. Government.  As insurer, theFDIC is authorized to conduct examinations of, and to require reporting by,FDIC-insured institutions.  It also mayprohibit any FDIC-insured institution from engaging in any activity the FDICdetermines by regulation or order to pose a serious threat to the FDIC.  The FDIC also has the authority to initiateenforcement actions against savings institutions, after giving the OTS anopportunity to take such action.

 

TheFDIC may terminate the deposit insurance of any insured depository institution,including the Bank, if it determines after a hearing that the institution hasengaged or is engaging in unsafe or unsound practices, is in an unsafe orunsound condition to continue operations, or has violated any applicable law,regulation, order or any condition imposed by an agreement with the FDIC.  It also may suspend deposit insurancetemporarily during the hearing process for the permanent termination of insurance,if the institution has no tangible capital. If insurance of accounts is terminated, the accounts at the institutionat the time of the termination, less subsequent withdrawals, shall continue tobe insured for a period of six months to two years, as determined by theFDIC.  Management is aware of no existingcircumstances that would result in termination of the Bank’s deposit insurance.

 

OnDecember 16, 2008, the FDIC approved the final rule to raise therisk-based deposit insurance assessment rates uniformly by seven basis pointsfor the first quarter of 2009 assessment period beginning on January 1,2009.  On February 26, 2009, theFDIC approved the final rule to raise the assessment rates for theassessment period beginning on April 1, 2009 and subsequent assessmentperiods.  The new assessment scheme willdifferentiate between risk profiles and will require riskier institutions topay higher assessment rates based on classification into one of four risk categories.  Initial base assessment rates will increaseto between 12 and 45 basis points, depending on the risk category.  Such initial base assessment rates aresubject to adjustment such that the total assessment rate could range from 7 to77.5 basis points on an annual basis.

 

OnFebruary 26, 2009, the FDIC adopted an interim rule, with request forcomment, to impose a one-time 20 basis point emergency special assessmenteffective on June 30, 2009 and to be collected on September 30,2009.  Based on our most recent FDICdeposit insurance assessment base, the emergency special assessment of 20 basispoints, if implemented, would increase our FDIC deposit insurance premiums byapproximately $1.2 million in 2009.  TheFDIC has indicated in recent press reports that it may consider reducing the emergencyspecial assessment by half to 10 basis points if, among other factors, Congressenacts legislation to expand the FDIC’s line of credit with the Department ofTreasury to $100 billion.

 

OnFebruary 26, 2009, the FDIC adopted another interim rule, with request forcomment, to have the option to impose a further special assessment of up to 10basis points on an institution’s assessment base on the last day of anycalendar quarter after June 30, 2009 to be collected at the same time therisk-based assessments are collected. The assessment will be imposed if the FDIC determines the DepositInsurance Fund reserve ratio will fall to a level that would adversely affectpublic confidence or to a level close to zero or negative, among otherfactors.  The ultimate goal of theincrease in assessment rates and the proposed special assessments is to restorethe DIF ratio to a minimum of 1.15 percent within the next seven years.   However, the interim rules are subjectto change and may or may not be enacted.

 

Giventhe enacted and proposed increases in assessments for insured financialinstitutions in 2009, the Company anticipates that FDIC assessments ondeposits will have a significantly greater impact upon operating expenses in2009 compared to 2008 and could materially affect our reported earnings,liquidity and capital.

 

**Temporary Liquidity Guarantee Program. **On November 21, 2008, the Board of Directors of the FDIC adopted afinal rule relating to the Temporary Liquidity Guarantee Program (“TLGProgram”). The TLG Program was announced by the FDIC on October 14, 2008,preceded by the determination of systemic risk by the Secretary of theDepartment of Treasury (after consultation with the President), as aninitiative to counter the system-wide crisis in the nation’s financial sector.Under the TLG Program the FDIC will (i) guarantee, through the earlier ofmaturity or June 30, 2012, certain newly issued senior unsecured debtissued by participating institutions on or after October 14, 2008, andbefore June 30, 2009 and (ii) provide full FDIC deposit insurancecoverage for non-interest bearing transaction deposit accounts, NegotiableOrder of Withdrawal (“NOW”) accounts paying less than 0.5% interest per annumand Interest on Lawyers Trust  Accountsheld at participating FDIC- insured institutions through December 31,2009. Coverage under the TLG Program was available for the first 30 dayswithout charge. The fee assessment for coverage of senior unsecured debt rangesfrom 50 basis points to 100 basis points per annum, depending on the initialmaturity of the debt. The fee assessment for 

 

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depositinsurance coverage is 10 basis points annualized collected quarterly on amountsin covered accounts exceeding $250,000. On December 5, 2008, the Companyelected to participate in both guarantee programs.

 

**Regulatory Capital Requirements.** Federally insured savings institutions are required to maintain minimumlevels of regulatory capital.  The OTShas established capital standards applicable to all savings institutions.  These standards generally must be asstringent as the comparable capital requirements imposed on national banks.  The OTS also is authorized to impose capitalrequirements in excess of these standards on individual institutions on acase-by-case basis.

 

CurrentOTS capital standards require savings institutions to satisfy three differentcapital requirements.  Under thesestandards, savings institutions must maintain “tangible” capital equal to atleast 1.5% of adjusted total assets, “core” capital equal to at least 4.0% ofadjusted total assets and “total” capital (a combination of core and “supplementary”capital) equal to at least 8.0% of “risk-weighted” assets.  For purposes of the regulation, core capitalgenerally consists of common stockholders’ equity (including retainedearnings), noncumulative perpetual preferred stock and related surplus,minority interests in the equity accounts of fully consolidated subsidiaries,certain nonwithdrawable accounts and pledged deposits and “qualifyingsupervisory goodwill.”  Tangible capitalis given the same definition as core capital but does not include qualifyingsupervisory goodwill and is reduced by the amount of all the savingsinstitution’s intangible assets, with only a limited exception for purchasedmortgage servicing rights.  Both core andtangible capital are further reduced by an amount equal to a savings institution’sdebt and equity investments in subsidiaries engaged in activities notpermissible to national banks (other than subsidiaries engaged in activitiesundertaken as agent for customers or in mortgage banking activities andsubsidiary depository institutions or their holding companies).  These adjustments do not materially affectthe Bank’s regulatory capital.  At December 31,2008, the Bank exceeded its tangible, core and risk-based capital requirements.

 

Indetermining compliance with the risk-based capital requirement, a savingsinstitution is allowed to include both core capital and supplementary capitalin its total capital, provided that the amount of supplementary capitalincluded does not exceed the savings institution’s core capital.  Supplementary capital generally consists ofhybrid capital instruments; perpetual preferred stock, which is not eligible tobe included as core capital; subordinated debt and intermediate-term preferredstock; and general allowances for loan losses up to a maximum of 1.25% ofrisk-weighted assets.  In determining therequired amount of risk-based capital, total assets, including certainoff-balance sheet items, are multiplied by a risk weight based on the risksinherent in the type of assets.  The riskweights assigned by the OTS for principal categories of assets are (i) 0%for cash and securities issued by the U.S. Government or unconditionally backedby the full faith and credit of the U.S. Government; (ii) 20% forsecurities (other than equity securities) issued by U.S. Government-sponsoredagencies and mortgage-backed securities issued by, or fully guaranteed as toprincipal and interest by, the FNMA or the FHLMC, except for those classes withresidual characteristics or stripped mortgage-related securities; (iii) 50%for prudently underwritten permanent one- to four-family first lien mortgageloans not more than 90 days delinquent and having a loan-to-value ratio of notmore than 90% at origination unless insured to such ratio by an insurerapproved by the FNMA or the FHLMC, qualifying residential bridge loans madedirectly for the construction of one- to four-family residences and qualifyingmultifamily residential loans; and (iv) 100% for all other loans andinvestments, including consumer loans, commercial loans, and one- tofour-family residential real estate loans more than 90 days delinquent, and forrepossessed assets.

 

**Qualified Thrift Lender Test.**  Allsavings institutions are required to meet a QTL test to avoid certainrestrictions on their operations.  A savings institution that does notmeet the QTL test must either convert to a bank charter or comply with thefollowing restrictions on its operations: (i) the institution may notengage in any new activity or make any new investment, directly or indirectly, unlesssuch activity or investment is permissible for a national bank; (ii) thebranching powers of the institution shall be restricted to those of a nationalbank; and (iii) payment of dividends by the institution shall be subjectto the rules regarding payment of dividends by a national bank.  Uponthe expiration of three years from the date the savings institution ceases tobe a QTL, it must cease any activity and not retain any investment notpermissible for a national bank.

 

Currently,the QTL test requires either (i) that a savings association qualifies as adomestic building and loan association as defined in Section 7701 (a)(19)of the Internal Revenue Code of 1986, as amended, (“Code”) or (ii) that65% of an institution’s “portfolio assets” (as defined) consist of certainhousing and consumer-related assets on a monthly average basis in nine out ofevery 12 months.  Assets that qualifywithout limit for inclusion as part of the 65% requirement are loans made topurchase, refinance, construct, improve or repair domestic residential housingand manufactured housing; home equity loans; educational loans; small businessloans; loans made through credit cards or credit card accounts; mortgage-backedsecurities (where the mortgages are secured by domestic residential housing ormanufactured housing); stock issued by the FHLB of Dallas; and direct orindirect obligations of the FDIC.  Inaddition, the following assets, among others, may be included in meeting thetest subject to an overall limit of 20% of the savings institution’s portfolioassets: 50% of residential mortgage loans originated and sold within 90 days oforigination; investments in a service corporation that derives at least 80% ofits gross revenues from activities related to domestic or manufacturedresidential housing; 200% of the amount of loans and investments in “starterhomes”; 200% of the amount of certain loans in “credit-needy” areas; loans forthe purchase, construction, development, or improvements of “community service 

 

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facilities”not in credit-needy areas; loans for personal, family, or household purchases(other than those in the includable without limit category); and stock issuedby the FHLMC or the FNMA.  Portfolioassets consist of total assets minus the sum of (i) goodwill and otherintangible assets, (ii) property used by the savings institution toconduct its business, and (iii) liquid assets up to 20% of the institution’stotal assets.  At December 31, 2008,the qualified thrift investments of the Bank were approximately 71.2% of itsportfolio assets.

 

**Federal Home Loan Bank System. **The Bank is a member of the FHLB of Dallas, which is one of 12 regionalFHLBs that administers the home financing credit function of savingsinstitutions.  Each FHLB serves as areserve or central bank for its members within its assigned region.  It is funded primarily from proceeds derivedfrom the sale of consolidated obligations of the FHLB System.  It makes loans to members (i.e., advances) inaccordance with policies and procedures established by the board of directorsof the FHLB.  At December 31, 2008,the Bank had $82.2 million of outstanding FHLB advances.

 

Asa member, the Bank is required to purchase and maintain stock in the FHLB ofDallas in an amount equal to the sum of 0.06% of total assets as of theprevious December 31 and 4.10% of outstanding advances.  At December 31, 2008, the Bank had $4.8million in FHLB stock, which was in compliance with this requirement.  No ready market exists for such stock and ithas no quoted market value.

 

TheFHLBs are required to provide funds for the resolution of troubled savingsinstitutions and to contribute to affordable housing programs through directloans or interest subsidies on advances targeted for community investment andlow- and moderate-income housing projects. These contributions have adversely affected the level of FHLB dividendspaid in the past and could continue to do so in the future.  These contributions also could have anadverse effect on the value of FHLB stock in the future.

 

**Federal Reserve System. **The FRBrequires all depository institutions to maintain reserves against their transactionaccounts and non-personal time deposits. As of December 31, 2008, no reserves were required to be maintainedon the first $9.3 million of transaction accounts, reserves of 3% were requiredto be maintained against the next $43.9 million of net transaction accounts(with such dollar amounts subject to adjustment by the FRB), and a reserve of10% against all remaining net transaction accounts.  Because required reserves must be maintainedin the form of vault cash or a noninterest bearing account at a Federal ReserveBank, the effect of this reserve requirement is to reduce an institution’searning assets.

 

**TAXATION**

 

**Federal Taxation**

 

**General. **The Company and the Bank are subject to thegenerally applicable corporate tax provisions of the Code, and the Bank issubject to certain additional provisions of the Code that apply to thrift andother types of financial institutions. The following discussion of federaltaxation is intended only to summarize certain pertinent federal income taxmatters material to the taxation of the Company and the Bank and is not acomprehensive discussion of the tax rules applicable to the Company andBank.

 

**Year. **The Bank files a federal income tax return onthe basis of a fiscal year ending on December 31.  The Company filed a consolidated federalincome tax return with both the Bank and the Service Corporation.

 

**Bad Debt Reserves. **Prior to theenactment of the Small Business Jobs Protection Act (the “Act”), which wassigned into law on August 21, 1996, certain thrift institutions, such asthe Bank, were allowed deductions for bad debts under methods more favorablethan those granted to other taxpayers. Qualified thrift institutions could compute deductions for bad debtsusing either the specific charge-off method of Section 166 of the Code orthe reserve method of Section 593 of the Code.   As a result of the 1996 Act, the Bank wasrequired to use the specific charge off method in computing its bad debtdeduction beginning with its 1996 federal tax return. Savings institutions wererequired to recapture any excess reserves over those established as of December 31,1987 (base year reserve).

 

Thebalance of the pre-1988 reserves is subject to the provisions of Section 593(e),as modified by the Act, which requires recapture in the case of certainexcessive distributions to shareholders. The pre-1988 reserves may not be utilized for payment of cash dividendsor other distributions to a shareholder (including distributions in dissolutionor liquidation) or for any other purpose (except to absorb bad debtlosses).  Distribution of a cash dividendby a thrift institution to a shareholder is treated as made:  first, out of the institution’s post-1951accumulated earnings and profits; second, out of the pre-1988 reserves; andthird, out of such other accounts as may be proper.  To the extent a distribution by the Bank tothe Company is deemed paid out of its pre-1988 reserves under these rules, thepre-1988 reserves would be reduced and the Bank’s gross income for tax purposeswould be increased by the amount which, when reduced by the income tax, if any,attributable to the inclusion of such amount in its gross income, equals theamount deemed paid out of the pre-1988 reserves.  As of December 31, 2008, the Bank’spre-1988 reserves for tax purposes totaled approximately $4.2 million.

 

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**Minimum Tax. **The Code imposes an alternative minimum tax ata rate of 20%.  The alternative minimumtax generally applies to a base of regular taxable income plus certain taxpreferences (“alternative minimum taxable income” or “AMTI”) and is payable tothe extent such AMTI is in excess of an exemption amount.  Items of tax preference that constitute AMTIinclude (a) tax-exempt interest on newly issued (generally, issued on orafter August 8, 1986) private activity bonds other than certainqualified bonds and (b) 75% of the excess (if any) of (i) adjustedcurrent earnings as defined in the Code, over (ii) AMTI (determinedwithout regard to this preference and prior to reduction by net operatinglosses).

 

**Net Operating Loss Carryovers. **A financial institution may, for federal income tax purposes, carry backnet operating losses (“NOLs”) to the preceding two taxable years and forward tothe succeeding 20 taxable years.  Thisprovision applies to losses incurred in taxable years beginning after1997.  The Job Creation and WorkerAssistance Act of 2002 temporarily increased the general NOL carryback periodfrom two years to five years for NOLs arising in taxable years ending in 2001and 2002.  At December 31, 2008, theBank had no NOL carryforwards for federal income tax purposes.

 

**Capital Gains and Corporate Dividends-ReceivedDeduction. **Corporate net capital gains are taxed at amaximum rate of 35%.  The corporate dividends-receiveddeduction is 80% in the case of dividends received from a “20-percent-ownedcorporation”, i.e., a corporation having at least twenty percent (but generallyless than 80 percent) of its stock owned by the recipient corporation andcorporations which own less than 20% of the stock of a corporation distributinga dividend may deduct only 70% of dividends received or accrued on theirbehalf.  However, a corporation maydeduct 100% of dividends from a member of the same affiliated group of corporations.

 

**Other Matters. **Federal legislation is introduced from time totime that would limit the ability of individuals to deduct interest paid onmortgage loans.  Individuals arecurrently not permitted to deduct interest on consumer loans.  Significant increases in tax rates or furtherrestrictions on the deductibility of mortgage interest could adversely affectthe Bank.

 

TheBank’s federal income tax returns for the tax years ended December 31,2005 forward are open under the statute of limitations and are subject toreview by the IRS.  The Company has beennotified that its 2007 tax return will be subject to examination by the IRS.

 

**State Taxation**

 

TheBank is subject to the Arkansas corporation income tax, which is a progressiverate up to a maximum of 6.5% of all taxable earnings.

 

TheCompany is incorporated under Texas law and, accordingly, is subject to the NewTexas Franchise Tax.  The New Texas Franchise Tax is based on taxablemargin apportioned to Texas pursuant to its gross receipts based uponwhere the Company conducts business.  The Company currently has noTexas Gross Receipts.

 

**Item 1A.  Risk Factors**

 

*In analyzing whether to make or to continue aninvestment in our securities, investors should consider, among other factors,the following risk factors.*

 

***The current economic environmentposes significant challenges for the Company and could adversely affect itsfinancial condition and results of operations.***

 

TheCompany is operating in a challenging and uncertain economic environment,including generally uncertain national and local conditions.  Financial institutions continue to beaffected by sharp declines in the real estate market and constrained financialmarkets.  Dramatic declines in thehousing market over the past year, with falling home prices and increasingforeclosures and unemployment, have resulted in significant write-downs ofasset values by financial institutions. Continued declines in real estate values, home sales volumes, andfinancial stress on borrowers as a result of the uncertain economic environmentcould have an adverse effect on the Bank’s borrowers or their customers, whichcould adversely affect the Company’s financial condition and results ofoperations.  A worsening of theseconditions would likely exacerbate the adverse effects on the Company andothers in the financial services industry. For example, further deterioration in local economic conditions in theCompany’s markets could drive losses beyond that which is provided for in itsallowance for loan losses.  The Companymay also face the following risks in connection with these events:

 

·                  Economic conditions that negatively affecthousing prices and the job market have resulted, and may continue to result, ina deterioration in credit quality of the Bank’s loan portfolio, and suchdeterioration in credit quality has had, and could continue to have, a negativeimpact on the Company’s business.

·                  Marketdevelopments may affect consumer confidence levels and may cause adversechanges in payment patterns, causing increases in delinquencies and defaultrates on loans and other credit facilities.

 

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·                  Theprocesses the Company uses to estimate the allowance for loan losses may nolonger be reliable because they rely on complex judgments, including forecastsof economic conditions, which may no longer be capable of accurate estimation.

·                  The Bank’s ability to assess the creditworthinessof its customers may be impaired if the processes and approaches it uses toselect, manage, and underwrite its customers become less predictive of futurecharge-offs.

·                  The Company expects to face increasedregulation of its industry, and compliance with such regulation may increaseits costs, limit its ability to pursue business opportunities, and increasecompliance challenges.

 

Asthese conditions or similar ones continue to exist or worsen, the Company couldexperience continuing or increased adverse effects on its financial conditionand results of operations.

 

**The Company’s business is subject to various lendingand other economic risks that could adversely impact the Company’s financialcondition and results of operations.**

 

Changein economic conditions, particularly an economic slowdown, could hurt theCompany’s business.  The Company’sbusiness is directly affected by political and market conditions, broad trendsin industry and finance, legislative and regulatory changes, and changes in governmentalmonetary and fiscal policies and inflation, all of which are beyond the Company’scontrol.  A deterioration in economicconditions, in particular an economic slowdown within the Company’s geographicregion, could result in the following consequences, any of which could have amaterial adverse effect on the Company’s business:

 

·                  loan delinquencies may increase;

·                  problem assets and foreclosures may increase;

·                  demand for the Company’s products and servicesmay decline; and

·                  collateral for loans made by the Bank manydecline in value, in turn reducing a client’s borrowing power, and reducing thevalue of assets and collateral associated with the Company’s loans held forinvestment.

 

**The declining real estate market could impact theCompany’s business.**

 

TheBank’s business activities and credit exposures are concentrated in NorthwestArkansas and the surrounding region. A continued downturn in this regional realestate market could hurt the Company’s business because of the geographicconcentration within this regional area. If there is a significant decline in real estate values, the collateralfor the Bank’s loans will provide less security.  As a result, the Bank’s ability to recover ondefaulted loans by selling the underlying real estate would be diminished, andwe would be more likely to suffer losses on defaulted loans.

 

**Changes in interest rates could have a material adverseeffect on our operations.**

 

Theoperations of financial institutions such as the Bank are dependent to a largeextent on net interest income, which is the difference between the interestincome earned on interest earning assets such as loans and investmentsecurities and the interest expense paid on interest bearing liabilities suchas deposits and borrowings.  Changes in thegeneral level of interest rates can affect our net interest income by affectingthe difference between the weighted average yield earned on our interestearning assets and the weighted average rate paid on our interest bearingliabilities, or interest rate spread, and the average life of our interestearning assets and interest bearing liabilities.  Changes in interest rates also can affect ourability to originate loans; the value of our interest earning assets; ourability to obtain and retain deposits in competition with other availableinvestment alternatives; and the ability of our borrowers to repay adjustableor variable rate loans.  Interest ratesare highly sensitive to many factors, including governmental monetary policies,domestic and international economic and political conditions and other factorsbeyond our control.  Although we believethat the estimated maturities and repricing of our interest earning assetscurrently are fairly well balanced in relation to the estimated maturities andrepricing of our interest bearing liabilities (which involves various estimatesas to how changes in the general level of interest rates will impact theseassets and liabilities), there can be no assurance that our profitability wouldnot be adversely affected during any period of changes in interest rates due toa number of factors which can have a material impact on the Bank’s interestrate risk position.  Such factors includeamong other items, call features and interest rate caps and floors on variousassets and liabilities, prepayments, the current interest rates on assets andliabilities to be repriced in each period, and the relative changes in interestrates on different types of assets and liabilities.

 

**There are increased risks involved with commercial realestate, construction, commercial business and consumer lending activities.**

 

Ourlending activities include loans secured by existing commercial realestate.  In addition, our portfolioincludes loans for the construction of single-family residential real estateand land development loans.  Commercialreal estate and construction lending generally is considered to involve ahigher degree of risk than single-family residential lending due to a varietyof factors, including generally larger loan balances, the dependency onsuccessful completion or operation of the

 

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projectfor repayment, the difficulties in estimating construction costs and loan termswhich often do not require full amortization of the loan over its term and,instead, provide for a balloon payment at stated maturity.  Our lending activities also include commercialbusiness loans to small- to medium-sized businesses, which generally aresecured by various equipment, machinery and other corporate assets, and a widevariety of consumer loans, including automobile loans, deposit account securedloans and unsecured loans.  Althoughcommercial business loans and consumer loans generally have shorter terms andhigher interest rates than mortgage loans, they generally involve more riskthan mortgage loans because of the nature of, or in certain cases the absenceof, the collateral which secures such loans.

 

AtDecember 31, 2008, total nonaccrual loans amounted to $25.4 million, a$7.9 million or 23.7% decrease compared to nonaccrual loans of $33.3 million atDecember 31, 2007.  Such decreasewas primarily due to a $8.9 million decrease in nonaccrual land developmentloans which were transferred to real estate owned during the year.  The Northwest Arkansas market has experiencedan oversupply of lots and speculative homes and certain of the Bank’s buildersare experiencing extended marketing times for the sale of their homes,resulting in inadequate cash flow to service the interest carry on theirloan.  As a result, the Bank hassubstantially curtailed such lending.

 

Theresolution of such nonaccrual loans may substantially impact the Company’sprovision for loan losses and allowance for loan losses.  A decrease in current values or an adversechange in loss experience may require us to increase both our provision forloan losses and our allowance for loan losses.

 

**Our allowance for losses on loans may not be adequateto cover probable losses.**

 

Wehave established an allowance for loan losses that we believe is adequate tooffset probable losses on our existing loans. There can be no assurance that any further declines in real estatemarket conditions, general economic conditions or changes in regulatorypolicies will not require us to increase our allowance for loan losses, whichwould adversely affect our results of operations.

 

**We are subject to extensive regulation that couldadversely affect our business and operations.**

 

Weare subject to extensive federal and state governmental supervision andregulation, which are intended primarily for the protection of depositors.  In addition, we are subject to changes infederal and state laws, as well as changes in regulations, governmentalpolicies and accounting principles.  Theeffects of any such potential changes cannot be predicted but could adverselyaffect our business and operations and that of our subsidiaries in the future.

 

**We face strong competition that may adversely affectour profitability.**

 

Weare subject to vigorous competition in all aspects and areas of our businessfrom banks and other financial institutions, including savings and loanassociations, savings banks, finance companies, credit unions and otherproviders of financial services, such as money market mutual funds, brokeragefirms, consumer finance companies and insurance companies.  We also compete with non-financialinstitutions, including retail stores that maintain their own credit programsand governmental agencies that make available low cost or guaranteed loans tocertain borrowers.  Certain of ourcompetitors are larger financial institutions with substantially greaterresources, lending limits, larger branch systems and a wider array of bankingservices.  Competition from both bank andnon-bank organizations will continue.

 

**Our ability to successfully compete may be reduced ifwe are unable to make technological advances.**

 

Thebanking industry is experiencing rapid changes in technology.  In addition to improving customer services,effective use of technology increases efficiency and enables financialinstitutions to reduce costs.  As aresult, our future success will depend in part on our ability to address ourcustomers’ needs by using technology.  Wecannot assure that we will be able to effectively develop new technology-drivenproducts and services or be successful in marketing these products to ourcustomers.  Many of our competitors havefar greater resources than we have to invest in technology.

 

**The Company is subject to restrictions on its abilityto declare or pay dividends and repurchase its shares as a result of itsparticipation in the Treasury’s Troubled Asset Relief Program Capital PurchaseProgram.**

 

OnMarch 6, 2009, the Company issued to the Treasury for aggregateconsideration of $16.5 million (i) 16,500 shares of Series APreferred Stock and (ii) a Warrant to purchase 321,847 shares of theCompany’s Common Stock pursuant to the terms of the Purchase Agreement.  Under the terms of the Purchase Agreement,the Company’s ability to declare or pay dividends on any of its shares isrestricted.  Specifically, the Companymay not declare dividend payments on common, junior preferred or *pari passu* preferred shares if it is in arrearson the dividends on the Series A Preferred Stock.  In addition, the Company may not increase thedividends on its Common Stock above the amount of the last quarter cashdividend per share declared prior to October 14, 2008, which was $0.16 pershare, without the Treasury’s approval until the third anniversary of theinvestment unless all of the Series A Preferred Stock has been redeemed ortransferred.

 

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Further,until the Series A Preferred Stock is redeemed, the Company may not pay aquarterly cash dividend in excess of $0.01 per share without approval of itsprimary regulator, the Office of Thrift Supervision.

 

TheCompany’s ability to repurchase its shares is also restricted under the termsof the Purchase Agreement.  The Treasury’sconsent generally is required for the Company to make any stock repurchasesuntil the third anniversary of the investment by the Treasury unless all of theSeries A Preferred Stock has been redeemed or transferred.  Further, common, junior preferred or *pari passu* preferred shares may not berepurchased if the Company is in arrears on the Series A Preferred Stockdividends.

 

**Holders of our common stock have no preemptive rightsand are subject to potential dilution.**

 

Ourcertificate of incorporation does not provide any shareholder with a preemptiveright to subscribe for additional shares of common stock upon any increasethereof.  Thus, upon the issuance of anyadditional shares of common stock or other voting securities of the Company orsecurities convertible into common stock or other voting securities,shareholders may be unable to maintain their pro rata voting or ownership interestin us.

 

**We may incur increased employee benefit costs.**

 

Ourpension benefits are dependent upon multiple factors resulting from actual planexperience and assumptions of future experience. Fluctuations in marketperformance and changes in interest rates may result in increased or decreasedpension costs in future periods. Changes in assumptions regarding expectedlong-term rate of return on plan assets, changes in our discount rate orexpected compensation levels could also increase or decrease pension costs.Future pension funding requirements, and the timing of funding payments, may besubject to changes in legislation.

 

**We are subject to security and operational risksrelating to our use of technology that could damage our reputation and ourbusiness.**

 

Securitybreaches in our internet banking activities could expose us to possibleliability and damage our reputation. Any compromise of our security also coulddeter customers from using our internet banking services that involve thetransmission of confidential information. We rely on standard internet securitysystems to provide the security and authentication necessary to effect securetransmission of data. These precautions may not protect our systems fromcompromises or breaches of our security measures that could result in damage toour reputation and our business. Additionally, we outsource our data processingto a third party. If our third party provider encounters difficulties or if wehave difficulty in communicating with such third party, it could significantlyaffect our ability to adequately process and account for customer transactions,which could significantly affect our business operations.

 

**The building of market share through our branchingstrategy could cause our expenses to increase faster than revenues.**

 

Weopened two new branches during calendar year 2008. There are considerable costsinvolved in opening branches and new branches generally require a period oftime to generate sufficient revenues to offset their costs, especially in areasin which we do not have an established presence. Accordingly, any new branchcan be expected to negatively impact our earnings for some period of time untilthe branch reaches certain economies of scale. We have no assurance our newbranches will be successful even after they have been established.

 

**If external funds are not available, this couldadversely impact our growth and future prospects.**

 

We primarily rely on deposits and Federal Home Loan Bank and FederalReserve Bank advances to fund our operations. Although we have historicallybeen able to replace maturing deposits if desired, no assurance can be giventhat we will be able to replace such funds in the future if our financialcondition or market conditions were to change. Although we consider the sourcesof existing funds adequate for our current liquidity needs, we may seekbrokered deposits or debt in the future to achieve our long-term businessobjectives. There can be no assurance additional funds, if sought, would beavailable to us or, if available, would be on favorable terms. If additionalfinancing sources are unavailable or are not available on reasonable terms, ourgrowth and future prospects could be adversely affected.

 

**Item 1B.  Unresolved Staff Comments**

 

None

 

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**Item 2. Properties****.**

 

At December 31, 2008, the Bank conducted its business from itsexecutive office in Harrison, Arkansas, and nineteen full service offices, allof which are located in Northcentral and Northwest Arkansas.

 

The following table sets forth information with respect to the officesand other properties of the Bank at December 31, 2008.

 
| **Description/Address**          | ** ** | **Leased/  Owned** | ** ** | **Description/Address**             | ** ** | **Leased/  Owned** | ** ** |
|----------------------------------|------------|--------------------|------------|-------------------------------------|------------|--------------------|------------|
|                             |       |               |       |                                |       |               |       |
| 1401 Highway  62/65 North        |       | Owned              |       | 2501 E.  Central Ave., Suite 2 |       | Leased(1)          |       |
| Harrison, AR  72601              |       |               |       | Bentonville,  AR 72712              |       |               |       |
|                             |       |               |       |                                |       |               |       |
| 200 West  Stephenson             |       | Owned              |       | 3460 North  College                 |       | Owned              |       |
| Harrison, AR  72601              |       |               |       | Fayetteville,  AR 72703             |       |               |       |
|                             |       |               |       |                                |       |               |       |
| Corner Central & Willow |       | Owned              |       | 1303 Hudson  Road                   |       | Owned              |       |
| Harrison, AR 72601               |       |               |       | Rogers, AR  72756                   |       |               |       |
|                             |       |               |       |                                |       |               |       |
| 324 Hwy. 62/65 Bypass            |       | Owned              |       | 201 East  Henri De Tonti Blvd.      |       | Owned              |       |
| Harrison, AR 72601               |       |               |       | Tontitown,  AR 72764                |       |               |       |
|                             |       |               |       |                                |       |               |       |
| 210 South Main                   |       | Owned              |       | 2025 North  Crossover Road          |       | Owned              |       |
| Berryville, AR 72616             |       |               |       | Fayetteville,  AR 72703             |       |               |       |
|                             |       |               |       |                                |       |               |       |
| 668 Highway 62 East              |       | Owned              |       | 191 West  Main Street               |       | Owned              |       |
| Mountain Home, AR 72653          |       |               |       | Farmington,  AR 72730               |       |               |       |
|                             |       |               |       |                                |       |               |       |
| 1337 Highway 62 SW               |       | Owned              |       | 2030 West  Elm                      |       | Owned              |       |
| Mountain Home, AR 72653          |       |               |       | Rogers, AR  72756                   |       |               |       |
|                             |       |               |       |                                |       |               |       |
| 301 Highway 62 West              |       | Owned              |       | 1023 East  Millsap Road             |       | Owned              |       |
| Yellville, AR 72687              |       |               |       | Fayetteville,  AR 72703             |       |               |       |
|                             |       |               |       |                                |       |               |       |
| 307 North Walton Blvd.           |       | Owned              |       | 3027 Highway  62 East               |       | Owned              |       |
| Bentonville, AR 72712            |       |               |       | Mountain  Home, AR 72653            |       |               |       |
|                             |       |               |       |                                |       |               |       |
| 3300 West Sunset                 |       | Owned              |       | 1190 East  Centerton Boulevard      |       | Leased (2)         |       |
| Springdale, AR 72762             |       |               |       | Centerton,  AR 72719                |       |               |       |
|                             |       |               |       |                                |       |               |       |
| 2000 Promenade Boulevard         |       | Leased (3)         |       | 225 N.  Bloomington Street, Ste. H  |       | Owned              |       |
| Rogers, AR 72758                 |       |               |       | Lowell, AR  72745                   |       |               |       |

 

----

(1)                Such property is subject to a five-year leaseexpiring August 1, 2013, with two five-year renewal options.

(2)                Such property is subject to a five-year leaseexpiring November 1, 2010, with three five-year renewal options.

(3)                Such property is subject to a ten-year leaseexpiring March 1, 2018, with five five-year renewal options.

 

**Item 3.  LegalProceedings.**

 

Neither the Company nor the Bank is involved in any pending legalproceedings other than nonmaterial legal proceedings occurring in the ordinarycourse of business.

 

**Item 4. Submission of Matters to Vote of Security Holders.**

 

No matters were submitted to a vote of security holders during thefourth quarter of 2008.

 

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**PART II.**

 

**Item 5.  Marketfor Registrant’s Common Equity, Related Stockholder Matters, and IssuerPurchases of Equity Securities.**

 

Shares of the Company’s common stock are traded under the symbol “FFBH”on the Nasdaq Global Market.  At February 20,2009, the Company had 4,846,785 shares of common stock outstanding and hadapproximately 1,877 beneficial holders of common stock.

 

The following table sets forth the dividends declared and the reportedhigh and low end of day closing prices of a share of the Company’s common stockas reported by Nasdaq for the periods indicated.

 
| **Quarter Ended** | ** ** | **Year Ended  December 31, 2008** | ** ** | **Year Ended  December 31, 2007** | ** ** |
|------------------------|------------|--------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **             | ** ** | **High**                                         | ** ** | **Low**                                          | ** ** | **Dividend** | ** ** | **High** | ** ** | **Low** | ** ** | **Dividend** | ** ** |
| **March 31**      |       | $                                                | 15.49      |                                             | $          | 11.79 |   | $ | 0.16 |   | $ | 25.24 |   | $ | 23.25 |   | $ | 0.16 |   |
| **June 30**       |       | $                                                | 13.95      |                                             | $          | 8.65 |   | $ | 0.16 |   | $ | 25.05 |   | $ | 23.43 |   | $ | 0.16 |   |
| **September 30**  |       | $                                                | 9.95       |                                             | $          | 7.07 |   | $ | 0.16 |   | $ | 23.95 |   | $ | 17.60 |   | $ | 0.16 |   |
| **December 31**   |       | $                                                | 9.89       |                                             | $          | 7.00 |   | $ | 0.16 |   | $ | 18.05 |   | $ | 14.00 |   | $ | 0.16 |   |

 

In conjunction with the Company’s participation in the U.S. Treasury’sCapital Purchase Program and in an effort to preserve and maintain capitalduring the current economic crisis, the board of directors of the Company hasdetermined to decrease the quarterly cash dividend rate to $0.01 pershare.  Until the preferred stock issuedto the U.S. Treasury under the Capital Purchase Program is redeemed, theCompany may not pay a quarterly cash dividend in excess of $0.01 per sharewithout approval from its primary regulator, the Office of ThriftSupervision.  The board of directorsintends to revisit this issue when the economy rebounds and the Company’searnings return to more normalized levels. Future dividends will be determined by the board of directors aftergiving consideration to the Company’s financial condition, results ofoperations, tax status, industry standards, economic conditions, regulatoryrequirements and other factors.

 

The following graph demonstrates comparison of the cumulative totalreturns for the common stock of the Company, the SNL Securities $500 million to$1 Billion Thrift Asset Size Index, and the NASDAQ Stock Market Index since theclose of trading of the Company’s common stock on December 31, 2003.  The graph represents $100 invested in theCompany’s common stock at $20.50 per share, the closing price per share as of December 31,2003.  The cumulative total returnsinclude the payment of dividends by the Company.

 

 
| ** **                                       | ** ** | **Period Ending** | ** ** |
|--------------------------------------------------|------------|------------------------|------------|
| **Index**                                        | ** ** | **12/31/03**           | ** ** | **12/31/04** | ** ** | **12/31/05** | ** ** | **12/31/06** | ** ** | **12/31/07** | ** ** | **12/31/08** | ** ** |
| First Federal Bancshares of  Arkansas, Inc. |       | 100.00                 |       | 112.06 |   | 123.40 |   | 126.51 |   | 75.80 |   | 43.49 |   |
| NASDAQ Composite                                 |       | 100.00                 |       | 108.59 |   | 110.08 |   | 120.56 |   | 132.39 |   | 78.72 |   |
| SNL Thrift $500M-$1B                             |       | 100.00                 |       | 110.61 |   | 105.12 |   | 128.81 |   | 101.83 |   | 75.51 |   |

 

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**Issuer Purchases of Equity Securities**

 

TheCompany did not repurchase any securities during the fourth quarter of2008.  The Company is in its nineteenthannounced repurchase program that was approved by the board of directors on July 25,2006, and publicly announced on November 8, 2006. Total shares approved tobe purchased in this program are 245,197, of which 214,587 had been purchasedas of December 31, 2008.  Alltreasury stock purchases are made under publicly announced repurchaseprograms.  The repurchase program iscurrently suspended.

 

**Item 6.  SelectedFinancial Data****.**

 

The selected consolidated financial and other data of the Company setforth below and on the following page is not complete and should be readin conjunction with, and is qualified in its entirety by, the more detailedinformation, including the Consolidated Financial Statements and related Notes,appearing elsewhere herein.

 
| ** **                                           | ** ** | **At or For the  Year Ended December 31,** | ** ** |
|------------------------------------------------------|------------|--------------------------------------------------------------------------|------------|
| ** **                                           | ** ** | **2008**                                                                 | ** ** | **2007** | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                           | ** ** | **(In Thousands, Except Per Share Data)**       | ** ** |
| **Selected Financial Condition Data:**               |       |                                                                     |       |   |   |   |   |   |   |   |   |
| Total assets                                         |       | $                                                                        | 795,172    |   | $ | 791,978 |   | $ | 852,475 |   | $ | 852,411 |   | $ | 751,665 |   |
| Cash and cash equivalents                            |       | 9,367                                                                    |       | 27,387 |   | 35,518 |   | 21,109 |   | 16,003 |   |
| Investment securities                                |       | 136,412                                                                  |       | 95,590 |   | 60,746 |   | 56,695 |   | 56,660 |   |
| Loans receivable, net                                |       | 568,123                                                                  |       | 601,256 |   | 693,095 |   | 719,214 |   | 634,217 |   |
| Allowance for loan losses                            |       | 6,441                                                                    |       | 5,162 |   | 2,572 |   | 2,114 |   | 1,846 |   |
| Deposits                                             |       | 618,003                                                                  |       | 630,414 |   | 652,265 |   | 611,667 |   | 582,424 |   |
| Other borrowings                                     |       | 92,212                                                                   |       | 82,087 |   | 120,305 |   | 158,240 |   | 89,756 |   |
| Stockholders’ equity                            |       | 73,117                                                                   |       | 73,663 |   | 75,573 |   | 77,842 |   | 75,301 |   |
|                                                 |       |                                                                     |       |   |   |   |   |   |   |   |   |
| **Selected Operating Data:**                         |       |                                                                     |       |   |   |   |   |   |   |   |   |
| Interest income                                      |       | $                                                                        | 43,947     |   | $ | 50,426 |   | $ | 54,119 |   | $ | 46,085 |   | $ | 39,370 |   |
| Interest expense                                     |       | 22,102                                                                   |       | 28,184 |   | 27,576 |   | 19,604 |   | 14,338 |   |
| Net interest income                                  |       | 21,845                                                                   |       | 22,242 |   | 26,543 |   | 26,481 |   | 25,032 |   |
| Provision for loan losses                            |       | 5,710                                                                    |       | 4,028 |   | 1,482 |   | 1,101 |   | 1,020 |   |
| Net interest income after provision for  loan losses |       | 16,135                                                                   |       | 18,214 |   | 25,061 |   | 25,380 |   | 24,012 |   |
| Noninterest income                                   |       | 9,417                                                                    |       | 7,769 |   | 8,222 |   | 6,936 |   | 6,201 |   |
| Noninterest expense                                  |       | 23,468                                                                   |       | 22,995 |   | 22,521 |   | 20,743 |   | 18,710 |   |
| Income before income taxes                           |       | 2,084                                                                    |       | 2,988 |   | 10,762 |   | 11,573 |   | 11,503 |   |
| Income tax provision (benefit)                       |       | (423                                                                     | )          | 345 |   | 3,379 |   | 3,723 |   | 3,698 |   |
| Net income                                           |       | $                                                                        | 2,507      |   | $ | 2,643 |   | $ | 7,383 |   | $ | 7,850 |   | $ | 7,805 |   |
|                                                 |       |                                                                     |       |   |   |   |   |   |   |   |   |
| **Earnings per Share:**                              |       |                                                                     |       |   |   |   |   |   |   |   |   |
| Basic                                                |       | $                                                                        | 0.52       |   | $ | 0.54 |   | $ | 1.48 |   | $ | 1.57 |   | $ | 1.54 |   |
| Diluted                                              |       | $                                                                        | 0.52       |   | $ | 0.54 |   | $ | 1.44 |   | $ | 1.50 |   | $ | 1.45 |   |
|                                                 |       |                                                                     |       |   |   |   |   |   |   |   |   |
| **Cash Dividends Declared per Share**                |       | $                                                                        | 0.64       |   | $ | 0.64 |   | $ | 0.58 |   | $ | 0.50 |   | $ | 0.42 |   |

 

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| ** **                                                                  |   | **At or For the Year Ended December 31,** |   |
|-----------------------------------------------------------------------------|--------|------------------------------------------------------------------------------|--------|
| ** **                                                                  |   | **2008**                                                                     |   | **2007** |   | **2006** |   | **2005** |   | **2004** |   |
| **Selected Operating Ratios(1):**                                           |   |                                                                         |   |   |   |   |   |   |   |   |   |
| Return on average assets                                                    |   | 0.31                                                                         | %      | 0.32 | % | 0.85 | % | 0.97 | % | 1.09 | % |
| Return on average equity                                                    |   | 3.38                                                                         |   | 3.52 |   | 9.40 |   | 10.27 |   | 10.37 |   |
| Average equity to average assets                                            |   | 9.24                                                                         |   | 9.21 |   | 9.04 |   | 9.46 |   | 10.53 |   |
| Interest rate spread(2)                                                     |   | 2.99                                                                         |   | 2.92 |   | 3.19 |   | 3.41 |   | 3.64 |   |
| Net interest margin(2)                                                      |   | 3.01                                                                         |   | 2.98 |   | 3.29 |   | 3.51 |   | 3.75 |   |
| Net interest income after provision for  loan losses to noninterest expense |   | 68.75                                                                        |   | 79.21 |   | 111.28 |   | 122.35 |   | 128.34 |   |
| Noninterest expense to average assets                                       |   | 2.92                                                                         |   | 2.82 |   | 2.59 |   | 2.57 |   | 2.62 |   |
| Average interest earning assets to average  interest bearing liabilities    |   | 100.49                                                                       |   | 101.68 |   | 102.92 |   | 103.80 |   | 105.12 |   |
| Operating efficiency(3)                                                     |   | 75.07                                                                        |   | 76.62 |   | 64.78 |   | 62.07 |   | 59.90 |   |
|                                                                        |   |                                                                         |   |   |   |   |   |   |   |   |   |
| **Asset Quality Ratios(4):**                                                |   |                                                                         |   |   |   |   |   |   |   |   |   |
| Nonaccrual and restructured loans to total  loans(5)                        |   | 5.87                                                                         |   | 5.55 |   | 2.68 |   | 1.67 |   | 1.14 |   |
| Nonperforming assets to total assets(5)                                     |   | 7.14                                                                         |   | 5.54 |   | 2.76 |   | 1.65 |   | 1.13 |   |
| Allowance for loan losses to non-performing  loans(5)                       |   | 18.73                                                                        |   | 14.44 |   | 13.07 |   | 16.06 |   | 23.21 |   |
| Allowance for loan losses to total loans                                    |   | 1.10                                                                         |   | 0.80 |   | 0.35 |   | 0.27 |   | 0.26 |   |
|                                                                        |   |                                                                         |   |   |   |   |   |   |   |   |   |
| **Capital Ratios(6):**                                                      |   |                                                                         |   |   |   |   |   |   |   |   |   |
| Tangible capital to adjusted total assets                                   |   | 8.89                                                                         |   | 9.22 |   | 8.76 |   | 8.78 |   | 9.74 |   |
| Core capital to adjusted total assets                                       |   | 8.89                                                                         |   | 9.22 |   | 8.76 |   | 8.78 |   | 9.74 |   |
| Risk-based capital to risk-weighted assets                                  |   | 13.35                                                                        |   | 13.20 |   | 11.94 |   | 12.06 |   | 13.75 |   |
|                                                                        |   |                                                                         |   |   |   |   |   |   |   |   |   |
| **Other Data:**                                                             |   |                                                                         |   |   |   |   |   |   |   |   |   |
| Dividend payout ratio(7)                                                    |   | 123.74                                                                       | %      | 117.71 | % | 39.26 | % | 32.19 | % | 27.91 | % |
| Full service offices at end of period                                       |   | 20                                                                           |   | 18 |   | 18 |   | 16 |   | 15 |   |

 

----

(1)   Ratios are based on average daily balances.

(2)   Interest rate spread represents the difference between the weightedaverage yield on average interest earning assets and the weighted average costof average interest bearing liabilities, and net interest margin represents netinterest income as a percent of average interest earning assets.

(3)   Noninterest expense to net interest income plus noninterest income.

(4)   Asset quality ratios are end of period ratios.

(5)   Nonperforming assets consist of nonperforming loans and real estateowned (“REO”).  Nonperforming loansconsist of nonaccrual loans, accruing loans 90 days or more, past due andrestructured loans, while REO consists of real estate owned.

(6)   Capital ratios are end of period ratios for First Federal Bank.

(7)   Dividend payout ratio is the total dividends declared divided by netincome.

 

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**Item 7.  Management’sDiscussions and Analysis ofFinancial Condition and Results of Operations****.**

 

**GENERAL**

 

Management’sdiscussion and analysis of financial condition and results of operations isintended to assist a reader in understanding the consolidated financial conditionand results of operations of the Company for the periods presented.  The information contained in this sectionshould be read in conjunction with the Consolidated Financial Statements andthe accompanying Notes to Consolidated Financial Statements and the othersections contained herein.

 

TheBank is a federally chartered stock savings and loan association that wasformed in 1934.  First Federal conductsbusiness from its main office and nineteen full-service branch offices, all ofwhich are located in a six county area in Northcentral and Northwest Arkansascomprised of Benton, Marion, Washington, Carroll, Baxter and Boone counties.The Bank will continue to focus its growth and expansion efforts in this sixcounty area, especially in Benton and Washington counties, one of the fastestgrowing areas of the state.    The Bankis a community-oriented financial institution offering a wide range of retailand commercial deposit accounts, including noninterest bearing and interestbearing checking, savings and money market accounts, certificates of deposit,and individual retirement accounts.  Loanproducts offered by the Bank include residential real estate, consumer,construction, lines of credit, commercial real estate and commercial businessloans. Other financial services include investment products offered throughFirst Federal Investment Services, Inc.; automated teller machines;24-hour telephone banking; internet banking, including account access,e-statements, bill payment and online loan applications; Bounce ProtectionTM overdraft service; debit cards;and safe deposit boxes.

 

FirstFederal’s lending focus has traditionally been on permanent residential realestate.  However, in recent years, anincreased emphasis has been placed on commercial real estate lending andconstruction lending based on opportunities in Washington and Bentoncounties.  Beginning in late 2005, wereduced our focus on construction lending due to an oversupply of homes andlots in Northwest Arkansas.  Whileoversupply continues to be a significant issue, the market in NorthwestArkansas continues to outperform the national and state economies with lowerunemployment and continued population growth. Washington and Benton County arethe headquarters of the state’s two largest employers, Wal-Mart and TysonFoods.  These employers attract supplierswho establish offices in the area and create jobs, which fosters demand forhousing and office space.  As of November 2008,unemployment in the Fayetteville/Springdale/Rogers metro area was 3.9% (notseasonally adjusted), compared to the Arkansas rate of 5.7% and the U.S. rateof 6.8%, both seasonally adjusted.

 

Certificatesof deposit continue to comprise the majority of our deposit accounts.  However, in recent years, increased emphasishas been placed on growth in checking accounts.   The Bank focused its marketing efforts toincrease checking accounts by offering a checking product which has a higherinterest rate than the Bank’s other checking account products. To earn themaximum rate under the new product, customers must qualify based on usage ofelectronic banking services such as debit card transactions, e-statements, anddirect deposits or automatic payments. The Bank will continue to promotechecking accounts as they are an attractive source of funds for the Bank asthey offer overall low-interest deposits, fee income potential, and theopportunity to cross-sell other financial services.

 

TheCompany’s results of operations depend primarily on its net interest income,which is the difference between interest income on interest earning assets,such as loans and investments, and interest expense on interest bearingliabilities, such as deposits and borrowings. Net interest income is affected by the level of nonperforming assets asthey provide no interest earnings to the Bank. The Company’s results of operations are also affected by the provisionfor loan losses, the level of its noninterest income and expenses, and incometax expense.

 

Noninterestincome is generated primarily through deposit account fee income, profit onsale of loans, loan fee income, and earnings on life insurance policies.

 

Noninterestexpense consists primarily of employee compensation and benefits, officeoccupancy expense, data processing expense, real estate owned expense, net, andother operating expense.

 

Likemany banks, First Federal Bank’s greatest challenge in this economicenvironment is reducing the level of nonperforming assets and managing interestrate risk and managing asset quality.  Westrive to maintain the asset quality of our loan portfolio at acceptable levelsthrough sound underwriting procedures, including the use of credit scoring; athorough loan review function; active collection procedures for delinquentloans; and, in the event of repossession, prompt and efficient liquidation ofreal estate, automobiles and other forms of collateral.   We have experienced an increase innonperforming assets, primarily due to the housing market oversupply issue inNorthwest Arkansas as well as the downturn in the general economy.  We attempt to work with troubled borrowers toreturn their loans to performing status where possible. However, given currentmarket conditions, the trend of increasing nonperforming assets may continuefor the foreseeable future.  Both theboard of directors and senior management place a high priority on reducing ournonperforming assets and managing asset quality.

 

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Inaddition, management is also challenged with managing interest rate risk.  The Bank’s current interest rate riskposition as measured by our regulator, the OTS, is at a minimal level asdefined by Thrift Bulletin 13a.  The movementof interest rates impacts the level of interest rate risk and the timing andmagnitude of assets repricing compared to liabilities repricing.  The Bank attempts to reduce the impact ofchanges in interest rates on its net interest income by managing the repricinggap as described in the “Asset and Liability Management” section.

 

## **CRITICAL ACCOUNTING POLICIES**

##  

Variouselements of our accounting policies, by their nature, are inherently subject toestimation techniques, valuation assumptions and other subjectiveassessments.  In particular, valuation ofreal estate owned and the methodology for the determination of our allowancefor loan losses, due to the judgments, estimates and assumptions inherent inthose policies, are critical to preparation of our financial statements.  These policies and the judgments, estimatesand assumptions are described in greater detail in subsequent sections ofManagement’s Discussion and Analysis and in the Notes to the ConsolidatedFinancial Statements included herein.  Inparticular, Note 1 to the Consolidated Financial Statements – “Summary ofSignificant Accounting Policies” describes generally our accountingpolicies.  We believe that the judgments,estimates and assumptions used in the preparation of our Consolidated FinancialStatements are appropriate given the factual circumstances at the time.  However, given the sensitivity of ourConsolidated Financial Statements to this critical accounting policy, the useof other judgments, estimates and assumptions could result in materialdifferences in our results of operations or financial condition.

 

Inestimating the amount of credit losses inherent in our loan portfolio, variousjudgments and assumptions are made.  Forexample, when assessing the condition of the overall economic environment,assumptions are made regarding market conditions and their impact on the loanportfolio.  In the event the economy wereto sustain a prolonged downturn, the loss factors applied to our portfolios mayneed to be revised, which may significantly impact the measurement of theallowance for loan losses.  For impairedloans that are collateral dependent and for real estate owned, the estimatedfair value of the collateral may deviate significantly from the proceedsreceived when the collateral is sold.

 

## **CHANGES IN FINANCIAL CONDITION**

##  

Changesin financial condition between December 31, 2008 and 2007 are presented inthe following table (dollars in thousands). Material changes between periods are discussed in the sections thatfollow the table.

 
| ** **                                    | ** ** | **December 31,** | ** ** | **Increase** | ** ** | ** **     | ** ** |
|-----------------------------------------------|------------|-----------------------|------------|--------------|------------|----------------|------------|
| ** **                                    | ** ** | **2008**              | ** ** | **2007**     | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
|                                          |       |                  |       |         |       |           |       |   |   |
| **ASSETS**                                    |       |                  |       |         |       |           |       |   |   |
| Cash and cash equivalents                     |       | $                     | 9,367      |         | $          | 27,387         |       | $ | (18,020 | ) | (65.8 | )% |
| Investment securities held to maturity        |       | 136,412               |       | 95,590       |       | 40,822         |       | 42.7 |   |
| FHLB Stock                                    |       | 4,825                 |       | 4,433        |       | 392            |       | 8.8 |   |
| Loans receivable, net                         |       | 568,123               |       | 601,256      |       | (33,133        | )          | (5.5 | ) |
| Accrued interest receivable                   |       | 6,701                 |       | 9,042        |       | (2,341         | )          | (25.9 | ) |
| Real estate owned, net                        |       | 22,385                |       | 8,120        |       | 14,265         |       | 175.7 |   |
| Office properties and equipment, net          |       | 24,694                |       | 24,263       |       | 431            |       | 1.8 |   |
| Prepaid expenses and other assets             |       | 22,665                |       | 21,887       |       | 778            |       | 3.6 |   |
|                                          |       |                  |       |         |       |           |       |   |   |
| TOTAL                                         |       | $                     | 795,172    |         | $          | 791,978        |       | $ | 3,194 |   | 0.4 | % |
|                                          |       |                  |       |         |       |           |       |   |   |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY** | ** ** | ** **            | ** ** | ** **   | ** ** | ** **     | ** ** | ** ** | ** ** |
| LIABILITIES:                                  |       |                  |       |         |       |           |       |   |   |
| Deposits                                      |       | $                     | 618,003    |         | $          | 630,414        |       | $ | (12,411 | ) | (2.0 | )% |
| Other borrowings                              |       | 92,212                |       | 82,087       |       | 10,125         |       | 12.3 |   |
| Other liabilities                             |       | 11,840                |       | 5,814        |       | 6,026          |       | 103.6 |   |
| Total liabilities                             |       | 722,055               |       | 718,315      |       | 3,740          |       | 0.5 |   |
|                                          |       |                  |       |         |       |           |       |   |   |
| STOCKHOLDERS’ EQUITY                     |       | 73,117                |       | 73,663       |       | (546           | )          | (0.7 | ) |
| TOTAL                                         |       | $                     | 795,172    |         | $          | 791,978        |       | $ | 3,194 |   | 0.4 | % |
|                                          |       |                  |       |         |       |           |       |   |   |
| BOOK VALUE PER SHARE                          |       | $                     | 15.09      |         | $          | 15.21          |       |   |   |   |   |
|                                          |       |                  |       |         |       |           |       |   |   |
| EQUITY TO ASSETS                              |       | 9.2                   | %          | 9.3          | %          |           |       |   |   |

 

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**Loans Receivable. **Changes in loancomposition between December 31, 2008 and 2007 are presented in thefollowing table (dollars in thousands).

 
| ** **                                             | ** ** | **December 31,** | ** ** | **Increase** | ** ** | ** **     | ** ** |
|--------------------------------------------------------|------------|-----------------------|------------|--------------|------------|----------------|------------|
| ** **                                             | ** ** | **2008**              | ** ** | **2007**     | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
|                                                   |       |                  |       |         |       |           |       |   |   |
| One- to four-family residences                         |       | $                     | 243,321    |         | $          | 230,005        |       | $ | 13,316 |   | 5.8 | % |
| Home equity and second mortgage                        |       | 31,712                |       | 34,315       |       | (2,603         | )          | (7.6 | ) |
| Multifamily                                            |       | 24,147                |       | 15,616       |       | 8,531          |       | 54.6 |   |
| Commercial real estate                                 |       | 115,935               |       | 117,548      |       | (1,613         | )          | (1.4 | ) |
| Land                                                   |       | 49,354                |       | 42,843       |       | 6,511          |       | 15.2 |   |
| Construction:                                          |       |                  |       |         |       |           |       |   |   |
| One- to four-family residences                         |       | 8,450                 |       | 20,815       |       | (12,365        | )          | (59.4 | ) |
| Speculative one- to four-family residences             |       | 17,096                |       | 40,893       |       | (23,797        | )          | (58.2 | ) |
| Multifamily                                            |       | 15,016                |       | 18,632       |       | (3,616         | )          | (19.4 | ) |
| Commercial real estate                                 |       | 18,297                |       | 31,239       |       | (12,942        | )          | (41.4 | ) |
| Land development                                       |       | 18,457                |       | 42,145       |       | (23,688        | )          | (56.2 | ) |
| Total mortgage loans                                   |       | 541,785               |       | 594,051      |       | (52,266        | )          | (8.8 | ) |
|                                                   |       |                  |       |         |       |           |       |   |   |
| Commercial                                             |       | 23,078                |       | 24,846       |       | (1,768         | )          | (7.1 | ) |
|                                                   |       |                  |       |         |       |           |       |   |   |
| Automobile                                             |       | 8,631                 |       | 9,531        |       | (900           | )          | (9.4 | ) |
| Other                                                  |       | 12,291                |       | 14,537       |       | (2,246         | )          | (15.5 | ) |
| Total consumer                                         |       | 20,922                |       | 24,068       |       | (3,146         | )          | (13.1 | ) |
|                                                   |       |                  |       |         |       |           |       |   |   |
| Total loans receivable                                 |       | 585,785               |       | 642,965      |       | (57,180        | )          | (8.9 | ) |
| Less:                                                  |       |                  |       |         |       |           |       |   |   |
| Undisbursed loan funds                                 |       | (11,750               | )          | (36,868      | )          | 25,118         |       | (68.1 | ) |
| Unearned discounts and net deferred loan  costs (fees) |       | 529                   |       | 321          |       | 208            |       | 64.8 |   |
| Allowance for loan losses                              |       | (6,441                | )          | (5,162       | )          | (1,279         | )          | 24.8 |   |
|                                                   |       |                  |       |         |       |           |       |   |   |
| Loans receivable, net                                  |       | $                     | 568,123    |         | $          | 601,256        |       | $ | (33,133 | ) | (5.5 | )% |

 

Thedecrease in the Bank’s loan portfolio was primarily due to continued softeningof the housing market in the Bank’s market area.  Market data indicates an overall decrease inhome sales in Benton and Washington counties in 2008 and 2007 compared to2006.   Although the Northwest Arkansasregion continues to experience job market and population growth, the supply ofnew residential lots and new speculative homes for sale has outpaced demand forthe past several years.  We expect thistrend to continue for the foreseeable future given the level of oversupply inthe market.

 

**Allowance for Loan Losses**. Changes in the composition of the allowance for loan losses between December 31,2008 and 2007 are presented in the following table (in thousands).

 
| ** ** | ** ** | **December 31,** | ** ** | ** ** | ** ** |
|------------|------------|-----------------------|------------|------------|------------|
| ** ** | ** ** | **2008**              | ** ** | **2007**   | ** ** | **Increase** | ** ** |
| General    |       | $                     | 3,525      |       | $          | 2,267 |   | $ | 1,258 |   |
| Specific   |       | 2,916                 |       | 2,895      |       | 21 |   |
|       |       | $                     | 6,441      |       | $          | 5,162 |   | $ | 1,279 |   |

 

Thegeneral component of the allowance for loan losses increased primarily due toincreases in the estimated loss rates applied to commercial loans, landdevelopment loans, land loans, and home equity loans, partially offset bydecreases in speculative single family construction and land development loan balances.  Such loss rates were increased due to ourloss experience with these types of loans.

 

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**Investment Securities. **Changes in thecomposition of investment securities held to maturity between December 31,2008 and 2007 are presented in the following table (in thousands).

 
| ** **                             | ** ** | **December 31,** | ** ** | ** ** | ** ** |
|----------------------------------------|------------|-----------------------|------------|------------|------------|
| ** **                             | ** ** | **2008**              | ** ** | **2007**   | ** ** | **Increase** | ** ** |
| U.S. Government and agency obligations |       | $                     | 116,847    |       | $          | 78,501 |   | $ | 38,346 |   |
| Municipal securities                   |       | 19,565                |       | 17,089     |       | 2,476 |   |
| Total                                  |       | $                     | 136,412    |       | $          | 95,590 |   | $ | 40,822 |   |

 

During 2008, investment securities totaling approximately $125.2 millionwith a weighted average tax equivalent yield of 5.94% were purchased and $84.4million with a weighted average tax equivalent yield of 6.15% matured or werecalled.   Due to lower loan demand, theBank used funds from loan repayments and borrowings to purchase investmentsecurities.

 

**Federal Home Loan Bank Stock. **FHLB stock increased by approximately $392,000 due to balancerequirements related to the FHLB advances.

 

**Accrued Interest Receivable. **The decrease in accrued interest receivable was primarily due to thedecrease in loans receivable balance as well as a decrease in the loan yieldand the number of days accrued at December 31, 2008.

 

**Real Estate Owned, net.** Changes in the composition of real estate owned between December 31,2008 and December 31, 2007 are presented in the following table (dollarsin thousands).

 
| ** **                      | ** ** | **December 31,  2007** | ** ** | **Additions** | ** ** | **Fair Value  Adjustments** | ** ** | **Net Sales  Proceeds(1)** | ** ** | **Gain  (Loss)** | ** ** | **December 31,  2008** | ** ** |
|---------------------------------|------------|-----------------------------|------------|---------------|------------|----------------------------------|------------|---------------------------------|------------|------------------|------------|-----------------------------|------------|
| One- to four-family residential |       | $                           | 1,566      |          | $          | 5,096                            |       | $                               | (537       | )                | $          | (2,648                      | )          | $ | (41 | ) | $ | 3,436 |   |
| Speculative one- to four-family |       | 5,956                       |       | 6,222         |       | (853                             | )          | (6,865                          | )          | (150             | )          | 4,310                       |       |
| Land                            |       | 598                         |       | 16,066        |       | (2,927                           | )          | (453                            | )          | 30               |       | 13,314                      |       |
| Commercial real estate          |       | —                      |       | 1,617         |       | (292                             | )          | —                          |       | —           |       | 1,325                       |       |
|                            |       | $                           | 8,120      |          | $          | 29,001                           |       | $                               | (4,609     | )                | $          | (9,966                      | )          | $ | (161 | ) | $ | 22,385 |   |

 

----

(1)   Net sales proceeds include $6.9 million ofloans made by the Bank to facilitate the sale of real estate owned.

 

**Deposits. **Changes in the composition of deposits betweenDecember 31, 2008 and 2007 are presented in the following table (dollarsin thousands).

 
| ** **              | ** ** | **December 31,** | ** ** | **Increase** | ** ** | ** **     | ** ** |
|-------------------------|------------|-----------------------|------------|--------------|------------|----------------|------------|
| ** **              | ** ** | **2008**              | ** ** | **2007**     | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
|                    |       |                  |       |         |       |           |       |   |   |
| Checking accounts       |       | $                     | 163,468    |         | $          | 127,491        |       | $ | 35,977 |   | 28.2 | % |
| Money market accounts   |       | 45,022                |       | 51,424       |       | (6,402         | )          | (12.5 | ) |
| Savings accounts        |       | 23,019                |       | 25,088       |       | (2,069         | )          | (8.3 | ) |
| Certificates of deposit |       | 386,494               |       | 426,411      |       | (39,917        | )          | (9.4 | ) |
|                    |       |                  |       |         |       |           |       |   |   |
| Total deposits          |       | $                     | 618,003    |         | $          | 630,414        |       | $ | (12,411 | ) | (2.0 | )% |

 

Depositsdecreased in the comparison period, primarily due to a decrease in certificatesof deposit. The decrease was partially offset by an increase in checkingaccounts. The Bank focused its marketing efforts to increase checking accountsby offering a checking product which has a higher interest rate than the Bank’sother checking account products.  To earnthe maximum rate under the new product, customers must qualify based on usageof electronic banking services such as debit card transactions, e-statements,and direct deposits or automatic payments. The Bank will continue to promotechecking accounts as they are an attractive source of funds for the Bank asthey offer overall low-interest deposits, fee income potential, and theopportunity to cross-sell other financial services.

 

**Other Borrowings.**  TheBank experienced a $10.1 million or 12.3% increase in FHLB of Dallas andFederal Reserve Bank borrowings during the year. The Bank used the fundsprimarily to purchase investment securities and to pay depositwithdrawals.  The balance of FHLB ofDallas advances at December 31, 2008 of $82.2 million consisted of $66.2million of fixed rate advances with an average cost of 3.9% and $16.0 millionof floating rate advances with an average cost of 0.7%.  Federal Reserve Bank overnight borrowingstotaled $10.0 million at December 31, 2008 with a cost of 0.5%.

 

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**Stockholders’ Equity. **Stockholders’equity decreased approximately $546,000 from December 31, 2007 to December 31,2008.  The decrease in stockholders’equity was primarily due to the payment of quarterly cash dividends in theamount of $3.1 million.  Such a decreasewas partially offset by net income in the amount of $2.5 million resulting fromcontinued profitable operations.  See theConsolidated Statements of Stockholders’ Equity for the years ended December 31,2008, 2007 and 2006 contained herein for more detail.

 

**Average Balance Sheets**

 

Thefollowing table sets forth certain information relating to the Company’saverage balance sheets and reflects the average yield on assets and averagecost of liabilities for the periods indicated. Such yields and costs are derived by dividing interest income orinterest expense by the average balance of assets or liabilities, respectively,for the periods presented.  Averagebalances are based on daily balances during the periods.

 
|                                                              |   | **Year Ended December 31,** |    |
|-------------------------------------------------------------------|--------|--------------------------------------------|---------|
|                                                              |   | **2008**                                   |    | **2007** |   | **2006** |   |
|                                                              |   | **Average  Balance**                       |    | **Interest** |   | **Average  Yield/  Cost** |   | **Average  Balance** |   | **Interest** |   | **Average  Yield/  Cost** |   | **Average  Balance** |   | **Interest** |   | **Average  Yield/  Cost** |   |
|                                                              |   | **(Dollars in Thousands)**       |    |
| Interest earning assets:                                          |   |                                       |    |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Loans receivable(1)                                               |   | $                                          | 583,063 |   | $ | 36,799 |   | 6.31 | % | $ | 649,062 |   | $ | 45,473 |   | 7.01 | % | $ | 726,642 |   | $ | 50,185 |   | 6.91 | % |
| Investment securities(2)                                          |   | 127,100                                    |    | 6,760 |   | 5.32 |   | 78,831 |   | 4,071 |   | 5.16 |   | 67,395 |   | 3,270 |   | 4.85 |   |
| Other interest earning assets                                     |   | 15,708                                     |    | 388 |   | 2.47 |   | 17,630 |   | 882 |   | 5.00 |   | 13,288 |   | 664 |   | 5.00 |   |
| Total interest earning assets                                     |   | 725,871                                    |    | 43,947 |   | 6.05 |   | 745,523 |   | 50,426 |   | 6.76 |   | 807,325 |   | 54,119 |   | 6.70 |   |
| Noninterest earning assets                                        |   | 76,875                                     |    |   |   |   |   | 68,478 |   |   |   |   |   | 61,841 |   |   |   |   |   |
| Total assets                                                      |   | $                                          | 802,746 |   |   |   |   |   | $ | 814,001 |   |   |   |   |   | $ | 869,166 |   |   |   |   |   |
| Interest bearing liabilities:                                     |   |                                       |    |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Deposits                                                          |   | $                                          | 629,808 |   | 18,549 |   | 2.95 |   | $ | 638,724 |   | 23,873 |   | 3.74 |   | $ | 630,230 |   | 20,643 |   | 3.28 |   |
| Other borrowings                                                  |   | 92,544                                     |    | 3,553 |   | 3.84 |   | 94,481 |   | 4,311 |   | 4.56 |   | 154,186 |   | 6,933 |   | 4.50 |   |
| Total interest bearing liabilities                                |   | 722,352                                    |    | 22,102 |   | 3.06 |   | 733,205 |   | 28,184 |   | 3.84 |   | 784,416 |   | 27,576 |   | 3.51 |   |
| Noninterest bearing liabilities                                   |   | 6,201                                      |    |   |   |   |   | 5,787 |   |   |   |   |   | 6,182 |   |   |   |   |   |
| Total liabilities                                                 |   | 728,553                                    |    |   |   |   |   | 738,992 |   |   |   |   |   | 790,598 |   |   |   |   |   |
| Stockholders’ equity                                         |   | 74,193                                     |    |   |   |   |   | 75,009 |   |   |   |   |   | 78,568 |   |   |   |   |   |
| Total liabilities and stockholders’ equity                   |   | $                                          | 802,746 |   |   |   |   |   | $ | 814,001 |   |   |   |   |   | $ | 869,166 |   |   |   |   |   |
|                                                              |   |                                       |    |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Net interest income                                               |   |                                       |    | $ | 21,845 |   |   |   |   |   | $ | 22,242 |   |   |   |   |   | $ | 26,543 |   |   |   |
| Net earning assets                                                |   | $                                          | 3,519   |   |   |   |   |   | $ | 12,318 |   |   |   |   |   | $ | 22,909 |   |   |   |   |   |
| Interest rate spread                                              |   |                                       |    |   |   | 2.99 | % |   |   |   |   | 2.92 | % |   |   |   |   | 3.19 | % |
| Net interest margin                                               |   |                                       |    |   |   | 3.01 | % |   |   |   |   | 2.98 | % |   |   |   |   | 3.29 | % |
| Ratio of interest earning assets to  interest bearing liabilities |   |                                       |    |   |   | 100.49 | % |   |   |   |   | 101.68 | % |   |   |   |   | 102.92 | % |

 

----

(1)  Includes nonaccrual loans.

(2)  Includes FHLB of Dallas stock.

 

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## **Rate/Volume Analysis**

##  

Thetable below sets forth certain information regarding changes in interest incomeand interest expense of the Company for the periods indicated.  For each category of interest earning assetsand interest bearing liabilities, information is provided on changesattributable to (i) changes in volume (changes in average volumemultiplied by prior rate); (ii) changes in rate (change in rate multipliedby prior average volume); (iii) changes in rate-volume (changes in ratemultiplied by the change in average volume); and (iv) the net change.

 
| ** **                         | ** ** | **Year Ended December 31,** | ** ** |
|------------------------------------|------------|--------------------------------------------|------------|
| ** **                         | ** ** | **2008 vs. 2007**                | ** ** |
| ** **                         | ** ** | **Increase (Decrease)  Due to**  | ** ** | **Total** | ** ** |
| ** **                         | ** ** | **Volume**                                 | ** ** | **Rate** | ** ** | **Rate/  Volume** | ** ** | **Increase  (Decrease)** | ** ** |
| ** **                         | ** ** | **(In Thousands)**                    | ** ** |
| Interest income:                   |       |                                       |       |   |   |   |   |   |   |
| Loans receivable                   |       | $                                          | (4,624     | ) | $ | (4,508 | ) | $ | 458 |   | $ | (8,674 | ) |
| Investment securities              |       | 2,493                                      |       | 122 |   | 74 |   | 2,689 |   |
| Other interest earning assets      |       | (96                                        | )          | (447 | ) | 49 |   | (494 | ) |
| Total interest earning assets      |       | (2,227                                     | )          | (4,833 | ) | 581 |   | $ | (6,479 | ) |
|                               |       |                                       |       |   |   |   |   |   |   |
| Interest expense:                  |       |                                       |       |   |   |   |   |   |   |
| Deposits                           |       | (333                                       | )          | (5,062 | ) | 71 |   | (5,324 | ) |
| Other borrowings                   |       | (88                                        | )          | (684 | ) | 14 |   | (758 | ) |
| Total interest bearing liabilities |       | (421                                       | )          | (5,746 | ) | 85 |   | (6,082 | ) |
| Net change in net interest income  |       | $                                          | (1,806     | ) | $ | 913 |   | $ | 496 |   | $ | (397 | ) |
|                               |       |                                       |       |   |   |   |   |   |   |
| ** **                         | ** ** | **Year Ended December 31,** | ** ** |
| ** **                         | ** ** | **2007 vs. 2006**                | ** ** |
| ** **                         | ** ** | **Increase (Decrease)  Due to**  | ** ** | **Total** | ** ** |
| ** **                         | ** ** | **Volume**                                 | ** ** | **Rate** | ** ** | **Rate/  Volume** | ** ** | **Increase  (Decrease)** | ** ** |
| ** **                         | ** ** | **(In Thousands)**                    | ** ** |
| Interest income:                   |       |                                       |       |   |   |   |   |   |   |
| Loans receivable                   |       | $                                          | (5,358     | ) | $ | 723 |   | $ | (77 | ) | $ | (4,712 | ) |
| Investment securities              |       | 555                                        |       | 210 |   | 36 |   | 801 |   |
| Other interest earning assets      |       | 217                                        |       | 1 |   | — |   | 218 |   |
| Total interest earning assets      |       | (4,586                                     | )          | 934 |   | (41 | ) | (3,693 | ) |
|                               |       |                                       |       |   |   |   |   |   |   |
| Interest expense:                  |       |                                       |       |   |   |   |   |   |   |
| Deposits                           |       | 278                                        |       | 2,913 |   | 39 |   | 3,230 |   |
| Other borrowings                   |       | (2,684                                     | )          | 101 |   | (39 | ) | (2,622 | ) |
| Total interest bearing liabilities |       | (2,406                                     | )          | 3,014 |   | — |   | 608 |   |
| Net change in net interest income  |       | $                                          | (2,180     | ) | $ | (2,080 | ) | $ | (41 | ) | $ | (4,301 | ) |
|                                    |            |                                            |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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**CHANGES IN RESULTS OF OPERATIONS**

 

Thetable below presents a comparison of results of operations for the years ended December 31,2008, 2007, and 2006 (dollars in thousands). Specific changes in captions are discussed following the table.

 
| ** **                                            | ** ** | **Year Ended December 31,** | ** ** | **Dollar Change** | ** ** | **Percentage Change** | ** ** |
|-------------------------------------------------------|------------|--------------------------------------------|------------|------------------------|------------|----------------------------|------------|
| ** **                                            | ** ** | **2008**                                   | ** ** | **2007**               | ** ** | **2006**                   | ** ** | **2008 vs 2007** | ** ** | **2007 vs 2006** | ** ** | **2008 vs 2007** | ** ** | **2007 vs 2006** | ** ** |
| Interest income:                                      |       |                                       |       |                   |       |                       |       |   |   |   |   |   |   |   |   |
| Loans receivable                                      |       | $                                          | 36,799     |                   | $          | 45,473                     |       | $ | 50,185 |   | $ | (8,674 | ) | $ | (4,712 | ) | (19.1 | )% | (9.4 | )% |
| Investment securities                                 |       | 6,760                                      |       | 4,071                  |       | 3,270                      |       | 2,689 |   | 801 |   | 66.1 |   | 24.5 |   |
| Other                                                 |       | 388                                        |       | 882                    |       | 664                        |       | (494 | ) | 218 |   | (56.0 | ) | 32.8 |   |
| Total interest income                                 |       | 43,947                                     |       | 50,426                 |       | 54,119                     |       | (6,479 | ) | (3,693 | ) | (12.9 | ) | (6.8 | ) |
| Interest expense:                                     |       |                                       |       |                   |       |                       |       |   |   |   |   |   |   |   |   |
| Deposits                                              |       | 18,549                                     |       | 23,873                 |       | 20,643                     |       | (5,324 | ) | 3,230 |   | (22.3 | ) | 15.6 |   |
| Other borrowings                                      |       | 3,553                                      |       | 4,311                  |       | 6,933                      |       | (758 | ) | (2,622 | ) | (17.6 | ) | (37.8 | ) |
| Total interest expense                                |       | 22,102                                     |       | 28,184                 |       | 27,576                     |       | (6,082 | ) | 608 |   | (21.6 | ) | 2.2 |   |
| Net interest income before provision for  loan losses |       | 21,845                                     |       | 22,242                 |       | 26,543                     |       | (397 | ) | (4,301 | ) | (1.8 | ) | (16.2 | ) |
| Provision for loan losses                             |       | 5,710                                      |       | 4,028                  |       | 1,482                      |       | 1,682 |   | 2,546 |   | 41.8 |   | 171.8 |   |
| Net interest income after provision for  loan losses  |       | 16,135                                     |       | 18,214                 |       | 25,061                     |       | (2,079 | ) | (6,847 | ) | (11.4 | ) | (27.3 | ) |
| Noninterest income:                                   |       |                                       |       |                   |       |                       |       |   |   |   |   |   |   |   |   |
| Deposit fee income                                    |       | 5,413                                      |       | 4,989                  |       | 4,839                      |       | 424 |   | 150 |   | 8.5 |   | 3.1 |   |
| Gain on sale of loans                                 |       | 354                                        |       | 823                    |       | 924                        |       | (469 | ) | (101 | ) | (57.0 | ) | (10.9 | ) |
| Other                                                 |       | 3,650                                      |       | 1,957                  |       | 2,459                      |       | 1,693 |   | (502 | ) | 86.5 |   | (20.4 | ) |
| Total noninterest income                              |       | 9,417                                      |       | 7,769                  |       | 8,222                      |       | 1,648 |   | (453 | ) | 21.2 |   | (5.5 | ) |
| Noninterest expenses:                                 |       |                                       |       |                   |       |                       |       |   |   |   |   |   |   |   |   |
| Salaries and employee benefits                        |       | 12,770                                     |       | 13,231                 |       | 13,464                     |       | (461 | ) | (233 | ) | (3.5 | ) | (1.7 | ) |
| Net occupancy expense                                 |       | 2,657                                      |       | 2,325                  |       | 2,405                      |       | 332 |   | (80 | ) | 14.3 |   | (3.3 | ) |
| Real estate owned, net                                |       | 1,946                                      |       | 1,162                  |       | 191                        |       | 784 |   | 971 |   | 67.5 |   | 508.4 |   |
| Data processing                                       |       | 1,431                                      |       | 1,513                  |       | 1,474                      |       | (82 | ) | 39 |   | (5.4 | ) | 2.7 |   |
| Advertising and public relations                      |       | 900                                        |       | 1,145                  |       | 1,338                      |       | (245 | ) | (193 | ) | (21.4 | ) | (14.4 | ) |
| Other                                                 |       | 3,764                                      |       | 3,619                  |       | 3,649                      |       | 145 |   | (30 | ) | 4.0 |   | (0.8 | ) |
| Total noninterest expenses                            |       | 23,468                                     |       | 22,995                 |       | 22,521                     |       | 473 |   | 474 |   | 2.1 |   | 2.1 |   |
| Income before provision for income taxes              |       | 2,084                                      |       | 2,988                  |       | 10,762                     |       | (904 | ) | (7,774 | ) | (30.3 | ) | (72.2 | ) |
| Income tax provision                                  |       | (423                                       | )          | 345                    |       | 3,379                      |       | (768 | ) | (3,034 | ) | (222.6 | ) | (89.8 | ) |
| Net income                                            |       | $                                          | 2,507      |                   | $          | 2,643                      |       | $ | 7,383 |   | $ | (136 | ) | $ | (4,740 | ) | 5.2 |   | (64.2 | )% |
|                                                  |       |                                       |       |                   |       |                       |       |   |   |   |   |   |   |   |   |
| Basic earnings per share                              |       | $                                          | 0.52       |                   | $          | 0.54                       |       | $ | 1.48 |   | $ | (0.02 | ) | $ | (0.94 | ) | (3.7 | )% | (63.3 | )% |
| Diluted earnings per share                            |       | $                                          | 0.52       |                   | $          | 0.54                       |       | $ | 1.44 |   | $ | (0.02 | ) | $ | (0.90 | ) | (3.7 | )% | (62.5 | )% |
|                                                  |       |                                       |       |                   |       |                       |       |   |   |   |   |   |   |   |   |
| Interest rate spread                                  |       | 2.99                                       | %          | 2.92                   | %          | 3.19                       | %          |   |   |   |   |   |   |   |   |
| Net interest margin                                   |       | 3.01                                       | %          | 2.98                   | %          | 3.29                       | %          |   |   |   |   |   |   |   |   |
|                                                  |       |                                       |       |                   |       |                       |       |   |   |   |   |   |   |   |   |
| Average full-time equivalents                         |       | 301                                        |       | 303                    |       | 306                        |       |   |   |   |   |   |   |   |   |
| Full service offices                                  |       | 20                                         |       | 18                     |       | 18                         |       |   |   |   |   |   |   |   |   |

 

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**Net Interest Income. **Net interestincome is determined by the Company’s interest rate spread (i.e., thedifference between the yields earned on its interest earning assets and therates paid on its interest bearing liabilities) and the relative amounts ofinterest earning assets and interest bearing liabilities.

 

**Interest Income and Interest Expense**

 

Dollarand percentage changes in interest income and interest expense for thecomparison periods are presented in the rate/volume analysis table that appearson a previous page.

 

**Interest Income.**  Thedecrease in interest income in the 2008 vs. 2007 period was primarily due to adecrease in the average balance of and average yield earned on loans receivableoffset by an increase in the average balance of investment securities.  The decrease in the average yield earned on loansreceivable was due to decreases in market interest rates.  The average balance of loans receivabledecreased due to repayments and maturities as well as a decrease in loanoriginations.

 

Thedecrease in interest income in the 2007 vs. 2006 period was primarily due to adecrease in the average balance of loans receivable and an increase in thelevel of deferred interest on nonperforming loans, offset by an increase in theaverage yield earned on loans receivable. The increase in average yield earned during the year was due primarilyto increases in market interest rates. The average balance of loans receivable decreased due to repayments andmaturities as well as a decrease in loan originations.

 

**Interest Expense.**   Thedecrease in interest expense in the 2008 vs. 2007 period was primarily due to adecrease in the rates paid on deposits and borrowings.  The decreases in the average rates paid ondeposit accounts and borrowings reflect decreases in market interest rates.

 

Theincrease in interest expense in the 2007 vs. 2006 period was primarily due toan increase in the average rate paid on deposits, offset by a decrease in theaverage balance of FHLB advances.  Thedecrease in FHLB advances was due to the use of funds generated from loanrepayments to pay down maturing advances. The increase in the average rates paid on deposit accounts reflectsincreases in market interest rates.

 

**Provision for Loan Losses.**  Theprovision for loan losses is determined by management as the amount to bringthe allowance for loan losses to a level that is considered adequate to absorbprobable losses inherent in the loan portfolio. Such provision and the adequacy of the allowance for loan losses isevaluated quarterly by management of the Bank based on the Bank’s past loanloss experience, known and inherent risks in the portfolio, adverse situationsthat may affect the borrower’s ability to repay, the estimated value of anyunderlying collateral and current economic conditions.

 

Theincrease in the provision for loan losses in the 2008 vs. 2007 period was primarilydue to an increase in loss experience on commercial and land loans, offset by adecrease in losses on land development loans.

 

Factorsinfluencing management’s decision to increase the provision in the 2007 vs.2006 periods include an increase in nonaccrual loans, conditions in thespeculative single-family real estate market in Northwest Arkansas, andspecific loan loss allowances of $1.4 million on two phases of a subdivision inLowell, Arkansas and $885,000 on a subdivision located in Cave Springs, Arkansas,as discussed in “Asset Quality” previously.

 

**Noninterest Income. **The increase indeposit fee income in 2008 vs. 2007 was primarily related to an increase indebit card usage and insufficient funds fees due to our new checking productwhich offers a higher interest rate than the Bank’s other checking accountproducts.  One of the qualifications toearn the higher rate is use of the debit card no less than a specified numberof times each month.  The Bank introducedthis product in January 2008.  TheBank believes this product will expand its customer base and provide costsavings and fee income due to the electronic requirements.

 

Deposit fee income increased in 2007 vs. 2006 as a result of an increasein debit card usage and insufficient funds fee income.  This increase resulted from an increase inthe number of checking accounts with overdrawn balances and a 4.2% increase inthe per item charge effective February 1, 2007.

 

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Gain on sale of loans changed in relation to increases or decreases inoriginations of loans for sale during the comparison periods.  The activity in loans held for sale issummarized below (in thousands):

** **
| ** **                               | ** ** | **Year Ended December 31,** | ** ** |
|------------------------------------------|------------|--------------------------------------------|------------|
| ** **                               | ** ** | **2008**                                   | ** ** | **2007** | ** ** | **2006** | ** ** |
| Loans held for sale, beginning of period |       | $                                          | 2,832      |   | $ | 1,099 |   | $ | 2,641 |   |
| Originations of loans held for sale      |       | 23,788                                     |       | 59,813 |   | 67,896 |   |
| Sales                                    |       | (25,034                                    | )          | (58,080 | ) | (69,438 | ) |
| Loans held for sale, end of period       |       | $                                          | 1,586      |   | $ | 2,832 |   | $ | 1,099 |   |
|                                     |       |                                       |       |   |   |   |   |
| Gain on sale of loans                    |       | $                                          | 354        |   | $ | 823 |   | $ | 924 |   |

 

Theincrease in other noninterest income for the 2008 vs. 2007 period was primarilydue to a $1.2 million increase in earnings on life insurance policies due to adeath benefit claim recorded during the first quarter in 2008.

 

Othernoninterest income fluctuated during the period between 2006 and 2007 due tononrecurring gains on the sales of two properties totaling $528,000, recognizedin 2006.  These properties representedexcess land and a building adjacent to two existing branches.

 

**Noninterest Expense**

 

**Salaries and Employee Benefits. **The changes in the composition of this line item are presented below (inthousands):

 
| ** **                        | ** ** | **Year Ended December 31,** | ** ** | **Change** | ** ** |
|-----------------------------------|------------|--------------------------------------------|------------|------------|------------|
| ** **                        | ** ** | **2008**                                   | ** ** | **2007**   | ** ** | **2006** | ** ** | **2008 vs 2007** | ** ** | **2007 vs 2006** | ** ** |
| Salaries                          |       | $                                          | 10,267     |       | $          | 10,419 |   | $ | 10,237 |   | $ | (152 | ) | $ | 182 |   |
| Payroll taxes                     |       | 844                                        |       | 868        |       | 866 |   | (24 | ) | 2 |   |
| Insurance                         |       | 673                                        |       | 673        |       | 696 |   | — |   | (23 | ) |
| ESOP expense (1)                  |       | —                                     |       | —     |       | 508 |   | — |   | (508 | ) |
| 401(k) (2)                   |       | 303                                        |       | 309        |       | 174 |   | (6 | ) | 135 |   |
| Stock compensation (3)            |       | 5                                          |       | 39         |       | 81 |   | (34 | ) | (42 | ) |
| Defined benefit plan contribution |       | 518                                        |       | 761        |       | 745 |   | (243 | ) | 16 |   |
| Other                             |       | 160                                        |       | 162        |       | 157 |   | (2 | ) | 5 |   |
| Total                             |       | $                                          | 12,770     |       | $          | 13,231 |   | $ | 13,464 |   | $ | (461 | ) | $ | (233 | ) |

 

----

(1)  Employee Stock Ownership Plan.

(2)  Represents Company matching contributions onthe 401(k) Plan.  Effective February 16,2009, the Company discontinued its matching contributions to the 401(k) Plan.

(3)  Includes stock options and ManagementRecognition and Retention Plan (“MRP”) expense.

 

2008 vs. 2007

 

Thedecrease in salaries and employee benefits was primarily due to a reduction inovertime and incentive compensation. The decrease in the defined benefit plancontribution was due to a change in the benefit formula during 2008.

 

2007 vs. 2006

 

Thedecrease in salaries and employee benefits was due primarily to the decrease inemployee stock ownership plan expense, as the plan shares became fullyallocated as of March 31, 2006. Salaries increased due to normal salary and merit increases.  The increase in 401(k) expense was dueto a full year of employer matching contributions being made in 2007 comparedto seven months in 2006, as the plan was adopted effective June 1, 2006.

 

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**Net occupancy expense. **The changes inthe composition of this line item are presented below (in thousands):

 
| ** **                         | ** ** | **Year Ended December 31,** | ** ** | **Change** | ** ** |
|------------------------------------|------------|--------------------------------------------|------------|------------|------------|
| ** **                         | ** ** | **2008**                                   | ** ** | **2007**   | ** ** | **2006** | ** ** | **2008 vs 2007** | ** ** | **2007 vs 2006** | ** ** |
| Depreciation                       |       | $                                          | 1,317      |       | $          | 1,205 |   | $ | 1,224 |   | $ | 112 |   | $ | (19 | ) |
| Furniture, fixtures, and equipment |       | 245                                        |       | 225        |       | 261 |   | 20 |   | (36 | ) |
| Utilities                          |       | 314                                        |       | 283        |       | 290 |   | 31 |   | (7 | ) |
| Building repairs and maintenance   |       | 300                                        |       | 299        |       | 313 |   | 1 |   | (14 | ) |
| Taxes and insurance                |       | 256                                        |       | 217        |       | 220 |   | 39 |   | (3 | ) |
| Rent                               |       | 225                                        |       | 96         |       | 97 |   | 129 |   | (1 | ) |
| Total                              |       | $                                          | 2,657      |       | $          | 2,325 |   | $ | 2,405 |   | $ | 332 |   | $ | (80 | ) |

 

2008 vs. 2007

 

The increase in depreciation is primarily due to the addition of two branchesduring the year.  The increase in rent isrelated to one of those additional branches being located in a leased building.

 

2007 vs. 2006

 

The decrease in furniture, fixtures and equipment is primarily relatedto branch remodeling expenses incurred during 2006.

 

**Real estate owned, net. **The changes inthe composition of this line item are presented below (in thousands):

 
| ** **               | ** ** | **Year Ended December 31,** | ** ** | **Change** | ** ** |
|--------------------------|------------|--------------------------------------------|------------|------------|------------|
| ** **               | ** ** | **2008**                                   | ** ** | **2007**   | ** ** | **2006** | ** ** | **2008 vs 2007** | ** ** | **2007 vs 2006** | ** ** |
| Loss provisions          |       | $                                          | 1,042      |       | $          | 494 |   | $ | 93 |   | $ | 548 |   | $ | 401 |   |
| Net loss (gain) on sales |       | 184                                        |       | 188        |       | (51 | ) | (4 | ) | 239 |   |
| Taxes and insurance      |       | 401                                        |       | 201        |       | 94 |   | 200 |   | 107 |   |
| Other                    |       | 319                                        |       | 279        |       | 55 |   | 40 |   | 224 |   |
| Total                    |       | $                                          | 1,946      |       | $          | 1,162 |   | $ | 191 |   | $ | 784 |   | $ | 971 |   |

 

Expenses associated with real estate owned have increased due to theincrease in real estate owned balances as discussed in “Asset Quality.”   Real estate owned is expected to continue toincrease in the foreseeable future and real estate owned expenses associatedwith maintaining the properties are expected to increase accordingly.  Future levels of loss provisions and netgains or losses on sales of real estate owned will be dependent on marketconditions.

 

**Advertising and public relations.**  Thedecrease in advertising for the 2008 vs. 2007 period was primarily due to adecrease in direct mail advertising.  Thedecrease in advertising for the 2007 vs. 2006 period was primarily due to adecrease in direct mail advertising as well as a decrease in expensesassociated with branch openings.

 

**Other.**  Other noninterest expenseincludes FDIC insurance expense, which totaled $374,000, $76,000 and $77,000for the years ended December 31, 2008, 2007, and 2006, respectively.  Due to the assessment credits that partiallyoffset FDIC premium expense in 2008 and 2007 as well as deposit insurancepremium increases projected for 2009 and possible emergency specialassessments, FDIC insurance expense will be significantly higher in 2009.  See “Regulation – Bank – Insurance ofAccounts.”

 

**Income Taxes.**

 

2008 vs. 2007

 

The income tax benefit increased during the period primarily due to anincrease in nontaxable life insurance earnings.

 

2007 vs. 2006

 

The decrease in income tax expense was primarily due to a decrease intaxable income and certain nontaxable income amounts remaining relativelyconstant and therefore representing a larger percentage of taxable income.

 

**OFF-BALANCE SHEET ARRANGEMENTS**

 

See Note 14 to the Consolidated Financial Statements.

 

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### **CONTRACTUAL OBLIGATIONS**

###  

We are contractually obligated to make future minimum payments asfollows (in thousands):

 
| ** **                         | ** ** | **Less Than** | ** ** | ** **         | ** ** | ** **                     | ** ** | **More Than** | ** ** | ** ** | ** ** |
|------------------------------------|------------|--------------------|------------|--------------------|------------|--------------------------------|------------|--------------------|------------|------------|------------|
| ** **                         | ** ** | **1 Year**    | ** ** | **1-3 Years** | ** ** | **3 - 5 Years** | ** ** | **5 Years**   | ** ** | **Total**  | ** ** |
|                               |       |               |       |               |       |                           |       |               |       |       |       |
| Certificates of deposit maturities |       | $                  | 270,155    |               | $          | 85,193                         |       | $                  | 24,566     |       | $          | 6,580 |   | $ | 386,494 |   |
| Other borrowings                   |       | $                  | 56,666     |               | $          | 28,867                         |       | $                  | 5,738      |       | $          | 941 |   | $ | 92,212 |   |
| Lease obligations                  |       | $                  | 201        |               | $          | 378                            |       | $                  | 352        |       | $          | 666 |   | $ | 1,597 |   |

 

### **LIQUIDITY AND CAPITALRESOURCES**

###  

TheBank’s liquidity, represented by cash and cash equivalents and eligibleinvestment securities, is a product of its operating, investing and financingactivities.  The Bank’s primary sourcesof funds are deposits, borrowings, payments on outstanding loans, maturitiesand calls of investment securities and other short-term investments and fundsprovided from operations.  Whilescheduled loan amortization and maturing investment securities and short-terminvestments are relatively predictable sources of funds, deposit flows and loanprepayments are greatly influenced by general interest rates, economicconditions and competition.  Calls ofinvestment securities are determined by the issuer and are generally influencedby the level of market interest rates at the bond’s call date compared to thecoupon rate of the bond.  The Bankmanages the pricing of its deposits to maintain deposit balances at levelscommensurate with the operating, investing and financing activities of theBank.  In addition, the Bank investsexcess funds in overnight deposits and other short-term interest-earning assetsthat provide liquidity to meet lending requirements and pay depositwithdrawals. When funds from the retail deposit market are inadequate for theliquidity needs of the Bank or the pricing of deposits is not as favorable asother sources, the Bank has borrowed from the FHLB of Dallas and the FederalReserve Bank of St. Louis (“FRB”).   During 2008, the use of FHLB and FRB borrowings increased by $10.1million or 12.3%.  The Bank uses U.S.government agency investment securities and eligible one- to four-family loansas collateral for FHLB advances and commercial real estate and U.S. governmentagency investment securities as collateral for FRB borrowings.  The Bank’s borrowing capacity is based on theamount of securities and loans pledged to the FHLB and FRB.  The Bank may transfer additional collateralto provide additional borrowing capacity if needed.  Currently, the Bank may borrow only short-termFHLB advances with maturities up to thirty days.  In addition, brokered deposits may be used toaugment the Bank’s primary funding sources. At December 31, 2008, the Bank had outstanding brokered deposits of$2.6 million.

 

Liquidity management is both a daily and long-term function of businessmanagement.  Excess liquidity isgenerally invested in short-term investments such as overnight deposits andcertificates of deposit.  On alonger-term basis, the Bank maintains a strategy of investing in variouslending products and investment securities.  The Bank uses its sources of funds primarily to meet its ongoingcommitments, to pay maturing savings certificates and savings withdrawals, torepay maturing borrowings to fund loan commitments, and to purchase investmentsecurities.

 

In both 2008 and 2007, the Company paid dividends of $0.64 pershare.  The dividend per share was $0.16in all quarters.  The determination offuture dividends on the Company’s common stock will depend on conditionsexisting at that time with consideration given to the Company’s earnings,capital, and liquidity needs.  See Item 5for further information regarding dividend restrictions.

 

As of December 31, 2008, the Bank’s regulatory capital was inexcess of all applicable regulatory requirements.  At December 31, 2008, the Bank’stangible, core and risk-based capital ratios amounted to 8.89%, 8.89% and13.35%, respectively, compared to regulatory requirements of 1.5%, 4.0% and8.0%, respectively.

 

### **IMPACT OF INFLATION ANDCHANGING PRICES**

###  

Thefinancial statements and related financial data presented herein have beenprepared in accordance with generally accepted accounting principles, whichrequire the measurement of financial position and operating results in terms ofhistorical dollars, without considering changes in relative purchasing powerover time due to inflation.

 

Unlike most industrial companies, virtually all of the Bank’s assets andliabilities are monetary in nature.  As aresult, interest rates generally have a more significant impact on a financialinstitution’s performance than does the effect of inflation.

 

### **IMPACT OF NEW ACCOUNTINGSTANDARDS**

###  

See Note 1 to the Consolidated Financial Statements.

 

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**Item 7A. Quantitative and Qualitative Disclosures aboutMarket Risk****.**

 

**ASSET AND LIABILITY MANAGEMENT**

 

The ability to maximize net interest income is largely dependent uponthe achievement of a positive interest rate spread that can be sustained duringfluctuations in prevailing interest rates. Interest rate sensitivity is a measure of the difference between amountsof interest earning assets and interest bearing liabilities that either repriceor mature within a given period of time. The difference, or the interest rate repricing “gap”, provides anindication of the extent to which an institution’s interest rate spread will beaffected by changes in interest rates.  Agap is considered positive when the amount of interest rate-sensitive assetsexceeds the amount of interest rate-sensitive liabilities, and is considerednegative when the amount of interest rate-sensitive liabilities exceeds theamount of interest rate-sensitive assets. Generally, during a period of rising interest rates, a negative gapwithin shorter maturities would adversely affect net interest income, while apositive gap within shorter maturities would result in an increase in netinterest income, and during a period of falling interest rates, a negative gapwithin shorter maturities would result in an increase in net interest incomewhile a positive gap within shorter maturities would have the oppositeeffect.  As of December 31, 2008,the Bank estimates that the ratio of its one-year gap to total assets was anegative 18.0% and its ratio of interest earning assets to interest bearingliabilities maturing or repricing within one year was 70.6%.  Due to inherent limitations in any static gapanalysis and since conditions change on a daily basis, these measurements maynot reflect future results.  A static gapanalysis does not include such factors as loan prepayments, interest ratefloors and caps on various assets and liabilities, the current interest rateson assets and liabilities to be repriced in each period, and the relativechanges in interest rates on different types of assets and liabilities.

 

The Bank focuses its residential lending activities for loans held inportfolio on the origination of one-, three-, five- and seven-year adjustablerate residential mortgage loans (“ARMs”). Although adjustable rate loans involve certain risks, includingincreased payments and the potential for default in an increasing interest rateenvironment, such loans decrease the risks associated with changes in interestrates.  As of December 31, 2008,$185.5 million or 76.3% of the Bank’s portfolio of one- to four-familyresidential mortgage loans consisted of ARMs, including $31.8 million inseven-year ARMs. ARMs subject to contractual repricing within one yeartotaled $44.8 million at an average interest rate of 6.6% at December 31,2008.

 

At December 31, 2008, the Bank’s portfolio of variable rate loanstied primarily to the Wall Street Journal Prime Rate (“Prime Rate”) amounted to$87.0 million with an average interest rate of 4.79%.  The interest rate on these loans adjusts atany time the Prime Rate adjusts, subject to interest rate caps or floors on theloans.  Of the $87.0 million,approximately 70.0% have interest rate floors below 6.0%.  The Prime Rate at December 31, 2008, was3.25%.

 

The Company’s investment portfolio, all of which is classified as heldto maturity, amounted to $136.4 million or 17.2% of the Company’s total assetsat December 31, 2008.  Of suchamount, $225,000 or 0.2% is contractually due within one year and $3.2 millionor 2.3% is contractually due from one year to five years.  However, actual maturities can be shorterthan contractual maturities due to the ability of borrowers to call or prepaysuch obligations without call or prepayment penalties.  As of December 31, 2008, there wasapproximately $135.8 million of investment securities at an average interestrate of 5.36% with call options held by the issuer, of which approximately$124.8 million, at an average interest rate of 5.44% are callable within oneyear.  In the current declining interestrate environment, it is projected that approximately 74% of the $124.8 millionin investment securities callable within one year will actually be called withinone year.

 

Deposits are the Bank’s primary funding source and the Bank prices itsdeposit accounts based upon competitive factors and the availability of prudentlending and investment opportunities. The Bank seeks to lengthen the maturities of its deposits by offeringlonger-term certificates of deposit when market conditions have createdopportunities to attract such deposits. However, the Bank does not solicit highrate jumbo certificates of deposit and does not pursue an aggressive growthstrategy that would force the Bank to focus exclusively on competitors’ ratesrather than deposit affordability.  At December 31,2008, the Bank had $386.5 million in certificates of deposit of which $270.2million at an average interest rate of 3.20% mature in one year or less.  At December 31, 2008, the Bank hadapproximately $45.0 million of money market deposit accounts at an average rateof 1.29%.  These accounts are subject torepricing at the discretion of the Bank.

 

At December 31, 2008, the Bank had $82.2 million of FHLB advances,of which $16.0 million at an average interest rate of 0.72% are variable withthe interest rate floating either monthly or quarterly based on movements inthe London Interbank Offering Rate (“LIBOR”). Fixed rate advances of $41.9 million at an average interest rate of3.79% are due in one year or less.  TheBank had overnight FRB borrowings totaling $10.0 million with a rate of 0.50%at December 31, 2008.

 

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### **Net Portfolio Value**

###  

The value of the Bank’s loan and investment portfolio will change asinterest rates change.  As a result ofthe Bank’s negative interest rate repricing gap, rising interest rates willgenerally decrease the Bank’s net portfolio value (“NPV”), while fallinginterest rates will generally increase the value of that portfolio.  NPV is the difference between incoming andoutgoing discounted cash flows from assets, liabilities, and off-balance sheetcontracts.  The following tables setforth, quantitatively, as of December 31, 2008 and 2007, the OTS estimateof the projected changes in NPV in the event of a 100, 200 and 300 basis pointinstantaneous and permanent increase in market interest rates and a 100 basispoint instantaneous and permanent decrease in market interest rates as of December 31,2008 as well as a 200 basis point instantaneous and permanent decrease inmarket interest rates as of December 31, 2007.  Due to the low interest rate environment in2008, the changes in NPV are not estimated for a decrease in interest rates of200 basis points in that year.

 

**2008**

 
| **Change in  Interest Rates  (basis points)** | ** ** | **Estimated NPV** | ** ** | **Estimated NPV as  a Percentage of  Present Value  of Assets** | ** ** | **Amount  of Change** | ** ** | **Percent  of Change** | ** ** |
|--------------------------------------------------------------|------------|------------------------|------------|-----------------------------------------------------------------------------------------------|------------|----------------------------|------------|-----------------------------|------------|
| **(Dollars in Thousands)**                         | ** ** |
| +300                                                         |       |                   | $          | 55,809                                                                                        |       | 7.11                       | %          | $                           | (24,839    | ) | (31 | )% |
| +200                                                         |       |                   | 64,084     |                                                                                          | 8.05       |                       | (16,564    | )                           | (21        | ) |
| +100                                                         |       |                   | 72,264     |                                                                                          | 8.94       |                       | (8,384     | )                           | (10        | ) |
| 0                                                            |       |                   | 80,648     |                                                                                          | 9.83       |                       | —     |                        | —     |   |
| -100                                                         |       |                   | 81,642     |                                                                                          | 9.90       |                       | 993        |                        | 1          |   |
|                                                              |            |                        |            |                                                                                               |            |                            |            |                             |            |  |  |  |

 

**2007**

 
| **Change in  Interest Rates  (basis points)** | ** ** | **Estimated NPV** | ** ** | **Estimated NPV as  a Percentage of  Present Value  of Assets** | ** ** | **Amount  of Change** | ** ** | **Percent  of Change** | ** ** |
|--------------------------------------------------------------|------------|------------------------|------------|-----------------------------------------------------------------------------------------------|------------|----------------------------|------------|-----------------------------|------------|
| **(Dollars in Thousands)**                         | ** ** |
| +300                                                         |       |                   | $          | 71,558                                                                                        |       | 9.11                       | %          | $                           | (22,031    | ) | (24 | )% |
| +200                                                         |       |                   | 80,684     |                                                                                          | 10.11      |                       | (12,905    | )                           | (14        | ) |
| +100                                                         |       |                   | 88,383     |                                                                                          | 10.93      |                       | (5,206     | )                           | (6         | ) |
| 0                                                            |       |                   | 93,589     |                                                                                          | 11.44      |                       | —     |                        | —     |   |
| -100                                                         |       |                   | 95,049     |                                                                                          | 11.55      |                       | 1,460      |                        | 2          |   |
| -200                                                         |       |                   | 91,443     |                                                                                          | 11.10      |                       | (2,146     | )                           | (2         | ) |
|                                                              |            |                        |            |                                                                                               |            |                            |            |                             |            |  |  |  |

 

Computations of prospective effects of hypothetical interest ratechanges are calculated by the OTS from data provided by the Bank and are basedon numerous assumptions, including relative levels of market interest rates,loan repayments, and deposit runoffs, and should not be relied upon asindicative of actual results.  Further,the computations do not contemplate any actions the Bank may undertake inresponse to changes in interest rates.

 

Management cannot predict future interest rates or their effect on theBank’s NPV.  Certain shortcomings areinherent in the method of analysis presented in the computation of NPV.  For example, although certain assets andliabilities may have similar maturities or periods to repricing, they may reactin differing degrees to changes in market interest rates.  Additionally, certain assets, such asadjustable rate loans, have features that restrict changes in interest ratesduring the initial term and over the remaining life of the asset.  In addition, the proportion of adjustablerate loans in the Bank’s portfolio could decrease in future periods due torefinancing activity if market rates decrease. Further, in the event of a change in interest rates, prepayment andearly withdrawal levels could deviate significantly from those assumed in thetable.  Finally, the ability of manyborrowers to service their adjustable rate debt may decrease in the event of aninterest rate increase.

 

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**Item 8. Financial Statements and Supplementary Data.**

 

**MANAGEMENT REPORT ON INTERNAL CONTROL**

 

Themanagement of First Federal Bancshares of Arkansas, Inc. and itssubsidiary, First Federal Bank, (collectively referred to as the “Company”) isresponsible for the preparation, integrity, and fair presentation of itspublished financial statements and all other information presented in thisannual report.  The financial statementshave been prepared in accordance with accounting principles generally acceptedin the United States of America (“GAAP”) and, as such, include amounts based oninformed judgments and estimates made by management.

 

Managementis responsible for establishing and maintaining adequate internal control overfinancial reporting for financial presentations in conformity with GAAP.Pursuant to the rules and regulations of the Securities and ExchangeCommission, internal control over financial reporting is a process designed by,or under the supervision of, the Company’s principal executive and principalfinancial officers, or persons performing similar functions, and effected bythe Company’s board of directors, management and other personnel, to providereasonable assurance regarding the reliability of financial reporting and thepreparation of financial statements for external purposes in accordance withGAAP and includes those policies and procedures that:

 

Pertain to the maintenance of records that inreasonable detail accurately and fairly reflect the transactions anddispositions of the assets of the Company;

 

Provide reasonable assurance that transactions arerecorded as necessary to permit preparation of financial statements inaccordance with GAAP, and that receipts and expenditures of the Company arebeing made only in accordance with authorizations of management and directorsof the Company; and

 

Provide reasonable assurance regarding prevention ortimely detection of unauthorized acquisition, use or disposition of the Company’sassets that could have a material effect on the financial statements.

 

Managementhas evaluated the effectiveness of its internal control over financialreporting for financial presentations in conformity with GAAP as of December 31,2008 based on the control criteria established in a report entitled *Internal Control—Integrated Framework*,issued by the Committee of Sponsoring Organizations of the Treadway Commission.Based on such evaluation, we have concluded that the Company’s internal controlover financial reporting is effective as of December 31, 2008.

 

Theindependent registered public accounting firm of Deloitte & ToucheLLP, as auditors of the Company’s consolidated financial statements, has issuedan attestation report on the Company’s internal control over financialreporting.

 
| Larry J. Brandt  President and Chief Executive Officer |   | Sherri R. Billings  Executive Vice President and Chief Financial Officer |
|--------------------------------------------------------|--------|--------------------------------------------------------------------------|

 

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## **REPORT OF INDEPENDENTREGISTERED PUBLIC ACCOUNTING FIRM**

##  

Tothe Board of Directors and Stockholders of

FirstFederal Bancshares of Arkansas, Inc.

Harrison,AR

 

Wehave audited the accompanying consolidated statements of financial condition ofFirst Federal Bancshares of Arkansas, Inc. and subsidiaries (the “Company”)as of December 31, 2008 and 2007, and the related consolidated statementsof income, stockholders’ equity, and cash flows for each of the three years inthe period ended December 31, 2008.  These financial statements arethe responsibility of the Company’s management.  Our responsibility is toexpress an opinion on the financial statements based on our audits.

 

Weconducted our audits in accordance with the standards of the Public CompanyAccounting Oversight Board (United States).  Those standards require thatwe plan and perform the audit to obtain reasonable assurance about whether thefinancial statements are free of material misstatement.  An audit includesexamining, on a test basis, evidence supporting the amounts and disclosures inthe financial statements.  An audit also includes assessing the accountingprinciples used and significant estimates made by management, as well asevaluating the overall financial statement presentation.  We believe thatour audits provide a reasonable basis for our opinion.

 

Inour opinion, such consolidated financial statements present fairly, in allmaterial respects, the financial position of First Federal Bancshares ofArkansas, Inc. and subsidiaries as of December 31, 2008 and 2007, andthe results of their operations and their cash flows for each of the threeyears in the period ended December 31, 2008, in conformity with accountingprinciples generally accepted in the United States of America.

 

Wehave also audited, in accordance with the standards of the Public CompanyAccounting Oversight Board (United States), the Company’s internal control overfinancial reporting as of December 31, 2008, based on the criteriaestablished in *Internal Control—IntegratedFramework* issued by the Committee of Sponsoring Organizations of theTreadway Commission and our report dated March 6, 2009 expressed anunqualified opinion on the Company’s internal control over financial reporting.

 

 

/s/ Deloitte & Touche LLP

LittleRock, AR

March 6,2009

 

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**REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**

 

Tothe Board of Directors and Stockholders of

FirstFederal Bancshares of Arkansas, Inc.

Harrison,AR

 

Wehave audited the internal control over financial reporting of First FederalBancshares of Arkansas, Inc. and subsidiaries (the “Company”) as of December 31,2008, based on**criteriaestablished in *Internal Control — IntegratedFramework*issued by the Committee of Sponsoring Organizations of theTreadway Commission.  The Company’s management is responsible formaintaining effective internal control over financial reporting and for itsassessment of the effectiveness of internal control over financial reporting,included in the accompanying Management Report on Internal Control.  Ourresponsibility is to express an opinion on the Company’s internal control overfinancial reporting based on our audit.

 

Weconducted our audit in accordance with the standards of the Public CompanyAccounting Oversight Board (United States).  Those standards require thatwe plan and perform the audit to obtain reasonable assurance about whethereffective internal control over financial reporting was maintained in allmaterial respects.  Our audit included obtaining an understanding ofinternal control over financial reporting, assessing the risk that a materialweakness exists, testing and evaluating the design and operating effectivenessof internal control based on the assessed risk, and performing such otherprocedures as we considered necessary in the circumstances.  We believethat our audit provides a reasonable basis for our opinion.

 

Acompany’s internal control over financial reporting is a process designed by,or under the supervision of, the company’s principal executive and principalfinancial officers, or persons performing similar functions, and effected bythe company’s board of directors, management, and other personnel to providereasonable assurance regarding the reliability of financial reporting and thepreparation of financial statements for external purposes in accordance withgenerally accepted accounting principles.  A company’s internal controlover financial reporting includes those policies and procedures that (1) pertainto the maintenance of records that, in reasonable detail, accurately and fairlyreflect the transactions and dispositions of the assets of the company; (2) providereasonable assurance that transactions are recorded as necessary to permitpreparation of financial statements in accordance with generally acceptedaccounting principles, and that receipts and expenditures of the company arebeing made only in accordance with authorizations of management and directorsof the company; and (3) provide reasonable assurance regarding preventionor timely detection of unauthorized acquisition, use, or disposition of thecompany’s assets that could have a material effect on the financial statements.

 

Becauseof the inherent limitations of internal control over financial reporting,including the possibility of collusion or improper management override ofcontrols, material misstatements due to error or fraud may not be prevented ordetected on a timely basis.  Also, projections of any evaluation of theeffectiveness of the internal control over financial reporting to futureperiods are subject to the risk that the controls may become inadequate becauseof changes in conditions, or that the degree of compliance with the policies orprocedures may deteriorate.

 

Inour opinion, the Company maintained, in all material respects, effectiveinternal control over financial reporting as of December 31, 2008, basedon the criteria established in *InternalControl — Integrated Framework*issued by the Committee of SponsoringOrganizations of the Treadway Commission.

 

Wehave also audited, in accordance with the standards of the Public CompanyAccounting Oversight Board (United States), the consolidated financialstatements as of and for the year ended December 31, 2008 of the Companyand our report dated March 6, 2009 expressed an unqualified opinion onthose financial statements.

 

 

/s/ Deloitte & Touche LLP

LittleRock, AR

March 6,2009

 

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**FIRSTFEDERAL BANCSHARES OF ARKANSAS, INC.**

 

**CONSOLIDATEDSTATEMENTS OF FINANCIAL CONDITION**

**DECEMBER 31,2008 AND 2007**

**(Inthousands, except share data)**

 
| ** **                                                                                                                                                                                     | ** ** | **2008** | ** ** | **2007** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|
| **ASSETS**                                                                                                                                                                                     |       |     |       |     |       |
|                                                                                                                                                                                           |       |     |       |     |       |
| Cash and cash equivalents:                                                                                                                                                                     |       |     |       |     |       |
| Cash and collection items                                                                                                                                                                      |       | $        | 9,359      |     | $          | 12,578 |   |
| Interest bearing deposits with banks                                                                                                                                                           |       | 8        |       | 13,809   |       |
| Federal funds sold                                                                                                                                                                             |       | —   |       | 1,000    |       |
|                                                                                                                                                                                           |       |     |       |     |       |
| Total cash and cash equivalents                                                                                                                                                                |       | 9,367    |       | 27,387   |       |
|                                                                                                                                                                                           |       |     |       |     |       |
| Investment securities—                                                                                                                                                                    |       |     |       |     |       |
| Held to maturity, at amortized cost (fair  value at December 31, 2008 and 2007, of $136,055 and $95,811,  respectively)                                                                   |       | 136,412  |       | 95,590   |       |
| Federal Home Loan Bank stock—at cost                                                                                                                                                      |       | 4,825    |       | 4,433    |       |
| Loans receivable, net of allowance at  December 31, 2008 and 2007, of $6,441 and $5,162, respectively                                                                                     |       | 568,123  |       | 601,256  |       |
| Accrued interest receivable                                                                                                                                                                    |       | 6,701    |       | 9,042    |       |
| Real estate owned—net                                                                                                                                                                     |       | 22,385   |       | 8,120    |       |
| Office properties and equipment—net                                                                                                                                                       |       | 24,694   |       | 24,263   |       |
| Cash surrender value of life insurance                                                                                                                                                         |       | 20,412   |       | 20,159   |       |
| Prepaid expenses and other assets                                                                                                                                                              |       | 2,253    |       | 1,728    |       |
|                                                                                                                                                                                           |       |     |       |     |       |
| TOTAL                                                                                                                                                                                          |       | $        | 795,172    |     | $          | 791,978 |   |
|                                                                                                                                                                                           |       |     |       |     |       |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                                                                  |       |     |       |     |       |
|                                                                                                                                                                                           |       |     |       |     |       |
| LIABILITIES:                                                                                                                                                                                   |       |     |       |     |       |
| Deposits:                                                                                                                                                                                      |       |     |       |     |       |
| Interest bearing                                                                                                                                                                               |       | $        | 590,465    |     | $          | 602,618 |   |
| Noninterest bearing                                                                                                                                                                            |       | 27,538   |       | 27,796   |       |
|                                                                                                                                                                                           |       |     |       |     |       |
| Total deposits                                                                                                                                                                                 |       | 618,003  |       | 630,414  |       |
|                                                                                                                                                                                           |       |     |       |     |       |
| Other borrowings                                                                                                                                                                               |       | 92,212   |       | 82,087   |       |
| Advance payments by borrowers for taxes and  insurance                                                                                                                                         |       | 810      |       | 575      |       |
| Other liabilities                                                                                                                                                                              |       | 11,030   |       | 5,239    |       |
|                                                                                                                                                                                           |       |     |       |     |       |
| Total liabilities                                                                                                                                                                              |       | $        | 722,055    |     | $          | 718,315 |   |
|                                                                                                                                                                                           |       |     |       |     |       |
| STOCKHOLDERS’ EQUITY:                                                                                                                                                                     |       |     |       |     |       |
| Preferred stock, no par value—5,000,000  shares authorized, none issued                                                                                                                   |       |     |       |     |       |
| Common stock, $.01 par value—20,000,000  shares authorized; 10,307,502 shares issued; 4,846,785 and 4,844,385 shares  outstanding  at December 31, 2008  and 2007, respectively |       | 103      |       | 103      |       |
| Additional paid-in capital                                                                                                                                                                     |       | 56,627   |       | 56,653   |       |
| Employee stock benefit plans                                                                                                                                                                   |       | —   |       | (42      | )          |
| Retained earnings—substantially restricted                                                                                                                                                |       | 87,005   |       | 87,600   |       |
|                                                                                                                                                                                           |       | 143,735  |       | 144,314  |       |
| Treasury stock—at cost; 5,460,717 and  5,463,117 shares at December 31, 2008 and 2007, respectively                                                                                  |       | (70,618  | )          | (70,651  | )          |
|                                                                                                                                                                                           |       |     |       |     |       |
| Total stockholders’ equity                                                                                                                                                                |       | 73,117   |       | 73,663   |       |
|                                                                                                                                                                                           |       |     |       |     |       |
| TOTAL                                                                                                                                                                                          |       | $        | 795,172    |     | $          | 791,978 |   |

 

See notes to consolidatedfinancial statements.

 

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**FIRST FEDERAL BANCSHARES OF ARKANSAS, INC**

 

**CONSOLIDATED STATEMENTS OF INCOME**

**YEARS ENDED DECEMBER 31, 2008, 2007, AND 2006**

**(In thousands, except earnings per share)**

 
| ** **                                           | ** ** | **2008** | ** ** | **2007** | ** ** | **2006** | ** ** |
|------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| INTEREST INCOME:                                     |       |     |       |     |       |     |       |
| Loans receivable                                     |       | $        | 36,799     |     | $          | 45,473   |       | $ | 50,185 |   |
| Investment securities:                               |       |     |       |     |       |     |       |
| Taxable                                              |       | 5,966    |       | 3,350    |       | 2,526    |       |
| Nontaxable                                           |       | 794      |       | 721      |       | 744      |       |
| Other                                                |       | 388      |       | 882      |       | 664      |       |
| Total interest income                                |       | 43,947   |       | 50,426   |       | 54,119   |       |
|                                                 |       |     |       |     |       |     |       |
| INTEREST EXPENSE:                                    |       |     |       |     |       |     |       |
| Deposits                                             |       | 18,549   |       | 23,873   |       | 20,643   |       |
| Other borrowings                                     |       | 3,553    |       | 4,311    |       | 6,933    |       |
|                                                 |       |     |       |     |       |     |       |
| Total interest expense                               |       | 22,102   |       | 28,184   |       | 27,576   |       |
|                                                 |       |     |       |     |       |     |       |
| NET INTEREST INCOME                                  |       | 21,845   |       | 22,242   |       | 26,543   |       |
|                                                 |       |     |       |     |       |     |       |
| PROVISION FOR LOAN LOSSES                            |       | 5,710    |       | 4,028    |       | 1,482    |       |
|                                                 |       |     |       |     |       |     |       |
| NET INTEREST INCOME AFTER PROVISION FOR  LOAN LOSSES |       | 16,135   |       | 18,214   |       | 25,061   |       |
|                                                 |       |     |       |     |       |     |       |
| NONINTEREST INCOME:                                  |       |     |       |     |       |     |       |
| Deposit fee income                                   |       | 5,413    |       | 4,989    |       | 4,839    |       |
| Earnings on life insurance policies                  |       | 1,962    |       | 763      |       | 742      |       |
| Gain on sale of loans                                |       | 354      |       | 823      |       | 924      |       |
| Other                                                |       | 1,688    |       | 1,194    |       | 1,717    |       |
|                                                 |       |     |       |     |       |     |       |
| Total noninterest income                             |       | 9,417    |       | 7,769    |       | 8,222    |       |
|                                                 |       |     |       |     |       |     |       |
| NONINTEREST EXPENSES:                                |       |     |       |     |       |     |       |
| Salaries and employee benefits                       |       | 12,770   |       | 13,231   |       | 13,464   |       |
| Net occupancy expense                                |       | 2,657    |       | 2,325    |       | 2,405    |       |
| Real estate owned, net                               |       | 1,946    |       | 1,162    |       | 191      |       |
| Data processing                                      |       | 1,431    |       | 1,513    |       | 1,474    |       |
| Professional fees                                    |       | 504      |       | 513      |       | 381      |       |
| Advertising and public relations                     |       | 900      |       | 1,145    |       | 1,338    |       |
| Postage and supplies                                 |       | 804      |       | 857      |       | 836      |       |
| Other                                                |       | 2,456    |       | 2,249    |       | 2,432    |       |
|                                                 |       |     |       |     |       |     |       |
| Total noninterest expenses                           |       | 23,468   |       | 22,995   |       | 22,521   |       |
|                                                 |       |     |       |     |       |     |       |
| INCOME BEFORE INCOME TAXES                           |       | 2,084    |       | 2,988    |       | 10,762   |       |
|                                                 |       |     |       |     |       |     |       |
| INCOME TAX PROVISION (BENEFIT)                       |       | (423     | )          | 345      |       | 3,379    |       |
|                                                 |       |     |       |     |       |     |       |
| NET INCOME                                           |       | $        | 2,507      |     | $          | 2,643    |       | $ | 7,383 |   |
|                                                 |       |     |       |     |       |     |       |
| EARNINGS PER SHARE:                                  |       |     |       |     |       |     |       |
| Basic                                                |       | $        | 0.52       |     | $          | 0.54     |       | $ | 1.48 |   |
|                                                 |       |     |       |     |       |     |       |
| Diluted                                              |       | $        | 0.52       |     | $          | 0.54     |       | $ | 1.44 |   |

 

See notes to consolidated financialstatements.

 

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**FIRST FEDERAL BANCSHARES OF ARKANSAS, INC.**

 

## **CONSOLIDATED STATEMENTSOF STOCKHOLDERS’ EQUITY**

## **YEARS ENDED DECEMBER 31,2008, 2007, AND 2006**

** **

**(In thousands, except share data)**

** **
| ** **                                | ** ** | ** **            | ** ** | ** **     | ** ** | ** **  | ** ** | **Employee** | ** ** | ** **              | ** ** | ** **             | ** ** | ** ** | ** ** | ** ** | ** ** |
|-------------------------------------------|------------|-----------------------|------------|----------------|------------|-------------|------------|--------------|------------|-------------------------|------------|------------------------|------------|------------|------------|------------|------------|
| ** **                                | ** ** | **Issued**            | ** ** | **Additional** | ** ** | **Stock**   | ** ** | ** **   | ** ** | ** **              | ** ** | ** **             | ** ** | **Total**  | ** ** |
| ** **                                | ** ** | **Common Stock** | ** ** | **Paid-In**    | ** ** | **Benefit** | ** ** | **Retained** | ** ** | **Treasury Stock** | ** ** | **Stockholders’** | ** ** |
| ** **                                | ** ** | **Shares**            | ** ** | **Amount**     | ** ** | **Capital** | ** ** | **Plans**    | ** ** | **Earnings**            | ** ** | **Shares**             | ** ** | **Amount** | ** ** | **Equity** | ** ** |
| BALANCE – January 1, 2006       |       | 10,307,502            |       | $              | 103        |        | $          | 56,252       |       | $                       | (140       | )                      | $          | 83,584     |       | 5,258,840  |       | $ | (61,957 | ) | $ | 77,842 |   |
|                                      |       |                  |       |           |       |        |       |         |       |                    |       |                   |       |       |       |       |       |
| Net income                                |       | —                |       | —         |       | —      |       | —       |       | 7,383                   |       | —                 |       | —     |       | 7,383      |       |
| Release of ESOP shares                    |       | —                |       | —         |       | 408         |       | 104          |       | —                  |       | —                 |       | —     |       | 512        |       |
| Stock compensation expense                |       | —                |       | —         |       | 70          |       | (36          | )          | —                  |       | (4,000                 | )          | 47         |       | 81         |       |
| Tax effect of stock compensation plans    |       | —                |       | —         |       | 274         |       | —       |       | —                  |       | —                 |       | —     |       | 274        |       |
| Purchase of treasury stock – at cost |       | —                |       | —         |       | —      |       | —       |       | —                  |       | 354,266                |       | (8,574     | )          | (8,574     | )          |
| Treasury shares reissued                  |       | —                |       | —         |       | (387        | )          | —       |       | —                  |       | (140,566               | )          | 1,341      |       | 954        |       |
| Dividends paid ($0.58 per share)          |       | —                |       | —         |       | —      |       | —       |       | (2,899                  | )          | —                 |       | —     |       | (2,899     | )          |
|                                      |       |                  |       |           |       |        |       |         |       |                    |       |                   |       |       |       |       |       |
| BALANCE – December 31, 2006     |       | 10,307,502            |       | 103            |       | 56,617      |       | (72          | )          | 88,068                  |       | 5,468,540              |       | (69,143    | )          | 75,573     |       |
|                                      |       |                  |       |           |       |        |       |         |       |                    |       |                   |       |       |       |       |       |
| Net income                                |       | —                |       | —         |       | —      |       | —       |       | 2,643                   |       | —                 |       | —     |       | 2,643      |       |
| Stock compensation expense                |       | —                |       | —         |       | 9           |       | 30           |       | —                  |       | —                 |       | —     |       | 39         |       |
| Tax effect of stock compensation plans    |       | —                |       | —         |       | 481         |       | —       |       | —                  |       | —                 |       | —     |       | 481        |       |
| Purchase of treasury stock – at cost |       | —                |       | —         |       | —      |       | —       |       | —                  |       | 101,542                |       | (2,312     | )          | (2,312     | )          |
| Treasury shares reissued                  |       | —                |       | —         |       | (454        | )          | —       |       | —                  |       | (106,965               | )          | 804        |       | 350        |       |
| Dividends paid ($0.64 per share)          |       | —                |       | —         |       | —      |       | —       |       | (3,111                  | )          | —                 |       | —     |       | (3,111     | )          |
|                                      |       |                  |       |           |       |        |       |         |       |                    |       |                   |       |       |       |       |       |
| BALANCE – December 31, 2007     |       | 10,307,502            |       | 103            |       | 56,653      |       | (42          | )          | 87,600                  |       | 5,463,117              |       | (70,651    | )          | 73,663     |       |
|                                      |       |                  |       |           |       |        |       |         |       |                    |       |                   |       |       |       |       |       |
| Net income                                |       | —                |       | —         |       | —      |       | —       |       | 2,507                   |       | —                 |       | —     |       | 2,507      |       |
| Stock compensation expense                |       | —                |       | —         |       | (18         | )          | 42           |       | —                  |       | 1,600                  |       | (19        | )          | 5          |       |
| Tax effect of stock compensation plans    |       | —                |       | —         |       | (2          | )          | —       |       | —                  |       | —                 |       | —     |       | (2         | )          |
| Treasury shares reissued                  |       | —                |       | —         |       | (6          | )          | —       |       | —                  |       | (4,000                 | )          | 52         |       | 46         |       |
| Dividends paid ($0.64 per share)          |       | —                |       | —         |       | —      |       | —       |       | (3,102                  | )          | —                 |       | —     |       | (3,102     | )          |
|                                      |       |                  |       |           |       |        |       |         |       |                    |       |                   |       |       |       |       |       |
| BALANCE – December 31, 2008     |       | 10,307,502            |       | $              | 103        |        | $          | 56,627       |       | $                       | —     |                   | $          | 87,005     |       | 5,460,717  |       | $ | (70,618 | ) | $ | 73,117 |   |

 

Seenotes to consolidated financial statements.

 

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**FIRST FEDERAL BANCSHARES OF ARKANSAS, INC.**

 

**CONSOLIDATED STATEMENTS OF CASH FLOWS**

**YEARS ENDED DECEMBER 31, 2008, 2007 AND 2006**

**(In thousands)**

 
| ** **                                                                         | ** ** | **2008**   | ** ** | **2007**   | ** ** | **2006**   | ** ** |
|------------------------------------------------------------------------------------|------------|------------|------------|------------|------------|------------|------------|
| ** **                                                                         | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| OPERATING ACTIVITIES:                                                              |       |       |       |       |       |       |       |
| Net income                                                                         |       | $          | 2,507      |       | $          | 2,643      |       | $ | 7,383 |   |
| Adjustments to reconcile net income to net  cash provided by operating activities: |       |       |       |       |       |       |       |
| Provision for loan losses                                                          |       | 5,710      |       | 4,028      |       | 1,482      |       |
| Provision for real estate losses                                                   |       | 1,042      |       | 494        |       | 92         |       |
| Deferred tax provision (benefit)                                                   |       | (657       | )          | (1,585     | )          | 137        |       |
| Accretion of discounts on investment  securities, net                              |       | (60        | )          | (16        | )          | (8         | )          |
| Federal Home Loan Bank stock dividends                                             |       | (131       | )          | (303       | )          | (403       | )          |
| Gain on disposition of fixed assets                                                |       | (18        | )          | (3         | )          | (522       | )          |
| Loss (gain) on sale of repossessed assets,  net                                    |       | 184        |       | 188        |       | (51        | )          |
| Originations of loans held for sale                                                |       | (23,788    | )          | (59,813    | )          | (67,896    | )          |
| Proceeds from sales of loans                                                       |       | 25,388     |       | 58,903     |       | 70,362     |       |
| Gain on sale of loans originated to sell                                           |       | (354       | )          | (823       | )          | (924       | )          |
| Depreciation                                                                       |       | 1,484      |       | 1,399      |       | 1,304      |       |
| Amortization of deferred loan costs, net                                           |       | 366        |       | 435        |       | 280        |       |
| Release of ESOP shares                                                             |       | —     |       | —     |       | 512        |       |
| Earnings on life insurance policies                                                |       | (782       | )          | (763       | )          | (742       | )          |
| Stock compensation expense                                                         |       | 5          |       | 39         |       | 81         |       |
| Changes in operating assets and  liabilities:                                      |       |       |       |       |       |       |       |
| Accrued interest receivable                                                        |       | 2,341      |       | 957        |       | (2,509     | )          |
| Prepaid expenses and other assets                                                  |       | 620        |       | 699        |       | (953       | )          |
| Other liabilities                                                                  |       | (12        | )          | 437        |       | 283        |       |
|                                                                               |       |       |       |       |       |       |       |
| Net cash provided by operating activities                                          |       | 13,845     |       | 6,916      |       | 7,908      |       |
|                                                                               |       |       |       |       |       |       |       |
| INVESTING ACTIVITIES:                                                              |       |       |       |       |       |       |       |
| Purchases of investment securities, held to  maturity                              |       | (119,353   | )          | (41,488    | )          | (7,533     | )          |
| Proceeds from maturities/calls of  investment securities, held to maturity         |       | 84,396     |       | 9,850      |       | 3,490      |       |
| Purchase of Federal Home Loan Bank stock                                           |       | (261       | )          | —     |       | —     |       |
| Federal Home Loan Bank stock redeemed                                              |       | —     |       | 2,959      |       | 1,726      |       |
| Loan originations, net of repayments                                               |       | 8,843      |       | 76,070     |       | 13,762     |       |
| Loan purchases                                                                     |       | (4,880     | )          | (4,763     | )          | (363       | )          |
| Loan participations sold                                                           |       | 4,045      |       | 7,208      |       | 3,419      |       |
| Proceeds from sales of repossessed assets                                          |       | 3,073      |       | 3,740      |       | 3,700      |       |
| Improvements to real estate owned                                                  |       | (724       | )          | (763       | )          | (724       | )          |
| Proceeds from sales of office properties  and equipment                            |       | 30         |       | 10         |       | 251        |       |
| Purchases of office properties and  equipment                                      |       | (1,927     | )          | (2,637     | )          | (3,190     | )          |
|                                                                               |       |       |       |       |       |       |       |
| Net cash provided by (used in) investing  activities                               |       | (26,758    | )          | 50,186     |       | 14,538     |       |
|                                                                                    |            |            |            |            |            |            |            |  |  |  |

 

(Continued)

 

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**FIRST FEDERAL BANCSHARES OF ARKANSAS, INC.**

** **

**CONSOLIDATED STATEMENTS OF CASH FLOWS**

**YEARS ENDED DECEMBER 31, 2008, 2007 AND 2006**

**(In thousands)**

 
| ** **                                                                        | ** ** | **2008** | ** ** | **2007** | ** ** | **2006** | ** ** |
|-----------------------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| FINANCING ACTIVITIES:                                                             |       |     |       |     |       |     |       |
| Net increase (decrease) in deposits                                               |       | $        | (12,411    | )        | $          | (21,851  | )          | $ | 40,598 |   |
| Advances from Federal Home Loan Bank                                              |       | 174,955  |       | 25,200   |       | 55,000   |       |
| Repayment of advances from Federal Home  Loan Bank                                |       | (174,860 | )          | (63,418  | )          | (92,935  | )          |
| Net borrowings from Federal Reserve Bank                                          |       | 10,030   |       | —   |       | —   |       |
| Net increase (decrease) in advance payments  by borrowers for taxes and insurance |       | 235      |       | (91      | )          | (181     | )          |
| Purchase of treasury stock                                                        |       | —   |       | (2,312   | )          | (8,574   | )          |
| Dividends paid                                                                    |       | (3,102   | )          | (3,111   | )          | (2,899   | )          |
| Stock options exercised                                                           |       | 46       |       | 350      |       | 954      |       |
|                                                                              |       |     |       |     |       |     |       |
| Net cash used in financing activities                                             |       | (5,107   | )          | (65,233  | )          | (8,037   | )          |
|                                                                              |       |     |       |     |       |     |       |
| NET INCREASE (DECREASE) IN CASH AND CASH  EQUIVALENTS                             |       | (18,020  | )          | (8,131   | )          | 14,409   |       |
|                                                                              |       |     |       |     |       |     |       |
| CASH AND CASH EQUIVALENTS:                                                        |       |     |       |     |       |     |       |
| Beginning of year                                                                 |       | 27,387   |       | 35,518   |       | 21,109   |       |
|                                                                              |       |     |       |     |       |     |       |
| End of year                                                                       |       | $        | 9,367      |     | $          | 27,387   |       | $ | 35,518 |   |
|                                                                              |       |     |       |     |       |     |       |
| SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION—                           |       |     |       |     |       |     |       |
| Cash paid for:                                                                    |       |     |       |     |       |     |       |
| Interest                                                                          |       | $        | 22,501     |     | $          | 28,483   |       | $ | 26,883 |   |
|                                                                              |       |     |       |     |       |     |       |
| Income taxes                                                                      |       | $        | —     |     | $          | 1,157    |       | $ | 3,494 |   |
|                                                                              |       |     |       |     |       |     |       |
| SUPPLEMENTAL SCHEDULE OF NONCASH INVESTING  ACTIVITIES:                           |       |     |       |     |       |     |       |
| Real estate and other assets acquired in  settlement of loans                     |       | $        | 24,708     |     | $          | 12,283   |       | $ | 5,997 |   |
|                                                                              |       |     |       |     |       |     |       |
| Loans to facilitate sales of real estate  owned                                   |       | $        | 6,905      |     | $          | 1,689    |       | — |   |
|                                                                              |       |     |       |     |       |     |       |
| Investment securities purchased—not settled                                  |       | $        | 8,995      |     | $          | 3,190    |       | — |   |
|                                                                              |       |     |       |     |       |     |       |
| Transfer of real estate owned to office  properties and equipment                 |       | $        | —     |     | $          | 2,648    |       | — |   |

 
| See  notes to consolidated financial statements. |   | (Concluded) |
|--------------------------------------------------|--------|-------------|

 

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**FIRST FEDERAL BANCSHARES OF ARKANSAS, INC.**

** **

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**YEARS ENDED DECEMBER 31, 2008, 2007, AND 2006**

 

**1.****                     ****SUMMARY OF SIGNIFICANTACCOUNTING POLICIES**

 

***Nature ofOperations and Principles of Consolidation—***First Federal Bancshares of Arkansas, Inc.(the “Company”) is a unitary holding company that owns all of the stock ofFirst Federal Bank (the “Bank”). The Bank provides a broad line of financialproducts to individuals and small- to medium-sized businesses. The consolidatedfinancial statements also include the accounts of the Bank’s wholly ownedsubsidiary, First Harrison Service Corporation (“FHSC”), which isinactive.  Intercompany transactions havebeen eliminated in consolidation.

 

***Use of Estimates—***The preparation of financial statements inconformity with accounting principles generally accepted in the United Statesof America requires management to make estimates and assumptions that affectthe reported amounts of assets and liabilities and disclosure of contingentassets and liabilities at the date of the financial statements and the reportedamounts of revenues and expenses during the reporting period. Actual resultscould differ from those estimates and such differences could be significant.Valuation of real estate owned and the allowance for loan losses are materialestimates that are particularly susceptible to significant change in the nearterm.

 

***Cash and CashEquivalents—***Forthe purpose of presentation in the consolidated statements of cash flows, cashand cash equivalents includes cash on hand and amounts due from depositoryinstitutions, which includes interest bearing amounts available upon demand.

 

***InvestmentSecurities—***TheCompany classifies investment securities into one of two categories: held tomaturity or available for sale. The Company does not engage in tradingactivities. Debt securities that the Company has the positive intent andability to hold to maturity are classified as held to maturity and recorded atcost, adjusted for the amortization of premiums and the accretion of discounts.

 

Investment securities that the Company intends tohold for indefinite periods of time are classified as available for sale andare recorded at fair value. Unrealized holding gains and losses are excludedfrom earnings and reported net of tax in other comprehensive income. Investmentsecurities in the available for sale portfolio may be used as part of theCompany’s asset and liability management practices and may be sold in responseto changes in interest rate risk, prepayment risk, or other economic factors.At December 31, 2008 and 2007, the Company did not own any investmentsecurities classified as available for sale.

 

Premiums are amortized into interest income using theinterest method to the earlier of maturity or call date. Discounts are accretedinto interest income using the interest method over the period to maturity. Thespecific identification method of accounting is used to compute gains or losseson the sales of investment securities.

 

Declines in the fair value of held to maturity andavailable for sale securities below their cost that are deemed to be other thantemporary are reflected in earnings as realized losses. In estimating otherthan temporary impairment losses, management considers independent pricequotations and the financial condition of the issuer.

 

***Loans Receivable—***The Bank originates and maintains loans receivablethat are substantially concentrated in its lending territory (primarilyNorthwest and Northcentral Arkansas). The majority of the Bank’s loans areresidential mortgage loans and commercial real estate loans. The Bank’s policycalls for collateral or other forms of repayment assurance to be received fromthe borrower at the time of loan origination. Such collateral or other form ofrepayment assurance is subject to changes in economic value due to variousfactors beyond the control of the Bank.

 

Loans receivable that management has the intent andability to hold for the foreseeable future or until maturity or pay-off arestated at unpaid principal balances adjusted for any charge-offs, the allowancefor loan losses, and any deferred loan fees or costs. Deferred loan fees orcosts and discounts on first mortgage loans are amortized or accreted to incomeusing the level-yield method over the remaining period to contractual maturity.

 

Mortgage loans originated and committed for sale inthe secondary market are carried at the lower of cost or estimated market valuein the aggregate. Such loans are generally carried at cost due to the shortperiod of time between funding and sale, generally two to three weeks.

 

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Theaccrual of interest on loans is generally discontinued when, in management’sopinion, the borrower may be unable to meet payments as they become due or whenthe loan becomes 90 days past due, whichever occurs first. When interestaccrual is discontinued, all unpaid accrued interest is reversed againstinterest income. The interest on these loans is accounted for on the cash basisuntil qualifying for return to accrual. Loans are generally returned to accrualstatus when payments are made to bring the loan less than 90 days past due and,in the opinion of management, collection of the remaining balance can bereasonably expected.  The Company maycontinue to accrue interest on certain loans that are 90 days past due or moreif such loans are in the process of collection and collection is reasonablyassured.

 

***Allowance for LoanLosses—***Theallowance for loan losses is established as losses are estimated to have occurredthrough a provision for loan losses charged to earnings. Loan losses arecharged against the allowance when management believes it is likely that a loanbalance is uncollectible.  Subsequentrecoveries, if any, are credited to the allowance.

 

The allowance for loan losses represents management’sestimate of incurred credit losses inherent in the Company’s loan portfolio asof the balance sheet date.  Theestimation of the allowance is based on a variety of factors, including pastloan loss experience, the current credit profile of the Company’s borrowers,adverse situations that have occurred that may affect the borrowers’ ability torepay, the estimated value of underlying collateral, and general economicconditions.  Losses are recognized whenavailable information indicates that it is probable that a loss has beenincurred and the amount of the loss can be reasonably estimated. Thisevaluation is inherently subjective as it requires estimates that aresusceptible to significant revision as more information becomes available orconditions change.

 

In determining the allowance for loan losses, theCompany allocates a portion of the allowance to its various loan categoriesbased on an analysis of individual loans and pools of loans.  However, the entire allowance is available toabsorb credit losses inherent in the total loan portfolio as of the balancesheet date.

 

A loan is considered impaired when, based on currentinformation and events, it is probable that the Bank will be unable to collectthe scheduled payments of principal or interest when due according to thecontractual terms of the loan agreement. Factors considered by management indetermining impairment include payment status, collateral value, and theprobability of collecting scheduled principal and interest payments when due.Loans that experience insignificant payment delays and payment shortfallsgenerally are not classified as impaired. Management determines thesignificance of payment delays and payment shortfalls on a case-by-case basis,taking into consideration all of the circumstances surrounding the loan and theborrower, including the length of the delay, the reasons for the delay, theborrower’s prior payment record, and the amount of the short fall in relationto the principal and interest owed. Impairment is measured on a loan by loanbasis by either the present value of expected future cash flows discounted atthe loan’s effective interest rate, the loan’s obtainable market price, or thefair value of the collateral if the loan is collateral dependent.  Multifamily residential, commercial realestate, land and land development, and commercial loans that are delinquent orwhere the borrower’s total loan relationship exceeds $1 million are evaluatedon a loan-by-loan basis at least annually.

 

Large groups of smaller balance homogeneous loans arecollectively evaluated for impairment. Accordingly, the Bank does notseparately identify individual consumer and residential loans for impairmentdisclosures.  Homogeneous loans are thosethat are considered to have common characteristics that provide for evaluationon an aggregate or pool basis. The Bank considers the characteristics of (1) one-to four-family residential mortgage loans; (2) unsecured consumer loans;and (3) collateralized consumer loans to permit consideration of theappropriateness of the allowance for losses of each group of loans on a poolbasis. The primary methodology used to determine the appropriateness of theallowance for losses includes segregating certain specific, poorly performingloans based on their performance characteristics from the pools of loans as totype, valuing these loans, and then applying a loss factor to the remainingpool balance based on several factors including past loss experience, inherent risks,and economic conditions in the primary market areas.

 

***Rate LockCommitments—***TheBank enters into commitments to originate loans whereby the interest rate onthe loan is determined prior to funding (rate lock commitments). Rate lockcommitments on mortgage loans that are intended to be sold are considered to bederivatives. Accordingly, such commitments, along with any related feesreceived from potential borrowers, are recorded at fair value in derivativeassets or liabilities, with changes in fair value recorded in the net gain orloss on sale of mortgage loans. Fair value is based on fees currently chargedto enter into similar agreements, and for fixed rate commitments also considersthe difference between current levels of interest rates and the committedrates.

 

***Real Estate Owned,Net—***Real estateowned represents foreclosed assets held for sale and is initially recorded atestimated fair value less estimated costs to sell, establishing a new costbasis. Subsequent to foreclosure, management periodically performs valuationsand the assets are carried at the lower of carrying amount or fair

 

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value less costs to sell. Adjustments for estimatedlosses are charged to operations when any decline reduces the fair value toless than the carrying value.  Costs andexpenses related to major additions and improvements are capitalized whilemaintenance and repairs that do not extend the lives of the respective assetsare expensed.

 

***Office Propertiesand Equipment, Net—***Landis carried at cost. Buildings and equipment are stated at cost less accumulateddepreciation and amortization. The Company computes depreciation using thestraight-line method over the estimated useful lives of the individual assets,which range from 3 to 40 years.

 

***Cash SurrenderValue of Life Insurance—***Cash surrender value of life insurance represents life insurancepurchased by the Bank on a qualifying group of officers with the Bankdesignated as owner and beneficiary of the policies.  The yield on these policies is used to offseta portion of employment benefit costs. The policies are recorded on the consolidated statements of financialcondition at their cash surrender values with changes in cash surrender valuesreported in noninterest income.  Deathbenefits in excess of the cash surrender value are recorded in noninterestincome at the time of death.

 

***Income Taxes—*** Deferred income tax assets and liabilitiesare determined using the liability (or balance sheet) method. Under thismethod, the net deferred tax asset or liability is determined based on the taxeffects of the temporary differences between the book and tax bases of thevarious statement of financial condition assets and liabilities and givescurrent recognition to changes in tax rates and laws.

 

***Interest RateRisk—***The Bank’sasset base is exposed to risk including the risk resulting from changes ininterest rates and changes in the timing of cash flows. The Bank monitors theeffect of such risks by considering the mismatch of the maturities of itsassets and liabilities in the current interest rate environment and thesensitivity of assets and liabilities to changes in interest rates. The Bank’smanagement has considered the effect of significant increases and decreases ininterest rates and believes such changes, if they occurred, would be manageableand would not affect the ability of the Bank to hold its assets as planned.However, the Bank is exposed to significant market risk in the event ofsignificant and prolonged interest rate changes.

 

***Employee StockOwnership Plan—***Compensationexpense for the Employee Stock Ownership Plan (“ESOP”) is determined based onthe average fair value of shares committed to be released during the period andis recognized as the shares are committed to be released. For the purpose ofearnings per share, ESOP shares are included in weighted-average common sharesoutstanding as the shares are committed to be released.

 

***Earnings PerCommon Share—***Basicearnings per share represents income available to common stockholders dividedby the weighted-average number of common shares outstanding during the period.Diluted earnings per share reflects additional common shares that would havebeen outstanding if dilutive potential common shares had been issued, as wellas any adjustment to income that would result from the assumed issuance.Potential common shares that may be issued by the Company relate solely tooutstanding stock options, and are determined using the treasury stock method.

 

***Recent Accounting Pronouncements—***In September 2006, the FASB issued SFAS No. 157,*Fair Value Measurements*. SFAS No. 157defines fair value, establishes a framework for measuring fair value, andexpands disclosures regarding fair value measurements. The statement applieswhenever other standards require or permit that assets or liabilities bemeasured at fair value. The statement does not require new fair valuemeasurements, but rather provides a definition and framework for measuring fairvalue, which will result in greater consistency and comparability amongfinancial statements prepared under accounting principles generally accepted inthe United States of America. The statement is effective for financialstatements issued for fiscal years beginning after November 15, 2007.  We adopted SFAS No. 157 effective January 1,2008 for financial assets and liabilities which adoption did not have amaterial effect on the financial statements of the Company but enhanced thelevel of disclosure for assets and liabilities for which fair value disclosuresare required.

 

OnOctober 10, 2008, the FASB issued FASB Staff Position (“FSP”) No. 157-3,*Determining the Fair Value of a FinancialAsset When the Market for That Asset Is Not Active*.  FSP No. 157-3 amended SFAS No. 157by incorporating an example to illustrate key considerations in determining thefair value of a financial asset in an inactive market.  The FSP was effective upon issuance.  This FSP did not have an effect on theCompany’s financial statements.

 

In February 2007, the FASB issued SFAS No. 159,*The Fair Value Option for Financial Assetsand Financial Liabilities — Including an amendment of FASB Statement No. 115.*SFAS No. 159 permits entities to choose to measure many financialinstruments and certain other items at fair value at specified election dates.SFAS No. 159 is effective for fiscal years beginning after November 15,2007.   We adopted this statementeffective January 1, 2008 and have elected not to measure any of ourcurrent eligible financial assets or liabilities at fair value upon adoption;however, we may elect to measure future eligible financial assets orliabilities at fair value.

 

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In December 2007, the FASB issued SFAS No. 160,*Noncontrolling Interests in ConsolidatedFinancial Statements*, an amendment of ARB No. 51.  This Statement applies to all entities thatprepare consolidated financial statements, except not-for-profit organizations,but will affect only those entities that have an outstanding noncontrollinginterest in one or more subsidiaries or that deconsolidate a subsidiary.  The Company does not have any noncontrollinginterests, therefore this Statement did not have an impact on us.

 

In December 2007, the FASB issued SFAS No. 141R,*Business Combinations.* Theobjective of this Statement is to improve the relevance, representationalfaithfulness, and comparability of the information that a reporting entityprovides in its financial reports about a business combination and its effects.To accomplish that, this Statement establishes principles and requirements forhow the acquirer:

 

a.                         Recognizes and measures in its financialstatements the identifiable assets acquired, the liabilities assumed, and anynoncontrolling interest in the acquiree

b.                        Recognizes and measures the goodwill acquiredin the business combination or a gain from a bargain purchase

c.                         Determines what information to disclose to enable users of the financialstatements to evaluate the nature and financial effects of the businesscombination.

 

This Statement applies prospectively to businesscombinations for which the acquisition date is on or after the beginning of thefirst annual reporting period beginning on or after December 15, 2008. Anentity may not apply it before that date. The effective date of this Statement is the same as that of the relatedFASB Statement No. 160, *NoncontrollingInterests in Consolidated Financial Statements.*  Based on our current activities, we estimatethat the adoption of this Statement will not have a material effect on thefinancial statements of the Company.

 

In March 2008, the FASB issued SFAS No. 161,*Disclosures about Derivative Instruments andHedging Activities*, effective for financial statements issued forfiscal years beginning after November 15, 2008.  The objective of this statement is to provideenhanced disclosures about derivative instruments and related hedgingitems.  Based on the Bank’s currentactivities, we estimate that the adoption of this statement will not have amaterial effect on the financial statements of the Company.

 

**2.****                     ****RESTRICTIONS ON CASH ANDAMOUNTS DUE FROM BANKS**

 

The Bank is required to maintain average cashbalances on hand or with the Federal Reserve Bank. At December 31, 2008and 2007, these reserve balances amounted to $575,000 and $436,000,respectively.

 

**3.****                     ****INVESTMENT SECURITIES**

 

Investment securities consisted of the following at December 31(in thousands):

 
| ** **                             | ** ** | **2008**      | ** ** |
|----------------------------------------|------------|---------------|------------|
| ** **                             | ** ** | ** **    | ** ** | **Gross** | ** ** | **Gross** | ** ** | ** ** | ** ** |
| ** **                             | ** ** | **Amortized** | ** ** | **Unrealized** | ** ** | **Unrealized** | ** ** | **Fair** | ** ** |
| **Held To Maturity**         | ** ** | **Cost**      | ** ** | **Gains** | ** ** | **Losses** | ** ** | **Value** | ** ** |
|                                   |       |          |       |   |   |   |   |   |   |
| Municipal securities                   |       | $             | 19,565     |   | $ | 75 |   | $ | (599 | ) | $ | 19,041 |   |
| U.S. Government and Agency obligations |       | 116,847       |       | 233 |   | (66 | ) | 117,014 |   |
|                                   |       |          |       |   |   |   |   |   |   |
| Total                                  |       | $             | 136,412    |   | $ | 308 |   | $ | (665 | ) | $ | 136,055 |   |
|                                   | ** ** | ** **    | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                             | ** ** | **2007**      | ** ** |
| ** **                             | ** ** | ** **    | ** ** | **Gross** | ** ** | **Gross** | ** ** | ** ** | ** ** |
| ** **                             | ** ** | **Amortized** | ** ** | **Unrealized** | ** ** | **Unrealized** | ** ** | **Fair** | ** ** |
| **Held To Maturity**         | ** ** | **Cost**      | ** ** | **Gains** | ** ** | **Losses** | ** ** | **Value** | ** ** |
|                                   |       |          |       |   |   |   |   |   |   |
| Municipal securities                   |       | $             | 17,089     |   | $ | 85 |   | $ | (92 | ) | $ | 17,082 |   |
| U.S. Government and Agency obligations |       | 78,501        |       | 259 |   | (31 | ) | 78,729 |   |
|                                   |       |          |       |   |   |   |   |   |   |
| Total                                  |       | $             | 95,590     |   | $ | 344 |   | $ | (123 | ) | $ | 95,811 |   |

 

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The following tables summarize the gross unrealizedlosses and fair value of the Company’s investments with unrealized losses thatare not deemed to be other-than-temporarily impaired (in thousands), aggregatedby investment category and length of time that individual securities have beenin a continuous unrealized loss position at December 31, 2008 and 2007:

 
| ** **                             | ** ** | **2008**                               | ** ** |
|----------------------------------------|------------|----------------------------------------|------------|
| ** **                             | ** ** | **Less than 12 Months** | ** ** | **12 Months or More** | ** ** | **Total** | ** ** |
| ** **                             | ** ** | **Fair**                               | ** ** | **Unrealized** | ** ** | **Fair** | ** ** | **Unrealized** | ** ** | **Fair** | ** ** | **Unrealized** | ** ** |
| ** **                             | ** ** | **Value**                              | ** ** | **Losses** | ** ** | **Value** | ** ** | **Losses** | ** ** | **Value** | ** ** | **Losses** | ** ** |
|                                   |       |                                   |       |   |   |   |   |   |   |   |   |   |   |
| Municipal securities                   |       | $                                      | 5,493      |   | $ | 171 |   | $ | 3,926 |   | $ | 428 |   | $ | 9,419 |   | $ | 599 |   |
| U.S. Government and Agency obligations |       | 15,503                                 |       | 66 |   | — |   | — |   | 15,503 |   | 66 |   |
|                                   |       |                                   |       |   |   |   |   |   |   |   |   |   |   |
|                                   |       | $                                      | 20,996     |   | $ | 237 |   | $ | 3,926 |   | $ | 428 |   | $ | 24,922 |   | $ | 665 |   |
|                                   |       |                                   |       |   |   |   |   |   |   |   |   |   |   |
| ** **                             | ** ** | **2007**                               | ** ** |
| ** **                             | ** ** | **Less than 12 Months** | ** ** | **12 Months or More** | ** ** | **Total** | ** ** |
| ** **                             | ** ** | **Fair**                               | ** ** | **Unrealized** | ** ** | **Fair** | ** ** | **Unrealized** | ** ** | **Fair** | ** ** | **Unrealized** | ** ** |
| ** **                             | ** ** | **Value**                              | ** ** | **Losses** | ** ** | **Value** | ** ** | **Losses** | ** ** | **Value** | ** ** | **Losses** | ** ** |
|                                   |       |                                   |       |   |   |   |   |   |   |   |   |   |   |
| Municipal securities                   |       | $                                      | 1,367      |   | $ | 45 |   | $ | 2,153 |   | $ | 47 |   | $ | 3,520 |   | $ | 92 |   |
| U.S. Government and Agency obligations |       | —                                 |       | — |   | 9,891 |   | 31 |   | 9,891 |   | 31 |   |
|                                   |       |                                   |       |   |   |   |   |   |   |   |   |   |   |
|                                   |       | $                                      | 1,367      |   | $ | 45 |   | $ | 12,044 |   | $ | 78 |   | $ | 13,411 |   | $ | 123 |   |

 

TheCompany has pledged investment securities held to maturity with carrying valuesof approximately $76.4  million and $46.7million at December 31, 2008 and 2007, respectively, as collateral forcertain deposits in excess of $250,000.

 

The scheduled maturities of debt securities at December 31,2008, by contractual maturity are shown below (in thousands). Expectedmaturities may differ from contractual maturities because borrowers may havethe right to call or prepay obligations with or without call or prepaymentpenalties.

 
| ** **                       | ** ** | **2008**      | ** ** |
|----------------------------------|------------|---------------|------------|
| ** **                       | ** ** | **Amortized** | ** ** | **Fair** | ** ** |
| ** **                       | ** ** | **Cost**      | ** ** | **Value** | ** ** |
|                             |       |          |       |   |   |
| Within one year                  |       | $             | 225        |   | $ | 229 |   |
| Due from one year to five years  |       | 3,180         |       | 3,114 |   |
| Due from five years to ten years |       | 17,889        |       | 17,872 |   |
| Due after ten years              |       | 115,118       |       | 114,840 |   |
|                             |       |          |       |   |   |
| Total                            |       | $             | 136,412    |   | $ | 136,055 |   |

 

As of December 31, 2008 and 2007, investmentswith carrying values of approximately $135.8 million and $95.0 million,respectively, have call options held by the issuer, of which approximately$124.8 million and $87.5 million, respectively, are or were callable within oneyear.

 

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**4.****                     ****LOANS RECEIVABLE**

 

Loans receivable consisted of the following at December 31(in thousands):

 
| ** **                                      | ** ** | **2008**   | ** ** | **2007**   | ** ** |
|-------------------------------------------------|------------|------------|------------|------------|------------|
| ** **                                      | ** ** | ** ** | ** ** | ** ** | ** ** |
| Mortgage loans:                                 |       |       |       |       |       |
| One- to four-family residences                  |       | $          | 243,321    |       | $          | 230,005 |   |
| Home equity and second mortgage                 |       | 31,712     |       | 34,315     |       |
| Commercial real estate                          |       | 115,935    |       | 119,681    |       |
| Multifamily                                     |       | 24,147     |       | 15,616     |       |
| Land                                            |       | 49,354     |       | 42,843     |       |
| Construction                                    |       | 77,316     |       | 153,724    |       |
|                                            |       |       |       |       |       |
| Total mortgage loans                            |       | 541,785    |       | 596,184    |       |
|                                            |       |       |       |       |       |
| Commercial loans                                |       | 23,078     |       | 22,713     |       |
|                                            |       |       |       |       |       |
| Consumer loans:                                 |       |       |       |       |       |
| Automobile                                      |       | 8,631      |       | 9,531      |       |
| Other                                           |       | 12,291     |       | 14,537     |       |
|                                            |       |       |       |       |       |
| Total consumer loans                            |       | 20,922     |       | 24,068     |       |
| Less:                                           |       |       |       |       |       |
| Undisbursed loan funds                          |       | (11,750    | )          | (36,868    | )          |
| Unearned discounts and net deferred loan  costs |       | 529        |       | 321        |       |
| Allowance for loan losses                       |       | (6,441     | )          | (5,162     | )          |
|                                            |       |       |       |       |       |
| Loans receivable—net                       |       | $          | 568,123    |       | $          | 601,256 |   |

 

At December 31, 2008 and 2007, loans receivableincluded loans committed to be sold with net book values of $1.6 million and$2.8 million, respectively.

 

Mortgage loans serviced for others are not includedin the accompanying consolidated statements of financial condition.  The unpaid principal balances of such loansat December 31, 2008 and 2007 were $28.5 million and $27.8 million,respectively.  Servicing loans for othersgenerally consists of collecting mortgage payments, maintaining escrowaccounts, disbursing payments to investors, and foreclosure processing.  Servicing income for the years ended December 31,2008, 2007, and 2006 was $117,000, $110,000, and $121,000, respectively.

 

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Thefollowing is a summary of information pertaining to impaired and nonaccrualloans (in thousands):

 
| ** **                                                   | ** ** | **December 31** | ** ** |
|--------------------------------------------------------------|------------|----------------------|------------|
| ** **                                                   | ** ** | **2008**             | ** ** | **2007** | ** ** |
| ** **                                                   | ** ** | ** **           | ** ** | ** ** | ** ** |
| Impaired loans without a valuation  allowance                |       | $                    | 4,815      |   | $ | 9,269 |   |
| Impaired loans with a valuation allowance                    |       | $                    | 5,102      |   | $ | 7,932 |   |
|                                                         |       |                 |       |   |   |
| Total impaired loans                                         |       | $                    | 9,917      |   | $ | 17,201 |   |
|                                                         |       |                 |       |   |   |
| Total nonaccrual loans                                       |       | $                    | 25,419     |   | $ | 33,329 |   |
|                                                         |       |                 |       |   |   |
| Total loans past-due ninety days or more  and still accruing |       | $                    | 8,961      |   | $ | 2,412 |   |

 
|                                                          |   | **Year Ended**  |       |
|---------------------------------------------------------------|--------|----------------------|------------|
|                                                          |   | **December 31** |       |
|                                                          |   | **2008**             | ** ** | **2007** |   |
|                                                          |   |                 |       |   |   |
| Average investment in impaired loans                          |   | $                    | 13,266     |   | $ | 9,760 |   |
|                                                          |   |                 |       |   |   |
| Interest income recognized on impaired  loans                 |   | $                    | 56         |   | $ | 195 |   |
|                                                          |   |                 |       |   |   |
| Interest income recognized on a cash basis  on impaired loans |   | $                    | —     |   | $ | — |   |

 

Interest income recorded during the years ended December 31,2008, 2007, and 2006 for nonaccrual loans was $415,000, $458,000, and $403,000,respectively.  Under the original terms,these loans would have reported approximately $1.8 million, $2.6 million, and$1.5 million, of interest income for the years ended December 31, 2008,2007, and 2006, respectively.

 

**5.****                   ****ACCRUED INTEREST RECEIVABLE**

 

Accrued interest receivable consisted of the followingat December 31 (in thousands):

 
| ** **            | ** ** | **2008** | ** ** | **2007** | ** ** |
|-----------------------|------------|----------|------------|----------|------------|
|                  |       |     |       |     |       |
| Loans                 |       | $        | 4,734      |     | $          | 7,899 |   |
| Investment securities |       | 1,967    |       | 1,143    |       |
|                  |       |     |       |     |       |
| Total                 |       | $        | 6,701      |     | $          | 9,042 |   |

 

**6.****                   ****ALLOWANCES FOR LOAN AND REAL ESTATE LOSSES**

 

A summary of the activity in the allowances for loanand real estate losses is as follows for the years ended December 31 (inthousands):

 
| ** **                      | ** ** | **2008**  | ** ** | **2007**         | ** ** | **2006**  | ** ** |
|---------------------------------|------------|-----------|------------|------------------|------------|-----------|------------|
| ** **                      | ** ** | **Loans** | ** ** | **Real  Estate** | ** ** | **Loans** | ** ** | **Real  Estate** | ** ** | **Loans** | ** ** | **Real  Estate** | ** ** |
|                            |       |      |       |             |       |      |       |   |   |   |   |   |   |
| Balance—beginning of year  |       | $         | 5,162      |             | $          | —    |       | $ | 2,572 |   | $ | — |   | $ | 2,114 |   | $ | — |   |
|                            |       |      |       |             |       |      |       |   |   |   |   |   |   |
| Provisions for estimated losses |       | 5,710     |       | 1,042            |       | 4,028     |       | 494 |   | 1,482 |   | 93 |   |
| Recoveries                      |       | 483       |       | —           |       | 181       |       | — |   | 171 |   | — |   |
| Losses charged off              |       | (4,914    | )          | (1,042           | )          | (1,619    | )          | (494 | ) | (1,195 | ) | (93 | ) |
|                            |       |      |       |             |       |      |       |   |   |   |   |   |   |
| Balance—end of year        |       | $         | 6,441      |             | $          | —    |       | $ | 5,162 |   | $ | — |   | $ | 2,572 |   | $ | — |   |

 

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**7.****                   ****OFFICE PROPERTIES AND EQUIPMENT**

 

Office properties and equipment consisted of thefollowing at December 31 (in thousands):

 
| ** **                               | ** ** | **2008** | ** ** | **2007** | ** ** |
|------------------------------------------|------------|----------|------------|----------|------------|
|                                     |       |     |       |     |       |
| Land and land improvements               |       | $        | 5,937      |     | $          | 6,318 |   |
| Buildings and improvements               |       | 21,406   |       | 16,842   |       |
| Furniture and equipment                  |       | 7,073    |       | 6,324    |       |
| Automobiles                              |       | 484      |       | 484      |       |
| Construction in progress                 |       | 107      |       | 3,376    |       |
|                                     |       |     |       |     |       |
| Total                                    |       | 35,007   |       | 33,344   |       |
|                                     |       |     |       |     |       |
| Accumulated depreciation                 |       | (10,313  | )          | (9,081   | )          |
|                                     |       |     |       |     |       |
| Office properties and equipment—net |       | $        | 24,694     |     | $          | 24,263 |   |

 

Depreciation expense for the years ended December 31,2008, 2007, and 2006, amounted to approximately $1.5 million, $1.4 million, and$1.3 million, respectively.

 

Pursuant to the terms of noncancelable leaseagreements in effect at December 31, 2008, pertaining to banking premisesand equipment, future minimum rent commitments (in thousands) under variousoperating leases are as follows:

 
| **Years Ending December 31** | ** ** | ** ** | ** ** |
|---------------------------------------------|------------|------------|------------|
|                                        |       |       |       |
| 2009                                        |       | $          | 201        |   |
| 2010                                        |       | 198        |       |
| 2011                                        |       | 180        |       |
| 2012                                        |       | 180        |       |
| 2013                                        |       | 172        |       |
| 2014 and thereafter                         |       | 666        |       |
|                                        |       |       |       |
| Total                                       |       | $          | 1,597      |   |

 

The leases contain options to extend for periods fromten to twenty-five years.  The cost ofsuch rentals is not included above. Total rent expense for the years ended December 31, 2008, 2007 and2006 amounted to $225,000, $96,000 and $97,000, respectively.

 

The Bank also leases certain of its banking premisesto third parties under operating lease agreements.  The following is a schedule by years ofminimum future rentals on noncancelable operating leases (in thousands):

 
| **Years Ending December 31** | ** ** | ** ** | ** ** |
|---------------------------------------------|------------|------------|------------|
|                                        |       |       |       |
| 2009                                        |       | $          | 63         |   |
| 2010                                        |       | 63         |       |
| 2011                                        |       | 40         |       |
| 2012                                        |       | 38         |       |
| 2013                                        |       | 18         |       |
| 2014 and thereafter                         |       | 3          |       |
|                                        |       |       |       |
| Total                                       |       | $          | 225        |   |

 

The leases contain options to extend for periods fromthree to ten years.  Such rentals are notincluded above.  Total rental income forthe years ended December 31, 2008, 2007 and 2006 amounted to $35,000,$23,000 and $10,000, respectively.

 

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**8.****                   ****DEPOSITS**

 

Deposits are summarized as follows at December 31(in thousands):

 
| ** **                                                                                                        | ** ** | **2008**   | ** ** | **2007**   | ** ** |
|-------------------------------------------------------------------------------------------------------------------|------------|------------|------------|------------|------------|
| ** **                                                                                                        | ** ** | ** ** | ** ** | ** ** | ** ** |
| Checking accounts, including noninterest  bearing deposits of $27,538  and $27,796 in 2008 and 2007, respectively | ** ** | $          | 163,468    |       | $          | 127,491 |   |
| Money market accounts                                                                                             |       | 45,022     |       | 51,424     |       |
| Savings accounts                                                                                                  |       | 23,019     |       | 25,088     |       |
| Certificates of deposit                                                                                           |       | 386,494    |       | 426,411    |       |
|                                                                                                              |       |       |       |       |       |
| Total                                                                                                             |       | $          | 618,003    |       | $          | 630,414 |   |

 

Overdraftsof checking accounts of $483,000 and $698,000 at December 31, 2008 and2007, respectively, have been reclassified for financial reporting and arereflected in net loans receivable on the consolidated statements of financialcondition.

 

The aggregate amount of time deposits indenominations of $100 thousand or more was approximately $123.3 million and$125.9 million at December 31, 2008 and 2007, respectively.

 

At December 31, 2008, scheduled maturities ofcertificates of deposit are as follows (in thousands):

 
| **Year Ending December 31** | ** ** | ** ** | ** ** |
|--------------------------------------------|------------|------------|------------|
| ** **                                 | ** ** | ** ** | ** ** |
| 2009                                       |       | $          | 270,155    |   |
| 2010                                       |       | 55,763     |       |
| 2011                                       |       | 29,430     |       |
| 2012                                       |       | 15,784     |       |
| 2013                                       |       | 8,782      |       |
| 2014 and thereafter                        |       | 6,580      |       |
|                                       |       |       |       |
| Total                                      |       | $          | 386,494    |   |

 

Interest expense on deposits consisted of thefollowing (in thousands):

 
| ** **                         | ** ** | **Year Ended December 31** | ** ** |
|------------------------------------|------------|-------------------------------------------|------------|
| ** **                         | ** ** | **2008**                                  | ** ** | **2007** | ** ** | **2006** | ** ** |
|                               |       |                                      |       |   |   |   |   |
| Interest bearing checking accounts |       | $                                         | 1,730      |   | $ | 1,877 |   | $ | 1,394 |   |
| Money market accounts              |       | 900                                       |       | 1,486 |   | 1,503 |   |
| Savings and certificate accounts   |       | 15,988                                    |       | 20,608 |   | 17,925 |   |
| Early withdrawal penalties         |       | (69                                       | )          | (98 | ) | (179 | ) |
|                               |       |                                      |       |   |   |   |   |
| Total                              |       | $                                         | 18,549     |   | $ | 23,873 |   | $ | 20,643 |   |

 

Eligibledeposits of the Bank are insured up to $250,000 by the Deposit Insurance Fundof the FDIC.

 

FullFDIC deposit insurance coverage is provided through the Transaction AccountGuarantee Program through December 31, 2009 for noninterest bearingtransaction deposit accounts, negotiable order of withdrawal accounts payingless than 0.5% interest per annum, and interest on lawyers trust accounts heldat participating FDIC institutions.

 

**9.****                   ****OTHER BORROWINGS**

 

**Federal Home Loan Bank. **The Bank is a member of the Federal Home Loan Bank System. As a memberof this system, it is required to maintain an investment in capital stock ofthe FHLB in an amount equal to the sum of 0.06% of total assets as of theprevious December 31 and 4.10% of outstanding advances. No ready marketexists for such stock and it has no quoted market value. The carrying value ofthe stock is its cost.

 

The Bank pledges as collateral for FHLB advancescertain qualifying one- to four-family mortgage loans and certain qualifyinginvestment securities.  Pledgedcollateral is held in the custody of the FHLB.

 

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Advances at December 31, 2008 and 2007,consisted of the following (in thousands):

 
| ** **                                              | ** ** | **2008**     | ** ** | **2007**   | ** ** |
|---------------------------------------------------------|------------|--------------|------------|------------|------------|
| ** **                                              | ** ** | **Weighted** | ** ** | ** ** | ** ** | **Weighted** | ** ** | ** ** | ** ** |
| **Amounts Maturing in Year Ending** | ** ** | **Average**  | ** ** | ** ** | ** ** | **Average** | ** ** | ** ** | ** ** |
| **December 31**                                    | ** ** | **Rate**     | ** ** | **Amount** | ** ** | **Rate** | ** ** | **Amount** | ** ** |
| ** **                                              | ** ** | ** **   | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| 2008                                                    |       | —       | %          | $          | —     |   | 4.48 | % | $ | 35,905 |   |
| 2009                                                    |       | 3.55         |       | 46,636     |       | 4.54 |   | 26,636 |   |
| 2010                                                    |       | 3.37         |       | 17,353     |       | 4.61 |   | 9,353 |   |
| 2011                                                    |       | 3.24         |       | 11,514     |       | 4.61 |   | 7,514 |   |
| 2012                                                    |       | 2.36         |       | 3,570      |       | 4.56 |   | 1,570 |   |
| 2013                                                    |       | 0.89         |       | 2,168      |       | 3.88 |   | 168 |   |
| Thereafter                                              |       | 4.33         |       | 941        |       | 4.33 |   | 941 |   |
|                                                    |       |         |       |       |       |   |   |   |   |
| Total                                                   |       | 3.36         | %          | $          | 82,182     |   | 4.53 | % | $ | 82,087 |   |

 

**Federal Reserve Bank.**  TheBank also utilizes borrowings from the FRB through the Discount Window PrimaryCredit Program which is available for a period of approximately one month togenerally sound depository institutions. On March 17, 2008, the Primary Credit Program was temporarily changedto allow for terms of up to 90 days and the spread of the primary credit rateover the FOMC’s target federal funds rate was reduced to 25 basis points.  At December 31, 2008, the Bank had $10.0million in overnight borrowings at a rate of 0.50% outstanding with the FRB.

 

**10.****            ****INCOME TAXES**

 

The provisions (benefits) for income taxes aresummarized as follows (in thousands):

 
| ** **                      | ** ** | **Year Ended December 31** | ** ** |
|---------------------------------|------------|-------------------------------------------|------------|
| ** **                      | ** ** | **2008**                                  | ** ** | **2007** | ** ** | **2006** | ** ** |
|                            |       |                                      |       |   |   |   |   |
| Income tax provision (benefit): |       |                                      |       |   |   |   |   |
| Current:                        |       |                                      |       |   |   |   |   |
| Federal                         |       | $                                         | 251        |   | $ | 1,800 |   | $ | 2,851 |   |
| State                           |       | (17                                       | )          | 130 |   | 391 |   |
| Total current                   |       | 234                                       |       | 1,930 |   | 3,242 |   |
|                            |       |                                      |       |   |   |   |   |
| Deferred:                       |       |                                      |       |   |   |   |   |
| Federal                         |       | (525                                      | )          | (1,328 | ) | 102 |   |
| State                           |       | (132                                      | )          | (257 | ) | 35 |   |
| Total deferred                  |       | (657                                      | )          | (1,585 | ) | 137 |   |
|                            |       |                                      |       |   |   |   |   |
| Total                           |       | $                                         | (423       | ) | $ | 345 |   | $ | 3,379 |   |

 

The reasons for the differences between the statutoryfederal income tax rates and the effective tax rates are summarized as follows(in thousands):

 
|                                |   | **Year Ended December 31** |       |
|-------------------------------------|--------|-------------------------------------------|------------|
|                                |   | **2008**                                  | ** ** | **2007** | ** ** | **2006** |   |
|                                |   |                                      |       |   |   |   |   |   |   |   |   |   |   |
| Taxes at statutory rate             |   | $                                         | 709        |   | 34.0 | % | $ | 1,016 |   | 34.0 | % | $ | 3,659 |   | 34.0 | % |
| Increase (decrease) resulting from: |   |                                      |       |   |   |   |   |   |   |   |   |   |   |
| State income tax—net           |   | (98                                       | )          | (4.7 | ) | (141 | ) | (4.7 | ) | 260 |   | 2.4 |   |
| Earnings on life insurance policies |   | (667                                      | )          | (32.0 | ) | (259 | ) | (8.7 | ) | (252 | ) | (2.3 | ) |
| Nontaxable investments              |   | (243                                      | )          | (11.7 | ) | (203 | ) | (6.8 | ) | (207 | ) | (1.9 | ) |
| Other—net                      |   | (124                                      | )          | (6.0 | ) | (68 | ) | (2.3 | ) | (81 | ) | (0.8 | ) |
|                                |   |                                      |       |   |   |   |   |   |   |   |   |   |   |
| Total                               |   | $                                         | (423       | ) | (20.3 | )% | $ | 345 |   | 11.5 | % | $ | 3,379 |   | 31.4 | % |

 

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The Company’s net deferred tax asset account isincluded in the caption “Prepaid expenses and other assets” on the ConsolidatedStatements of Financial Condition and was comprised of the following at December 31(in thousands):

 
| ** **                     | ** ** | **2008** | ** ** | **2007** | ** ** |
|--------------------------------|------------|----------|------------|----------|------------|
|                           |       |     |       |     |       |
| Deferred tax assets:           |       |     |       |     |       |
| Allowance for loan losses      |       | $        | 2,466      |     | $          | 1,977 |   |
| Real estate owned              |       | 360      |       | 147      |       |
| Other                          |       | 14       |       | —   |       |
|                           |       |     |       |     |       |
| Total deferred tax assets      |       | 2,840    |       | 2,124    |       |
|                           |       |     |       |     |       |
| Deferred tax liabilities:      |       |     |       |     |       |
| Office properties              |       | (919     | )          | (853     | )          |
| Federal Home Loan Bank stock   |       | (559     | )          | (509     | )          |
| Pension plan contribution      |       | (106     | )          | (208     | )          |
| Prepaid expenses               |       | (151     | )          | (106     | )          |
|                           |       |     |       |     |       |
| Total deferred tax liabilities |       | (1,735   | )          | (1,676   | )          |
|                           |       |     |       |     |       |
| Net deferred tax asset         |       | $        | 1,105      |     | $          | 448 |   |

 

Specificallyexempted from deferred tax recognition requirements are bad debt reserves fortax purposes of U.S. savings and loans in the institution’s base year, asdefined. Base year reserves totaled approximately $4.2 million. Consequently, adeferred tax liability of approximately $1.6 million related to such reserveswas not provided for in the consolidated statements of financial condition at December 31,2008 and 2007. Payment of dividends to shareholders out of retained earningsdeemed to have been made out of earnings previously set aside as bad debtreserves may create taxable income to the Bank. No provision has been made forincome tax on such a distribution as the Bank does not anticipate making suchdistributions.

 

The Company files income tax returns in the U.S.federal jurisdiction and the state of Arkansas. The Company is subject to U.S.federal and state income tax examinations by tax authorities for tax yearsended December 31, 2005 and forward. The Company has been notified of an examination by the Internal RevenueService for the fiscal year 2007.

 

**11.****            ****STOCK BASED COMPENSATION**

 

In December 2004, the FASB issued SFAS No. 123(R),*Share-Based Payment*. SFAS No. 123(R) amendedSFAS No. 123, *Accounting forStock-Based Compensation* and superseded Accounting PrinciplesBoard (“APB”) Opinion No. 25, *Accountingfor Stock Issued to Employees*. In March 2005, the SEC issuedSAB No. 107 to provide its guidance on the valuation of share-basedpayments for public companies. SFAS No. 123(R) requires companies torecognize all share-based payments, which include stock options andrestricted stock, in compensation expense over the service period of theshare-based payment award. SFAS No. 123(R) establishes fairvalue as the measurement objective in accounting for share-based paymentarrangements and requires all entities to apply a fair-value-basedmeasurement method in accounting for share-based payment transactionswith employees, except for equity instruments held by employee share ownershipplans. At December 31, 2008, the Company had stock awards outstandingunder a Stock Option Plan (the “SOP”). The remaining unvested shares which had been awarded under theManagement Recognition and Retention Plan (the “MRR Plan”) were canceled during2008.

 

Compensation expense related to the amortization of MRR Plan awards wasrecognized in the income statement prior to the implementation of SFAS No. 123(R).Compensation expense attributable to stock options during the years ended December 31,2008, 2007 and 2006 totaled approximately $4,000, $10,000, and $16,000,respectively.

 

***Stock Option Plan***—The Stock Option Plan provided for acommittee of the Company’s Board of Directors to award incentive stock options,non-qualified or compensatory stock options and stock appreciation rightsrepresenting up to 1,030,750 shares of Company stock. One-fifth of the optionsgranted vested immediately upon grant, with the balance vesting in equalamounts on the four subsequent anniversary dates of the grant. Options grantedvest immediately in the event of retirement, disability, or death. Stockoptions granted expire in ten years unless grantee terminates employment, inwhich case the award expires five years after termination date or ten 

 

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yearsafter grant date, whichever comes first. The SOP expired during 2007, so no further option grants will be made.

 

Under the SOP, options have been granted to directorsand key employees to purchase common stock of the Company. The exercise pricein each case equals the fair market value of the Company’s stock at the date ofgrant. Options granted are summarized as follows:

 
| ** **        | ** ** | ** **                              | ** ** | **Options Outstanding  December 31, 2008** | ** ** | **Options Exercisable  December 31, 2008** | ** ** |
|-------------------|------------|-----------------------------------------|------------|-----------------------------------------------------------|------------|-----------------------------------------------------------|------------|
| **Year  Granted** | ** ** | **Range of  Exercise Prices** | ** ** | **Number of  Options  Outstanding**                  | ** ** | **Weighted  Average  Remaining  Contractual  Life**       | ** ** | **Weighted  Average  Exercise  Price Per  Share** | ** ** | **Number of  Options  Exercisable** | ** ** | **Weighted  Average  Exercise  Price Per  Share** | ** ** |
| 2000              |       | $9.13                                   |       | 450                                                       |       | 1.7 years                                                 |       | $ | 9.13 |   | 450 |   | $ | 9.13 |   |
| 2001              |       | 9.34 – 11.35                       |       | 9,200                                                     |       | 2.3 years                                                 |       | 10.67 |   | 9,200 |   | 10.67 |   |
| 2002              |       | 12.32                                   |       | 1,200                                                     |       | 1.4 years                                                 |       | 12.32 |   | 1,200 |   | 12.32 |   |
| 2003              |       | 12.93 – 16.11                      |       | 1,712                                                     |       | 4.4 years                                                 |       | 15.41 |   | 1,712 |   | 15.41 |   |
| 2004              |       | 19.25 – 21.50                      |       | 2,680                                                     |       | 5.1 years                                                 |       | 20.29 |   | 2,680 |   | 20.29 |   |
| 2005              |       | 24.81                                   |       | 1,000                                                     |       | 6.9 years                                                 |       | 24.81 |   | 800 |   | 24.81 |   |
| 2006              |       | 22.40 – 25.50                      |       | 1,000                                                     |       | 5.5 years                                                 |       | 24.57 |   | 800 |   | 24.34 |   |
|              |       |                                    |       | 17,242                                                    |       | 3.3 years                                                 |       | $ | 14.34 |   | 16,842 |   | $ | 14.08 |   |

 

A summary of the status of the Company’s SOP as of December 31,2008, 2007, and 2006, and changes during the years ending on those dates arepresented below:

 
| ** **                              | ** ** | ** ** | ** ** | **Weighted** | ** ** |
|-----------------------------------------|------------|------------|------------|--------------|------------|
| ** **                              | ** ** | ** ** | ** ** | **Average**  | ** ** |
| ** **                              | ** ** | ** ** | ** ** | **Exercise** | ** ** |
| ** **                              | ** ** | **Shares** | ** ** | **Price**    | ** ** |
| ** **                              | ** ** | ** ** | ** ** | ** **   | ** ** |
| Outstanding—January 1, 2006   |       | 345,268    |       | $            | 9.98       |   |
|                                    |       |       |       |         |       |
| Exercised                               |       | (166,997   | )          | 9.74         |       |
| Granted                                 |       | 1,500      |       | 24.47        |       |
| Forfeited                               |       | (412       | )          | 14.66        |       |
|                                    |       |       |       |         |       |
| Outstanding—December 31, 2006 |       | 179,359    |       | $            | 10.30      |   |
|                                    |       |       |       |         |       |
| Exercised                               |       | (154,817   | )          | 9.80         |       |
| Expired                                 |       | (1,200     | )          | 8.53         |       |
| Forfeited                               |       | (300       | )          | 25.50        |       |
|                                    |       |       |       |         |       |
| Outstanding—December 31, 2007 |       | 23,042     |       | $            | 13.59      |   |
|                                    |       |       |       |         |       |
| Exercised                               |       | (4,000     | )          | 11.63        |       |
| Expired                                 |       | (1,600     | )          | 9.31         |       |
| Forfeited                               |       | (200       | )          | 22.40        |       |
|                                    |       |       |       |         |       |
| Outstanding—December 31, 2008 |       | 17,242     |       | $            | 14.34      |   |

 

***ManagementRecognition and Retention Plan—***The MRR Plan provided for a committee of the Company’s Board ofDirectors to award restricted stock to key officers as well as non-employeedirectors. The MRR Plan authorized the Company to grant up to 412,300 shares ofthe Company stock, of which 405,688 shares have been granted through December 31,2008. The MRR Plan expired during 2007, so no further awards will be made.  Compensation expense has been recognized overthe vesting period based on the fair market value of the shares on the grantdate. Shares granted will be deemed vested in the event of disability or death.Approximately $2,000, $29,000, and $66,000 in compensation expense wasrecognized during each of the years ended December 31, 2008, 2007 and2006.  On October 31, 2008, 1,600previously awarded yet unvested MRR Plan shares were canceled.

 

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**12.****            ****EMPLOYEE BENEFIT PLANS**

 

***ESOP—***The Company established an ESOP on May 3,1996. During 1996, the ESOP borrowed $4.1 million from the Company to purchaseshares of Company stock.  The ESOP’s loanwas paid in full on March 31, 2006, and all shares in the ESOP wereallocated to participant accounts as of that date.  The Company has determined that there will beno future Employer contributions to the ESOP and that effective May 31,2006, no employee shall become eligible to participate in the ESOP.

 

Effective June 1, 2006, the Company adopted theFirst Federal Bancshares of Arkansas, Inc. Employees’ Savings &Profit Sharing Plan and Trust (the “401(k) Plan”).  The Company merged the ESOP into the 401(k) Planeffective June 1, 2006.  Participantaccounts under the ESOP will be maintained as a separate source under the 401(k) Planwith ESOP provisions concerning matters such as vesting, withdrawals, loans,dividends, and distributions remaining in effect.  During the year ended December 31, 2006,ESOP expense was approximately $508,000. There was no expense incurred related to the ESOP during 2007 or 2008.

 

***401(k) Plan******—*** The Company has established a 401(k) Planwhereby substantially all employees participate in the Plan.  Employees may contribute up to 75% of theirsalary subject to certain limits based on federal tax laws.  The Company makes matching contributionsequal to 100% of the first 3% plus 50% of contributions between 3% and 5% of anemployee’s compensation contributed to the Plan.  Matching contributions vest immediately to theemployee upon enrollment in the Plan. During the years ended December 31, 2008, 2007 and 2006, 401(k) Planexpense was approximately $303,000, $309,000 and $174,000, respectively.  Effective February 16, 2009, the Companywill be suspending its matching contributions.

 

***OtherPostretirement Benefits—***The Bank is a participant in a multi-employer retirement plan andtherefore separate information is not available. The plan is noncontributoryand covers substantially all employees. The plan provides a retirement benefitand a death benefit. Retirement benefits are payable in monthly installmentsfor life and must begin not later than the first day of the month coincidentwith or the next month following the seventieth birthday or the participant mayelect a lump-sum distribution. Death benefits are paid in a lump-sumdistribution, the amount of which depends on years of service. Net pensionexpense was approximately $518,000, $761,000, and $745,000 for the years ended December 31,2008, 2007, and 2006, respectively.

 

**13.****            ****EARNINGS PER SHARE**

 
| ** **                                                                        | ** ** | **Year Ended December 31, 2008** | ** ** |
|-----------------------------------------------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                                                                        | ** ** | **Income**                                           | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                                                        | ** ** | **(In Thousands)**                              | ** ** | **Shares** | ** ** | **Per Share** | ** ** |
| ** **                                                                        | ** ** | **(Numerator)**                                      | ** ** | **(Denominator)** | ** ** | **Amount** | ** ** |
| Basic EPS—Income available to common  stockholders                           |       | $                                                    | 2,507      |   | 4,848,092 |   | $ | 0.52 |   |
|                                                                              |       |                                                 |       |   |   |   |   |
| Effect of dilutive securities—Stock options                                  |       | —                                               |       | 374 |   |   |   |
|                                                                              |       |                                                 |       |   |   |   |   |
| Diluted EPS—Income available to common stockholders  and assumed conversions |       | $                                                    | 2,507      |   | 4,848,466 |   | $ | 0.52 |   |

 
| ** **                                                                        | ** ** | **Year Ended December 31, 2007** | ** ** |
|-----------------------------------------------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                                                                        | ** ** | **Income**                                           | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                                                        | ** ** | **(In Thousands)**                              | ** ** | **Shares** | ** ** | **Per Share** | ** ** |
| ** **                                                                        | ** ** | **(Numerator)**                                      | ** ** | **(Denominator)** | ** ** | **Amount** | ** ** |
| Basic EPS—Income available to common  stockholders                           |       | $                                                    | 2,643      |   | 4,865,127 |   | $ | 0.54 |   |
|                                                                              |       |                                                 |       |   |   |   |   |
| Effect of dilutive securities—Stock options                                  |       | —                                               |       | 15,734 |   |   |   |
|                                                                              |       |                                                 |       |   |   |   |   |
| Diluted EPS—Income available to common stockholders  and assumed conversions |       | $                                                    | 2,643      |   | 4,880,861 |   | $ | 0.54 |   |

 

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| ** **                                                                        | ** ** | **Year Ended December 31, 2006** | ** ** |
|-----------------------------------------------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                                                                        | ** ** | **Income**                                           | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                                                        | ** ** | **(In Thousands)**                              | ** ** | **Shares** | ** ** | **Per Share** | ** ** |
| ** **                                                                        | ** ** | **(Numerator)**                                      | ** ** | **(Denominator)** | ** ** | **Amount** | ** ** |
| Basic EPS—Income available to common  stockholders                           |       | $                                                    | 7,383      |   | 4,993,229 |   | $ | 1.48 |   |
|                                                                              |       |                                                 |       |   |   |   |   |
| Effect of dilutive securities—Stock options                                  |       | —                                               |       | 118,553 |   |   |   |
|                                                                              |       |                                                 |       |   |   |   |   |
| Diluted EPS—Income available to common stockholders  and assumed conversions |       | $                                                    | 7,383      |   | 5,111,782 |   | $ | 1.44 |   |

 

**14.****            ****OFF-BALANCE SHEET ARRANGEMENTS AND COMMITMENTS**

 

The Bank is a party to financial instruments withoff-balance sheet risk in the normal course of business to meet the financingneeds of its customers. These financial instruments include commitments toextend credit and standby letters of credit. Those instruments involve, tovarying degrees, elements of credit risk in excess of the amount recognized inthe consolidated statements of financial condition.

 

The Bank does not use financial instruments withoff-balance sheet risk as part of its asset/liability management program or fortrading purposes. The Bank’s exposure to credit loss in the event ofnonperformance by the other party to the financial instrument for commitmentsto extend credit and standby letters of credit is represented by thecontractual amounts of those instruments. The Bank uses the same creditpolicies in making commitments and conditional obligations as it does foron-balance sheet instruments.

 

Commitments to extend credit are agreements to lendto a customer as long as there is no violation of any condition established inthe contract. Commitments generally have fixed expiration dates or othertermination clauses. The Bank evaluates each customer’s creditworthiness on acase-by-case basis. The amount of collateral obtained, if deemed necessary bythe Bank upon extension of credit, is based on management’s credit evaluationof the counterparty. Such collateral consists primarily of residentialproperties. Standby letters of credit are conditional commitments issued by theBank to guarantee the performance of a customer to a third party. The creditrisk involved in issuing letters of credit is essentially the same as thatinvolved in extending loan facilities to customers.

 

The funding period for construction loans isgenerally six to eighteen months and commitments to originate mortgage loansare generally outstanding for 60 days or less.

 

The Company, in the normal course of business, makescommitments to buy or sell assets or to incur or fund liabilities. Commitmentsinclude, but are not limited to:

 

·                  the origination, purchase or sale of loans;

·                  thefulfillment of commitments under letters of credit, extensions of credit onhome equity lines of credit, construction loans, and under predeterminedoverdraft protection limits; and

·                  thecommitment to fund withdrawals of certificates of deposit at maturity.

 

At December 31, 2008, the Bank’s off-balancesheet arrangements principally included lending commitments, which aredescribed below. At December 31, 2008, the Company had no interests innon-consolidated special purpose entities.

 

At December 31, 2008, commitments included:

·                  total approved loan origination commitmentsoutstanding amounting to $3.0 million, including approximately $475,000 ofloans committed to sell;

·                  ratelock agreements with customers of $4.7 million, all of which have been lockedwith an investor;

·                  fundedmortgage loans committed to sell of $1.6 million;

·                  unadvancedportion of construction loans of $11.7 million;

·                  unusedlines of credit of $19.5 million;

·                  outstandingstandby letters of credit of $3.7 million;

·                  totalpredetermined overdraft protection limits of $15.4 million; and

·                  certificatesof deposit scheduled to mature in one year or less totaling $270.2 million.

 

Total unfunded commitments to originate loans forsale and the related commitments to sell of $4.7 million meet the definition ofa derivative financial instrument. The related asset and liability areconsidered immaterial at December 31, 2008.

 

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Historically, a very small percentage ofpredetermined overdraft limits have been used. At December 31, 2008,overdrafts of accounts with Bounce ProtectionTM represented usage of 3.10% of the limit.

 

Based on historical experience, management believesthat a significant portion of maturing deposits will remain with the Bank.Management anticipates that the Bank will continue to have sufficient funds,through repayments, deposits and borrowings, to meet our current commitments.

 

**15.****            ****FAIR VALUE MEASUREMENT**

 

Effective January 1, 2008, the Bank adopted SFAS157, which provides a framework for measuring fair value. SFAS 157 defines fairvalue as the exchange price that would be received for an asset or paid totransfer a liability (an exit price) in the principal or most advantageousmarket for the asset or liability in an orderly transaction between marketparticipants on the measurement date. SFAS 157 also establishes a fair valuehierarchy which requires an entity to maximize the use of observable inputs andminimize the use of unobservable inputs when measuring fair value. The standarddescribes three levels of inputs that may be used to measure fair value:

 
| Level 1 |   | Unadjusted, quoted prices in active markets for identical assets or  liabilities at the measurement date.                                                                                                                                                                                                                          |
|--------------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|         |   |                                                                                                                                                                                                                                                                                                                               |
| 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 at the measurement date for substantially the full term of the  assets or liabilities. |
|         |   |                                                                                                                                                                                                                                                                                                                               |
| Level 3 |   | Unobservable inputs that reflect management’s best estimate of what  market participants would use in pricing the asset or liability at the  measurement date.                                                                                                                                                                |

 

The assets presented at fair value on the Bank’sfinancial statements are related to real estate owned, net, and impaired loans,both of which are valued based on Level 3 inputs. Management utilizesappraisals, listing prices, market information from local realtors and marketresearch reports to base the fair value measurement.

 

The table below presents a reconciliation for allassets and liabilities measured at fair value on a recurring basis usingsignificant unobservable inputs (Level 3):

 
| ** **             | ** ** | **Dec. 31,  2007** | ** ** | **Additions** | ** ** | **Fair Value  Adjustments** | ** ** | **Transfers  Out** | ** ** | **Gain  (Loss)** | ** ** | **Dec. 31,  2008** | ** ** |
|------------------------|------------|-------------------------|------------|---------------|------------|----------------------------------|------------|--------------------|------------|------------------|------------|-------------------------|------------|
| ** **             | ** ** | **(in thousands)** | ** ** |
| Real estate owned, net |       | $                       | 8,120      |          | $          | 29,001                           |       | $                  | (4,609     | )                | $          | (9,966                  | )          | $ | (161 | ) | $ | 22,385 |   |
| Impaired loans, net    |       | $                       | 14,894     |          | $          | 3,643                            |       | $                  | (665       | )                | $          | (9,528                  | )          | $ | — |   | $ | 8,344 |   |

#  

# Realized and unrealized gains and losseson real estate owned are recognized in noninterest expenses in the consolidatedstatements of income under the caption “Real estate owned, net.”  Gains on sales of real estate owned which arefinanced by the Bank are deferred in certain circumstances and recognized asthe borrower pays down the related loan. Fair value adjustments to impaired loans are recorded through theallowance for loan losses.

 

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**16.****              ****FAIR VALUE OF FINANCIALINSTRUMENTS**

 

The estimated fair value amounts have been determined by the Companyusing available market information and appropriate valuation methodologies.However, considerable judgment is required to interpret market data to developthe estimates of fair value. Accordingly, the estimates presented herein arenot necessarily indicative of the amounts the Company could realize in a currentmarket exchange. The use of different market assumptions and/or estimationmethodologies may have a material effect on the estimated fair value amounts.The estimated fair values of financial instruments are as follows (inthousands):

 
| ** **                                             | ** ** | **December 31, 2008** | ** ** | **December 31, 2007** | ** ** |
|--------------------------------------------------------|------------|---------------------------------|------------|---------------------------------|------------|
| ** **                                             | ** ** | ** **                      | ** ** | **Estimated**                   | ** ** | ** ** | ** ** | **Estimated** | ** ** |
| ** **                                             | ** ** | **Carrying**                    | ** ** | **Fair**                        | ** ** | **Carrying** | ** ** | **Fair** | ** ** |
| ** **                                             | ** ** | **Value**                       | ** ** | **Value**                       | ** ** | **Value** | ** ** | **Value** | ** ** |
| ASSETS:                                                |       |                            |       |                            |       |   |   |   |   |
| Cash and cash equivalents                              |       | $                               | 9,367      |                            | $          | 9,367 |   | $ | 27,387 |   | $ | 27,387 |   |
| Investment securities—held to maturity            |       | 136,412                         |       | 136,055                         |       | 95,590 |   | 95,811 |   |
| Federal Home Loan Bank stock                           |       | 4,825                           |       | 4,825                           |       | 4,433 |   | 4,433 |   |
| Loans receivable—net                              |       | 568,123                         |       | 581,213                         |       | 601,256 |   | 605,171 |   |
| Cash surrender value of life insurance                 |       | 20,412                          |       | 20,412                          |       | 20,159 |   | 20,159 |   |
| Accrued interest receivable                            |       | 6,701                           |       | 6,701                           |       | 9,042 |   | 9,042 |   |
| Commitments                                            |       | 14                              |       | 14                              |       | 7 |   | 7 |   |
|                                                   |       |                            |       |                            |       |   |   |   |   |
| LIABILITIES:                                           |       |                            |       |                            |       |   |   |   |   |
| Deposits:                                              |       |                            |       |                            |       |   |   |   |   |
| Checking, money market and savings accounts            |       | 231,509                         |       | 231,509                         |       | 204,003 |   | 204,003 |   |
| Certificates of deposit                                |       | 386,494                         |       | 390,638                         |       | 426,411 |   | 428,859 |   |
| Other borrowings                                       |       | 92,212                          |       | 94,114                          |       | 82,087 |   | 82,379 |   |
| Accrued interest payable                               |       |                            |       |                            |       |   |   |   |   |
| Advance payments by borrowers for taxes and  insurance |       | 810                             |       | 810                             |       | 575 |   | 575 |   |
| Commitments                                            |       | 14                              |       | 14                              |       | 7 |   | 7 |   |
|                                                        |            |                                 |            |                                 |            |  |  |  |  |  |  |  |  |

 

Forcash and cash equivalents, Federal Home Loan Bank stock, cash surrender valueof life insurance and accrued interest receivable, the carrying value is areasonable estimate of fair value, primarily because of the short-term natureof the instruments or, as to Federal Home Loan Bank stock, the ability to sellthe stock back to the Federal Home Loan Bank at cost. The fair value ofinvestment securities is based on quoted market prices, dealer quotes andprices obtained from independent pricing services. The fair value of variablerate loans is based on repricing dates. Fixed rate loans were valued usingdiscounted cash flows. The discount rates used to determine the present valueof these loans were based on interest rates currently being charged by the Bankon comparable loans as to credit risk and term.

 

Thefair value of checking accounts, savings accounts and money market deposits isthe amount payable on demand at the reporting date. The fair value offixed-maturity certificates of deposit and Federal Home Loan Bank advances isestimated using the rates currently offered for deposits of similar terms andadvances of similar remaining maturities at the reporting date. For advancepayments by borrowers, for taxes and insurance and for accrued interest payablethe carrying value is a reasonable estimate of fair value, primarily because ofthe short-term nature of the instruments.

 

Thefair value estimates presented herein are based on pertinent informationavailable to management as of December 31, 2008 and 2007. Althoughmanagement is not aware of any factors that would significantly affect theestimated fair value amounts, such amounts have not been comprehensivelyrevalued for purposes of these financial statements since the reporting dateand, therefore, current estimates of fair value may differ significantly fromthe amounts presented herein.

 

**17.****              ****CONTINGENCIES**

 

The Company is a defendant in certain claims and legal actions arisingin the ordinary course of business. In the opinion of management, afterconsultation with legal counsel, the ultimate disposition of these matters isnot expected to have a material adverse effect on the consolidated financialstatements of the Company.

 

**18.****              ****RETAINEDEARNINGS—SUBSTANTIALLY RESTRICTED**

 

Upon conversion, the Company established a special liquidation accountfor the benefit of eligible account holders and the supplemental eligibleaccount holders in an amount equal to the net worth of the Bank as of the dateof its latest statement of financial condition contained in the final offeringcircular used in connection with the conversion. The liquidation account willbe maintained for the benefit of eligible account holders and supplementaleligible account holders who continue to maintain their accounts in the Bankafter conversion. In the event of a complete 

 

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liquidation (and only in such event), each eligible and supplementaleligible account holder will be entitled to receive a liquidation distributionfrom the liquidation account in an amount proportionate to the current adjustedqualifying balances for accounts then held.

 

The Company may not declare or pay cash dividends on its shares ofcommon stock if the effect thereof would cause the Company’s stockholders’equity to be reduced below applicable regulatory capital maintenancerequirements for insured institutions or below the special liquidation accountreferred to above.

 

**19.****              ****REGULATORY MATTERS**

 

The Bank is subject to various regulatory capital requirementsadministered by the OTS. Failure to meet minimum capital requirements caninitiate certain mandatory—and possible additional discretionary—actions byregulators that, if undertaken, could have a direct and material effect on theBank’s financial statements. Under capital adequacy guidelines and theregulatory framework for prompt corrective action, the Bank must meet specificcapital guidelines that involve quantitative measures of the Bank’s assets,liabilities, and certain off-balance sheet items as calculated under regulatoryaccounting practices. The Bank’s capital amounts and classification are alsosubject to qualitative judgments by the regulators about components, riskweightings, and other factors.

 

Quantitative measures established by regulation to ensure capitaladequacy require the Bank to maintain minimum amounts and ratios (set forth inthe following table) of tangible capital (as defined) to tangible assets (as defined)and core capital (as defined) to adjusted tangible assets (as defined), and oftotal risk-based capital (as defined) to risk-weighted assets (as defined).Management believes, as of December 31, 2008, that the Bank meets allcapital adequacy requirements to which it is subject.

 

At December 31, 2008 and 2007, the most recent notification fromthe OTS categorized the Bank as well capitalized under the regulatory frameworkfor prompt corrective action. To be categorized as well capitalized the Bank mustmaintain minimum core (Tier I leverage), Tier I risk-based, and totalrisk-based ratios as set forth in the table. There are no conditions or eventssince that notification that management believes have changed the Bank’scategory.

 

The Bank’s actual capital amounts (in thousands) and ratios are alsopresented in the table:

 
| ** **                               | ** ** | ** ** | ** ** | ** **                 | ** ** | ** **                 | ** ** | ** **                 | ** ** | **To be Categorized** | ** ** |
|------------------------------------------|------------|------------|------------|----------------------------|------------|----------------------------|------------|----------------------------|------------|---------------------------------|------------|
| ** **                               | ** ** | ** ** | ** ** | ** **                 | ** ** | ** **                 | ** ** | ** **                 | ** ** | **as Well**                | ** ** |
| ** **                               | ** ** | ** ** | ** ** | ** **                 | ** ** | ** **                 | ** ** | ** **                 | ** ** | **Capitalized Under**      | ** ** |
| ** **                               | ** ** | ** ** | ** ** | ** **                 | ** ** | **For Capital**       | ** ** | **Prompt Corrective** | ** ** |
| ** **                               | ** ** | **Actual** | ** ** | **Adequacy Purposes** | ** ** | **Action Provisions** | ** ** |
| ** **                               | ** ** | **Amount** | ** ** | **Ratio**                  | ** ** | **Amount**                 | ** ** | **Ratio**                  | ** ** | **Amount**                      | ** ** | **Ratio** | ** ** |
|                                     |       |       |       |                       |       |                       |       |                       |       |                            |       |   |   |
| As of December 31, 2008:            |       |       |       |                       |       |                       |       |                       |       |                            |       |   |   |
|                                     |       |       |       |                       |       |                       |       |                       |       |                            |       |   |   |
| Tangible Capital to Tangible Assets      |       | $          | 70,703     |                       | 8.89       | %                          | $          | 11,925                     |       | 1.50                            | %          | N/A |   | N/A |   |
|                                     |       |       |       |                       |       |                       |       |                       |       |                            |       |   |   |
| Core Capital to Adjusted Tangible Assets |       | 70,703     |       | 8.89                       | %          | 31,799                     |       | 4.00                       | %          | $                               | 39,748     |   | 5.00 | % |
|                                     |       |       |       |                       |       |                       |       |                       |       |                            |       |   |   |
| Total Capital to Risk-Weighted Assets    |       | 74,144     |       | 13.35                      | %          | 44,436                     |       | 8.00                       | %          | 55,545                          |       | 10.00 | % |
|                                     |       |       |       |                       |       |                       |       |                       |       |                            |       |   |   |
| Tier I Capital to Risk-Weighted Assets   |       | 70,703     |       | 12.73                      | %          | N/A                        |       | N/A                        |       | 33,327                          |       | 6.00 | % |
| ** **                               | ** ** | ** ** | ** ** | ** **                 | ** ** | ** **                 | ** ** | ** **                 | ** ** | ** **                      | ** ** | ** ** | ** ** |
| As of December 31, 2007:            |       |       |       |                       |       |                       |       |                       |       |                            |       |   |   |
|                                     |       |       |       |                       |       |                       |       |                       |       |                            |       |   |   |
| Tangible Capital to Tangible Assets      |       | $          | 72,996     |                       | 9.22       | %                          | $          | 11,875                     |       | 1.50                            | %          | N/A |   | N/A |   |
|                                     |       |       |       |                       |       |                       |       |                       |       |                            |       |   |   |
| Core Capital to Adjusted Tangible Assets |       | 72,996     |       | 9.22                       | %          | 31,666                     |       | 4.00                       | %          | $                               | 39,582     |   | 5.00 | % |
|                                     |       |       |       |                       |       |                       |       |                       |       |                            |       |   |   |
| Total Capital to Risk-Weighted Assets    |       | 75,185     |       | 13.20                      | %          | 45,550                     |       | 8.00                       | %          | 56,937                          |       | 10.00 | % |
|                                     |       |       |       |                       |       |                       |       |                       |       |                            |       |   |   |
| Tier I Capital to Risk-Weighted Assets   |       | 72,996     |       | 12.82                      | %          | N/A                        |       | N/A                        |       | 34,162                          |       | 6.00 | % |

 

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**Dividend Restrictions.**  Theprincipal source of the Company’s revenues is dividends from the Bank.  The Company’s ability to pay dividends to ourshareholders depends to a large extent upon the dividends we receive from theBank.  In conjunction with the approvalunder the U.S. Treasury’s Capital Purchase Program disclosed in Note 21 and inan effort to preserve and maintain capital during the current economic crisis,the board of directors of the Company has determined to decrease the quarterlycash dividend rate to $0.01 per share. Until the preferred stock issued to the U.S. Treasury under the CapitalPurchase Program is redeemed, the Company may not pay a quarterly cash dividendin excess of $0.01 per share without approval from its primary regulator, theOffice of Thrift Supervision.  The boardof directors intends to revisit this issue when the economy rebounds and theCompany’s earnings return to more normalized levels.  Future dividends will be determined by theboard of directors after giving consideration to the Company’s financialcondition, results of operations, tax status, industry standards, economicconditions, regulatory requirements and other factors.

 

**20.****              ****RELATED PARTY TRANSACTIONS**

 

In the normal course of business, the Bank has made loans to itsdirectors, officers, and their related business interests. In the opinion ofmanagement, related party loans are made on substantially the same terms,including interest rates and collateral, as those prevailing at the time forcomparable transactions with unrelated persons and do not involve more than thenormal risk of collectibility. The aggregate dollar amount of loans outstandingto directors, officers, and their related business interests was approximately$1.1 and $1.2 million at December 31, 2008 and 2007, respectively.

 

Deposits from related parties held by the Bank at December 31, 2008and 2007 amounted to $5.2 million and $6.1 million, respectively.

 

**21.****              ****SUBSEQUENT EVENT**

 

On March 6, 2009, as part of the Troubled Asset Relief Program (“TARP”)Capital Purchase Program, the Company entered into a Securities PurchaseAgreement (collectively, the “Purchase Agreement”) with the United StatesDepartment of the Treasury (“Treasury”), pursuant to which the Company for apurchase price of $16.5 million in cash (i) sold 16,500 shares of theCompany’s Fixed Rate Cumulative Perpetual Preferred Stock, Series A (the “Series APreferred Stock”) and (ii) issued a warrant (the “Warrant”) to purchase321,847 shares of the Company’s common stock, par value $1.00 per share (the “CommonStock”), for a price of $7.69 per share. The total proceeds will be recorded inequity based on the relative fair value of the preferred stock and relatedwarrants.  The Series A PreferredStock qualifies as Tier 1 capital and is entitled to cumulative dividends. Thepreferred stock dividend reduces earnings available to common shareholders andis computed at an annual rate of 5% per annum for the first five years, and 9%per annum thereafter. The Series A Preferred Stock may be redeemed by theCompany with regulatory approval and when such preferred shares are redeemed,the Treasury shall liquidate the Warrant associated with such preferredshares.  The Warrant has a 10-year termand is immediately exercisable upon its issuance, with an exercise price,subject to anti-dilution adjustments, equal to $7.69 per share of the CommonStock. Treasury has agreed not to exercise voting power with respect to anyshares of Common Stock issued upon exercise of the Warrant that it holds.  The Company’s ability to repurchase itsshares is restricted. Consent of the Treasury generally is required for theCompany to make any stock repurchase until the third anniversary of theinvestment by Treasury unless all of the Series A Preferred Stock has beenredeemed or transferred. Further, common, junior preferred or *pari passu* preferred shares may not berepurchased if the Company is in arrears on the Series A Preferred Stockdividends. Under the terms of the Purchase Agreement, the Company’s ability todeclare or pay dividends on any of its shares is restricted.  Specifically, the Company may not declaredividend payments on common, junior preferred or *pari passu* preferred shares if it is in arrears on thedividends on the Series A Preferred Stock. In addition, the Company may not increase the dividends on its CommonStock above the amount of the last quarter cash dividend per share declaredprior to October 14, 2008, which was $0.16 per share, without the Treasury’sapproval until the third anniversary of the investment unless all of the Series APreferred Stock has been redeemed or transferred.  Further, until the Series A PreferredStock is redeemed, the Company may not pay a quarterly cash dividend in excessof $0.01 per share without approval of its primary regulator, the Office ofThrift Supervision.

 

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**22.****              ****PARENT COMPANY ONLY FINANCIALINFORMATION**

 

The following condensed statements of financial condition, as of December 31,2008 and 2007, and condensed statements of income and of cash flows for each ofthe three years in the period ended December 31, 2008, for First FederalBancshares of Arkansas, Inc. should be read in conjunction with theconsolidated financial statements and the notes herein.

 

**FIRST FEDERAL BANCSHARES OF ARKANSAS, INC.**

**(Parent Company Only)**

 

**CONDENSED STATEMENTS OF FINANCIAL CONDITION**

**DECEMBER 31, 2008 AND 2007**

**(In thousands)**

 
| ** **                                    | ** ** | **2008** | ** ** | **2007** | ** ** |
|-----------------------------------------------|------------|----------|------------|----------|------------|
| **ASSETS**                                    |       |     |       |     |       |
| Cash and cash equivalents (deposits in  Bank) |       | $        | 97         |     | $          | 97 |   |
| Loan to Bank subsidiary                       |       | 1,565    |       | 236      |       |
| Accrued interest receivable                   |       | —   |       | 3        |       |
| Investment in Bank                            |       | 70,877   |       | 73,193   |       |
| Other assets                                  |       | 673      |       | 286      |       |
|                                          |       |     |       |     |       |
| TOTAL                                         |       | $        | 73,212     |     | $          | 73,815 |   |
|                                          |       |     |       |     |       |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY** |       |     |       |     |       |
|                                          |       |     |       |     |       |
| Accrued expenses and other liabilities        |       | $        | 95         |     | $          | 152 |   |
| Stockholders’ equity                     |       | 73,117   |       | 73,663   |       |
|                                          |       |     |       |     |       |
| TOTAL                                         |       | $        | 73,212     |     | $          | 73,815 |   |

 

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**FIRST FEDERAL BANCSHARES OF ARKANSAS, INC.**

**(Parent Company Only)**

 

**CONDENSED STATEMENTS OF INCOME**

**YEARS ENDED DECEMBER 31, 2008, 2007, AND 2006**

**(In thousands)**

 
| ** **                                                                                       | ** ** | **2008**   | ** ** | **2007**   | ** ** | **2006**   | ** ** |
|--------------------------------------------------------------------------------------------------|------------|------------|------------|------------|------------|------------|------------|
| ** **                                                                                       | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| INCOME:                                                                                          |       |       |       |       |       |       |       |
| Dividends from the Bank                                                                          |       | $          | 5,000      |       | $          | 5,000      |       | $ | 8,000 |   |
| Interest income—loan to the Bank                                                            |       | 39         |       | 50         |       | 52         |       |
|                                                                                             |       |       |       |       |       |       |       |
| Total income                                                                                     |       | 5,039      |       | 5,050      |       | 8,052      |       |
|                                                                                             |       |       |       |       |       |       |       |
| EXPENSES:                                                                                        |       |       |       |       |       |       |       |
| Management fees                                                                                  |       | 66         |       | 66         |       | 66         |       |
| Other operating expenses                                                                         |       | 263        |       | 290        |       | 259        |       |
|                                                                                             |       |       |       |       |       |       |       |
| Total expenses                                                                                   |       | 329        |       | 356        |       | 325        |       |
|                                                                                             |       |       |       |       |       |       |       |
| INCOME BEFORE INCOME TAX BENEFIT AND EQUITY  IN UNDISTRIBUTED EARNINGS (LOSS) OF BANK SUBSIDIARY |       | 4,710      |       | 4,694      |       | 7,727      |       |
|                                                                                             |       |       |       |       |       |       |       |
| INCOME TAX BENEFIT                                                                               |       | 111        |       | 118        |       | 105        |       |
|                                                                                             |       |       |       |       |       |       |       |
| INCOME BEFORE EQUITY IN UNDISTRIBUTED EARNINGS  (LOSS) OF BANK SUBSIDIARY                        |       | 4,821      |       | 4,812      |       | 7,832      |       |
|                                                                                             |       |       |       |       |       |       |       |
| EQUITY IN UNDISTRIBUTED EARNINGS (LOSS) OF  BANK SUBSIDIARY                                      |       | (2,314     | )          | (2,169     | )          | (449       | )          |
|                                                                                             |       |       |       |       |       |       |       |
| NET INCOME                                                                                       |       | $          | 2,507      |       | $          | 2,643      |       | $ | 7,383 |   |

 

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**FIRST FEDERAL BANCSHARES OF ARKANSAS, INC.**

**(Parent Company Only)**

 

**CONDENSED STATEMENTS OF CASH FLOWS**

**YEARS ENDED DECEMBER 31, 2008, 2007, AND 2006**

**(In thousands)**

 
| ** **                                                                         | ** ** | **2008**   | ** ** | **2007**   | ** ** | **2006**   | ** ** |
|------------------------------------------------------------------------------------|------------|------------|------------|------------|------------|------------|------------|
| ** **                                                                         | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| OPERATING ACTIVITIES:                                                              |       |       |       |       |       |       |       |
| Net income                                                                         |       | $          | 2,507      |       | $          | 2,643      |       | $ | 7,383 |   |
| Adjustments to reconcile net income to net  cash provided by operating activities: |       |       |       |       |       |       |       |
| Equity in undistributed net loss (earnings)  of Bank                               |       | 2,314      |       | 2,169      |       | 449        |       |
| Release of ESOP shares                                                             |       | —     |       | —     |       | 512        |       |
| Stock compensation expense                                                         |       | 5          |       | 39         |       | 81         |       |
| Changes in operating assets and  liabilities:                                      |       |       |       |       |       |       |       |
| Accrued interest receivable                                                        |       | 3          |       | 4          |       | (2         | )          |
| Other assets                                                                       |       | (386       | )          | 307        |       | (40        | )          |
| Accrued expenses and other liabilities                                             |       | (58        | )          | (156       | )          | 163        |       |
|                                                                               |       |       |       |       |       |       |       |
| Net cash provided by operating activities                                          |       | 4,385      |       | 5,006      |       | 8,546      |       |
|                                                                               |       |       |       |       |       |       |       |
| INVESTING ACTIVITIES—                                                         |       |       |       |       |       |       |       |
| Loan to Bank, net of repayments                                                    |       | (1,329     | )          | 141        |       | 1,669      |       |
|                                                                               |       |       |       |       |       |       |       |
| Net cash provided by (used in) investing  activities                               |       | (1,329     | )          | 141        |       | 1,669      |       |
|                                                                               |       |       |       |       |       |       |       |
| FINANCING ACTIVITIES:                                                              |       |       |       |       |       |       |       |
| Purchase of treasury stock                                                         |       | —     |       | (2,312     | )          | (8,574     | )          |
| Dividends paid                                                                     |       | (3,102     | )          | (3,111     | )          | (2,899     | )          |
| Stock options exercised                                                            |       | 46         |       | 350        |       | 954        |       |
|                                                                               |       |       |       |       |       |       |       |
| Net cash used in financing activities                                              |       | (3,056     | )          | (5,073     | )          | (10,519    | )          |
|                                                                               |       |       |       |       |       |       |       |
| NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS                               |       | —     |       | 74         |       | (304       | )          |
|                                                                               |       |       |       |       |       |       |       |
| CASH AND CASH EQUIVALENTS:                                                         |       |       |       |       |       |       |       |
| Beginning of period                                                                |       | 97         |       | 23         |       | 327        |       |
|                                                                               |       |       |       |       |       |       |       |
| End of period                                                                      |       | $          | 97         |       | $          | 97         |       | $ | 23 |   |

 

******

 

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**SELECTED QUARTERLY OPERATING RESULTS (UNAUDITED)**

**(IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)**

 
| ** **                                           | ** ** | **Fourth  Quarter** | ** ** | **Third  Quarter** | ** ** | **Second  Quarter** | ** ** | **First  Quarter** | ** ** |
|------------------------------------------------------|------------|---------------------|------------|--------------------|------------|---------------------|------------|--------------------|------------|
| **YEAR ENDED DECEMBER 31, 2008** | ** ** | ** **          | ** ** | ** **         | ** ** | ** **          | ** ** | ** **         | ** ** |
| Interest income                                      |       | $                   | 10,493     |               | $          | 10,451              |       | $                  | 11,467     |   | $ | 11,536 |   |
| Interest expense                                     |       | 4,818               |       | 5,155              |       | 5,658               |       | 6,471              |       |
| Net interest income                                  |       | 5,675               |       | 5,296              |       | 5,809               |       | 5,065              |       |
| Provision for loan losses                            |       | 1,600               |       | 1,611              |       | 971                 |       | 1,528              |       |
| Net interest income after provision for  loan losses |       | 4,075               |       | 3,685              |       | 4,838               |       | 3,537              |       |
| Noninterest income                                   |       | 1,952               |       | 2,213              |       | 2,048               |       | 3,204              |       |
| Noninterest expense                                  |       | 5,983               |       | 5,766              |       | 5,648               |       | 6,071              |       |
| Income (loss) before income taxes                    |       | 44                  |       | 132                |       | 1,238               |       | 670                |       |
| Income tax provision (benefit)                       |       | (149                | )          | (86                | )          | 229                 |       | (417               | )          |
| Net income                                           |       | $                   | 193        |               | $          | 218                 |       | $                  | 1,009      |   | $ | 1,087 |   |
|                                                 |       |                |       |               |       |                |       |               |       |
| Earnings per share(1):                               |       |                |       |               |       |                |       |               |       |
| Basic                                                |       | $                   | 0.04       |               | $          | 0.05                |       | $                  | 0.21       |   | $ | 0.22 |   |
| Diluted                                              |       | $                   | 0.04       |               | $          | 0.05                |       | $                  | 0.21       |   | $ | 0.22 |   |
|                                                 |       |                |       |               |       |                |       |               |       |
| Selected Ratios (Annualized):                        |       |                |       |               |       |                |       |               |       |
| Net interest margin                                  |       | 3.19                | %          | 2.92               | %          | 3.15                | %          | 2.78               | %          |
| Return on average assets                             |       | 0.10                |       | 0.11               |       | 0.49                |       | 0.54               |       |
| Return on average equity                             |       | 1.05                |       | 1.17               |       | 5.43                |       | 5.86               |       |

 
| ** **                                           | ** ** | **Fourth  Quarter** | ** ** | **Third  Quarter** | ** ** | **Second  Quarter** | ** ** | **First  Quarter** | ** ** |
|------------------------------------------------------|------------|---------------------|------------|--------------------|------------|---------------------|------------|--------------------|------------|
| **YEAR ENDED DECEMBER 31, 2007** |       |                |       |               |       |                |       |               |       |
| Interest income                                      |       | $                   | 11,622     |               | $          | 12,381              |       | $                  | 13,196     |   | $ | 13,227 |   |
| Interest expense                                     |       | 6,840               |       | 7,086              |       | 7,150               |       | 7,108              |       |
| Net interest income                                  |       | 4,782               |       | 5,295              |       | 6,046               |       | 6,119              |       |
| Provision for loan losses                            |       | 367                 |       | 1,330              |       | 370                 |       | 1,961              |       |
| Net interest income after provision for  loan losses |       | 4,415               |       | 3,965              |       | 5,676               |       | 4,158              |       |
| Noninterest income                                   |       | 1,955               |       | 1,995              |       | 1,961               |       | 1,858              |       |
| Noninterest expense                                  |       | 5,659               |       | 5,809              |       | 5,461               |       | 6,066              |       |
| Income before income taxes                           |       | 711                 |       | 151                |       | 2,176               |       | (50                | )          |
| Income tax provision                                 |       | 62                  |       | (150               | )          | 642                 |       | (209               | )          |
| Net income                                           |       | $                   | 649        |               | $          | 301                 |       | $                  | 1,534      |   | $ | 159 |   |
|                                                 |       |                |       |               |       |                |       |               |       |
| Earnings per share(1):                               |       |                |       |               |       |                |       |               |       |
| Basic                                                |       | $                   | 0.13       |               | $          | 0.06                |       | $                  | 0.32       |   | $ | 0.03 |   |
| Diluted                                              |       | $                   | 0.13       |               | $          | 0.06                |       | $                  | 0.32       |   | $ | 0.03 |   |
|                                                 |       |                |       |               |       |                |       |               |       |
| Selected Ratios (Annualized):                        |       |                |       |               |       |                |       |               |       |
| Net interest margin                                  |       | 2.66                | %          | 2.88               | %          | 3.19                | %          | 3.19               | %          |
| Return on average assets                             |       | 0.33                |       | 0.15               |       | 0.74                |       | 0.08               |       |
| Return on average equity                             |       | 3.51                |       | 1.60               |       | 8.19                |       | 0.84               |       |

 

----

(1) Basic and diluted shares outstanding are summarized below.

 
| ** **                         | ** ** | **Fourth  Quarter** | ** ** | **Third  Quarter** | ** ** | **Second  Quarter** | ** ** | **First  Quarter** | ** ** |
|------------------------------------|------------|---------------------|------------|--------------------|------------|---------------------|------------|--------------------|------------|
| YEAR ENDED DECEMBER 31,  2008      |       |                |       |               |       |                |       |               |       |
| Basic weighted - average  shares   |       | 4,847,307           |       | 4,848,385          |       | 4,848,385           |       | 4,848,297          |       |
| Effect of dilutive  securities     |       | —              |       | —             |       | 1,091               |       | 2,338              |       |
| Diluted weighted - average  shares |       | 4,847,307           |       | 4,848,385          |       | 4,849,476           |       | 4,850,635          |       |
|                               |       |                |       |               |       |                |       |               |       |
| YEAR ENDED DECEMBER 31,  2007      |       |                |       |               |       |                |       |               |       |
| Basic weighted - average shares    |       | 4,857,406           |       | 4,865,007          |       | 4,868,377           |       | 4,869,855          |       |
| Effect of dilutive  securities     |       | 4,555               |       | 7,700              |       | 16,140              |       | 38,509             |       |
| Diluted weighted - average  shares |       | 4,861,961           |       | 4,872,707          |       | 4,884,517           |       | 4,908,364          |       |

 

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**Item 9.  Changesin and Disagreements with Accountants on Accounting and Financial Disclosure.**

 

Not Applicable.

 

**Item 9A. Controls and Procedures.**

 

Ourmanagement evaluated, with the participation of our Chief Executive Officer andChief Financial Officer, the effectiveness of the design and operation of ourdisclosure controls and procedures (as defined in Rules 13a-15(e) and15d-15(e) under the Securities Exchange Act of 1934) as of the end of theperiod covered by this report.  Based onsuch evaluation, our Chief Executive Officer and Chief Financial Officer haveconcluded that our disclosure controls and procedures are designed to ensurethat information required to be disclosed by us in the reports that we file orsubmit under the Securities Exchange Act of 1934 is recorded, processed,summarized and reported within the time periods specified in the SEC’s rules andregulations and are operating in an effective manner.

 

Management’sannual report on internal control over financial reporting and the attestationreport of the Company’s independent registered public accounting firm areincluded in Item 8 under the headings “Management Report on Internal Control”and “Report of Independent Registered Public Accounting Firm,” respectively,and are incorporated herein by reference.

 

No change in the Company’sinternal control over financial reporting (as defined in Rules 13a-15(f) and15d-15(f) under the Exchange Act) occurred during the fiscal quarter endedDecember 31, 2008 that has materially affected, or is reasonably likely tomaterially affect, the Company’s internal control over financial reporting.

 

**Item 9B.  OtherInformation.**

 

Not Applicable.

 

**PART III.**

 

**Item 10. Directors, Executive Officers and Corporate Governance.**

 

Theinformation regarding directors and executive officers is incorporated hereinby reference from the section entitled “Information with Respect to Nominee forDirector, Continuing Directors and Executive Officers” in our definitive ProxyStatement (“2009 Proxy Statement”) to be filed pursuant to Regulation 14A ofthe Securities Exchange Act of 1934, as amended, for our Annual Meeting ofStockholders to be held on April 28, 2009. The 2009 Proxy Statement willbe filed within 120 days after the end of our fiscal year ended December 31,2008.

 

Theinformation regarding compliance with Section 16(a) of the Securitiesand Exchange Act of 1934 is incorporated herein by reference from the sectionentitled “Section 16(a) Beneficial Ownership Reporting Compliance” ofour 2009 Proxy Statement.

 

Theinformation regarding the audit committee and audit committee financial expertsis incorporated by reference herein from the subsection entitled “Committeesand Meetings of the Board of the Company and the Bank” in the section entitled “Informationwith Respect to Nominee for Director, Continuing Directors and ExecutiveOfficers” in our 2009 Proxy Statement.

 

Theinformation regarding the code of ethics applicable to our principal executiveofficer, principal financial officer and principal accounting officer isincorporated herein by reference from the subsection entitled—“Code of Ethicsfor Executive Officers and Financial Professionals” in the section entitled “Informationwith Respect to Nominee for Director, Continuing Directors and ExecutiveOfficers” in our 2009 Proxy Statement.

 

**Item 11. Executive Compensation.**

 

Informationregarding executive compensation is incorporated herein by reference from thesection entitled “Executive Compensation” in our 2009 Proxy Statement.

 

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**Item 12.  Security Ownership of Certain BeneficialOwners and Management and Related Stockholder Matters.**

 

Informationregarding security ownership of certain beneficial owners and management isincorporated herein by reference from the section entitled “BeneficialOwnership of Common Stock By Certain Beneficial Owners and Management andRelated Stockholder Matters” and information regarding securities authorizedfor issuance under equity compensation plans is incorporated herein byreference from the subsection entitled “Equity-Based Compensation Plans” in our2009 Proxy Statement.

 

**Item 13.  CertainRelationships and Related Transactions, and Director Independence.**

 

Informationregarding certain relationships and related transactions is incorporated hereinby reference from the section entitled “Transactions with Certain RelatedPersons” in our 2009 Proxy Statement.

 

Informationregarding director independence is incorporated herein by reference from thesubsection entitled “Election of Directors” in the section entitled “Informationwith Respect to Nominee for Director, Continuing Directors and ExecutiveOfficers” in our 2009 Proxy Statement.

 

**Item 14. Principal Accountant Fees and Services.**

 

Theinformation regarding principal auditor fees and services is incorporatedherein by reference from the section entitled “Relationship with IndependentRegistered Public Accounting Firm” in our 2009 Proxy Statement.

 

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**PART IV.**

 

**Item 15. Exhibits and Financial Statement Schedules.**

 

**(a)  Documents Filed as Part of thisReport**

 

(1) Financial statements have been included in Item 8.

 

(2) All schedules for which provision is made in the applicableaccounting regulation of the SEC are omitted because of the absence ofconditions under which they are required or because the required information isincluded in the financial statements and related notes thereto.

 

**(b) Exhibit Index.**

 
| 2.1*      | Plan  of Conversion                                                                                                                                                                                                           |
|-----------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.1*      | Articles  of Incorporation of First Federal Bancshares of Arkansas, Inc.                                                                                                                                                 |
| 3.2**     | Amended  and Restated Bylaws of First Federal Bancshares of Arkansas, Inc.                                                                                                                                               |
| 3.3***    | Statement  of Designations for the Preferred Stock                                                                                                                                                                            |
| 4.0****   | Stock  Certificate of First Federal Bancshares of Arkansas, Inc.                                                                                                                                                         |
| 4.1***    | Form of  Certificate for the Preferred Stock                                                                                                                                                                             |
| 4.2***    | Warrant  for Purchase of Shares of Common Stock                                                                                                                                                                               |
| 10.1***** | Employment  Agreement between the Company, the Bank and Larry J. Brandt as amended and  restated                                                                                                                              |
| 10.2***** | Employment  Agreement between the Company, the Bank and Tommy W. Richardson as amended  and restated                                                                                                                          |
| 10.3***** | Employment  Agreement between the Company, the Bank and Sherri R. Billings as amended and  restated                                                                                                                           |
| 10.4***   | Letter  Agreement, dated March 6, 2009, between First Federal Bancshares of  Arkansas, Inc. and the U.S. Department of the Treasury                                                                                 |
| 10.5***   | ARRA  Letter Agreement, dated March 6, 2009, between First Federal Bancshares  of Arkansas, Inc. and the U.S. Department of the Treasury                                                                            |
| 10.6***   | Form of  Amendment to the Amended and Restated Employment Agreements among First  Federal Bancshares of Arkansas, Inc., First Federal Bank and each of  Larry J. Brandt, Tommy W. Richardson and Sherri R. Billings |
| 21.0      | Subsidiaries  of the Registrant - Reference is made to                                                                                                                                                                        |
|      | “Item  1 Business - Subsidiaries” for the required information                                                                                                                                                      |
| 23.0      | Consent  of Deloitte & Touche LLP                                                                                                                                                                                    |
| 31.1      | Certification  of Chief Executive Officer pursuant to Rule 13a-14(a) of Exchange  Act, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of  2002                                                   |
| 31.2      | Certification  of Chief Financial Officer pursuant to Rule 13a-14(a) of Exchange  Act, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of  2002                                                   |
| 32.1      | Section 906  Certification of the CEO                                                                                                                                                                                    |
| 32.2      | Section 906  Certification of the CFO                                                                                                                                                                                    |

 

----

|   | (*)     | Incorporated herein by reference from the Company’s  Registration Statement on Form S-1 (File No. 333-612) filed with  the SEC.           |
|--------|---------|----------------------------------------------------------------------------------------------------------------------------------------------------------|
|   | (**)    | Incorporated herein by reference from the Company’s  Annual Report on Form 10-K for the year ended December 31, 2007  filed with the SEC. |
|   | (***)   | Incorporated  herein by reference from the Company’s Form 8-K filed with the SEC on  March 6, 2009.                                       |
|   | (****)  | Incorporated  herein by reference from the Company’s Registration Statement on  Form 8-A filed with the SEC.                                   |
|   | (*****) | Incorporated  herein by reference from the Company’s Form 8-K filed with the SEC on  December 20, 2007.                                   |

 

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**SIGNATURES**

 

Pursuant to the requirements of Section 13 or 15(d) of theSecurities Exchange Act of 1934, the Registrant has duly caused this report tobe signed on its behalf by the undersigned, thereunto duly authorized.

 

 
|   | FIRST  FEDERAL BANCSHARES OF ARKANSAS, INC. |
|--------|---------------------------------------------|
|   |                                        |
|   |                                        |
|   | By:                                         | /s/ Larry J. Brandt |
|   |                                        | Larry J. Brandt |
|   |                                        | President and Chief Executive Officer |
|   |                                        |   |
|   |                                        | March 6, 2009 |

 

Pursuant to the requirements of the Securities Exchange Act of 1934,this report has been signed below by the following persons on behalf of theRegistrant and in the capacities and on the dates indicated.

 
| /s/ Larry J. Brandt                    | March 6, 2009 |
|----------------------------------------|--------------------|
| Larry J. Brandt                        |               |
| President and Chief  Executive Officer |               |
|                                   |               |   |
|                                   |               |   |
| /s/ John P. Hammerschmidt              | March 6, 2009 |
| John P. Hammerschmidt                  |               |
| Chairman                               |               |
|                                   |               |
|                                   |               |
| /s/ Jeff Brandt                        | March 6, 2009 |
| Jeff Brandt                            |               |
| Director                               |               |
|                                   |               |
|                                   |               |
| /s/ Kenneth C. Savells                 | March 6, 2009 |
| Kenneth C. Savells                     |               |
| Director                               |               |
|                                   |               |
|                                   |               |
| /s/ Frank Conner                       | March 6, 2009 |
| Frank Conner                           |               |
| Director                               |               |
|                                   |               |
|                                   |               |
| /s/ Sherri R. Billings                 | March 6, 2009 |
| Sherri R. Billings                     |               |
| Executive Vice President  and Chief    |               |
| Financial and Accounting  Officer      |               |

 

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