# **SECURITIESAND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

# **FORM10-K**

 
| **ý** | **ANNUAL  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES  EXCHANGE ACT OF 1934**    |
|------------|-----------------------------------------------------------------------------------------------|
|       |                                                                                          |
|       | **For the fiscal year ended December 31, 2003**                                               |
|       |                                                                                          |
|       | **OR**                                                                                        |
|       |                                                                                          |
| **o**      | **TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE  SECURITIES EXCHANGE ACT OF 1934** |

 

**For the transition period from                    to                    **

 

**Commission File No.: 0-28312**

 

| **First Federal Bancshares of Arkansas, Inc.**                   |
|------------------------------------------------------------------|
| (Exact name of registrant as specified in its charter)           |
|                                                             |   |   |
| **Texas**                                                        |   | **71-0785261** |
| (State  or other jurisdiction  of incorporation or organization) |   | (I.R.S.  Employer  Identification Number) |
|                                                             |   |   |
| **1401  Highway 62-65 North  Harrison, Arkansas**                |   | **72601** |
| (Address)                                                        |   | (Zip  Code) |

 

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

 

Securitiesregistered pursuant to Section 12(b) of the Act:

**Not Applicable**

 

Securitiesregistered pursuant to Section 12(g) of the Act

 

**Common Stock (par value $.01 per share)**

(Titleof Class)

 

Indicate by check mark whetherthe Registrant (1) has filed all reports required by Section 13 or 15(d) of theSecurities Exchange Act of 1934 during the preceding 12 months (or for suchshorter period that the Registrant was required to file such reports), and (2)has been subject to such filing requirements for the past 90 days.

Yes ý    No o

 

Indicate by check mark ifdisclosure of delinquent filers pursuant to Item 405 of Regulation S-K is notcontained herein, and will not be contained, to the best of Registrant’sknowledge, in definitive proxy or information statements incorporated byreference in Part III of this Form 10-K or any amendment to this Form10-K. ý

 

Indicate by check mark whetherthe registrant is an accelerated filer (as defined in Rule 12b-2 of the Act).

 

Yes ý    No o

 

As of June 30, 2003, theaggregate value of the 4,767,226 shares of Common Stock of the Registrantissued and outstanding on such date, which excludes 568,660 shares held bydirectors and officers of the Registrant as a group, was approximately $75.7million.  This figure is based on thelast sales price of $15.88 per share of the Registrant’s Common Stock on June30, 2003.

 

Number of shares of CommonStock outstanding as of March 2, 2004: 5,315,256

 

# **DOCUMENTSINCORPORATED BY REFERENCE**

 

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

 

Portions of the definitiveproxy statement for the 2004 Annual Meeting of Stockholders are incorporatedinto Part III, Items 10 through 14 of this Form 10-K.

 

 

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**PARTI.**

 

**Item 1.  Business**

 

**General**

 

**First Federal Bancshares of Arkansas, Inc. **First Federal Bancshares of Arkansas, Inc. (the “Company”) is a Texascorporation organized in January 1996 by First Federal Bank of Arkansas, FA (“FirstFederal” or the “Bank”) for the purpose of becoming a unitary holding companyof the Bank.  The only significantassets of the Company are the capital stock of the Bank, the Company’s loan tothe Employee Stock Ownership Plan (“ESOP”), and cash.  The business and management of the Company consists of thebusiness and management of the Bank. The Company does not presently own or lease any property, but insteaduses the premises, equipment and furniture of the Bank.  At the present time, the Company does notemploy any persons other than officers of the Bank, and the Company utilizesthe support staff of the Bank from time to time.  Additional employees will be hired as appropriate to the extentthe Company expands or changes its business in the future.  At December 31, 2003, the Company had $690.7million in total assets, $573.6 million in total deposits and $75.1 million instockholders’ equity.

 

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

 

**First Federal Bank of Arkansas, FA. **TheBank is a federally chartered stock savings and loan association formed in1934.  First Federal conducts businessfrom its main office and fourteen full service branch offices, all of which arelocated in a six county area in Northcentral and Northwest Arkansas comprisedof Benton, Marion, Washington, Carroll, Baxter and Boone counties.  First Federal’s deposits are insured by theSavings Association Insurance Fund (“SAIF”), which is administered by theFederal Deposit Insurance Corporation (“FDIC”), to the maximum extent permittedby law.

 

The Bank is a community-orientedfinancial institution offering a wide range of retail and small businessdeposit accounts, including non-interest bearing and interest bearing checking,savings and money market accounts, certificates of deposit, and individualretirement accounts.  Loan productsoffered by the Bank include residential real estate, consumer, construction,lines of credit, commercial real estate and commercial non-real estate.  Other financial services include investmentproducts offered through PrimeVest® Financial Services, Inc.; automated tellermachines; 24-hour telephone banking; internet banking, including accountaccess, bill payment and online loan applications; Bounce ProtectionTM overdraft service; debit cards; andsafe deposit 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 SAIF.  The Bank is also subject to certain reserve requirementsestablished by the Board of Governors of the Federal Reserve System (“FRB”) andis a member of the Federal Home Loan Bank (“FHLB”) of Dallas, which is one ofthe 12 regional banks comprising the FHLB System.

 

This Form 10-K and theCompany’s Annual Report to Stockholders contain certain forward-lookingstatements and information relating to the Company that are based on thebeliefs of management as well as assumptions made by and information currentlyavailable to management.  In addition,in those and other portions of this document and the Company’s Annual Report toStockholders, the words “anticipate”, “believe,” “estimate,” “expect,”“intend,” “should” and similar expressions, or the negative thereof, as theyrelate to the 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 andassumptions.  Should one or more ofthese risks or uncertainties materialize or should underlying assumptions proveincorrect, actual results may vary materially from those described herein asanticipated, believed, estimated, expected or intended.  The Company does not intend to update theseforward-looking statements.

 

## **Employees**

 

The Bank had 237 full-time employees and 37part-time employees at December 31, 2003, compared to 222 full-time employeesand 33 part-time employees at December 31, 2002.   None of these employees is represented by a collectivebargaining agent, and the Bank believes that it enjoys good relations with itspersonnel.

 

1

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## **AvailableInformation**

 

The Company makes availablefree of charge its annual report on Form 10-K, quarterly reports on Form 10-Q,current reports on Form 8-K, and all amendments to such reports filed pursuantto Sections 13(a) or 15(d) of the Exchange Act, as soon as reasonablypracticable on or through its website located at www.ffbh.com after filing withthe United States Securities and Exchange Commission.

 

## **Competition**

 

The Bank faces strong competition both inattracting deposits and making loans. Its most direct competition for deposits has historically come fromother savings associations, community banks, credit unions and commercialbanks, including many large financial institutions that have greater financialand marketing resources available to them. In addition, the Bank has faced additional significant competition forinvestors’ funds from short-term money market securities, mutual funds andother corporate and government securities. The ability of the Bank to attract and retain savings and certificatesof deposit depends on its ability to generally provide a rate of return,liquidity and risk comparable to that offered by competing investmentopportunities.  The Bank’s ability toincrease checking deposits depends on offering competitive checking accountsand promoting these products through effective channels.  Additionally, the Bank must offer convenienthours, locations and online services to attract customers.

 

The Bank experiences strong competition forloans principally from savings associations, community banks, commercial banksand mortgage companies.  The Bankcompetes for loans principally through the interest rates and loan fees itcharges and the efficiency and quality of services it provides borrowers.  Competition has increased as a result of thecontinuing reduction of restrictions on the interstate operations of financialinstitutions.

 

**Lending Activities**

 

**General. **At December 31, 2003, the Bank’s totalportfolio of loans receivable (“total loan portfolio”), amounted to $550.2million or 79.7% of the Company’s total assets.  The Bank has traditionally concentrated its lending activities on   loans collateralized by real estate.  Consistent with such approach, $441.3million or 80.2% of the Bank’s total loan portfolio consisted of loanscollateralized by first mortgage loans at December 31, 2003.

 

Inrecent years, the Bank has placed an increased emphasis on commercial realestate lending, construction lending, commercial lending and consumerlending.  The Bank has placed anincreased emphasis on these loan types to diversify its loan portfolio,increase the average yield on its loan portfolio, expand its operations andprovide greater opportunities to cross-sell its products.  Atable is included below that summarizes the changes in the composition of theloan portfolio between December 31, 1999 and December 31, 2003 (dollars inmillions):

 
|                      |   | **2003  vs 1999  Increase (Decrease)** |       | **Year  Ended December 31,** |          |
|---------------------------|--------|----------------------------------------|------------|------------------------------|---------------|
| **2003**                  |   | **1999**                               |
|                      |   | **Percentage**                         |       |                         |          | **Percentage** |
| **Amount**                |   | **Percentage**                         | **Amount** |                         | **of  Loans** |   | **Amount** |   | **of  Loans** |
| Real estate loans:        |   |                                   |       |                         |          |   |   |   |   |   |   |   |   |
| Single-family residential |   | $                                      | (111.8     | )                            | (31.0         | )% | $ | 256.8 |   | 46.7 | % | $ | 368.6 |   | 77.7 | % |
| Multi-family residential  |   | 7.2                                    |       | 1.2                          |          | 10.0 |   | 1.8 |   | 2.8 |   | 0.6 |   |
| Commercial real estate    |   | 59.1                                   |       | 10.0                         |          | 85.1 |   | 15.5 |   | 26.0 |   | 5.5 |   |
| Construction              |   | 63.5                                   |       | 10.8                         |          | 89.3 |   | 16.2 |   | 25.8 |   | 5.4 |   |
| Total real estate loans   |   | 18.0                                   |       | (9.0                         | )             | 441.2 |   | 80.2 |   | 423.2 |   | 89.2 |   |
|                      |   |                                   |       |                         |          |   |   |   |   |   |   |   |   |
| Commercial loans          |   | 19.5                                   |       | 3.1                          |          | 33.7 |   | 6.1 |   | 14.2 |   | 3.0 |   |
|                      |   |                                   |       |                         |          |   |   |   |   |   |   |   |   |
| Consumer loans            |   | 38.5                                   |       | 5.9                          |          | 75.3 |   | 13.7 |   | 36.8 |   | 7.8 |   |
|                      |   |                                   |       |                         |          |   |   |   |   |   |   |   |   |
| Total                     |   | $                                      | 76.0       |                         | 0.0           | % | $ | 550.2 |   | 100.0 | % | $ | 474.2 |   | 100.0 | % |

 

2

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**Loan Composition. **The following table sets forth certain datarelating to the composition of the Bank’s loan portfolio by type of loan at thedates indicated.

 
|                                           |   | **December 31,**           |    |
|------------------------------------------------|--------|----------------------------|---------|
|                                           |   | **2003**                   |    | **2002** |   | **2001** |   | **2000** |   | **1999** |   |
|                                           |   | **Amount**                 |    | **Percentage  of Loans** |   | **Amount** |   | **Percentage  of Loans** |   | **Amount** |   | **Percentage  of Loans** |   | **Amount** |   | **Percentage**** ****of  Loans** |   | **Amount** |   | **Percentage  of Loans** |   |
|                                           |   | **(Dollars in Thousands)** |    |
| Real estate loans:                             |   |                       |    |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Single-family residential                      |   | $                          | 256,796 |   | 46.67 | % | $ | 289,106 |   | 57.03 | % | $ | 330,844 |   | 67.85 | % | $ | 377,341 |   | 73.87 | % | $ | 368,589 |   | 77.73 | % |
| Multi-family residential                       |   | 9,998                      |    | 1.82 |   | 5,821 |   | 1.15 |   | 4,386 |   | .90 |   | 3,666 |   | .72 |   | 2,812 |   | .59 |   |
| Commercial real estate                         |   | 85,129                     |    | 15.47 |   | 66,622 |   | 13.14 |   | 46,896 |   | 9.62 |   | 38,085 |   | 7.46 |   | 26,018 |   | 5.49 |   |
| Construction                                   |   | 89,332                     |    | 16.24 |   | 49,144 |   | 9.69 |   | 24,842 |   | 5.09 |   | 24,937 |   | 4.88 |   | 25,797 |   | 5.44 |   |
| Total first mortgage loans                     |   | 441,255                    |    | 80.20 |   | 410,693 |   | 81.01 |   | 406,968 |   | 83.46 |   | 444,029 |   | 86.93 |   | 423,216 |   | 89.25 |   |
|                                           |   |                       |    |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Commercial loans                               |   | 33,672                     |    | 6.12 |   | 28,213 |   | 5.57 |   | 23,451 |   | 4.81 |   | 20,239 |   | 3.96 |   | 14,171 |   | 2.99 |   |
|                                           |   |                       |    |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Consumer loans:                                |   |                       |    |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Home equity and second mortgage loans          |   | 36,332                     |    | 6.60 |   | 31,670 |   | 6.25 |   | 24,933 |   | 5.11 |   | 19,797 |   | 3.87 |   | 15,009 |   | 3.17 |   |
| Automobile                                     |   | 22,087                     |    | 4.01 |   | 22,570 |   | 4.45 |   | 20,506 |   | 4.20 |   | 16,051 |   | 3.14 |   | 13,205 |   | 2.78 |   |
| Other                                          |   | 16,869                     |    | 3.07 |   | 13,807 |   | 2.72 |   | 11,781 |   | 2.42 |   | 10,703 |   | 2.10 |   | 8,577 |   | 1.81 |   |
| Total consumer loans                           |   | 75,288                     |    | 13.68 |   | 68,047 |   | 13.42 |   | 57,220 |   | 11.73 |   | 46,551 |   | 9.11 |   | 36,791 |   | 7.76 |   |
|                                           |   |                       |    |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Total loans receivable                         |   | 550,215                    |    | 100.00 | % | 506,953 |   | 100.00 | % | 487,639 |   | 100.00 | % | 510,819 |   | 100.00 | % | 474,178 |   | 100.00 | % |
|                                           |   |                       |    |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Less:                                          |   |                       |    |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Undisbursed loan funds                         |   | (35,181                    | )       |   |   | (20,618 | ) |   |   | (10,144 | ) |   |   | (9,126 | ) |   |   | (10,437 | ) |   |   |
| Unearned discounts and net deferred  loan fees |   | (657                       | )       |   |   | (1,338 | ) |   |   | (2,078 | ) |   |   | (2,697 | ) |   |   | (3,011 | ) |   |   |
| Allowance for loan losses                      |   | (1,621                     | )       |   |   | (1,529 | ) |   |   | (923 | ) |   |   | (691 | ) |   |   | (752 | ) |   |   |
| Total loans receivable, net                    |   | $                          | 512,756 |   |   |   | $ | 483,468 |   |   |   | $ | 474,494 |   |   |   | $ | 498,305 |   |   |   | $ | 459,978 |   |   |   |

 

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**Loan Maturity and Interest Rates. **Thefollowing table sets forth certain information at December 31, 2003 regardingthe dollar amount of loans maturing in the Bank’s loan portfolio based on theircontractual terms to maturity.  Demandloans and loans having no stated schedule of repayments and no stated maturityare reported as due in one year or 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)**  |   |
| Real estate loans:        |   |                 |   |                                |   |                   |   |      |    |
| Single-family residential |   | $                    | 1,024  |                                | $      | 8,777                  |   | $         | 246,995 |   | $ | 256,796 |   |
| Multi-family residential  |   | —               |   | 4,678                               |   | 5,320                  |   | 9,998     |    |
| Commercial real estate    |   | 5,510                |   | 49,540                              |   | 30,079                 |   | 85,129    |    |
| Construction              |   | 37,700               |   | 15,946                              |   | 35,686                 |   | 89,332    |    |
| Commercial loans          |   | 17,991               |   | 12,949                              |   | 2,732                  |   | 33,672    |    |
| Consumer loans            |   | 18,519               |   | 51,100                              |   | 5,669                  |   | 75,288    |    |
| Total(1)                  |   | $                    | 80,744 |                                | $      | 142,990                |   | $         | 326,481 |   | $ | 550,215 |   |

 

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(1)          Gross of undisbursed loan funds,unearned discounts and net deferred loan fees and the allowance for loanlosses.

 

Thefollowing table sets forth the dollar amount of the Bank’s loans at December31, 2003 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)** |    |
| Real estate loans:        |   |                |    |                               |   |      |   |
| Single-family residential |   | $                   | 69,859  |                               | $      | 185,913   |   | $ | 255,772 |   |
| Multi-family residential  |   | 9,226               |    | 772                                |   | 9,998     |   |
| Commercial real estate    |   | 79,308              |    | 311                                |   | 79,619    |   |
| Construction              |   | 25,748              |    | 25,884                             |   | 51,632    |   |
| Commercial loans          |   | 14,630              |    | 1,051                              |   | 15,681    |   |
| Consumer loans            |   | 49,052              |    | 7,717                              |   | 56,769    |   |
| Total                     |   | $                   | 247,823 |                               | $      | 221,648   |   | $ | 469,471 |   |

 

Scheduled contractualmaturities of loans do not necessarily reflect the actual term of the Bank’sloan portfolio.  The average life ofmortgage loans is substantially less than their average contractual termsbecause of loan prepayments and refinancing. The average life of mortgage loans tends to increase, however, whencurrent mortgage loan rates substantially exceed rates on existing mortgageloans and, conversely, decrease when rates on existing mortgage loanssubstantially exceed current mortgage loan 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 (Loan Prospector).  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.

 

Applications are initially received by loan officers or from the Bank’ssecure website.   Applications receivedover the Bank’s website are forwarded to loan officers.  To a lesser extent, the Bank does utilize acommercial loan consultant/broker.  Thisconsultant has extensive experience in commercial lending and his fee isnegotiated on a loan-by-loan basis by the executive committee of the Bank.  All work performed by the consultant isreviewed by the Executive

 

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Vice President/Chief Lending Officer and the Senior VicePresident/Commercial Lending Manager as well as the appropriate loan committeemembers as described herein.   All loansare subject to review by members of the Bank’s loan committee.   The loan committee is made up of loanofficers of the Bank.  Each loancommittee member has a designated lending approval authority which is basedupon the individual’s expertise in the various lending areas, which includeresidential loans, consumer loans, commercial real estate loans, and non-realestate commercial loans.  Variousmembers of the loan committee may approve loans based upon an aggregateapproval authority by up to three members of the committee.  Larger loans requiring more than three loancommittee members also require the additional approval of the President/ChiefExecutive Offier, Executive Vice President/Chief Operating Officer, or theExecutive Vice President/Chief Lending Officer.  Residential loans of $1,000,000 or more, consumer loans of $500,000 or more, commercial real estate loans of  $1,000,000 or more, and non-real estateloans of  $500,000 or more requireapproval by the Bank’s board of directors.  All loans are ratified, subsequent to the loan being closed, bythe board of directors.

 

During2003 the Bank purchased two commercial loan participations totaling $3.1million.  No loans were purchased during2002 or 2001.

 

To minimize interest rate risk, loans with fixed-rate terms of fifteenyears or greater are typically sold to specific investors in the secondarymortgage market.  The rights to servicesuch loans are typically sold with the loans. This allows the Bank to provide its customers competitive long-termfixed-rate mortgage products which are very popular financing products for homebuyers in today’s market, while not exposing the Bank to undue interest raterisk.  These loans are originatedsubject to Fannie Mae and/or Freddie Mac underwriting guidelines and aretypically underwritten and validated by a third party prior to loanclosing.  The Secondary MarketDepartment of the Bank typically locks and confirms the purchase price of theloan on the day of the loan application which protects the Bank from marketprice movements and ensures that the Bank will receive a fair and reasonableprice on the sale of the respective loan. Due to the loans being underwritten by a third party, the repurchaserisk associated with these loans is substantially assumed by theunderwriter.  The Bank believes it hasminimal risk of repurchase of these loans based upon the contracts with thespecific investors.  This risk typicallyinvolves potential early prepayments of the mortgage or an early default of aloan.  In 2003, 2002, and 2001, the Bankwas not required to repurchase any loans. In 2003, 2002, and 2001, the Bank’s loan sales amounted to $130.2million, $67.4 million, and $60.5 million, respectively.  The Bank is not involved in loan hedging orother speculative mortgage loan origination activities.

 

Setforth below is a table showing the Bank’s originations, sales, purchases, andrepayments of loans during the periods indicated.

 
|                                    |   | **Year Ended  December 31,** |    |
|-----------------------------------------|--------|------------------------------|---------|
|                                    |   | **2003**                     |    | **2002** |   | **2001** |   |
|                                    |   | **(In  Thousands)**          |    |
|                                    |   |                         |    |   |   |   |   |
| Loans receivable at beginning of period |   | $                            | 506,953 |   | $ | 487,639 |   | $ | 510,819 |   |
| Loan originations:                      |   |                         |    |   |   |   |   |
| Real estate:                            |   |                         |    |   |   |   |   |
| Single-family residential               |   | 199,984                      |    | 136,154 |   | 129,181 |   |
| Multi-family residential                |   | 6,103                        |    | 2,756 |   | 2,643 |   |
| Commercial real estate                  |   | 44,958                       |    | 31,878 |   | 16,713 |   |
| Construction                            |   | 94,105                       |    | 54,504 |   | 28,876 |   |
| Commercial loans                        |   | 24,646                       |    | 16,880 |   | 14,943 |   |
| Consumer:                               |   |                         |    |   |   |   |   |
| Home equity and second mortgage loans   |   | 27,507                       |    | 24,653 |   | 22,884 |   |
| Automobile                              |   | 15,245                       |    | 17,348 |   | 18,392 |   |
| Other                                   |   | 15,029                       |    | 15,207 |   | 11,307 |   |
| Total loan originations                 |   | 427,577                      |    | 299,380 |   | 244,939 |   |
| Loan purchases                          |   | 3,140                        |    |   |   |   |   |
| Repayments                              |   | (254,015                     | )       | (212,166 | ) | (207,059 | ) |
| Loan sales                              |   | (130,169                     | )       | (67,350 | ) | (60,452 | ) |
| Transfers to real estate owned          |   | (1,771                       | )       | (1,029 | ) | (717 | ) |
| Other                                   |   | (1,500                       | )       | 479 |   | 109 |   |
| Net loan activity                       |   | 43,262                       |    | 19,314 |   | (23,180 | ) |
| Loans receivable at end of period       |   | $                            | 550,215 |   | $ | 506,953 |   | $ | 487,639 |   |

 

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**Loans-to-One Borrower. **A savings institutiongenerally may not make loans-to-one borrower and related entities in an amountwhich exceeds 15% of its unimpaired capital and surplus, although loans in anamount equal to an additional 10% of unimpaired capital and surplus may be madeto a borrower if the loans are fully secured by readily marketablesecurities.  At December 31, 2003, theBank’s limit on loans-to-one borrower was approximately $10.8 million.  At December 31, 2003, the Bank’s largestloan or group of loans-to-one borrower, including persons or entities relatedto the borrower, amounted to $ 9.5 million. Such amount consists of 32 loans, 6 of which are commercial real estateloans totaling $7.2 million and 26 of which are single-family residential loanstotaling $2.3 million.  The Bank’s tenlargest loans or groups of loans-to-one borrower, including persons or entitiesrelated to the borrower, including unfunded commitments, totaled $67.9 millionat December 31, 2003.  None ofthese loans were 90 days or more past due at December 31, 2003.

 

**One- to Four-Family Residential Real Estate Loans. **The Bank has historically concentrated its lending activities on theorigination of loans collateralized by first mortgage liens on existing one- tofour-family residences.  AtDecember 31, 2003, $256.8 million or 46.7% of the Bank’s total loanportfolio consisted of one- to four-family residential real estate loans.   Of the $256.8 million of such loans atDecember 31, 2003, $185.9 million or 72.4% had adjustable rates ofinterest (including $75.9 million of seven-year adjustable-rate loans) and$70.9 million or 27.6% 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 for portfolio are typically originated withmaximum terms of fifteen years and are typically fully amortizing with monthlypayments sufficient to repay the total amount of the loan with interest by theend of the loan term.  The Bank doesoffer fixed-rate loans with terms exceeding fifteen years and such loans aretypically sold in the secondary market. The Bank’s one- to four-family loans are typically originated underterms, conditions and documentation which permit them to be sold to U.S.Government-sponsored agencies such as Fannie Mae or Freddie Mac.  However, as stated above, such loans withterms of less than fifteen years are generally originated for portfolio whilesubstantially all of such loans with terms of fifteen years or longer are soldin the secondary market.  The Bank’sfixed-rate loans typically include “due on sale” clauses.

 

The Bank’s adjustable-ratemortgage loans typically provide for an interest rate which adjusts every one-,three-, five- or seven-years in accordance with a designated index plus amargin.  Such loans are typically basedon a 15-, 20-, 25- or 30-year amortization schedule.  The Bank generally does not offer below market rates, and theamount of any increase or decrease in the interest rate per one- or three-yearperiod is generally limited to 2%, with a limit of 6% over the life of theloan.  The Bank’s five-yearadjustable-rate loans provide that any increase or decrease in the interestrate per period is limited to 3%, with a limit of 6% over the life of theloan.  The Bank’s seven-yearadjustable-rate loans provide that any increase or decrease in the interestrate per period is limited to 5% with a limit of 5% over the life of theloan.  The Bank’s adjustable-rate loansare assumable (generally without release of the initial borrower), do notcontain prepayment penalties and do not provide for negative amortization.  The Bank’s adjustable-rate mortgage loanstypically include “due on sale” clauses. Such loans may be converted to a fixed-rate loan at the discretion ofthe Bank.  The Bank generallyunderwrites its one- and three-year adjustable-rate loans on the basis of theborrowers’ ability to pay at the rate after the first interest rateadjustment.  Adjustable-rate loansdecrease the risks associated with changes in interest rates but involve otherrisks, primarily because as interest rates rise, the payment by the borrowerrises to the extent permitted by the terms of the loan, thereby increasing thepotential for default.  At the sametime, the marketability of the underlying property may be adversely affected byhigher interest rates.

 

The Bank’s residential mortgage loans typically do not exceed 80% ofthe appraised value of the secured property. However, pursuant to theunderwriting guidelines adopted by the board of directors, the Bank may lend upto 97% of the appraised value of the property securing a one- to-four familyresidential loan with private mortgage insurance to protect the portion of theloan that exceeds 80% of the appraised value. The Bank may, on occasion, extend a loan up to 90% of the appraisedvalue of the secured property without private mortgage insurance coverage.  However, these exceptions are minimal andare only approved on loans with exceptional credit scores, sizeable assetreserves, or other compensating factors. At December 31, 2003, the Bank had $1.5 million of nonperforming,single-family residential loans.  See“Asset Quality”.

 

**Multi-Family Residential Real Estate Loans. **The Bank offers mortgage loans for the acquisition and refinancing ofmulti-family residential properties. This area of lending continues to be emphasized in order to increase theBank’s loan portfolio and its interest rate yield.  At December 31, 2003, $10.0 million or 1.8% of the Bank’s totalloan portfolio consisted of loans collateralized by existing multi-familyresidential real estate properties.

 

6

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TheBank currently originates both fixed- and adjustable- rate multi-familyloans.  Fixed-rate loans are generally originatedwith amortization periods not to exceed 25 years, and typically have balloonperiods of three, five or seven years. Adjustable-rate loans are typically amortized over terms up to 30 years,with interest rate adjustments every five to seven years.  Loan-to-value ratios on the Bank’smulti-family 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 multi-familyresidential real estate loans from the principals of the borrower.

 

Multi-familyreal 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.  Thepayment experience on such loans is typically dependent on the successfuloperation of the real estate project. The success of such projects is sensitive to changes in supply anddemand conditions in the market for multi-family real estate as well asregional and economic conditions generally. At December 31, 2003, the Bank did not have any nonperformingmulti-family real estate loans.  See“Asset Quality”.

 

**Commercial Real Estate Loans. **TheBank originates mortgage loans for the acquisition and refinancing ofcommercial real estate properties.  AtDecember 31, 2003, $85.1 million or 15.5% of the Bank’s total loan portfolioconsisted of loans collateralized by existing commercial real estate properties.   In recent years, the Bank has placed anincreased emphasis on this type of lending in order to diversify the Bank’sloan portfolio and increase its interest rate yield.

 

The majority of the Bank’s commercial real estate loans arecollateralized by office buildings, convenience stores, service stations,mini-storage facilities, motels, churches, and small shopping malls and stripcenters.  The majority of these loansare collateralized by properties located in the Bank’s market areas.  These loans have increased in the last fewyears and are underwritten specifically in relation with the type of propertybeing collateralized.  Cash flows andvacancy rates are primary considerations when underwriting loans collateralizedby office buildings, mini-storage facilities, motels, etc.  Loans with borrowers that are corporations,limited liability companies, trusts, or other such legal entities are alsotypically personally guaranteed by the principals of the respective entity.

 

The Bank’s policy requires real estate appraisals of all propertiessecuring commercial real estate loans by licensed real estate appraiserspursuant to state licensing requirements. The Bank considers the quality and location of the real estate, thecredit of the borrower, the cash flow of the project, and the quality of managementinvolved with the property.  The Bank’scommercial real estate loans are typically originated with amortizations not toexceed 20 years, and typically have balloon periods of three-, five-, orseven-year terms.  The Bank has in thepast offered a limited number of fixed-rate commercial real estate loans withterms not to exceed fifteen years, subject to then-current interest ratescenarios.  As part of the criteria forunderwriting multi-family and commercial real estate loans, the Bank generallyprepares a cash flow analysis that includes a vacancy rate projection; expensesfor taxes, insurance, maintenance, and repair reserves; and debt coverageratios.

 

Commercial real estate lending entails additional risks, as compared tothe Bank’s single-family residential property loans. Commercial real estateloans generally involve larger loan balances to single borrowers or groups ofrelated borrowers.  The paymentexperience on such loans is typically dependent on the successful operation ofthe real estate project. The success of such projects is sensitive to changesin supply and demand conditions in the market for commercial real estate, aswell as regional and economic conditions generally.    At December 31, 2003, the Bank had $99,000 of nonperforming commercialreal estate loans.  See “Asset Quality”.

 

**Construction Loans. **TheBank originates single-family residential, multi-family, 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, 2003, construction loansamounted to $89.3 million or 16.2% of the Bank’s total loan portfolio, ofwhich, $62.0 million consisted of one-to four-family residential constructionloans, $12.2 million consisted of commercial real estate construction loans,and $15.1 million consisted of multi-family residential construction loans.  The Bank’s construction loans generally have fixed interest ratesand are typically issued for terms of six- to twelve-months. However, the Bankis permitted to originate construction loans with terms up to two years underits loan policy.  This practice isgenerally limited to larger projects that cannot be completed in the typicalsix- to twelve-month period. Construction loans are typically made with a maximum loan-to-value ratioof 80% on an as-completed basis.

 

Themajority of the Bank’s construction loans are made to individual homeowners andlocal builders and developers for the purpose of constructing one- tofour-family residences.  To a lesser butgrowing extent, construction loans are also

 

7

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originatedfor multi-family and commercial properties.  The Bank typically requires that permanent financing with the Bank orsome other lender be in place prior to closing any construction loan.  Interest on construction/permanent loans isdue upon completion of the construction phase of the loan.  At such time, the loan automaticallyconverts to a permanent loan at the interest rate established at the initialclosing of the construction/permanent loan.

 

The Bank makes construction loans to local builders for the purpose ofconstruction of speculative (or unsold) residential properties, and for theconstruction of pre-sold single-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 reviewsand inspects the project prior to the disbursement of funds (draws) during theconstruction term.  Loan proceeds aredisbursed after a satisfactory inspection of the project has been made basedupon percentage of completion.  Intereston these construction loans is due upon maturity.  The Bank may extend the term of a construction loan upon paymentof interest accrued if the property has not been sold by the maturity date.  The Bank has not experienced any materialcredit or delinquency problems in this regard.

 

Construction lending is generally considered to involve a higher levelof risk as compared to one- to four-family residential loans.  This is due, in part, to the concentrationof principal in a limited number of loans and borrowers, and the effects ofgeneral economic conditions on developers and builders.  In addition, construction loans to a builderfor construction of homes that are not pre-sold possess a greater potentialrisk to the Bank than construction loans to individuals on their personalresidences or on houses that are pre-sold prior to the inception of the loan.

 

The Bank has attempted to minimize the risks as outlined above byadopting underwriting guidelines that impose stricter loan-to-value ratios anddebt service requirements.  In addition,the Bank analyzes each borrower involved in speculative building and limits theprincipal amount and number of unsold spec homes at any one time with suchborrower.  At December 31, 2003,the Bank did not have any nonperforming construction loans.  See “Asset Quality”.

 

**Commercial Loans. **The Bank also offers commercial loans whichprimarily consist of equipment and inventory loans which are typicallycross-collateralized by commercial real estate.  The Bank does not actively market such loans and offers suchloans primarily as an accommodation to its present customers.  At December 31, 2003, such loansamounted to $33.7 million or 6.1% of the total loan portfolio.  At December 31, 2003, the Bank hadnonperforming commercial loans totaling $131,000.  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.  To a lesser extent, the Bankdoes originate interest-only loans and variable-rate loans.

 

**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. The consumer loans offered by the Bankprimarily include home equity and second mortgage loans, automobile loans,deposit account secured loans, and unsecured loans.  Consumer loans amounted to $75.3 million or 13.7% of the totalloan portfolio at December 31, 2003, of which $36.3 million, $22.1 million and$16.9 million consisted of home equity and second mortgage loans, automobileloans, and other consumer loans, respectively. The Bank intends to continue its emphasis on consumer loans in furtheranceof its role as a community-oriented financial institution.

 

TheBank’s home equity and second mortgage loans are fixed-rate loans withfully-amortized terms of up to fifteen years, or variable-rate interest-onlyloans with terms up to three years.  Thevariable-rate loans are typically tied to Wall Street Journal Prime, plus amargin commensurate with the risk as determined by the borrower’s creditscore.  Longer-term amortizing loanstypically have a balloon feature in five, seven, or ten years.  Although the Bank does not require that ithold the first mortgage on the secured property, the Bank does hold the firstmortgage on a significant number of its home equity loans.  The Bank generally limits the total loan-to-valueon these mortgages to 90% of the value of the secured property.

 

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.

 

8

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Otherconsumer loans consist primarily of deposit account loans and unsecuredloans.  Loans secured by depositaccounts are originated for up to 95% of the account balance, with a holdplaced on the account restricting the withdrawal of the account balance.

 

Consumerloans entail greater risk than do residential first mortgage loans,particularly in the case of consumer loans which are unsecured or secured byrapidly depreciating assets such as automobiles.  In such cases, any repossessed collateral for a defaultedconsumer loan may not provide an adequate source of repayment of theoutstanding loan balance as a result of the greater likelihood of damage, lossor depreciation.  In addition, consumerloan collections are dependent on the borrower’s continuing financialstability, and thus are more likely to be adversely affected by job loss,divorce, illness or personal bankruptcy. Furthermore, the application of various federal and state laws,including federal and state bankruptcy and insolvency laws, may limit theamount which can be recovered on such loans. At December 31, 2003, the Bank had $564,000 of nonperforming consumerloans.  See “Asset Quality”.

 

**Asset Quality**

 

Whena borrower fails to make a required payment on a loan, the Bank attempts tocure the deficiency by contacting the borrower and seeking the payment.  Depending upon the type of loan, latenotices are sent and/or personal contacts are made. In most cases, deficienciesare cured promptly.  While the Bankgenerally prefers to work with borrowers to resolve such problems, when amortgage loan becomes 90 days delinquent, the Bank generally institutesforeclosure or other proceedings, as necessary, to minimize any potential loss.

 

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 generallydoes not accrue interest on loans past due 90 days or more.  Loans may be reinstated to accrual statuswhen payments are made to bring the loan under 90 days past due and, in theopinion of management, collection of the remaining balance can be reasonablyexpected.

 

Realestate properties acquired through foreclosure are initially recorded at fairvalue less estimated selling costs. Valuations are periodically performed by management and the real estateis carried at the lower of carrying amount or fair value less cost to sell.

 

**Delinquent Loans. **The following table sets forth informationconcerning delinquent loans at December 31, 2003, in dollar amounts and asa percentage of the Bank’s total loan portfolio.  The amounts presented represent the total outstanding principalbalances of the related loans, rather than the actual payment amounts which arepast due.

 
|              |   | **Single-family  Residential** |   | **Construction**                |   | **Commercial  Real Estate** |   | **Commercial**                  |   | **Consumer** |   |
|-------------------|--------|--------------------------------|--------|---------------------------------|--------|-----------------------------|--------|---------------------------------|--------|--------------|--------|
|              |   | **Amount**                     |   | **Percentage  of Total  Loans** |   | **Amount**                  |   | **Percentage  of Total  Loans** |   | **Amount**   |   | **Percentage  of Total  Loans** |   | **Amount** |   | **Percentage  of Total  Loans** |   | **Amount** |   | **Percentage  of Total  Loans** |   |
|              |   |                           |   |                            |   |                        |   | **(Dollars  in Thousands)**     |   |         |   |   |   |   |   |   |   |
| Loans delinquent: |   |                           |   |                            |   |                        |   |                            |   |         |   |   |   |   |   |   |   |   |   |   |   |
|              |   |                           |   |                            |   |                        |   |                            |   |         |   |   |   |   |   |   |   |   |   |   |   |
| 30-59 days        |   | $                              | 4,003  |                            | .73    | %                           | $      | 721                             |   | .13          | %      | $ | 1,379 |   | .25 | % | $ | 280 |   | .05 | % | $ | 1,120 |   | .20 | % |
|              |   |                           |   |                            |   |                        |   |                            |   |         |   |   |   |   |   |   |   |   |   |   |   |
| 60-89 days        |   | 841                            |   | .15                             |   | 127                         |   | .02                             |   | —       |   | — |   | 1,294 |   | .24 |   | 293 |   | .05 |   |
|              |   |                           |   |                            |   |                        |   |                            |   |         |   |   |   |   |   |   |   |   |   |   |   |
| 90 days and over  |   | 1,537                          |   | .28                             |   | 350                         |   | .06                             |   | 99           |   | .02 |   | 131 |   | .02 |   | 614 |   | .11 |   |
|              |   |                           |   |                            |   |                        |   |                            |   |         |   |   |   |   |   |   |   |   |   |   |   |
| Total             |   | $                              | 6,381  |                            |   |                        | $      | 1,198                           |   |         |   | $ | 1,478 |   |   |   | $ | 1,705 |   |   |   | $ | 2,027 |   |   |   |

 

The table above includes a$350,000 construction loan and a $50,000 consumer loan which were over 90 dayspast due at December 31, 2003, but were maintained on accrual status.  These two loans were in the process of beingrefinanced into a single commercial real estate loan and such refinancing wascompleted in 2004.

 

9

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Interest income that would havebeen recorded under the original terms of the Bank’s nonaccruing loans for theyear ended December 31, 2003 amounted to $274,000, and the interest recognizedduring this period amounted to $112,000.

 

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

 
|                                                                               |   | **December  31,**          |   |
|------------------------------------------------------------------------------------|--------|----------------------------|--------|
|                                                                               |   | **2003**                   |   | **2002** |   | **2001** |   | **2000** |   | **1999** |   |
|                                                                               |   | **(Dollars in Thousands)** |   |
| Nonaccrual loans:                                                                  |   |                       |   |   |   |   |   |   |   |   |   |
| Single-family residential                                                          |   | $                          | 1,537  |   | $ | 2,184 |   | $ | 2,024 |   | $ | 1,438 |   | $ | 1,203 |   |
| Multi-family residential                                                           |   | —                     |   | — |   | — |   | — |   | — |   |
| Construction loans                                                                 |   | —                     |   | — |   | 350 |   | — |   | — |   |
| Commercial real estate                                                             |   | 99                         |   | 124 |   | 269 |   | 48 |   | — |   |
| Commercial loans                                                                   |   | 131                        |   | 245 |   | 54 |   | 20 |   | 23 |   |
| Consumer loans                                                                     |   | 564                        |   | 175 |   | 409 |   | 140 |   | 121 |   |
| Total nonaccrual loans                                                             |   | 2,331                      |   | 2,728 |   | 3,106 |   | 1,646 |   | 1,347 |   |
|                                                                               |   |                       |   |   |   |   |   |   |   |   |   |
| Restructured loans                                                                 |   | 1,352                      |   | 4,219 |   | — |   | — |   | — |   |
| Real estate owned                                                                  |   | 822                        |   | 320 |   | 455 |   | 261 |   | 3,940 |   |
|                                                                               |   |                       |   |   |   |   |   |   |   |   |   |
| Total nonperforming assets                                                         |   | $                          | 4,505  |   | $ | 7,267 |   | $ | 3,561 |   | $ | 1,907 |   | $ | 5,287 |   |
|                                                                               |   |                       |   |   |   |   |   |   |   |   |   |
| Total nonaccrual and restructured loans as a percentage of total  loans receivable |   | 0.67                       | %      | 1.37 | % | 0.64 | % | 0.32 | % | 0.28 | % |
|                                                                               |   |                       |   |   |   |   |   |   |   |   |   |
| Total nonperforming assets as a percentage of total assets                         |   | 0.65                       | %      | 1.07 | % | 0.53 | % | 0.27 | % | 0.78 | % |

 

**Classified Assets. **Federal regulations require that each insuredsavings association classify its assets on a regular basis.  In addition, in connection with examinationsof insured institutions, federal examiners have authority to identify problemassets and, if appropriate, classify them. There are three classifications for problem assets: “substandard,”“doubtful” and “loss.”  Substandardassets have one or more defined weaknesses and are characterized by thedistinct possibility that the insured institution will sustain some loss if thedeficiencies are not corrected. Doubtful assets have the weaknesses of substandard assets with theadditional characteristic that the weaknesses make collection or liquidation infull on the basis of currently existing facts, conditions and valuesquestionable, and there is a high possibility of loss.  An asset classified loss is considereduncollectible and of such little value that continuance as an asset of theinstitution is not warranted.  AtDecember 31, 2003, the Bank had $4.5 million of classified assets, $4.4million of which were classified as substandard and $183,000 of which wereclassified as loss.  In addition, atsuch date, the Bank had $4.9 million of assets designated as specialmention.  Special mention assets have potentialweaknesses that deserve management’s close attention.  If left uncorrected, these potential weaknesses may result indeterioration of the repayment prospects for the asset or the institution’scredit position at some future date.

 

**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 theallowance when management believes the uncollectibility of a loan balance isconfirmed.  Subsequent recoveries, ifany, are credited to the allowance.

 

Theallowance for loan losses is evaluated on a regular basis by management and isbased upon management’s periodic review of the collectibility of the loans inlight of historical experience, the nature and volume of the loan portfolio,adverse situations that may affect the borrower’s ability to repay, estimatedvalue of any underlying collateral and prevailing economic conditions.  This evaluation is inherently subjective asit requires estimates that are susceptible to significant revision as moreinformation becomes available.

 

The allowance consists of specific, generaland unallocated components. The specific component relates to loans that areclassified as loss, doubtful, substandard or special mention. For such loansthat are also classified as impaired, an

 

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allowance is established when the discountedcash flows (or collateral value or observable market price) of the impairedloan is lower than the carrying value of that loan. The general componentcovers non-classified loans and is based primarily on historical lossexperience. An unallocated component is maintained to cover uncertainties thatcould affect management’s estimate of probable losses. The unallocatedcomponent of the allowance reflects the margin of imprecision inherent in theunderlying assumptions used in the methodologies for estimating specific andgeneral losses in the portfolio.

 

TheBank reviews its non-homogeneous loans for impairment on a quarterlybasis.  The Bank considers commercialreal estate, construction, multi-family, other non-residential real estate, andcommercial loans to be non-homogeneous loans. A loan is considered impaired when, based on current information andevents, it is probable that the Bank will be unable to collect the scheduledpayments of principal or interest when due according to the contractual termsof the loan agreement.  Factorsconsidered by management in determining impairment include payment status,collateral value, and the probability of collecting scheduled principal andinterest payments when due.  Loans thatexperience insignificant payment delays and payment shortfalls generally arenot classified as impaired.  Managementdetermines the significance of payment delays and payment shortfalls on acase-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 shortfall in relation to 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.

 

Largegroups of smaller balance homogeneous loans are collectively evaluated forimpairment.  Accordingly, the Bank doesnot separately identify individual consumer and residential loans forimpairment disclosures.  Homogeneousloans are those that are considered to have common characteristics that providefor evaluation on an aggregate or pool basis. The Bank considers the characteristics of (1) one- to- four familyresidential first mortgage loans; (2) unsecured consumer loans; and (3)collateralized consumer loans to permit consideration of the appropriateness ofthe allowance for losses of each group of loans on a pool basis.  The primary methodology used to determinethe appropriateness of the allowance for losses includes segregating certainspecific, poorly performing loans based on their performance characteristicsfrom the pools of loans as to type, valuing these loans, and then applying aloss factor to the remaining pool balance based on several factors includingpast loss experience, inherent risks, and economic conditions in the primarymarket areas.

 

Estimatesof the probability of loan losses involve judgment.  While it is possible that in the near term the Bank may sustainlosses which are substantial in relation to the allowance for loan losses, itis the judgment of management that the allowance for loan losses at December31, 2003, is appropriate and adequate considering the estimated probable lossesin the portfolio at such time.

 

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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,** |       |
|----------------------------------------------------------------------------------------|--------|------------------------------|------------|
|                                                                                   |   | **2003**                     |       | **2002** |   | **2001** |   | **2000** |   | **1999** |   |
|                                                                                   |   | **(Dollars  in Thousands)**  | ** ** |
| Total loans outstanding at end of period                                               |   | $                            | 550,215    |   | $ | 506,953 |   | $ | 487,639 |   | $ | 510,819 |   | $ | 474,178 |   |
| Average loans outstanding                                                              |   | $                            | 492,492    |   | $ | 481,330 |   | $ | 488,942 |   | $ | 481,112 |   | $ | 447,631 |   |
| Allowance at beginning of period                                                       |   | $                            | 1,529      |   | $ | 923 |   | $ | 691 |   | $ | 752 |   | $ | 771 |   |
| Charge-offs:                                                                           |   |                         |       |   |   |   |   |   |   |   |   |
| Single-family residential                                                              |   | (73                          | )          | (54 | ) | (75 | ) | (28 | ) | (9 | ) |
| Commercial real estate                                                                 |   | —                       |       | (56 | ) | — |   | — |   | — |   |
| Commercial loans                                                                       |   | (109                         | )          | (415 | ) | (41 | ) | (20 | ) | — |   |
| Consumer loans                                                                         |   | (496                         | )          | (461 | ) | (121 | ) | (40 | ) | (57 | ) |
| Total charge-offs                                                                      |   | (678                         | )          | (986 | ) | (237 | ) | (88 | ) | (66 | ) |
| Recoveries:                                                                            |   |                         |       |   |   |   |   |   |   |   |   |
| Single-family residential                                                              |   | 1                            |       | 6 |   | — |   | — |   | — |   |
| Commercial real estate                                                                 |   | —                       |       | 2 |   | — |   | — |   | — |   |
| Consumer loans                                                                         |   | 79                           |       | 84 |   | 17 |   | 27 |   | 27 |   |
| Total recoveries                                                                       |   | 80                           |       | 92 |   | 17 |   | 27 |   | 27 |   |
| Net charge-offs                                                                        |   | (598                         | )          | (894 | ) | (220 | ) | (61 | ) | (39 | ) |
| Total provisions for losses                                                            |   | 690                          |       | 1,500 |   | 452 |   | — |   | 20 |   |
| Allowance at end of period                                                             |   | $                            | 1,621      |   | $ | 1,529 |   | $ | 923 |   | $ | 691 |   | $ | 752 |   |
|                                                                                   |   |                         |       |   |   |   |   |   |   |   |   |
| Allowance for loan losses as a percentage of total loans outstanding  at end of period |   | 0.29                         | %          | 0.30 | % | 0.19 | % | 0.14 | % | 0.16 | % |
| Net loans charged-off as a percentage of average loans outstanding                     |   | 0.12                         | %          | 0.19 | % | 0.05 | % | 0.01 | % | 0.01 | % |

 

Theincrease in the level of charge-offs during 2002 was primarily the result of a$450,000 charge-off on a single commercial loan and increases in charge-offs onautomobile loans and account balances related to the Bank’s overdraftprotection program introduced in the fourth quarter of 2001.

 

12

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Thefollowing table presents the allocation of the Bank’s allowance for loan lossesby the type of loan at each of the dates indicated.

** **
|                       |   | **December 31,**           |       |
|----------------------------|--------|----------------------------|------------|
|                       |   | **2003**                   |       | **2002** |   | **2001** |   | **2000** |   | **1999** |   |
|                       |   | **Amount**                 |       | **Percentage of  Total Loans  by Category** |   | **Amount** |   | **Percentage of  Total Loans  by Category** |   | **Amount** |   | **Percentage of  Total Loans  by Category** |   | **Amount** |   | **Percentage of  Total Loans  by Category** |   | **Amount** |   | **Percentage of  Total Loans  by Category** |   |
|                       |   | **(Dollars in Thousands)** | ** ** |
| Single-family residential  |   | $                          | 239        |   | 46.67 | % | $ | 128 |   | 57.03 | % | $ | 66 |   | 67.85 | % | $ | 57 |   | 73.87 | % | $ | 50 |   | 77.73 | % |
| Multi-family residential   |   | 31                         |       | 1.82 |   | 1 |   | 1.15 |   | 1 |   | .90 |   | — |   | .72 |   | — |   | .59 |   |
| Commercial real estate (1) |   | 256                        |       | 15.47 |   | 719 |   | 13.14 |   | 240 |   | 9.62 |   | 190 |   | 7.46 |   | 149 |   | 5.49 |   |
| Construction loans         |   | —                     |       | 16.24 |   | — |   | 9.69 |   | 25 |   | 5.09 |   | — |   | 4.88 |   | — |   | 5.44 |   |
| Commercial loans           |   | 404                        |       | 6.12 |   | 209 |   | 5.57 |   | 133 |   | 4.81 |   | 101 |   | 3.96 |   | 31 |   | 2.99 |   |
| Consumer loans             |   | 628                        |       | 13.68 |   | 463 |   | 13.42 |   | 327 |   | 11.73 |   | 158 |   | 9.11 |   | 144 |   | 7.76 |   |
| Unallocated                |   | 63                         |       | — |   | 9 |   | — |   | 131 |   | — |   | 185 |   | — |   | 378 |   | — |   |
| Total                      |   | $                          | 1,621      |   | 100.00 | % | $ | 1,529 |   | 100.00 | % | $ | 923 |   | 100.00 | % | $ | 691 |   | 100.00 | % | $ | 752 |   | 100.00 | % |

 

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(1)** **Theallowance allocated to commercial real estate loans decreased between 2002 and2003 primarily due to two factors.  AtDecember 31, 2002, there was a valuation allowance on an impaired loan that isnot recorded in 2003 and the loss experience factor was revised downward in2003 due to a more established history of low levels of charge-offs.

 

13

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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 and to generate a favorable returnon investments.  The Bank’s investmentpolicy is currently implemented by the Bank’s President/Chief Executive Officerwithin the parameters set by the investment committee and the board ofdirectors.  The Bank is authorized toinvest in obligations issued or fully guaranteed by the U.S. Government,certain federal agency obligations, certain time deposits, negotiablecertificates of deposit issued by commercial banks and other insured financialinstitutions, municipal securities, investment grade corporate debt securitiesand other specified investments.

 

Investmentsecurities that management has the positive intent and ability to hold tomaturity are classified as held to maturity and are reported at amortizedcost.  Investment securities classifiedas available for sale are reported at fair value, with unrealized gains and lossesexcluded from earnings, net of taxes, and reported as a separate component ofequity.  At December 31, 2003, the Bankheld no investment securities classified as available for sale.  At December 31, 2003,approximately $15.5 million of the Bank’s investment securities were pledged ascollateral for certain deposits in excess of $100,000.  In addition, certain U.S. Government andagency securities are pledged as collateral for Federal Home Loan Bank ofDallas (“FHLB”) advances under the FHLB’s blanket lien.  At December 31, 2003, investments in thedebt and/or equity securities of any one issuer, other than those issued byU.S. Government agencies, did not exceed more than 10% of the Company’sstockholders’ equity.

 

Thefollowing table sets forth the amount of investment securities held to maturitywhich contractually mature during each of the periods indicated and theweighted average yields for each range of maturities at December 31,2003.  Weighted average yields formunicipal obligations 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** |   |
|                                   |   | **(In  Thousands)**     |   |
|                                   |   |                    |   |                    |   |                    |   |                 |   |       |   |   |   |   |   |   |   |   |   |   |   |
| Certificates of deposit                |   | $                       | 9,000  |                    | 1.07   | %                       | $      | —               |   | —     |   | $ | — |   | — |   | $ | — |   | — |   | $ | 9,000 |   | 1.07 | % |
| Municipal securities                   |   | —                  |   | —                  |   | 100                     |   | 4.45                 | %      | 1,610      |   | 4.52 | % | 12,593 |   | 4.62 | % | 14,303 |   | 4.60 |   |
| U.S. Government and agency obligations |   | 500                     |   | 5.25                    |   | 2,000                   |   | 4.96                 |   | 8,000      |   | 5.24 |   | 46,576 |   | 5.60 |   | 57,076 |   | 5.53 |   |
| Total                                  |   | $                       | 9,500  |                    | 1.29   | %                       | $      | 2,100                |   | 4.94       | %      | $ | 9,610 |   | 5.12 | % | $ | 59,169 |   | 5.39 | % | $ | 80,379 |   | 4.86 | % |

 

As of December 31, 2003, there wereapproximately $70 million of investment securities at an average interest rateof 5.35% with issuer call options, of which approximately $55 million at anaverage interest rate of 5.51% are callable within one year.  In a rising interest rate environment, theCompany believes that the issuers would not call these investment securities.

 

The following table sets forth the carryingvalue of the Company’s investment securities classified as held tomaturity.  The Company held noinvestment securities as available for sale at the dates indicated.

 
|                                    |   | **December  31,**   |   |
|-----------------------------------------|--------|---------------------|--------|
|                                    |   | **2003**            |   | **2002** |   | **2001** |   |
|                                    |   | **(In  Thousands)** |   |
| Investment securities held to maturity: |   |                |   |   |   |   |   |
| Certificates of deposit                 |   | $                   | 9,000  |   | $ | 40,341 |   | $ | — |   |
| Municipal securities                    |   | 14,303              |   | 8,728 |   | 5,514 |   |
| U.S. Government and agency obligations  |   | 57,076              |   | 65,402 |   | 95,364 |   |
| Total                                   |   | $                   | 80,379 |   | $ | 114,471 |   | $ | 100,878 |   |

 

14

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As a member of the FHLB of Dallas, the Bankis required to maintain an investment in FHLB stock.  At December 31, 2003, the Bank’s investment in FHLB stockamounted to $3.7 million.  No readymarket exists for such stock and it has no quoted market value.

 

**Sources ofFunds**

 

**General.  **Deposits are the primary source of the Bank’s funds for lending andother investment purposes.  In additionto deposits, the Bank derives funds from loan principal repayments andprepayments and interest payments, maturities of investment securities and advancesfrom the FHLB of Dallas.  Loanrepayments are a relatively stable source of funds, while deposit inflows andoutflows are significantly influenced by general interest rates and moneymarket conditions.  Borrowings may beused on a short-term basis to compensate for reductions in the availability offunds from other sources.  They may alsobe used on a longer term basis for general business purposes.

 

**Deposits. **The Bank’s deposit products include a broad selection of depositinstruments, including negotiable order of withdrawal (“NOW”) accounts, demanddeposit accounts (“DDA”), money market accounts, regular savings accounts andterm certificate accounts.  Depositaccount terms vary, with the principal differences being the minimum balancerequired, the time period the funds must remain on deposit, early withdrawalpenalties and the interest rate.

 

The Bank considers its primary market area tobe Northcentral and Northwest Arkansas. The Bank utilizes traditional marketing methods to attract new customersand savings deposits.  The Bank does notadvertise for deposits outside of its primary market area or utilize theservices of deposit brokers, and management believes that an insignificantnumber of deposit accounts were held by non-residents of Arkansas at December31, 2003.

 

The Bank has been competitive in the types ofaccounts and in interest rates it has offered on its deposit products but doesnot necessarily seek to match the highest rates paid by competinginstitutions.  Although market demand generallydictates which deposit maturities and rates will be accepted by the public, theBank intends to continue to promote longer-term deposits to the extent possibleand consistent with its asset and liability management goals.

 

The following table shows the distributionof, and certain other information relating to, the Bank’s deposits by type ofdeposit, as of the dates indicated.

 
|                       |   | **December  31,**          |    |
|----------------------------|--------|----------------------------|---------|
|                       |   | **2003**                   |    | **2002** |   | **2001** |   |
|                       |   | **Amount**                 |    | **%** |   | **Amount** |   | **%** |   | **Amount** |   | **%** |   |
|                       |   | **(Dollars in Thousands)** |    |
| Certificate accounts:      |   |                       |    |   |   |   |   |   |   |   |   |   |   |
| Less than 3.00%            |   | $                          | 180,301 |   | 31.4 | % | $ | 136,015 |   | 23.9 | % | $ | 46,651 |   | 8.4 | % |
| 3.00% - 3.99%              |   | 38,057                     |    | 6.6 |   | 78,571 |   | 13.8 |   | 36,284 |   | 6.5 |   |
| 4.00% - 5.99%              |   | 99,801                     |    | 17.4 |   | 118,401 |   | 20.8 |   | 212,212 |   | 38.2 |   |
| 6.00% - 7.99%              |   | 21,271                     |    | 3.7 |   | 34,547 |   | 6.1 |   | 116,809 |   | 21.0 |   |
| 8.00% and over             |   | 391                        |    | 0.1 |   | 6,585 |   | 1.2 |   | 6,225 |   | 1.1 |   |
| Total certificate accounts |   | 339,821                    |    | 59.2 |   | 374,119 |   | 65.8 |   | 418,181 |   | 75.2 |   |
|                       |   |                       |    |   |   |   |   |   |   |   |   |   |   |
| Transaction accounts:      |   |                       |    |   |   |   |   |   |   |   |   |   |   |
| Statement savings          |   | 29,269                     |    | 5.1 |   | 27,772 |   | 4.9 |   | 26,784 |   | 4.8 |   |
| Money market accounts      |   | 108,400                    |    | 18.9 |   | 80,020 |   | 14.1 |   | 35,119 |   | 6.3 |   |
| NOW accounts/DDA           |   | 96,090                     |    | 16.8 |   | 86,851 |   | 15.2 |   | 75,849 |   | 13.7 |   |
| Total transaction accounts |   | 233,759                    |    | 40.8 |   | 194,643 |   | 34.2 |   | 137,752 |   | 24.8 |   |
| Total deposits             |   | $                          | 573,580 |   | 100.0 | % | $ | 568,762 |   | 100.0 | % | $ | 555,933 |   | 100.0 | % |

 

15

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The following table presentsthe average balance of each type of deposit and the average rate paid on eachtype of deposit and/or total deposits for the periods indicated.

 
|                       |   | **Year Ended****December 31,** |    |
|----------------------------|--------|--------------------------------|---------|
|                       |   | **2003**                       |    | **2002** |   | **2001** |   |
|                       |   | **Average  Balance**           |    | **Average  Rate  Paid** |   | **Average  Balance** |   | **Average  Rate  Paid** |   | **Average  Balance** |   | **Average  Rate  Paid** |   |
|                       |   | **(Dollars in Thousands)**     |    |
| Statement savings accounts |   | $                              | 28,664  |   | 0.66 | % | $ | 27,955 |   | 1.04 | % | $ | 25,669 |   | 2.41 | % |
| Money market accounts      |   | 99,426                         |    | 1.71 |   | 67,814 |   | 2.42 |   | 22,342 |   | 3.29 |   |
| NOW accounts               |   | 69,168                         |    | .73 |   | 61,532 |   | 1.26 |   | 52,519 |   | 2.26 |   |
| Demand deposit accounts    |   | 23,969                         |    | — |   | 19,619 |   | — |   | 16,312 |   | — |   |
| Certificates of deposit    |   | 350,180                        |    | 3.49 |   | 389,127 |   | 4.30 |   | 427,077 |   | 5.84 |   |
| Total deposits             |   | $                              | 571,407 |   | 2.56 | % | $ | 566,047 |   | 3.44 | % | $ | 543,919 |   | 5.06 | % |

 

The following table presents, by variousinterest rate categories, the amount of certificates of deposit atDecember 31, 2003 and 2002 and the amounts at December 31, 2003 whichmature during the periods indicated.

 
|                       |   | **December  31,**  |    | **Balance at December 31, 2003  Maturing in the 12 Months Ending December 31,** |   |
|----------------------------|--------|--------------------|---------|---------------------------------------------------------------------------------|--------|
|                       |   | **2003**           |    | **2002**                                                                        |   | **2004** |   | **2005** |   | **2006** |   | **Thereafter** |   |
|                       |   | **(In Thousands)** |    |
| Certificate accounts:      |   |               |    |                                                                            |   |   |   |   |   |   |   |   |   |
| Less than 3.00%            |   | $                  | 180,301 |                                                                            | $      | 136,015 |   | $ | 143,030 |   | $ | 25,697 |   | $ | 9,675 |   | $ | 1,899 |   |
| 3.00% - 3.99%              |   | 38,057             |    | 78,571                                                                          |   | 19,997 |   | 908 |   | 3,580 |   | 13,572 |   |
| 4.00% - 5.99%              |   | 99,801             |    | 118,401                                                                         |   | 19,237 |   | 12,894 |   | 18,442 |   | 49,228 |   |
| 6.00% - 7.99%              |   | 21,271             |    | 34,547                                                                          |   | 5,321 |   | 8,190 |   | 3,994 |   | 3,766 |   |
| 8.00% and over             |   | 391                |    | 6,585                                                                           |   | — |   | — |   | 391 |   | — |   |
| Total certificate accounts |   | $                  | 339,821 |                                                                            | $      | 374,119 |   | $ | 187,585 |   | $ | 47,689 |   | $ | 36,082 |   | $ | 68,465 |   |

 

The following table sets forth maturities ofthe Bank’s certificates of deposit of $100,000 or more atDecember 31, 2003 by time remaining to maturity.

 

|                                                           |   | **Amount**          |   |
|----------------------------------------------------------------|--------|---------------------|--------|
|                                                           |   | **(In  Thousands)** |   |
| Period Ending:                                                 |   |                |   |
| March 31, 2004                                                 |   | $                   | 10,831 |   |
| June 30, 2004                                                  |   | 17,571              |   |
| September 30, 2004                                             |   | 9,357               |   |
| December 31, 2004                                              |   | 3,687               |   |
| After December 31, 2004                                        |   | 38,657              |   |
| Total certificates of deposit withbalances of $100,000 or more |   | $                   | 80,103 |   |

 

**Borrowedfunds.**  The Bank utilizes FHLB advances in itsnormal operating and investing activities. The Bank pledges as collateral for FHLB advances its FHLB stock and FHLBdemand deposit account and has entered into a blanket collateral agreement withthe FHLB.  Eligible collateral under theblanket lien includes First Mortgage Collateral (as defined), multifamilyresidential mortgages meeting the requirements for eligibility as FirstMortgage Collateral, U.S. Government and Agency Securities (as defined),privately issued mortgage-backed securities that qualify as eligible collateralunder applicable regulations, FHLB Term Deposit Accounts, and othernon-securitized real estate related collateral.

 

16

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Advances at December 31, 2003, have maturitydates and weighted average rates as follows:

 

| **Year Ending  December 31,** |   | **Weighted  Average  Rate** |   | **Amount**                  |   |
|-------------------------------|--------|-----------------------------|--------|-----------------------------|--------|
|                          |   |                        |   | **(Dollars  in Thousands)** |   |
| 2004                          |   | 2.22                        | %      | $                           | 15,456 |   |
| 2005                          |   | 4.79                        |   | 9,503                       |   |
| 2006                          |   | 2.93                        |   | 4,740                       |   |
| 2007                          |   | 3.53                        |   | 5,551                       |   |
| 2008                          |   | 2.96                        |   | 1,677                       |   |
| Thereafter                    |   | 4.06                        |   | 2,635                       |   |
| Total                         |   | 3.26                        | %      | $                           | 39,562 |   |

 

The following table sets forth informationwith respect to the Company’s FHLB advances at and during the periodsindicated.

 
|                            |   | **At or For  the Year Ended December 31,** |   |
|---------------------------------|--------|--------------------------------------------|--------|
|                            |   | **2003**                                   |   | **2002** |   | **2001** |   |
|                            |   | **(Dollars  in Thousands)**                |   |
| Maximum balance                 |   | $                                          | 49,458 |   | $ | 47,844 |   | $ | 93,359 |   |
| Average balance                 |   | 43,321                                     |   | 38,434 |   | 66,409 |   |
| Year end balance                |   | 39,562                                     |   | 38,610 |   | 47,844 |   |
| Weighted averageinterest  rate: |   |                                       |   |   |   |   |   |
| At end of year                  |   | 3.26                                       | %      | 3.86 | % | 6.41 | % |
| During the year                 |   | 3.18                                       |   | 5.69 |   | 6.57 |   |
|                                 |        |                                            |        |  |  |  |  |  |  |  |

 

## **Subsidiaries**

 

The Bank is permitted to invest up to 2% ofits assets in the capital stock of, or secured or unsecured loans to,subsidiary corporations, with an additional investment of 1% of assets whensuch additional investment is utilized primarily for community developmentpurposes.  The Bank’s only subsidiary,First Harrison Service Corporation (the “Service Corporation”), was formed in1971.  At December 31, 2003, the ServiceCorporation was inactive.

 

**REGULATION**

 

*Set forthbelow is a brief description of those laws and regulations which, together withthe descriptions of laws and regulations contained elsewhere herein, are deemedmaterial to an investor’s understanding of the extent to which the Company andthe Bank are regulated.  The descriptionof the laws and regulations hereunder, as well as descriptions of laws andregulations contained elsewhere herein, does not purport to be complete and isqualified in its entirety by reference to applicable laws and regulations.*

 

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**The Company**

 

**General. **The Company, as a savings and loan holding company within the meaningof the Home Owners Loan Act (“HOLA”), has registered with the OTS and issubject to OTS regulations, examinations, supervision and reportingrequirements.  As a subsidiary of asavings and loan holding company, the Bank is subject to certain restrictionsin its dealings with the Company and affiliates thereof.

 

**HoldingCompany Acquisitions. **Federal law generally prohibits a savings andloan holding company, without prior OTS approval, from acquiring the ownershipor control of any other savings institution or savings and loan holdingcompany, or all, or substantially all, of the assets or more than 5% of thevoting shares thereof.  These provisionsalso prohibit, among other things, any director or officer of a savings andloan holding company, or any individual who owns or controls more than 25% ofthe voting shares of such holding company, from acquiring control of anysavings institution not a subsidiary of such savings and loan holding company,unless the acquisition is approved by the OTS.

 

**HoldingCompany Activities. **The Company operates as a unitary savings andloan holding company.  As a result ofrecently enacted legislation, the activities of a new unitary savings and loanholding company like the Company and its non-savings institution subsidiariesare restricted to activities traditionally permitted to multiple savings andloan holding companies and to financial holding companies under newly addedprovisions of the Bank Holding Company Act. Multiple savings 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 theFederal Reserve 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.

 

The activities financial holding companiesmay engage in include:

 

•                                          lending, exchanging, transferring orinvesting for others, or safeguarding money or securities;

 

•                                          insuring, guaranteeing or indemnifyingothers, issuing annuities, and acting as principal, agent or broker forpurposes of the foregoing;

 

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

 

•              issuing or selling interests inpooled assets that a bank could hold directly;

 

•              underwriting,dealing in or making a market in securities; and

 

•              merchantbanking activities.

 

If the OTS determines that there isreasonable cause to believe that the continuation by a savings and loan holdingcompany of an activity constitutes a serious risk to the financial safety,soundness or stability of its subsidiary savings institution, the OTS mayimpose such restrictions as deemed necessary to address such risk.  These restrictions include limiting thefollowing:

 

•              thepayment of dividends by the savings institution;

 

18

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•              transactionsbetween the savings institution and its affiliates; and

 

•                                          any activities of the savings institutionthat might create a serious risk that the liabilities of the holding companyand its affiliates may be imposed on the savings institution.

 

Every savings institution subsidiary of asavings and loan holding company is required to give the OTS at least 30 days’advance notice of any proposed dividends to be made on its guaranteed,permanent or other non-withdrawable stock, or else such dividend will beinvalid.

 

**Restrictionson Transactions with Affiliates**.   Transactions between asavings institution and its “affiliates” are subject to quantitative andqualitative restrictions under Sections 23A and 23B of the Federal Reserve Actand OTS regulations.  Affiliates of asavings institution generally include, among other entities, the savingsinstitution’s holding company and companies that are controlled by or undercommon control with the savings institution.

 

In general, a savings institution or itssubsidiaries may engage in certain “covered transactions” with affiliates up tocertain limits.  In addition, a savingsinstitution and its subsidiaries may engage in covered transactions and certainother transactions only on terms and under circumstances that are substantiallythe same, or at least as favorable to the savings institution or itssubsidiary, as those prevailing at the time for comparable transactions withnonaffiliated companies.  A “coveredtransaction” is defined to include a loan or extension of credit to anaffiliate; a purchase of investment securities issued by an affiliate; apurchase of assets from an affiliate, with certain exceptions; the acceptanceof securities issued by an affiliate as collateral for a loan or extension ofcredit to any party; or the issuance of a guarantee, acceptance or letter ofcredit on behalf of an affiliate.  Inaddition, a savings institution may not:

 

•                                          make a loan or extension of credit to anaffiliate unless the affiliate is engaged only in activities permissible forbank holding companies;

 

•                                          purchase or invest in securities of anaffiliate other than shares of a subsidiary;

•                                          purchase a low-quality asset from anaffiliate; or

 

•                                          engage in covered transactions and certainother transactions between a savings institution or its subsidiaries and anaffiliate except on terms and conditions that are consistent with safe andsound banking practices.

 

With certain exceptions, each loan orextension of credit by a savings institution to an affiliate must be secured bycollateral with a market value ranging from 100% to 130% (depending on the typeof collateral) of the amount of the loan or extension of credit.

 

**Sarbanes-OxleyAct of 2002*.**** *OnJuly 30, 2002, President George W. Bush signed into law the Sarbanes-Oxley Actof 2002, which generally establishes a comprehensive framework to modernize andreform the oversight of public company auditing, improve the quality andtransparency of financial reporting by those companies and strengthen theindependence of auditors.  Certain ofthe legislation’s more significant reforms are noted below.

 

The legislation creates apublic company accounting oversight board which is empowered to set auditing,quality control and ethics standards, to inspect registered public accountingfirms, to conduct investigations and to take disciplinary actions, subject toSEC oversight and review.  The boardwill be funded by mandatory fees paid by all public companies. The legislation alsoimproves the Financial Accounting Standards Board, giving it full financialindependence from the accounting industry.

 

The legislation strengthensauditor independence from corporate management by, among other things, limitingthe scope of consulting services that auditors can offer their public companyaudit clients.

 

The legislation heightens theresponsibility of public company directors and senior managers for the qualityof the financial reporting and disclosure made by their companies.  Among other things, the legislation providesfor a strong public company audit committee that will be directly responsiblefor the appointment, compensation and oversight of the work of the publiccompany auditors.

 

The legislation contains anumber of provisions to deter wrongdoing. CEOs and CFOs will have to certify that company financial statementsfairly present the company’s financial condition.  If a misleading financial statement later resulted in

 

19

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a restatement, the CEO and CFOmust forfeit and return to the company any bonus, stock or stock optioncompensation received in the twelve months following the misleading financialreport.  The legislation also prohibits anycompany officer or director from attempting to mislead or coerce anauditor.  Among other reforms, thelegislation empowers the SEC to bar certain persons from serving as officers ordirectors of a public company; prohibits insider trades during pension fund“blackout periods;” directs the SEC to adopt rules requiring attorneys toreport securities law violations; and requires that civil penalties imposed bythe SEC go into a disgorgement fund to benefit harmed investors.

 

The legislation imposes a rangeof corporate disclosure requirements.  Amongother things, the legislation requires public companies to report alloff-balance-sheet transactions and conflicts, as well as to present any proforma disclosures in a way that is not misleading and in accordance withrequirements to be established by the SEC. The legislation also accelerated the required reporting of insidertransactions, which now generally must be reported by the end of the secondbusiness day following a covered transaction; requires that annual reportsfiled with the SEC include a statement by management asserting that it isresponsible for creating and maintaining adequate internal controls andassessing the effectiveness of those controls; and requires companies todisclose whether or not they have adopted an ethics code for senior financialofficers, and, if not, why not, and whether the audit committee includes atleast one “financial expert,” as defined by the SEC.  The legislation also requires the SEC, based on certainenumerated factors, to regularly and systematically review corporate filings.

 

The legislation containsprovisions which generally seek to limit and expose to public view possibleconflicts of interest affecting securities analysts.

 

Finally, the legislationimposes a range of criminal penalties for fraud and other wrongful acts, aswell as extends the period during which certain types of lawsuits can bebrought against a company or its insiders.

 

**The Bank**

 

**General. **The OTS has extensive authority over the operations of federallychartered savings institutions.  As partof this authority, savings institutions are required to file periodic reportswith the OTS and are subject to periodic examinations by the OTS and theFDIC.  The last regulatory examinationof the Bank by the OTS was completed in November 2002.  The Bank was not required to make anymaterial changes to its operations as a result of such examination.  The investment and lending authority ofsavings institutions are prescribed by federal laws and regulations, and suchinstitutions are prohibited from engaging in any activities not permitted bysuch laws and regulations.  Those lawsand regulations generally are applicable to all federally chartered savingsinstitutions and may also apply to state-chartered savings institutions.  Such regulation and supervision is primarilyintended for the protection of depositors.

 

The OTS’ enforcement authority over allsavings institutions and their holding companies includes, among other things,the ability to assess civil money penalties, to issue cease and desist orremoval orders and to initiate injunctive actions.  In general, these enforcement actions may be initiated forviolations of laws and regulations and unsafe or unsound practices.  Other actions or inactions may provide thebasis for enforcement action, including misleading or untimely reports filedwith the OTS.

 

**Insuranceof Accounts. **The deposits of the Bank are insured to themaximum extent permitted by the SAIF, which is administered by the FDIC, andare backed by the full faith and credit of the U.S. Government.  As insurer, the FDIC is authorized toconduct examinations of, and to require reporting by, FDIC-insuredinstitutions.  It also may prohibit anyFDIC-insured institution from engaging in any activity the FDIC determines byregulation 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.

 

Currently, FDIC deposit insurance ratesgenerally range from zero basis points to 27 basis points, depending on theassessment risk classification assigned to the depository institution.  The FDIC also assesses depositoryinstitutions the Financing Corporation (“FICO”) debt service assessment whichbecame applicable to all insured institutions as of January 1, 1997, inaccordance with the Deposit Insurance Act of 1996.  SAIF and Bank Insurance Fund (“BIF”) members both paidapproximately 1.60 basis points and 1.75 basis points in 2003 and 2002,respectively, for the FICO debt service assessment.

 

The FDIC may terminate the deposit insuranceof any insured depository institution, including the Bank, if it determinesafter a hearing that the institution has engaged or is engaging in unsafe orunsound practices, is in an unsafe or unsound

 

20

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condition to continue operations, or hasviolated any applicable law, regulation, order or any condition imposed by anagreement with the FDIC.  It also maysuspend deposit insurance temporarily during the hearing process for thepermanent termination of insurance, if the institution has no tangiblecapital.  If insurance of accounts isterminated, the accounts at the institution at the time of the termination,less subsequent withdrawals, shall continue to be insured for a period of sixmonths to two years, as determined by the FDIC.  Management is aware of no existing circumstances which wouldresult in termination of the Bank’s deposit insurance.

 

**RegulatoryCapital Requirements.  **Federally insured savings institutions arerequired to maintain minimum levels of regulatory capital.  The OTS has established capital standardsapplicable to all savings institutions. These standards generally must be as stringent as the comparable capitalrequirements imposed on national banks. The OTS also is authorized to impose capital requirements in excess ofthese standards on individual institutions on a case-by-case basis.

 

Current OTS capital standards require savingsinstitutions to satisfy three different capital requirements.  Under these standards, savings institutionsmust maintain “tangible” capital equal to at least 1.5% of adjusted totalassets, “core” capital equal to at least 4.0% of adjusted total assets and“total” capital (a combination of core and “supplementary” capital) equal to atleast 8.0% of “risk-weighted” assets. For purposes of the regulation, core capital generally consists ofcommon stockholders’ equity (including retained earnings), noncumulativeperpetual preferred stock and related surplus, minority interests in the equityaccounts of fully consolidated subsidiaries, certain nonwithdrawable accountsand pledged deposits and “qualifying supervisory goodwill.”  Tangible capital is given the samedefinition as core capital but does not include qualifying supervisory goodwilland is reduced by the amount of all the savings institution’s intangibleassets, with only a limited exception for purchased mortgage servicingrights.  Both core and tangible capitalare further reduced by an amount equal to a savings institution’s debt andequity investments in subsidiaries engaged in activities not permissible tonational banks (other than subsidiaries engaged in activities undertaken asagent for customers or in mortgage banking activities and subsidiary depositoryinstitutions or their holding companies). These adjustments do not materially affect the Bank’s regulatorycapital.  At December 31, 2003, the Bankexceeded its tangible, core and risk-based capital requirements.

 

In determining compliance with the risk-basedcapital requirement, a savings institution is allowed to include both corecapital and supplementary capital in its total capital, provided that theamount of supplementary capital included does not exceed the savingsinstitution’s core capital. Supplementary capital generally consists of hybrid capital instruments;perpetual preferred stock which is not eligible to be included as core capital;subordinated debt and intermediate-term preferred stock; and general allowancesfor loan losses up to a maximum of 1.25% of risk-weighted assets.  In determining the required amount ofrisk-based capital, total assets, including certain off-balance sheet items,are multiplied by a risk weight based on the risks inherent in the type ofassets.  The risk weights assigned bythe OTS for principal categories of assets are (i) 0% for cash and securitiesissued by the U.S. Government or unconditionally backed by the full faith andcredit of the U.S. Government; (ii) 20% for securities (other than equitysecurities) issued by U.S. Government-sponsored agencies and mortgage-backedsecurities issued by, or fully guaranteed as to principal and interest by, theFNMA or the FHLMC, except for those classes with residual characteristics or strippedmortgage-related securities; (iii) 50% for prudently underwritten permanentone- to four-family first lien mortgage loans not more than 90 days delinquentand having a loan-to-value ratio of not more than 90% at origination unlessinsured to such ratio by an insurer approved by the FNMA or the FHLMC,qualifying residential bridge loans made directly for the construction of one-to four-family residences and qualifying multi-family residential loans; and(iv) 100% for all other loans and investments, including consumer loans,commercial loans, and one- to four-family residential real estate loansmore than 90 days delinquent, and for repossessed assets.

 

**QualifiedThrift Lender Test. **All savings institutions are required to meeta QTL test to avoid certain restrictions on their operations.  A savings institution that does not meet theQTL test must either convert to a bank charter or comply with the followingrestrictions on its operations: (i) the institution may not engage in any newactivity or make any new investment, directly or indirectly, unless suchactivity or investment is permissible for a national bank; (ii) the branchingpowers of the institution shall be restricted to those of a national bank;(iii) the institution shall not be eligible to obtain any advances from itsFHLB; and (iv) payment of dividends by the institution shall be subject to therules regarding payment of dividends by a national bank.  Upon the expiration of three years from thedate the savings institution ceases to be a QTL, it must cease any activity andnot retain any investment not permissible for a national bank and immediatelyrepay any outstanding FHLB advances (subject to safety and soundnessconsiderations).

 

Currently, the QTL test requires that 65% ofan institution’s “portfolio assets” (as defined) consist of certain housing andconsumer-related assets on a monthly average basis in nine out of every 12months.  Assets that qualify withoutlimit for

 

21

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inclusion as part of the 65% requirement areloans made to purchase, refinance, construct, improve or repair domesticresidential housing and manufactured housing; home equity loans; 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; 100% of consumer and educational loans (limited to 10% of totalportfolio assets); and stock issued by the FHLMC or the FNMA.  Portfolio assets consist of total assetsminus the sum of (i) goodwill and other intangible assets, (ii) propertyused by the savings institution to conduct its business, and (iii) liquidassets up to 20% of the institution’s total assets.  At December 31, 2003, the qualified thrift investments of theBank were approximately 69.1% of its portfolio assets.

 

**FederalHome Loan Bank System. **The Bank is a member of the FHLB of Dallas,which is one of 12 regional FHLBs that administers the home financing creditfunction of savings institutions.  EachFHLB serves as a reserve or central bank for its members within its assignedregion.  It is funded primarily fromproceeds derived from the sale of consolidated obligations of the FHLBSystem.  It makes loans to members(i.e., advances) in accordance with policies and procedures established by theboard of directors of the FHLB.  AtDecember 31, 2003, the Bank had $39.6 million of outstanding FHLB advances.

 

As a member, the Bank is required to purchaseand maintain stock in the FHLB of Dallas in an amount equal to the sum of .20%of total assets as of the previous December 31 and 4.25% of outstandingadvances.  At December 31, 2003, theBank had $3.7 million in FHLB stock, which was in compliance with thisrequirement.  No ready market exists forsuch stock and it has no quoted market value.

 

The FHLBs are required to provide funds forthe resolution of troubled savings institutions and to contribute to affordablehousing programs through direct loans or interest subsidies on advancestargeted for community investment and low- and moderate-income housingprojects.  These contributions haveadversely affected the level of FHLB dividends paid in the past and couldcontinue to do so in the future.  Thesecontributions also could have an adverse effect on the value of FHLB stock inthe future.

 

**FederalReserve System. **The FRB requires all depository institutionsto maintain reserves against their transaction accounts and non-personal timedeposits.  As of December 31, 2003, noreserves were required to be maintained on the first $6.6 million oftransaction accounts, reserves of 3% were required to be maintained against thenext $38.8 million of net transaction accounts (with such dollar amountssubject to adjustment by the FRB), and a reserve of 10% (which is subject toadjustment by the FRB to a level between 8% and 14%) against all remaining nettransaction accounts.  Because requiredreserves must be maintained in the form of vault cash or a noninterest-bearingaccount at a Federal Reserve Bank, the effect of this reserve requirement is toreduce an institution’s earning assets.

 

## **TAXATION**

**FederalTaxation**

 

**General. **The Company and Bank are subject to the generally applicable corporatetax provisions of the Internal Revenue Code of 1986, as amended (“Code”), andthe Bank is subject to certain additional provisions of the Code which apply tothrift and other types of financial institutions.  The following discussion of federal taxation is intended only tosummarize certain pertinent federal income tax matters material to the taxationof the Company and the Bank and is not a comprehensive discussion of the taxrules applicable to the Company and Bank.

 

**Year. **The Bank files a federal income tax return on the basis of a fiscalyear ending on December 31.  The Companyfiled a consolidated federal income tax return with both the Bank and theService Corporation.

 

**Bad DebtReserves. **Prior to the enactment of the Small BusinessJobs Protection Act (the “Act”), which was signed into law on August 21, 1996,certain thrift institutions, such as the Bank, were allowed deductions for baddebts under methods more favorable than those granted to other taxpayers.  Qualified thrift institutions could computedeductions for bad debts using either the specific charge-off method of Section166 of the Code or the reserve method of Section 593 of the Code.

 

Under Section 593, a thrift institutionannually could elect to deduct bad debts under either (i) the “percentage oftaxable income” method applicable only to thrift institutions, or (ii) the“experience” method that also was available to small

 

22

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banks. Under the percentage of taxable income method, a thrift institutiongenerally was allowed a deduction for an addition to its bad debt reserve equalto 8% of its taxable income (determined without regard to this deduction andwith additional adjustments).  Under theexperience method, a thrift institution was generally allowed a deduction foran addition to its bad debt reserve equal to the greater of (i) an amount basedon its actual average experience for losses in the current and five precedingtaxable years, or (ii) an amount necessary to restore the reserve to itsbalance as of the close of the base year. A thrift institution could elect annually to compute its allowableaddition to bad debt reserves for qualifying loans either under the experiencemethod or the percentage of taxable income method.

 

Section 1616(a) of the Act repealed theSection 593 reserve method of accounting for bad debts by thrift institutions,effective for taxable years beginning after 1995.  Thrift institutions that are treated as “small banks” are allowedto utilize the experience method applicable to such institutions, while thrift institutionsthat are treated as “large banks” are required to use only the specificcharge-off method.  The percentage oftaxable income method of accounting for bad debts is no longer available forany financial institution.

 

A thrift institution required to change itsmethod of computing reserves for bad debts will treat such change as a changein the method of accounting, initiated by the taxpayer and having been madewith the consent of the Secretary of the Treasury.  Section 481(a) of the Code requires certain amounts to berecaptured with respect to such change. Generally, the amounts to be recaptured will be determined solely withrespect to the “applicable excess reserves” of the taxpayer.  The amount of the applicable excess reserveswill be taken into account ratably over a period of six taxable years,beginning with the first taxable year after 1995, subject to the residentialloan requirement described below.  Inthe case of a thrift institution that is treated as a large bank, the amount ofthe institution’s applicable excess reserves generally is the excess of (i) thebalance of its reserve for losses on qualifying real property loans (generallyloans secured by improved real estate) and its reserve for losses onnonqualifying loans (all other types of loans) as of the close of its lasttaxable year beginning before January 1, 1996, over (ii) the balances of suchreserves as of the close of its last taxable year beginning before January 1,1988 (i.e., the “pre-1988 reserves”). In the case of a thrift institution that is treated as a small bank, theamount of the institution’s applicable excess reserves generally is the excessof (i) the balance of its reserve for losses on qualifying real property loansand its reserve for losses on nonqualifying loans as of the close of its lasttaxable year beginning before January 1, 1996, over (ii) the greater of thebalance of (a) its pre-1988 reserves or, (b) what the thrift’s reserves wouldhave been at the close of its last year beginning before January 1, 1996, hadthe thrift always used the experience method.

 

For taxable years that begin after December31, 1995, and before January 1, 1998, if a thrift meets the residential loanrequirement for a tax year, the recapture of the applicable excess reserves otherwiserequired to be taken into account as a Code Section 481(a) adjustment for theyear will be suspended.  A thrift meetsthe residential loan requirement if, for the tax year, the principal amount ofresidential loans made by the thrift during the year is not less than its baseamount.  The “base amount” generally isthe average of the principal amounts of the residential loans made by thethrift during the six most recent tax years beginning before January 1,1996.  A residential loan is a loan as describedin Section 7701(a) (19) (C) (v) (generally a loan secured by residential orchurch property and certain mobile homes), but only to the extent that the loanis made to the owner of the property. As of December 31, 2003, the Bank’s applicable excess reserves remainingto be recaptured are $220,513.

 

The balance of the pre-1988 reserves issubject to the provisions of Section 593(e), as modified by the Act, whichrequires recapture in the case of certain excessive distributions toshareholders.  The pre-1988 reserves maynot be utilized for payment of cash dividends or other distributions to ashareholder (including distributions in dissolution or liquidation) or for anyother purpose (except to absorb bad debt losses).  Distribution of a cash dividend by a thrift institution to ashareholder is treated as made:  first,out of the institution’s post-1951 accumulated earnings and profits; second,out of the pre-1988 reserves; and third, out of such other accounts as may beproper.  To the extent a distribution bythe Bank to the Company is deemed paid out of its pre-1988 reserves under theserules, the pre-1988 reserves would be reduced and the Bank’s gross income fortax purposes would be increased by the amount which, when reduced by the incometax, if any, attributable to the inclusion of such amount in its gross income,equals the amount deemed paid out of the pre-1988 reserves.  As of December 31, 2003, the Bank’s pre-1988reserves for tax purposes totaled approximately $4.2 million.

 

**MinimumTax. **The Code imposes an alternative minimum taxat a rate of 20%.  The alternativeminimum tax generally applies to a base of regular taxable income plus certaintax preferences (“alternative minimum taxable income” or “AMTI”) and is payableto the extent such AMTI is in excess of an exemption amount.  The Code provides that an item of taxpreference is the excess of the bad debt deduction allowable for a taxable yearpursuant to the percentage of

 

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taxable income method over the amountallowable under the experience method. Other items of tax preference that constitute AMTI include (a)tax-exempt interest on newly issued (generally, issued on or afterAugust 8, 1986) private activity bonds other than certain qualifiedbonds and (b) 75% of the excess (if any) of (i) adjusted current earnings asdefined in the Code, over (ii) AMTI (determined without regard to thispreference and prior to reduction by net operating losses).

 

**NetOperating Loss Carryovers. **A financial institution may, for federalincome tax purposes, carry back net operating losses (“NOLs”) to the precedingtwo taxable years and forward to the succeeding 20 taxable years.  This provision applies to losses incurred intaxable years beginning after 1997.  TheJob Creation and Worker Assistance Act of 2002 temporarily increased thegeneral NOL carryback period from two years to five years for NOLs arising intaxable years ending in 2001 and 2002. At December 31, 2003, the Bank had no NOL carryforwards for federalincome tax purposes.

 

**CapitalGains and Corporate Dividends-Received Deduction. **Corporatenet capital gains are taxed at a maximum rate of 35%.  The corporate dividends-received deduction is 80% in the case ofdividends received from a “20-percent-owned corporation”, i.e., a corporationhaving at least twenty percent (but generally less than 80 percent) of itsstock owned by the recipient corporation and corporations which own less than20% of the stock of a corporation distributing a dividend may deduct only 70%of dividends received or accrued on their behalf.  However, a corporation may deduct 100% of dividends from a memberof the same affiliated group of corporations.

 

**OtherMatters. **Federal legislation is introduced from timeto time 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 orfurther restrictions on the deductibility of mortgage interest could adverselyaffect the Bank.

 

The Bank’s federal income tax returns for thetax years ended December 31, 2000 forward are open under the statute oflimitations and are subject to review by the IRS.

 

**StateTaxation**

 

The Bank will continue to be subject toArkansas corporation income tax which is a progressive rate up to a maximum of6.7% of all taxable earnings.

 

The Company is incorporated under Texas lawand, accordingly, is subject to Texas franchise tax in an amount equal to 4.5%of net income allocated to Texas pursuant to apportionments of gross receiptsbased upon where the Company conducts business.

 

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**Item2.  Properties****.**

 

At December 31, 2003, the Bank conducted itsbusiness from its executive office in Harrison, Arkansas, and fourteen fullservice offices, all of which are located in Northcentral and NorthwestArkansas.

 

The following table sets forth the net bookvalue (including leasehold improvements and equipment) and certain otherinformation with respect to the offices and other properties of the Bank atDecember 31, 2003.

 
| **Description/Address**                                     |   | **Leased/  Owned** |   | **Net Book  Value  of Property** |   | **Amount of  Deposits** |   |
|-------------------------------------------------------------|--------|--------------------|--------|----------------------------------|--------|-------------------------|--------|
|                                                        |   |               |   | **(In  Thousands)**              |   |
| 1401 Highway 62-65 North  Harrison, AR  72601          |   | Owned              |   | $8,527                           |   | $152,252                |   |
|                                                        |   |               |   |                             |   |                    |   |
| 200 West Stephenson  Harrison, AR 72601                     |   | Owned              |   | 165                              |   | 37,078                  |   |
|                                                        |   |               |   |                             |   |                    |   |
| Corner Central &  Willow  Harrison, AR  72601      |   | Owned              |   | 206                              |   | —                  | (1)    |
|                                                        |   |               |   |                             |   |                    |   |
| 324 Hwy. 62-65 Bypass  Harrison, AR  72601             |   | Owned              |   | 237                              |   | 48,852                  |   |
|                                                        |   |               |   |                             |   |                    |   |
| 210 South Main  Berryville, AR  72616                  |   | Owned              |   | 186                              |   | 30,544                  |   |
|                                                        |   |               |   |                             |   |                    |   |
| 668 Highway 62 East  Mountain Home, AR  72653          |   | Owned              |   | 490                              |   | 134,479                 |   |
|                                                        |   |               |   |                             |   |                    |   |
| 1337 Highway 62 SW  Mountain Home, AR 72653                 |   | Owned              |   | 877                              |   | 18,137                  |   |
|                                                        |   |               |   |                             |   |                    |   |
| 301 Highway 62 West  Yellville, AR  72687              |   | Owned              |   | 132                              |   | 21,651                  |   |
|                                                        |   |               |   |                             |   |                    |   |
| 307 North Walton Blvd.  Bentonville, AR  72712         |   | Owned              |   | 378                              |   | 34,733                  |   |
|                                                        |   |               |   |                             |   |                    |   |
| 2501 E. Central Ave.,  Suite 2  Bentonville, AR  72712 |   | Leased             | (3)    | 223                              |   | 520                     |   |
|                                                        |   |               |   |                             |   |                    |   |
| 3460 North College  Fayetteville, AR  72703            |   | Owned              |   | 380                              |   | 42,468                  |   |
|                                                        |   |               |   |                             |   |                    |   |
| 1303 West Hudson  Rogers, AR  72756                    |   | Owned              |   | 193                              |   | 3,653                   |   |
|                                                        |   |               |   |                             |   |                    |   |
| 201 East Henri De Tonti  Blvd.  Tontitown, AR  72764   |   | Owned              |   | 185                              |   | 12,765                  |   |
|                                                        |   |               |   |                             |   |                    |   |
| 2025 North Crossover Road  Fayetteville, AR 72703           |   | Owned              |   | 723                              |   | 12,839                  |   |
|                                                        |   |               |   |                             |   |                    |   |
| 249 West Main Street  Farmington, AR 72730                  |   | Leased             | (2)    | 137                              |   | 9,902                   |   |
|                                                        |   |               |   |                             |   |                    |   |
| 2030 West Elm  Rogers, AR 72756                             |   | Owned              |   | 512                              |   | 13,707                  |   |
|                                                        |   |               |   |                             |   |                    |   |
| 1023 East Millsap Road  Fayetteville, AR  72703        |   | Owned              |   | 687                              |   | —                  | (1)    |

 

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(1)                                  Such offices do not open deposit accounts.

(2)                                  Such property is subject to a five-year leaseexpiring November 1, 2007.

(3)                                  Such property is subject to a five-year leaseexpiring August 1, 2008, with three five-year renewal options.

 

25

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**Item 3.  LegalProceedings.**

 

Neither the Company nor theBank is involved in any pending legal proceedings other than nonmaterial legalproceedings occurring in the ordinary course of business.

 

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

 

No matters were submitted toa vote of security holders during the fourth quarter of 2003.

 

**PART II.**

 

**Item 5.  Market forRegistrant’s Common Equity and Related Stockholder Matters.**

 

Shares of the Company’s common stock aretraded under the symbol “FFBH” on the Nasdaq National Market System.  At March 2, 2004, the Company had5,315,256 shares of common stock outstanding and had approximately 2,000 beneficialholders of common stock.

 

The following table sets forth the dividendsdeclared and the reported high and low sale prices of a share of the Company’scommon stock as reported by Nasdaq for the periods indicated.   Such table has been adjusted for thetwo-for-one stock split paid on December 31, 2003.

** **
| **QUARTER**      |   | **YEAR ENDED  DECEMBER 31, 2003** |       | **YEAR ENDED  DECEMBER 31, 2002** |       |
|------------------|--------|-----------------------------------|------------|-----------------------------------|------------|
| **ENDED**        |   | **High**                          |       | **Low**                           |       | **Dividend** |   | **High** |   | **Low** |   | **Dividend** |   |
| **March 31**     |   | **$**                             | **13.11**  | ** **                        | **$**      | **12.66** | ** ** | **$** | **0.08** | ** ** | **$** | **12.00** | ** ** | **$** | **11.13** | ** ** | **$** | **0.06** | ** ** |
|             |   |                              | ** ** |                              | ** ** |   | ** ** |   | ** ** |   | ** ** |   | ** ** |
| **June 30**      |   | **$**                             | **16.75**  | ** **                        | **$**      | **12.87** | ** ** | **$** | **0.08** | ** ** | **$** | **13.18** | ** ** | **$** | **11.63** | ** ** | **$** | **0.06** | ** ** |
|             |   |                              | ** ** |                              | ** ** |   | ** ** |   | ** ** |   | ** ** |   | ** ** |
| **September 30** |   | **$**                             | **18.95**  | ** **                        | **$**      | **15.86** | ** ** | **$** | **0.09** | ** ** | **$** | **12.90** | ** ** | **$** | **12.05** | ** ** | **$** | **0.07** | ** ** |
|             |   |                              | ** ** |                              | ** ** |   | ** ** |   | ** ** |   | ** ** |   | ** ** |
| **December 31**  |   | **$**                             | **20.50**  | ** **                        | **$**      | **18.39** | ** ** | **$** | **0.09** | ** ** | **$** | **12.97** | ** ** | **$** | **11.90** | ** ** | **$** | **0.07** | ** ** |

 

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

 

**SELECTED CONSOLIDATEDFINANCIAL AND OTHER DATA**

 

The selected consolidated financial and otherdata of the Company set forth below and on the following page is not completeand should be read in conjunction with, and is qualified in its entirety by,the more detailed information, including the Consolidated Financial Statementsand related Notes, appearing elsewhere herein.

 
|                                                |   | **At  or For the  Year Ended December 31,** |    |
|-----------------------------------------------------|--------|---------------------------------------------|---------|
|                                                |   | **2003**                                    |    | **2002** |   | **2001** |   | **2000** |   | **1999** |   |
|                                                |   | **(In  Thousands, Except Per Share Data)**  |    |
|                                                |   |                                        |    |   |   |   |   |   |   |   |   |
| **Selected Financial  Condition Data:**             |   |                                        |    |   |   |   |   |   |   |   |   |
| Total assets                                        |   | $                                           | 690,653 |   | $ | 679,896 |   | $ | 680,255 |   | $ | 713,902 |   | $ | 680,719 |   |
| Cash and cash equivalents                           |   | 56,201                                      |    | 44,493 |   | 72,326 |   | 11,564 |   | 9,983 |   |
| Investment securities                               |   | 80,379                                      |    | 114,471 |   | 100,878 |   | 184,310 |   | 189,263 |   |
| Loans receivable, net                               |   | 512,756                                     |    | 483,468 |   | 474,494 |   | 498,305 |   | 459,978 |   |
| Allowance for loan losses                           |   | 1,621                                       |    | 1,529 |   | 923 |   | 691 |   | 752 |   |
| Deposits                                            |   | 573,580                                     |    | 568,762 |   | 555,933 |   | 540,327 |   | 507,875 |   |
| Federal Home Loan Bank advances                     |   | 39,562                                      |    | 38,610 |   | 47,844 |   | 93,359 |   | 83,972 |   |
| Stockholders’ equity                           |   | 75,078                                      |    | 69,266 |   | 71,065 |   | 76,622 |   | 78,815 |   |
|                                                |   |                                        |    |   |   |   |   |   |   |   |   |
| **Selected Operating  Data:**                       |   |                                        |    |   |   |   |   |   |   |   |   |
| Interest income                                     |   | $                                           | 38,745  |   | $ | 44,094 |   | $ | 50,152 |   | $ | 51,982 |   | $ | 47,066 |   |
| Interest expense                                    |   | 15,986                                      |    | 21,633 |   | 31,862 |   | 33,243 |   | 27,799 |   |
| Net interest income                                 |   | 22,759                                      |    | 22,461 |   | 18,290 |   | 18,739 |   | 19,267 |   |
| Provision for loan losses                           |   | 690                                         |    | 1,500 |   | 452 |   | —— |   | 20 |   |
| Net interest income after provision for loan losses |   | 22,069                                      |    | 20,961 |   | 17,838 |   | 18,739 |   | 19,247 |   |
| Noninterest income                                  |   | 6,989                                       |    | 5,346 |   | 3,745 |   | 1,998 |   | 1,776 |   |
| Noninterest expense                                 |   | 18,263                                      |    | 14,524 |   | 13,596 |   | 12,398 |   | 11,594 |   |
| Income before income taxes                          |   | 10,795                                      |    | 11,783 |   | 7,987 |   | 8,339 |   | 9,429 |   |
| Provision for income taxes                          |   | 3,339                                       |    | 4,005 |   | 2,527 |   | 2,747 |   | 3,149 |   |
| Net income                                          |   | $                                           | 7,456   |   | $ | 7,778 |   | $ | 5,460 |   | $ | 5,592 |   | $ | 6,280 |   |
|                                                |   |                                        |    |   |   |   |   |   |   |   |   |
| **Earnings per Share  (1):**                        |   |                                        |    |   |   |   |   |   |   |   |   |
| Basic                                               |   | $                                           | 1.46    |   | $ | 1.44 |   | $ | 0.88 |   | $ | 0.80 |   | $ | 0.78 |   |
| Diluted                                             |   | 1.38                                        |    | 1.38 |   | 0.87 |   | 0.80 |   | 0.78 |   |
|                                                |   |                                        |    |   |   |   |   |   |   |   |   |
| **Cash Dividends  Declared per Share (1)**          |   | $                                           | 0.34    |   | $ | 0.26 |   | $ | 0.22 |   | $ | 0.20 |   | $ | 0.16 |   |

 

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(1) Per share amounts have been restated for the two-for-one stock splitthat was paid on December 31, 2003.

 

27

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|                                                                        |   | **At or For the Year Ended December 31,** |   |
|-----------------------------------------------------------------------------|--------|-------------------------------------------|--------|
|                                                                        |   | **2003**                                  |   | **2002** |   | **2001** |   | **2000** |   | **1999** |   |
| **Selected Operating  Ratios(1):**                                          |   |                                      |   |   |   |   |   |   |   |   |   |
| Return on average assets                                                    |   | 1.08                                      | %      | 1.14 | % | .79 | % | .80 | % | .97 | % |
| Return on average equity                                                    |   | 10.25                                     |   | 11.01 |   | 7.36 |   | 7.21 |   | 7.84 |   |
| Average equity to average assets                                            |   | 10.52                                     |   | 10.39 |   | 10.74 |   | 11.07 |   | 12.41 |   |
| Interest rate spread(2)                                                     |   | 3.40                                      |   | 3.30 |   | 2.35 |   | 2.29 |   | 2.59 |   |
| Net interest margin(2)                                                      |   | 3.52                                      |   | 3.50 |   | 2.76 |   | 2.77 |   | 3.10 |   |
| Net interest income after provision  for loan losses to noninterest expense |   | 120.84                                    |   | 144.32 |   | 131.20 |   | 151.14 |   | 166.02 |   |
| Noninterest expense to average  assets                                      |   | 2.64                                      |   | 2.14 |   | 1.97 |   | 1.77 |   | 1.80 |   |
| Average interest-earning assets to average  interest-bearing liabilities    |   | 105.08                                    |   | 106.10 |   | 108.61 |   | 109.77 |   | 111.21 |   |
| Operating efficiency(3)                                                     |   | 61.39                                     |   | 52.23 |   | 61.70 |   | 59.79 |   | 55.15 |   |
|                                                                        |   |                                      |   |   |   |   |   |   |   |   |   |
| **Asset Quality  Ratios(4):**                                               |   |                                      |   |   |   |   |   |   |   |   |   |
| Nonaccrual and restructured loans to  total loans(5)                        |   | 0.67                                      |   | 1.37 |   | 0.64 |   | 0.32 |   | 0.28 |   |
| Nonperforming assets to total  assets(5)                                    |   | 0.66                                      |   | 1.07 |   | 0.53 |   | 0.27 |   | 0.78 |   |
| Allowance for loan losses to non-  performing loans(5)                      |   | 43.69                                     |   | 22.01 |   | 29.71 |   | 41.96 |   | 55.82 |   |
| Allowance for loan losses to total  loans                                   |   | 0.29                                      |   | 0.30 |   | 0.19 |   | 0.14 |   | 0.16 |   |
|                                                                        |   |                                      |   |   |   |   |   |   |   |   |   |
| **Capital Ratios(6):**                                                      |   |                                      |   |   |   |   |   |   |   |   |   |
| Tangible capital to adjusted total  assets                                  |   | 10.27                                     |   | 9.78 |   | 9.79 |   | 10.37 |   | 11.09 |   |
| Core capital to adjusted total  assets                                      |   | 10.27                                     |   | 9.78 |   | 9.79 |   | 10.37 |   | 11.09 |   |
| Risk-based capital to risk-weighted  Assets                                 |   | 16.25                                     |   | 17.03 |   | 17.29 |   | 19.69 |   | 21.52 |   |
|                                                                        |   |                                      |   |   |   |   |   |   |   |   |   |
| **Other Data:**                                                             |   |                                      |   |   |   |   |   |   |   |   |   |
| Dividend payout ratio(7)                                                    |   | 24.32                                     |   | 18.91 |   | 26.33 |   | 26.39 |   | 21.66 |   |
| Full service offices at end  of period                                      |   | 15                                        |   | 14 |   | 14 |   | 14 |   | 13 |   |

 

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(1)                                  Ratios arebased on average daily balances.

 

(2)                                  Interestrate spread represents the difference between the weighted average yield onaverage interest-earning assets and the weighted average cost of averageinterest-bearing liabilities, and net interest margin represents net interestincome as a percent of average interest-earning assets.

 

(3)                                  Noninterestexpense to net interest income plus noninterest income.

 

(4)                                  Assetquality ratios are end of period ratios.

 

(5)                                  Nonperforming assets consist ofnonperforming loans and real estate owned (“REO”).  Nonperforming loans consist of nonaccrual loans and restructuredloans while REO consists of real estate acquired in settlement of loans.

 

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

 

(7)                                  Dividend payout ratiois the total dividends declared divided by net income.

 

28

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**Item 7.  Management’sDiscussion and Analysis of Financial Condition and Results of Operations.**

 

**GENERAL**

 

Management’sdiscussion and analysis of financial condition and results of operations isintended to assist a reader inunderstanding the consolidated financial condition and results ofoperations of the Company for the periods presented.  The information contained in this sectionshould be read in conjunction with the Consolidated Financial Statements and theaccompanying Notes to Consolidated Financial Statements and the other sectionscontained herein.

 

The Bank is a federallychartered stock savings and loan association formed in 1934.  First Federal conducts business from itsmain office and fourteen full-service branch offices, all of which are locatedin a six county area in Northcentral and Northwest Arkansas comprised ofBenton, Marion, Washington, Carroll, Baxter and Boone counties. The Bank willcontinue to focus its growth and expansion efforts in this six county area,especially in Benton and Washington counties, one of the fastest growing areasof the state.    The Bank is a community-orientedfinancial institution offering a wide range of retail and commercial depositaccounts, including non-interest bearing and interest bearing checking, savingsand money market accounts, certificates of deposit, and individual retirementaccounts.  Loan products offered by theBank include residential real estate, consumer, construction, lines of credit,commercial real estate and commercial business loans.  Other financial services include investment products offeredthrough PrimeVest Financial Services, Inc.; automated teller machines; 24-hourtelephone banking; internet banking, including account access, bill payment andonline loan applications; Bounce ProtectionTM overdraft service; debit cards; andsafe deposit boxes.

 

First Federal’s lending focushas traditionally been on permanent residential real estate.  This continues to hold true, although inrecent years an increased emphasis has been placed on commercial real estatelending and construction lending. Most of our lending growth is expected tooccur in the Washington and Benton county areas, which are the headquarters ofthe state’s two largest employers, Wal-Mart and Tyson Foods.  These employers attract suppliers whoestablish offices in the area and create jobs, which fosters demand for housingand office space.  As of the thirdquarter of 2003, unemployment in each of these counties was approximately 2.8%,according to the fdic.gov website.

 

Certificates of deposit andsavings accounts continue to comprise the majority of our depositaccounts.  However, in recent years,increased emphasis has been placed on growth in checking accounts   This emphasis will continue with plans toattract checking accounts through the utilization of targeted direct mailthroughout our market area.   Checkingaccounts offer low interest deposits, fee income potential, and the opportunityto cross-sell other financial services.

 

The Company’s results of operations dependprimarily on its net interest income, which is the difference between interestincome on interest-earning assets, such as loans and investments, and interestexpense on interest-bearing liabilities, such as deposits and borrowings.  The Company’s results of operations are alsoaffected by the provision for loan losses, the level of its noninterest incomeand expenses, and income tax expense.

 

Noninterest income is generated primarilythrough deposit account fee income, profit on sale of loans, mortgage andinstallment lending fee income, and bank owned life insurance income.

 

Noninterest expense consists primarily ofemployee compensation and benefits, office occupancy expense, data processingexpense, and other operating expense.

 

Likemost banks, First Federal Bank’s two greatest challenges are managing interestrate risk and asset quality.  The Bank’scurrent interest rate risk position as measured by our regulator, the Office ofThrift Supervision (“OTS”), is at a minimal level as defined by Thrift Bulletin13a.  The level of interest rate risk isimpacted by the movement of interest rates and the timing and magnitude ofassets repricing compared to liabilities repricing.  The Bank attempts to reduce the impact of changes in interestrates on its net interest income by managing the repricing gap as describedbelow in the “Asset and Liability Management” section. The Bank’s present assetquality, measured by levels of charge-offs, non-performing loans and repossessedassets, compares favorably with our peers. We strive to maintain the asset quality of our loan portfolio atacceptable levels through sound underwriting procedures, including the use ofcredit scoring; an independent loan review function; active collectionprocedures for delinquent loans; and, in the event of repossession, prompt andefficient liquidation of real estate, automobiles and other forms ofcollateral.  Both the board of directorsand senior management place a high priority on managing interest rate risk andasset quality.

### ** **

29

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### **CRITICAL ACCOUNTINGPOLICIES**

 

Various elements of our accounting policies,by their nature, are inherently subject to estimation techniques, valuationassumptions and other subjective assessments. In particular, the methodology for the determination of our allowancefor loan losses, due to the judgments, estimates and assumptions inherent inthat policy, is critical to preparation of our financial statements.  This policy and the judgments, estimates andassumptions are described in greater detail in subsequent sections ofManagement’s Discussion and Analysis and in the Notes to the ConsolidatedFinancial Statements included herein. In particular, Note 1 to the Consolidated Financial Statements –“Summary of Significant Accounting Policies” describes generally our accountingpolicies.  We believe that thejudgments, estimates and assumptions used in the preparation of our ConsolidatedFinancial Statements are appropriate given the factual circumstances at thetime.  However, given the sensitivity ofour Consolidated Financial Statements to this critical accounting policy, theuse of other judgments, estimates and assumptions could result in materialdifferences in our results of operations or financial condition.

 

In estimating the amount of credit lossesinherent in our loan portfolio, various judgments and assumptions aremade.  For example, when assessing thecondition of the overall economic environment, assumptions are made regardingfuture market conditions and their impact on the loan portfolio.  In the event the national economy were tosustain 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, the estimated fair value of the collateralmay deviate significantly from the proceeds received when the collateral issold.

## ** **

## **CHANGES IN FINANCIAL CONDITION**

 

Changes in financial condition betweenDecember 31, 2003 and 2002 are presented in the following table (dollars inthousands).  Material changes betweenperiods will be discussed in the sections which follow the table.

 
|                                          |   | **December 31,** |    | **Increase********(Decrease)** |   | **%****Change** |   |
|-----------------------------------------------|--------|------------------|---------|--------------------------------|--------|-----------------|--------|
| **2003**                                      |   | **2002**         |    |                           |
| **ASSETS**                                    |   |             |    |                           |   |            |   |   |   |
| Cash and cash equivalents                     |   | $                | 56,201  |                           | $      | 44,493          |   | $ | 11,708 |   | 26.3 | % |
| Investment securities held to maturity        |   | 80,379           |    | 114,471                        |   | (34,092         | )      | (29.8 | )% |
| Loans receivable, net                         |   | 512,756          |    | 483,468                        |   | 29,288          |   | 6.1 | % |
| Office properties and equipment, net          |   | 14,238           |    | 10,690                         |   | 3,548           |   | 33.2 | % |
| Prepaid expenses and other assets             |   | 27,079           |    | 26,774                         |   | 305             |   | 1.1 | % |
|                                          |   |             |    |                           |   |            |   |   |   |
| TOTAL                                         |   | $                | 690,653 |                           | $      | 679,896         |   | $ | 10,757 |   | 1.6 | % |
|                                          |   |             |    |                           |   |            |   |   |   |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY** |   |             |    |                           |   |            |   |   |   |
| LIABILITIES:                                  |   |             |    |                           |   |            |   |   |   |
| Deposits                                      |   | $                | 573,580 |                           | $      | 568,762         |   | $ | 4,818 |   | 0.8 | % |
| Other borrowings                              |   | 39,562           |    | 38,610                         |   | 952             |   | 2.5 | % |
| Other liabilities                             |   | 2,433            |    | 3,258                          |   | (825            | )      | (25.3 | )% |
| Total liabilities                             |   | 615,575          |    | 610,630                        |   | 4,945           |   | 0.8 | % |
|                                          |   |             |    |                           |   |            |   |   |   |
| STOCKHOLDERS’ EQUITY                     |   | 75,078           |    | 69,266                         |   | 5,812           |   | 8.4 | % |
| TOTAL                                         |   | $                | 690,653 |                           | $      | 679,896         |   | $ | 10,757 |   | 1.6 | % |
|                                          |   |             |    |                           |   |            |   |   |   |
| BOOK VALUE PER SHARE                          |   | $                | 14.06   |                           | $      | 12.89           |   |   |   |   |   |
|                                          |   |             |    |                           |   |            |   |   |   |
| EQUITY TO ASSETS                              |   | 10.9             | %       | 10.2                           | %      |            |   |   |   |

 

30

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**Loans Receivable. **Changes in loan composition betweenDecember 31, 2003 and 2002 are presented in the following table (dollars inthousands).

 
|                                          |   | **December 31,** |    | **Increase  (Decrease)** |   |    |            |
|-----------------------------------------------|--------|------------------|---------|--------------------------|--------|---------|-----------------|
|                                          |   | **2003**         |    | **2002**                 |   |    | **%****Change** |   |
|                                          |   |             |    |                     |   |    |            |   |   |
| One- to four- family residences               |   | $                | 256,796 |                     | $      | 289,106 |            | $ | (32,310 | ) |   |   |
| Multi-family                                  |   | 9,998            |    | 5,821                    |   | 4,177   |            |   |   |
| Commercial real estate                        |   | 85,129           |    | 66,622                   |   | 18,507  |            |   |   |
| Construction                                  |   | 89,332           |    | 49,144                   |   | 40,188  |            |   |   |
| Total first mortgage loans                    |   | 441,255          |    | 410,693                  |   | 30,562  |            | 7.4 | % |
|                                          |   |             |    |                     |   |    |            |   |   |
| Commercial                                    |   | 33,672           |    | 28,213                   |   | 5,459   |            | 19.3 | % |
|                                          |   |             |    |                     |   |    |            |   |   |
| Home equity and second mortgage               |   | 36,332           |    | 31,670                   |   | 4,662   |            |   |   |
| Automobile                                    |   | 22,087           |    | 22,570                   |   | (483    | )               |   |   |
| Other                                         |   | 16,869           |    | 13,807                   |   | 3,062   |            |   |   |
| Total consumer                                |   | 75,288           |    | 68,047                   |   | 7,241   |            | 10.6 | % |
|                                          |   |             |    |                     |   |    |            |   |   |
| Total loans receivable                        |   | 550,215          |    | 506,953                  |   | 43,262  |            | 8.5 | % |
| Less:                                         |   |             |    |                     |   |    |            |   |   |
| Undisbursed loan funds                        |   | (35,181          | )       | (20,618                  | )      | 14,563  |            |   |   |
| Unearned discounts and net deferred loan fees |   | (657             | )       | (1,338                   | )      | (681    | )               |   |   |
| Allowance for loan losses                     |   | (1,621           | )       | (1,529                   | )      | 92      |            |   |   |
|                                          |   |             |    |                     |   |    |            |   |   |
| Total loans receivable, net                   |   | $                | 512,756 |                     | $      | 483,468 |            | $ | 29,288 |   | 6.1 | % |

 

The Bank continued to experience increaseddemand for commercial real estate loans, construction loans, consumer loans,and commercial loans.  The increases inthese loan categories were partially offset by a decrease in one- to four- familyresidential loans.  As a result of thelow interest rate environment during the year, the Bank experienced increasedrefinancing activity, most of which loans were sold on the secondarymarket.  This had the effect of reducingthe balance of one- to four- family residential loans held in theportfolio.  However, the interest rateenvironment and robust economy of our market area provided increased demand forour other loan products.   In recentyears, the Bank has placed an increased emphasis on commercial real estatelending, construction lending, commercial lending and consumer lending todiversify its loan portfolio, increase the average yield on its loan portfolio,expand its operations and provide greater opportunities to cross-sell itsproducts.

 

The decrease in unearned loan fees is due tothe decrease in one-to four- family residential loans and a decrease inorigination fees collected.

 

**Allowance for Loan Losses**.  Changes in the composition of the allowancefor loan losses between December 31, 2003 and 2002 are presented in thefollowing table (in thousands).

 
|        |   | **December 31,** |   | **Increase  (Decrease)** |   |
|-------------|--------|------------------|--------|--------------------------|--------|
|        |   | **2003**         |   | **2002**                 |   |   |
| General     |   | $                | 1,306  |                     | $      | 895 |   | $ | 411 |   |
| Specific    |   | 252              |   | 625                      |   | (373 | ) |
| Unallocated |   | 63               |   | 9                        |   | 54 |   |
|        |   | $                | 1,621  |                     | $      | 1,529 |   | $ | 92 |   |

 

The increase in the general loan lossallowance was due to increases in loan balances as well as changes in the lossexperience factors used.  Managementcompared the loan portfolio’s loss experience ratios from year to year andadjusted the ratios to reflect current loss experience. The decrease in thespecific allowance for loan losses was due to a valuation

 

31

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allowance recorded at December 31, 2002,related to a single commercial loan relationship that was not required atDecember 31, 2003.

 

The allowance for loan losses is evaluated ona regular basis by management and is based upon management’s periodic review ofthe collectibility of the loans in light of historical experience, the natureand volume of the loan portfolio, adverse situations that may affect theborrower’s ability to repay, estimated value of any underlying collateral and prevailingeconomic conditions.  This evaluation isinherently subjective as it requires estimates that are susceptible tosignificant revision as conditions change and more information becomesavailable.

 

The allowance consists ofspecific, general and unallocated components. The specific component relates toloans that are classified as loss, doubtful, substandard or special mention.For such loans that are also classified as impaired, an allowance isestablished when the discounted cash flows (or collateral value or observablemarket price) of the impaired loan is lower than the carrying value of thatloan. The general component covers non-classified loans and is based primarilyon historical loss experience. An unallocated component is maintained to coveruncertainties that could affect management’s estimate of probable losses. Theunallocated component of the allowance reflects the margin of imprecisioninherent in the underlying assumptions used in the methodologies for estimatingspecific and general losses in the portfolio.

 

The Bank reviews its non-homogeneous loansfor impairment on a quarterly basis. The Bank considers commercial real estate, construction, multi-family,and commercial loans to be non-homogeneous loans.  A loan is considered impaired when, based on current informationand events, it is probable that the Bank will be unable to collect thescheduled payments of principal or interest when due according to thecontractual terms of the loan agreement. 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 insignificant payment delays and payment shortfallsgenerally are not classified as impaired. Management determines the significance of payment delays and paymentshortfalls on a case-by-case basis, taking into consideration all of thecircumstances surrounding the loan and the borrower, including the length ofthe delay, the reasons for the delay, the borrower’s prior payment record, andthe amount of the shortfall in relation to the principal and interestowed.  Impairment is measured on a loanby loan basis by either the present value of expected future cash flowsdiscounted at the loan’s effective interest rate, the loan’s obtainable marketprice, or the fair value of the collateral if the loan is collateral dependent.

 

Large groups of smaller balance homogeneousloans are collectively evaluated for impairment.  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 Bankconsiders the characteristics of (1) one- to- four family residential firstmortgage loans; (2) unsecured consumer loans; and (3) collateralized consumerloans to permit consideration of the appropriateness of the allowance forlosses of each group of loans on a pool basis. 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, inherentrisks, and economic conditions in the primary market areas.

 

In estimating the amount of credit lossesinherent in our loan portfolio, various judgments and assumptions aremade.  For example, when assessing thecondition of the overall economic environment, assumptions are made regardingfuture market conditions and their impact on the loan portfolio.  In the event the national economy were tosustain 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, the estimated fair value of the collateralmay deviate significantly from the proceeds received when the collateral issold.

 

Although we consider the allowance for loanlosses of $1.6 million appropriate and adequate to cover losses inherent in ourloan portfolio at December 31, 2003, no assurance can be given that we will notsustain loan losses that are significantly different from the amount reserved,or that subsequent evaluations of the loan portfolio, in light of factors thenprevailing, would not result in a significant change in the allowance for loanlosses.

 

32

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**Investment Securities. **Changes in the composition ofinvestment securities held to maturity between December 31, 2003 and 2002 arepresented in the following table (dollars in thousands).

 
|                                   |   | **December 31,** |   | **Increase  (Decrease)** |   |
|----------------------------------------|--------|------------------|--------|--------------------------|--------|
|                                   |   | **2003**         |   | **2002**                 |   |   |
| Certificates of deposit                |   | $                | 9,000  |                     | $      | 40,341 |   | $ | (31,341 | ) |
| U.S. Government and agency obligations |   | 57,076           |   | 65,402                   |   | (8,326 | ) |
| Municipal securities                   |   | 14,303           |   | 8,728                    |   | 5,575 |   |
| Total                                  |   | $                | 80,379 |                     | $      | 114,471 |   | $ | (34,092 | ) |

 

During 2003, investment securities totaling $304.1million were purchased and $338.3 million matured or were called.   The majority of these purchases andmaturities were shorter-term certificates of deposit.  The decreases in certificates of deposit and U.S. Government andagency obligations were due to calls and maturities in excess of purchases.

 

**OfficeProperties and Equipment.  **The increasein office properties and equipment of $3.5 million was due primarily to the newcorporate headquarters building in Harrison. Construction was completed in June 2003 at a cost of approximately $6.2million, $3.0 million of which was included in construction in progress atDecember 31, 2002.

 

**Deposits. **Changes in the composition of depositsbetween December 31, 2003 and 2002 are presented in the following table(dollars in thousands).

 
|                    |   | **December 31,** |    | **Increase (Decrease)** |   |    |            |
|-------------------------|--------|------------------|---------|-------------------------|--------|---------|-----------------|
|                    |   | **2003**         |    | **2002**                |   |    | **%****Change** |   |
|                    |   |             |    |                    |   |    |            |   |   |
| DDA and NOW accounts    |   | $                | 96,090  |                    | $      | 86,851  |            | $ | 9,239 |   | 10.6 | % |
| Money Market accounts   |   | 108,400          |    | 80,020                  |   | 28,380  |            | 35.5 | % |
| Savings accounts        |   | 29,269           |    | 27,772                  |   | 1,497   |            | 5.4 | % |
| Certificates of deposit |   | 339,821          |    | 374,119                 |   | (34,298 | )               | (9.2 | )% |
|                    |   |             |    |                    |   |    |            |   |   |
| Total deposits          |   | $                | 573,580 |                    | $      | 568,762 |            | $ | 4,818 |   | 0.8 | % |

 

The Bank experienced a change in the mix ofdeposits due to the low interest rate environment during the year.  Certificates of deposit decreased whilemoney market and demand and NOW deposit accounts increased.   Checkingaccounts are an attractive source of funds for the Bank as they offerlow-interest deposits, fee income potential, and the opportunity to cross-sellother financial services.  The Bank doesnot advertise for deposits outside of its primary market area, Northcentral andNorthwest Arkansas, or utilize the services of deposit brokers.  In the fourth quarter of 2001, the Bankbegan offering Bounce ProtectionTM and continued to emphasize thisprogram in 2003.  This program allowscustomers in good standing to overdraw their checking account up to definedlimits.  Customers have access toadditional funds while providing the Bank additional fee revenue.

 

**Stockholders’ Equity. **Stockholders’ equity increased $5.8million from December 31, 2002 to December 31, 2003.  The increase in stockholders’ equity was primarily due to netincome of $7.5 million, offset by the purchase of treasury stock totaling $2.8million during 2003.  In addition,during the twelve months ended December 31, 2003 cash dividends aggregating $1.8million were paid.  See the ConsolidatedStatements of Stockholders’ Equity for the years ended December 31, 2003,2002 and 2001 for more detail.

 

33

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**Average Balance Sheets**

 

The following table sets forthcertain information relating to the Company’s average balance sheets andreflects the average yield on assets and average cost of liabilities for theperiods indicated and the yields earned and rates paid at December 31, 2003.  Such yields and costs are derived by dividingincome or expense by the average balance of assets or liabilities,respectively, for the periods presented and outstanding balances at December31, 2003.  Average balances are based ondaily balances during the period.

 
|                                                                  |   | **December  31,  2003** |     | **Year  Ended December 31,** |     |
|-----------------------------------------------------------------------|--------|-------------------------|----------|------------------------------|----------|
|                                                                  |   |                    | **2003** |                         | **2002** |   | **2001** |   |
|                                                                  |   | **Yield/  Cost**        |     | **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)                                                   |   | 6.57                    | %        | $                            | 492,492  |   | $ | 34,188 |   | 6.94 | % | $ | 481,330 |   | $ | 36,859 |   | 7.66 | % | $ | 488,942 |   | $ | 39,678 |   | 8.12 | % |
| Investment securities(2)                                              |   | 4.76                    |     | 92,564                       |     | 3,938 |   | 4.25 |   | 111,189 |   | 6,450 |   | 5.80 |   | 144,457 |   | 9,561 |   | 6.62 |   |
| Other interest-earning assets                                         |   | 0.88                    |     | 60,881                       |     | 619 |   | 1.02 |   | 48,839 |   | 785 |   | 1.61 |   | 29,457 |   | 913 |   | 3.10 |   |
| Total interest-earning assets                                         |   | 5.94                    |     | 645,937                      |     | 38,745 |   | 6.00 |   | 641,358 |   | 44,094 |   | 6.88 |   | 662,856 |   | 50,152 |   | 7.57 |   |
| Noninterest-earning assets                                            |   |                    |     | 45,383                       |     |   |   |   |   | 38,336 |   |   |   |   |   | 27,662 |   |   |   |   |   |
| Total assets                                                          |   |                    |     | $                            | 691,320  |   |   |   |   |   | $ | 679,694 |   |   |   |   |   | $ | 690,518 |   |   |   |   |   |
| Interest-bearing liabilities:                                         |   |                    |     |                         |     |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Deposits                                                              |   | 2.29                    |     | $                            | 571,407  |   | 14,607 |   | 2.56 |   | $ | 566,047 |   | 19,446 |   | 3.44 |   | $ | 543,919 |   | 27,497 |   | 5.06 |   |
| Other borrowings                                                      |   | 3.26                    |     | 43,321                       |     | 1,379 |   | 3.18 |   | 38,434 |   | 2,187 |   | 5.69 |   | 66,409 |   | 4,365 |   | 6.57 |   |
| Total interest-bearing liabilities                                    |   | 2.35                    |     | 614,728                      |     | 15,986 |   | 2.60 |   | 604,481 |   | 21,633 |   | 3.58 |   | 610,328 |   | 31,862 |   | 5.22 |   |
| Noninterest-bearing liabilities                                       |   |                    |     | 3,886                        |     |   |   |   |   | 4,562 |   |   |   |   |   | 6,033 |   |   |   |   |   |
| Total liabilities                                                     |   |                    |     | 618,614                      |     |   |   |   |   | 609,043 |   |   |   |   |   | 616,361 |   |   |   |   |   |
| Stockholders’ equity                                             |   |                    |     | 72,706                       |     |   |   |   |   | 70,651 |   |   |   |   |   | 74,157 |   |   |   |   |   |
| Total liabilities andstockholders’ equity                        |   |                    |     | $                            | 691,320  |   |   |   |   |   | $ | 679,694 |   |   |   |   |   | $ | 690,518 |   |   |   |   |   |
|                                                                  |   |                    |     |                         |     |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Net interest income                                                   |   |                    |     |                         |     | $ | 22,759 |   |   |   |   |   | $ | 22,461 |   |   |   |   |   | $ | 18,290 |   |   |   |
| Net earning assets                                                    |   |                    |     | $                            | 31,209   |   |   |   |   |   | $ | 36,877 |   |   |   |   |   | $ | 52,528 |   |   |   |   |   |
| Interest rate spread                                                  |   | 3.59                    | %        |                         |     |   |   | 3.40 | % |   |   |   |   | 3.30 | % |   |   |   |   | 2.35 | % |
| Net interest margin                                                   |   |                    |     |                         |     |   |   | 3.52 | % |   |   |   |   | 3.50 | % |   |   |   |   | 2.76 | % |
| Ratio of interest-earning assets to interest-bearing liabilities |   |                    |     |                         |     |   |   | 105.08 | % |   |   |   |   | 106.10 | % |   |   |   |   | 108.61 | % |

 

----

(1) Includes nonaccrual loans.

(2) Includes FHLB of Dallas stock.

## ** **

34

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**Rate/VolumeAnalysis**

 

The table below sets forthcertain information regarding changes in interest income and interest expenseof the Company for the periods indicated. For each category of interest-earning assets and interest-bearingliabilities, information is provided on changes attributable to (i) changes involume (changes in average volume multiplied by prior rate); (ii) changes inrate (change in rate multiplied by prior average volume); (iii) changes inrate-volume (changes in rate multiplied by the change in average volume); and(iv) the net change.

 
|                               |   | **Year  Ended December 31,**    |       |
|------------------------------------|--------|---------------------------------|------------|
|                               |   | **2003  vs. 2002**              |       | **2002  vs. 2001** |   |
|                               |   | **Increase (Decrease)  Due to** |       |   |   | **Increase (Decrease)********Due to** |   |   |   |
|                               |   | **Volume**                      |       | **Rate** |   | **Rate/  Volume** |   | **Total  Increase  (Decrease)** |   | **Volume** |   | **Rate** |   | **Rate/  Volume** |   | **Total  Increase  (Decrease)** |   |
|                               |   | **(In Thousands)**              | ** ** |
| Interest income:                   |   |                            |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Loans receivable                   |   | $                               | 855        |   | $ | (3,446 | ) | $ | (80 | ) | $ | (2,671 | ) | $ | (618 | ) | $ | (2,236 | ) | $ | 35 |   | $ | (2,819 | ) |
| Investment securities              |   | (1,080                          | )          | (1,720 | ) | 288 |   | (2,512 | ) | (2,202 | ) | (1,181 | ) | 272 |   | (3,111 | ) |
| Other interest-earning assets      |   | 193                             |       | (288 | ) | (71 | ) | (166 | ) | 601 |   | (440 | ) | (289 | ) | (128 | ) |
| Total interest-earning Assets      |   | (32                             | )          | (5,454 | ) | 137 |   | (5,349 | ) | (2,219 | ) | (3,857 | ) | 18 |   | (6,058 | ) |
|                               |   |                            |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Interest expense:                  |   |                            |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Deposits                           |   | 184                             |       | (4,976 | ) | (47 | ) | (4,839 | ) | 1,119 |   | (8,811 | ) | (359 | ) | (8,051 | ) |
| Other borrowings                   |   | 278                             |       | (964 | ) | (122 | ) | (808 | ) | (1,839 | ) | (586 | ) | 247 |   | (2,178 | ) |
| Total interest-bearing liabilities |   | 462                             |       | (5,940 | ) | (169 | ) | (5,647 | ) | (720 | ) | (9,397 | ) | (112 | ) | (10,229 | ) |
| Net change in net interest income  |   | $                               | (494       | ) | $ | 486 |   | $ | 306 |   | $ | 298 |   | $ | (1,499 | ) | $ | 5,540 |   | $ | 130 |   | $ | 4,171 |   |

 

35

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**CHANGES IN RESULTS OFOPERATIONS**

 

The table below presents a comparison ofresults of operations for the years ended December 31, 2003, 2002, and 2001(dollars in thousands).  Specificchanges in captions will be discussed below the table.

 
|                                                 |   | **Year Ended December 31,** |   | **Dollar Change** |   | **Percentage  Change** |   |
|------------------------------------------------------|--------|-----------------------------|--------|-------------------|--------|------------------------|--------|
|                                                 |   | **2003**                    |   | **2002**          |   | **2001**               |   | **2003 vs 2002** |   | **2002 vs 2001** |   | **2003 vs 2002** |   | **2002 vs 2001** |   |
| Interest income:                                     |   |                        |   |              |   |                   |   |   |   |   |   |   |   |   |   |
| Loans receivable                                     |   | $                           | 34,188 |              | $      | 36,859                 |   | $ | 39,678 |   | $ | (2,671 | ) | $ | (2,819 | ) |   |   |   |   |
| Investment securities                                |   | 3,938                       |   | 6,450             |   | 9,561                  |   | (2,512 | ) | (3,111 | ) |   |   |   |   |
| Other                                                |   | 619                         |   | 785               |   | 913                    |   | (166 | ) | (128 | ) |   |   |   |   |
| Total interest income                                |   | 38,745                      |   | 44,094            |   | 50,152                 |   | (5,349 | ) | (6,058 | ) | (12.1 | )% | (12.1 | )% |
| Interest expense:                                    |   |                        |   |              |   |                   |   |   |   |   |   |   |   |   |   |
| Deposits                                             |   | 14,607                      |   | 19,446            |   | 27,497                 |   | (4,839 | ) | (8,051 | ) |   |   |   |   |
| Other borrowings                                     |   | 1,379                       |   | 2,187             |   | 4,365                  |   | (808 | ) | (2,178 | ) |   |   |   |   |
| Total interest expense                               |   | 15,986                      |   | 21,633            |   | 31,862                 |   | (5,647 | ) | (10,229 | ) | (26.1 | )% | (32.1 | )% |
| Net interest income before provision for loan losses |   | 22,759                      |   | 22,461            |   | 18,290                 |   | 298 |   | 4,171 |   |   |   |   |   |
| Provision for loan losses                            |   | 690                         |   | 1,500             |   | 452                    |   | (810 | ) | 1,048 |   |   |   |   |   |
| Net interest income after provision for loan losses  |   | 22,069                      |   | 20,961            |   | 17,838                 |   | 1,108 |   | 3,123 |   | 5.3 | % | 17.5 | % |
| Noninterest income:                                  |   |                        |   |              |   |                   |   |   |   |   |   |   |   |   |   |
| Deposit fee income                                   |   | 2,611                       |   | 2,375             |   | 1,394                  |   | 236 |   | 981 |   |   |   |   |   |
| Gain on sale of loans                                |   | 1,696                       |   | 888               |   | 748                    |   | 808 |   | 140 |   |   |   |   |   |
| Gain on contribution                                 |   | 414                         |   | 0                 |   | 0                      |   | 414 |   | — |   |   |   |   |   |
| Other                                                |   | 2,268                       |   | 2,083             |   | 1,603                  |   | 185 |   | 480 |   |   |   |   |   |
| Total noninterest income                             |   | 6,989                       |   | 5,346             |   | 3,745                  |   | 1,643 |   | 1,601 |   | 30.7 | % | 42.8 | % |
| Noninterest expenses:                                |   |                        |   |              |   |                   |   |   |   |   |   |   |   |   |   |
| Salaries and employee benefits                       |   | 10,399                      |   | 8,575             |   | 8,488                  |   | 1,824 |   | 87 |   |   |   |   |   |
| Net occupancy expense                                |   | 1,874                       |   | 1,297             |   | 1,136                  |   | 577 |   | 161 |   |   |   |   |   |
| Data processing                                      |   | 1,559                       |   | 1,240             |   | 1,031                  |   | 319 |   | 209 |   |   |   |   |   |
| Contributions                                        |   | 526                         |   | 120               |   | 38                     |   | 406 |   | 82 |   |   |   |   |   |
| Other                                                |   | 3,905                       |   | 3,292             |   | 2,903                  |   | 613 |   | 389 |   |   |   |   |   |
| Total noninterest expenses                           |   | 18,263                      |   | 14,524            |   | 13,596                 |   | 3,739 |   | 928 |   | 25.7 | % | 6.8 | % |
| Income before provision forincome taxes              |   | 10,795                      |   | 11,783            |   | 7,987                  |   | (988 | ) | 3,796 |   |   |   |   |   |
| Provision for income taxes                           |   | 3,339                       |   | 4,005             |   | 2,527                  |   | (666 | ) | 1,478 |   |   |   |   |   |
| Net income                                           |   | $                           | 7,456  |              | $      | 7,778                  |   | $ | 5,460 |   | $ | (322 | ) | $ | 2,318 |   | (4.1 | )% | 42.5 | % |
|                                                 |   |                        |   |              |   |                   |   |   |   |   |   |   |   |   |   |
| Basic earnings per share                             |   | $                           | 1.46   |              | $      | 1.44                   |   | $ | 0.88 |   | $ | 0.02 |   | $ | 0.56 |   | 1.4 | % | 63.6 | % |
| Diluted earnings per share                           |   | $                           | 1.38   |              | $      | 1.38                   |   | $ | 0.87 |   | $ | — |   | $ | 0.51 |   | 0.0 | % | 58.6 | % |
|                                                 |   |                        |   |              |   |                   |   |   |   |   |   |   |   |   |   |
| Interest rate spread                                 |   | 3.40                        | %      | 3.30              | %      | 2.35                   | %      | 0.10 | % | 0.95 | % | 3.0 | % | 40.4 | % |
| Net interest margin                                  |   | 3.52                        | %      | 3.50              | %      | 2.76                   | %      | 0.02 | % | 0.74 | % | 0.6 | % | 26.8 | % |
|                                                 |   |                        |   |              |   |                   |   |   |   |   |   |   |   |   |   |
| Full-time equivalents                                |   | 252                         |   | 235               |   | 215                    |   | 17 |   | 20 |   | 7.2 | % | 9.3 | % |
| Full-service offices                                 |   | 15                          |   | 14                |   | 14                     |   | 1 |   | — |   | 7.1 | % | 0.0 | % |

 

36

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**Net Interest Income. **Net interest income is determined by theCompany’s interest rate spread (i.e., the difference between the yields earnedon its interest-earning assets and the rates paid on its interest-bearingliabilities) and the relative amounts of interest-earning assets andinterest-bearing liabilities.  TheCompany’s net interest income increased in both comparison periods due toincreases in interest rate spread and interest rate margin.  During both comparison periods there was ageneral decrease in market interest rates as evidenced by the changes in keyinterest rates presented below:

 
|           |   | **2003** |   | **2002** |   | **2001** |   |
|----------------|--------|----------|--------|----------|--------|----------|--------|
| Fed funds rate |   | 1.13     | %      | 1.67     | %      | 3.88     | %      |
| Prime rate     |   | 4.12     | %      | 4.67     | %      | 6.91     | %      |

 

Source:  www.federalreserve.gov

 

In the 2002 vs. 2001 period,due to the Bank’s negative repricing gap, rates paid on deposits decreased morequickly than rates on earning assets. As a result, the Company experienced an increase in the interest ratespread and net interest margin.  Thiscontinued in the 2003 vs. 2002 period at a diminished level because interestrates were near their floor and rates on deposits could no longer be reduced asdramatically.

 

**Interest Income and Interest Expense**

 

Dollar and percentage changesin interest income and interest expense for the comparison periods arepresented in the rate/volume analysis table which appears on page 15.

 

**Interest Income. **The decrease in the 2003 vs. 2002 period wasprimarily due to a decrease in the average yield earned on loans, investmentsecurities, and other interest-earning assets and a decrease in the averagebalance of investment securities, offset by an increase in the average balanceof loans.   The decrease in the averageyield earned on loans, investment securities, and other interest-earning assetswas primarily due to the declining level of interest rates in 2003.  The decrease in the average balance ofinvestment securities held to maturity was primarily the result of maturingFHLB CDs.  The average balance of loansincreased primarily due to construction loan activity in 2003.

 

The decrease in the 2002 vs. 2001 period was primarily due to adecrease in the average balance of and average yield earned on loans andinvestment securities.  Such decrease ininterest income was partially offset by an increase in interest income as aresult of an increase in the average balance of other interest-earning assets,primarily overnight interest bearing cash accounts.    The decrease in the average balance of loans in 2002 wasprimarily due to a portion of one- to four- family mortgage originations beingsold in the secondary market.  Thedecrease in the average balance of investment securities held to maturity wasprimarily the result of the call of government agency bonds.  The decrease in the average yield earned onloans and investment securities was primarily due to the declining level ofinterest rates in 2002.  The increase inthe balance of overnight interest bearing funds was primarily due to theproceeds from callable government agency securities being placed in overnightfunds.

 

**Interest Expense.  **The decrease in interest expense in the 2003vs. 2002 period was primarily due to a decrease in the average rate paid ondeposit accounts and FHLB advances.  Thedecrease in the average interest rate paid on deposits was primarily the resultof maturing certificates and variable interest bearing deposits beingreinvested at lower interest rates.

 

The decease in interest expense in the 2002 vs. 2001 period wasprimarily due to a decrease in the average rate paid on deposit accounts andFHLB advances and a decrease in the average balance of FHLB advances.  Such decreases were partially offset by anincrease in the average balance of deposits. The decrease in the average interest rate paid on deposits was primarilythe result of maturing certificates and variable interest bearing depositsbeing reinvested at lower interest rates. The average balance of FHLB advances decreased due to the use ofinvestment proceeds from securities to repay advances.

 

**Provision for Loan Losses.** Provisions for loan losses include charges to reduce the recordedbalance of loans to their estimated fair value.  Such provision and the adequacy of the allowance for loan lossesis evaluated quarterly by management of the Bank based on the Bank’s past loanloss experience, known and inherent risks in the portfolio,

 

37

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adversesituations that may affect the borrower’s ability to repay, the estimated valueof any underlying collateral and current economic conditions.

 

Factors influencing management’s decision to increase the provision inthe 2002 vs. 2001 period include an increase in loss experience during 2002, anincrease in the overall risk of the loan portfolio due to an increase in commercialreal estate, construction, commercial and consumer loans, an increase innonaccrual and restructured loans, and general economic conditions.  The aforementioned loan types are generallyconsidered to entail additional risks as compared to single-family lending dueto, among other factors, supply and demand and, in some respects, rapidlydepreciating assets, such as automobiles.

 

In 2003, the primary factor contributing to the decrease in theprovision from 2002 was a decline in charge-offs, which were $308,000 less thanin 2002.

 

**Noninterest Income. **Deposit fee income increased as a result ofthe Bank’s continued promotion of Bounce ProtectionTM overdraftservice that was introduced bythe Bank in the fourth quarter of 2001. The Bank plans to aggressively promote checking accounts in 2004 throughdirect mail campaigns to expand its checking accounts and increase deposit feeincome.

 

Gainon sale of loans increased due to an increase in originations of loans forsale.  The activity in loans held for saleis summarized below (in thousands):

** **
|                                     |   | **Year Ended December 31,** |   |
|------------------------------------------|--------|-----------------------------|--------|
|                                     |   | **2003**                    |   | **2002** |   | **2001** |   |
| Loans held for sale, beginning of period |   | $                           | 8,264  |   | $ | 5,560 |   | $ | 789 |   |
| Originations                             |   | 119,833                     |   | 69,631 |   | 64,655 |   |
| Sales                                    |   | (126,410                    | )      | (66,927 | ) | (59,884 | ) |
| Loans held for sale, end of period       |   | $                           | 1,687  |   | $ | 8,264 |   | $ | 5,560 |   |
|                                     |   |                        |   |   |   |   |   |
| Gain on sale of loans                    |   | $                           | 1,696  |   | $ | 888 |   | $ | 748 |   |

 

Sales of loans peaked in 2003 due to record low interest rates in 2003and the resulting refinancing activity. We do not expect the level of loan sales to continue at this level in2004.

 

Other noninterest income increased primarily due to an adjustment ofthe carrying value of donated real estate from its cost to its estimated fair value.  A corresponding expense in the amount of $500,000, the fair valueof the donated real estate, was also recorded and is included in the balance ofcontributions expense.

 

**Noninterest Expense**

 

**Salaries and Employee Benefits. **Thechanges in the composition of this line item are presented below (in thousands):

 
|                              |   | **Year Ended  December 31,** |   | **Change** |   |
|-----------------------------------|--------|------------------------------|--------|------------|--------|
|                              |   | **2003**                     |   | **2002**   |   | **2001** |   | **2003 vs 2002** |   | **2002 vs 2001** |   |
| Salaries                          |   | $                            | 7,315  |       | $      | 6,374 |   | $ | 6,057 |   | $ | 941 |   | $ | 317 |   |
| Payroll taxes                     |   | 638                          |   | 540        |   | 505 |   | 98 |   | 35 |   |
| Insurance                         |   | 561                          |   | 510        |   | 422 |   | 51 |   | 88 |   |
| ESOP expense (1)                  |   | 1,230                        |   | 924        |   | 754 |   | 306 |   | 170 |   |
| MRP expense (2)                   |   | 45                           |   | —     |   | 298 |   | 44 |   | (298 | ) |
| Defined benefit plan contribution |   | 480                          |   | 108        |   | — |   | 372 |   | 108 |   |
| Other                             |   | 130                          |   | 119        |   | 452 |   | 12 |   | (333 | ) |
| Total                             |   | $                            | 10,399 |       | $      | 8,575 |   | $ | 8,488 |   | $ | 1,824 |   | $ | 87 |   |

 

----

(1)          Employee Stock Ownership Plan

(2)          Management Recognition and Retention Plan

 

38

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2003vs. 2002

Theincrease in salaries was due to an increase in personnel and normal salary andmerit increases.  Payroll taxes andinsurance increased due to the increase in salaries.  The increase in employee stock ownership plan expense was due toan increase in the Company’s average stock price from $24.42 in 2002 to $31.78in 2003.  The defined benefit planexpense increased due to an increase in the Bank’s required contribution to themultiemployer pension plan as a result of decreased yields on plan assets.

 

2002vs. 2001

Theincrease in salaries was due to an increase in personnel and normal salary andmerit increases.  Payroll taxes and insuranceincreased due to the increase in salaries. The increase in employee stock ownership plan expense was due to anincrease in the Company’s average stock price from $20.43 in 2001 to $24.42 in2002.  Management Recognition andRetention Plan expense decreased as a result of the awarded shares being fullyvested in May 2001.  No additionalshares were granted after the original shares were vested until the new grantin 2003.  The defined benefit planexpense increased due to an increase in the Bank’s required contribution to themultiemployer pension plan.  There wasno pension cost in 2001 due to the plan’s fully-funded status at such time.Other expenses decreased due to the nonrecurring death benefit recognized in2001 of $352,000 in connection with the death of the Company’s former ChiefExecutive Officer in 2001.  There was nosuch expense in 2002.

 

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

 
|                                       |   | **Year Ended December 31,** |   | **Change** |   |
|--------------------------------------------|--------|-----------------------------|--------|------------|--------|
|                                       |   | **2003**                    |   | **2002**   |   | **2001** |   | **2003 vs 2002** |   | **2002 vs 2001** |   |
| Depreciation                               |   | $                           | 1,053  |       | $      | 719 |   | $ | 618 |   | $ | 334 |   | $ | 101 |   |
| Furniture, fixtures, and equipment expense |   | 238                         |   | 95         |   | 67 |   | 143 |   | 28 |   |
| Utilities                                  |   | 190                         |   | 131        |   | 154 |   | 59 |   | (23 | ) |
| Building repairs and maintenance           |   | 190                         |   | 174        |   | 137 |   | 16 |   | 37 |   |
| Taxes and insurance                        |   | 137                         |   | 103        |   | 92 |   | 34 |   | 11 |   |
| Rent                                       |   | 66                          |   | 75         |   | 68 |   | (9 | ) | 7 |   |
| Total                                      |   | $                           | 1,874  |       | $      | 1,297 |   | $ | 1,136 |   | $ | 577 |   | $ | 161 |   |

 

2003vs. 2002

Theincrease in net occupancy expense was primarily due to an increase indepreciation expense on buildings and equipment.  This increase in depreciation was due to completion of the newcorporate headquarters in Harrison in June 2003.  Furniture, fixtures, and equipment expense also increased for thesame reason and represents furnishings for the new building with unit costsbelow the Company’s capitalization level.

 

2002vs. 2001

Theincrease in net occupancy expense was primarily due to an increase indepreciation expense on buildings and equipment.  This increase in depreciation was due to a change in the usefullife of some of the Bank’s computers, as well as a general increase in officeproperties and equipment related to the overall growth of the Bank.

 

**Data processing expense.**  Dataprocessing expense increased in both comparison periods due primarily to anupgrade of the Bank’s wide area network, increased ATM volume, and growth inelectronic banking services.

 

**Contributions.**  Contributionsexpense increased between the 2003 and 2002 periods mainly due to thecontribution of real estate discussed above in the noninterest incomenarrative.  The $526,000 balance ofcontributions expense for the year ended December 31, 2003, includes the fairvalue of the donated real estate of $500,000.

 

39

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**Other expenses.**  The changes in the composition of this lineitem are presented below (in thousands):

 
|                             |   | **Year Ended  December 31,** |   | **Change** |   |
|----------------------------------|--------|------------------------------|--------|------------|--------|
|                             |   | **2003**                     |   | **2002**   |   | **2001** |   | **2003 vs 2002** |   | **2002 vs 2001** |   |
| Consultant and management fees   |   | $                            | 382    |       | $      | 98 |   | $ | 26 |   | $ | 284 |   | $ | 72 |   |
| Postage and supplies             |   | 737                          |   | 598        |   | 546 |   | 139 |   | 52 |   |
| Loan related expenses            |   | 194                          |   | 153        |   | 92 |   | 41 |   | 61 |   |
| Real estate owned expenses       |   | 135                          |   | 88         |   | 49 |   | 47 |   | 39 |   |
| Telephone                        |   | 228                          |   | 190        |   | 177 |   | 38 |   | 13 |   |
| Advertising and public relations |   | 613                          |   | 596        |   | 489 |   | 17 |   | 107 |   |
| Other                            |   | 1,616                        |   | 1,569      |   | 1,524 |   | 47 |   | 45 |   |
| Total                            |   | $                            | 3,905  |       | $      | 3,292 |   | $ | 2,903 |   | $ | 613 |   | $ | 389 |   |

 

2003vs. 2002

Otherexpenses in this period increased primarily due to consultant and managementfees.  These fees increased due to feespaid to a consulting firm related to preparation for compliance with Section404 of the Sarbanes-Oxley Act of 2002, which will require management to reporton its assessment of the effectiveness of internal control and our independentauditors to attest to such assertion. Fees paid to a third party vendor related to the BounceProtectionTM programalso increased due to increased overdraft activity during 2003.  Other components of the increase inconsultant and management fees include fees paid to a consultant for the depositreclassification program and fees paid to a consultant for work performed inthe area of human resources.  Thedeposit reclassification program allows the Bank to reduce its reserverequirement, thereby freeing up funds to be invested in interest-earningaccounts.

 

2002vs. 2001

Otherexpenses in this period increased primarily due to advertising and publicrelations expense resulting from growth and increased advertising rates.  Consultant and management fees increasedprimarily due fees related to the Bounce ProtectionTM program introduced in the fourthquarter of 2001.

 

**Income Taxes.**

 

2003vs. 2002

The decrease in income tax expense was primarily due to a decrease intaxable income and, to a lesser extent, a decrease in the effective taxrate.  The decrease in the effective taxrate from 34.0% in 2002 to 30.9% in 2003 was attributable to the tax benefit ofthe contribution of real estate and an increase in nontaxable interest income.

 

2002vs. 2001

Theincrease in income tax expense was primarily due to an increase in taxableincome and, to a lesser extent, an increase in the effective tax rate.  The increase in the effective rate from31.6% in 2001 to 34.0% in 2002 resulted primarily from the Company being in ataxable position for state taxes during 2002 but not in 2001.

 

**OFF-BALANCE SHEET ARRANGEMENTS**

 

The Company, in the normal course of business, makes commitments to buyor sell assets or to incur or fund liabilities.  Commitments include, but are not limited to:

 

•                  the origination,purchase or sale of loans;

•                  the purchase ofinvestment securities;

•                  the fulfillmentof commitments under letters-of-credit, extensions of credit on home equitylines of credit, construction loans, and predetermined overdraft protectionlimits; and

•                  the commitmentto fund withdrawals of certificates of deposit at maturity.

 

At December 31, 2003, the Bank’s off-balance sheet arrangementsprincipally included lending commitments, which are described below.  At December 31, 2003, the Company had nointerests in non-consolidated special purpose entities.  At December 31, 2003, commitments included:

 

40

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•                  total approvedloan origination commitments outstanding amounting to $14.2 million, including$4.3 million of loans committed to sell;

•                  commitments topurchase loans of $3.9 million;

•                  rate lockagreements with customers of $4.3 million, all of which have been locked withan investor;

•                  funded mortgageloans committed to sell of $1.7 million;

•                  unadvancedportion of construction loans of $35.2 million;

•                  unused lines ofcredit of $20.8 million;

•                  outstandingstandby letters of credit of $1.7 million;

•                  totalpredetermined overdraft protection limits of $9.7 million; and

•                  certificates ofdeposit scheduled to mature in one year or less totaling $187.6 million.

 

Total unfunded commitments to originate loans for sale and the relatedcommitments to sell of $4.3 million meet the definition of a derivativefinancial instrument.  The related assetand liability are considered immaterial at December 31, 2003.

 

Historically, a very small percentage of predetermined overdraft limitshave been used.  At December 31, 2003,overdrafts of accounts with Bounce ProtectionTMrepresented usage of 2.1% of the limit. We expect this trend to continue in the future.

 

Based on historical experience, management believes that a significantportion of maturing deposits will remain with the Bank.  We anticipate that we will continue to havesufficient funds, through repayments, deposits and borrowings, to meet ourcurrent commitments.

 

**CONTRACTUAL OBLIGATIONS**

 

Weare contractually obligated to make future minimum payments as follows (inthousands):

 
|                               |   | **Less Than  1 Year** |    | **1-3 Years** |   | **3 - 5 Years** |   | **More Than  5 Years** |   | **Total** |   |
|------------------------------------|--------|-----------------------|---------|---------------|--------|-----------------|--------|------------------------|--------|-----------|--------|
|                               |   |                  |    |          |   |            |   |                   |   |      |   |
| Certificates of deposit maturities |   | $                     | 187,585 |          | $      | 83,771          |   | $                      | 41,649 |      | $      | 26,816 |   | $ | 339,821 |   |
| FHLB advances maturities           |   | $                     | 15,456  |          | $      | 14,243          |   | $                      | 7,228  |      | $      | 2,635 |   | $ | 39,562 |   |

 

### **LIQUIDITY AND CAPITAL RESOURCES**

 

The Bank’s liquidity, represented by cash andcash equivalents and eligible investment securities, is a product of itsoperating, investing and financing activities. The Bank’s primary sources of funds are deposits, collections onoutstanding loans, maturities and calls of investment securities and othershort-term investments and funds provided from operations.  While scheduled loan amortization andmaturing investment securities and short-term investments are relativelypredictable sources of funds, deposit flows and loan prepayments are greatlyinfluenced by general interest rates, economic conditions and competition.  The Bank manages the pricing of its depositsto maintain a steady deposit balance. In addition, the Bank invests excess funds in overnight deposits andother short-term interest-earning assets which provide liquidity to meetlending requirements.  The Bank hasgenerally been able to generate enough cash through the retail deposit market,its traditional funding source, to offset the cash utilized in investingactivities.  As an additional source of funds,the Bank has borrowed from the FHLB of Dallas. At December 31, 2003, available borrowing capacity with the FHLB was inexcess of $200 million.

 

Liquidity management is both a daily andlong-term function of business management. Excess liquidity is generally invested in short-term investments such asovernight deposits and certificates of deposit.  On a longer-term basis, the Bank maintains a strategy ofinvesting in various lending products.  The Bank uses its sources of funds primarily to meet its ongoingcommitments, to pay maturing savings certificates and savings withdrawals, torepay maturing FHLB of Dallas advances, and to fund loan commitments.

 

41

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As of December 31, 2003, the Bank’s regulatorycapital was in excess of all applicable regulatory requirements.  At December 31, 2003, the Bank’s tangible,core and risk-based capital ratios amounted to 10.27%, 10.27% and 16.25%,respectively, compared to regulatory requirements of 1.5%, 4.0% and 8.0%,respectively.

 

### **IMPACT OF INFLATION AND CHANGING PRICES**

 

The financial statements and related financial data presented hereinhave been prepared in accordance with generally accepted accounting principles,which require the measurement of financial position and operating results interms of historical dollars, without considering changes in relative purchasingpower over time due to inflation.

 

Unlike most industrial companies, virtuallyall of the Bank’s assets and liabilities are monetary in nature.  As a result, interest rates generally have amore significant impact on a financial institution’s performance than does theeffect of inflation.

 

### **IMPACT OF NEW ACCOUNTING STANDARDS**

 

See Note 1 to the Consolidated Financial Statements.

 

### **FORWARD-LOOKING STATEMENTS**

 

TheCompany’s Annual Report on Form 10-K contains certain forward-lookingstatements and information relating to the Company that are based on thebeliefs of management as well as assumptions made by and information currentlyavailable to management.  In addition,in this document, the words “anticipate”, “believe,” “estimate,”****“expect,” “intend,” “should” and similarexpressions, or the negative thereof, as they relate to the Company or theCompany’s management, are intended to identify forward-looking statements.  Such statements reflect the current views ofthe Company with respect to future looking events and are subject to certainrisks, uncertainties and assumptions. Should one or more of these risks or uncertainties materialize or shouldunderlying assumptions prove incorrect, actual results may vary materially fromthose described herein as anticipated, believed, estimated, expected orintended.  The Company does not intendto update these forward-looking statements.

 

**Item 7A. Quantitative and Qualitative Disclosure about MarketRisk****.**

 

**ASSET AND LIABILITYMANAGEMENT**

 

The ability to maximize net interest incomeis largely dependent upon the achievement of a positive interest rate spreadthat can be sustained during fluctuations in prevailing interest rates.  Interest rate sensitivity is a measure ofthe difference between amounts of interest-earning assets and interest-bearingliabilities that either reprice or mature within a given period of time.  The difference, or the interest raterepricing “gap”, provides an indication of the extent to which an institution’sinterest rate spread will be affected by changes in interest rates.  A gap is considered positive when the amountof interest-rate sensitive assets exceeds the amount of interest-rate sensitiveliabilities, and is considered negative when the amount of interest-ratesensitive liabilities exceeds the amount of interest-rate sensitiveassets.  Generally, during a period ofrising interest rates, a negative gap within shorter maturities would adverselyaffect net interest income, while a positive gap within shorter maturitieswould result in an increase in net interest income, and during a period offalling interest rates, a negative gap within shorter maturities would resultin an increase in net interest income while a positive gap within shortermaturities would have the opposite effect. As of December 31, 2003, the Bank estimates that the ratio of itsone-year gap to total assets was a negative 24.6% and its ratio ofinterest-earning assets to interest-bearing liabilities maturing or repricingwithin one year was 60.5%.

 

The Bank focuses its residential lendingactivities on the origination of one-, three-, five- and seven-yearadjustable-rate 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, 2003, $185.9million or 72.4% of the Bank’s portfolio of one- to four-family residentialmortgage loans consisted of ARMs, including $75.9 million in seven-year ARMs.

 

The Company’s investment portfolio amountedto $80.4 million or 11.6% of the Company’s total assets at December 31,2003.  Of such amount, $9.5 million or11.8% is contractually due within one year and $2.1 million or 2.6% is

 

42

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contractually due after one year to fiveyears.  However, actual maturities canbe shorter than contractual maturities due to the ability of borrowers to callor prepay such obligations without call or prepayment penalties.  As of December 31, 2003, there wasapproximately $70 million of investment securities at an average interest rateof 5.35% with call options held by the issuer, of which approximately $55million, at an average interest rate of 5.51%, are callable within one year. Tothe extent that these higher yielding securities are called, the Company mayreinvest such funds at prevailing interest rates which may have a downwardimpact on the Company’s interest rate spread.

 

Deposits are the Bank’s primary fundingsource and the Bank prices its deposit accounts based upon competitive factorsand the availability of prudent lending and investment opportunities.  The Bank seeks to lengthen the maturities ofits deposits by soliciting longer term certificates of deposit when marketconditions have created opportunities to attract such deposits. However, theBank does not solicit high-rate jumbo certificates of deposit and does notpursue an aggressive growth strategy which would force the Bank to focusexclusively on competitors’ rates rather than deposit affordability.  At December 31, 2003 the Bank had $339.8 millionin certificates of deposit of which $187.6 million mature in one year orless.  At December 31, 2003, the Bankhad $39.6 million of FHLB advances of which $15.5 million is due in one year orless.

 

### **Net Portfolio Value**

 

The value of the Bank’s loan and investmentportfolio will change as interest rates change.  As a result of the Bank’s interest rate repricing gap, risinginterest rates will generally decrease the Bank’s net portfolio value (“NPV”),while falling interest 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, 2003 and 2002, the OTS estimate ofthe projected changes in NPV in the event of a 100, 200 and 300 basis pointinstantaneous and permanent increase and a 100 basis point instantaneous andpermanent decrease in market interest rates. Due to the current low prevailing interest rate environment the changesin NPV are not estimated for a decrease in interest rates of 200 or 300 basispoints.

 

 

 
| **2003**                                       |   |
|------------------------------------------------|--------|
| **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                                           |   |   | 69,875 |   | 10.16 | % | $ | (27,143 | ) | (28 | )% |
| +200                                           |   |   | 80,304 |   | 11.45 |   | (16,714 | ) | (17 | ) |
| +100                                           |   |   | 89,647 |   | 12.55 |   | (7,371 | ) | (8 | ) |
| 0                                              |   |   | 97,018 |   | 13.37 |   | — |   | — |   |
| -100                                           |   |   | 100,441 |   | 13.69 |   | 3,423 |   | 4 |   |

 

 

 
| **2002**                                       |   |
|------------------------------------------------|--------|
| **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                                           |   |   | 70,311 |   | 10.35 | % | $ | (16,750 | ) | (19 | )% |
| +200                                           |   |   | 77,180 |   | 11.15 |   | (9,881 | ) | (11 | ) |
| +100                                           |   |   | 83,239 |   | 11.82 |   | (3,822 | ) | (4 | ) |
| 0                                              |   |   | 87,061 |   | 12.19 |   | — |   | — |   |
| -100                                           |   |   | 87,588 |   | 12.14 |   | 527 |   | 1 |   |

 

Computations of prospective effects ofhypothetical interest rate changes are calculated by the OTS from data providedby the Bank and are based on numerous assumptions, including relative levels ofmarket interest rates, loan repayments, and deposit runoffs, and should not berelied upon as indicative of actual results. Further, the computations do not contemplate any actions the Bank mayundertake in response to changes in interest rates.

 

43

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Management cannot predict future interestrates or their effect on the Bank’s NPV. Certain shortcomings are inherent in the method of analysis presented inthe computation of NPV.  For example,although certain assets and liabilities may have similar maturities or periodsto repricing, they may react in differing degrees to changes in market interestrates.  Additionally, certain assets,such as adjustable-rate loans, have features that restrict changes in interestrates during the initial term and over the remaining life of the asset.  In addition, the proportion ofadjustable-rate loans in the Bank’s portfolio could decrease in future periodsdue to refinancing activity if market rates decrease.  Further, in the event of a change in interest rates, prepaymentand early withdrawal levels could deviate significantly from those assumed inthe table.  Finally, the ability of manyborrowers to service their adjustable-rate debt may decrease in the event of aninterest rate increase.

 

44

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**Item 8.  FinancialStatements and Supplementary Data.**

 

 

**INDEPENDENT AUDITORS’ REPORT**

 

 

Board of Directors

First Federal Bancshares of Arkansas, Inc.

 

We have audited the accompanying consolidated statements of financialcondition of First Federal Bancshares of Arkansas, Inc. and its subsidiary (the“Company”) as of December 31, 2003 and 2002, and the related consolidatedstatements of income, stockholders’ equity, and cash flows for each of thethree years in the period ended December 31, 2003. These financialstatements are the responsibility of the Company’s management. Ourresponsibility is to express an opinion on these financial statements based onour audits.

 

We conducted our audits in accordance with auditing standards generallyaccepted in the United States of America. Those standards require that we planand 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 that ouraudits provide a reasonable basis for our opinion.

 

In our opinion, such consolidated financial statements present fairly,in all material respects, the financial position of First Federal Bancshares ofArkansas, Inc. and its subsidiary at December 31, 2003 and 2002, and theresults of their operations and their cash flows for each of the three years inthe period ended December 31, 2003, in conformity with accountingprinciples generally accepted in the United States of America.

 

 
| /s/ Deloitte & Touche LLP |   |
|-------------------------------|--------|
|                          |
| Little Rock, Arkansas         |
| March 5, 2004            |

 

45

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

 

**CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION**

**DECEMBER 31, 2003 AND 2002**

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

 
|                                                                                                                                                                               |   | **2003** |       | **2002** |       |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|----------|------------|----------|------------|
| **ASSETS**                                                                                                                                                                         |   |     | ** ** |     | ** ** |
|                                                                                                                                                                               |   |     |       |     |       |
| Cash and cash equivalents:                                                                                                                                                         |   |     |       |     |       |
| Cash and collection items                                                                                                                                                          |   | $        | 11,376     |     | $          | 13,791 |   |
| Interest-bearing deposits with banks                                                                                                                                               |   | 44,825   |       | 30,702   |       |
|                                                                                                                                                                               |   |     |       |     |       |
| Total cash and cash equivalents                                                                                                                                                    |   | 56,201   |       | 44,493   |       |
|                                                                                                                                                                               |   |     |       |     |       |
| Investment securities—                                                                                                                                                        |   |     |       |     |       |
| Held to maturity, at amortized cost (fair value at  December 31, 2003 

    and  2002, of $80,163 and $115,734, respectively)                                       |   | 80,379   |       | 114,471  |       |
| Federal Home Loan Bank stock—at cost                                                                                                                                          |   | 3,749    |       | 5,064    |       |
| Loans receivable, net of allowance at December 31,  2003 

    and  2002, of $1,621 and $1,529, respectively                                                        |   | 512,756  |       | 483,468  |       |
| Accrued interest receivable                                                                                                                                                        |   | 4,089    |       | 4,380    |       |
| Real estate acquired in settlement of loans—net                                                                                                                               |   | 822      |       | 320      |       |
| Office properties and equipment—net                                                                                                                                           |   | 14,238   |       | 10,690   |       |
| Cash surrender value of life insurance                                                                                                                                             |   | 17,102   |       | 16,254   |       |
| Prepaid expenses and other assets                                                                                                                                                  |   | 1,317    |       | 756      |       |
|                                                                                                                                                                               |   |     |       |     |       |
| TOTAL                                                                                                                                                                              |   | $        | 690,653    |     | $          | 679,896 |   |
|                                                                                                                                                                               |   |     |       |     |       |
| **LIABILITIES AND STOCKHOLDERS’  EQUITY**                                                                                                                                     |   |     |       |     |       |
|                                                                                                                                                                               |   |     |       |     |       |
| LIABILITIES:                                                                                                                                                                       |   |     |       |     |       |
| Deposits:                                                                                                                                                                          |   |     |       |     |       |
| Interest-bearing                                                                                                                                                                   |   | $        | 549,759    |     | $          | 545,872 |   |
| Noninterest-bearing                                                                                                                                                                |   | 23,821   |       | 22,890   |       |
|                                                                                                                                                                               |   |     |       |     |       |
| Total deposits                                                                                                                                                                     |   | 573,580  |       | 568,762  |       |
|                                                                                                                                                                               |   |     |       |     |       |
| Federal Home Loan Bank advances                                                                                                                                                    |   | 39,562   |       | 38,610   |       |
| Advance payments by borrowers for taxes and  insurance                                                                                                                             |   | 725      |       | 760      |       |
| Other liabilities                                                                                                                                                                  |   | 1,708    |       | 2,498    |       |
|                                                                                                                                                                               |   |     |       |     |       |
| Total liabilities                                                                                                                                                                  |   | 615,575  |       | 610,630  |       |
|                                                                                                                                                                               |   |     |       |     |       |
| 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, 5,340,086 and 5,374,718 shares  outstanding at December 31, 2003 and 2002, respectively |   | 103      |       | 103      |       |
| Additional paid-in capital                                                                                                                                                         |   | 52,950   |       | 52,040   |       |
| Employee stock benefit plans                                                                                                                                                       |   | (1,025   | )          | (1,551   | )          |
| Retained earnings—substantially restricted                                                                                                                                    |   | 72,634   |       | 66,992   |       |
|                                                                                                                                                                               |   |     |       |     |       |
|                                                                                                                                                                               |   | 124,662  |       | 117,584  |       |
| Treasury stock—at cost, 4,967,416 and 4,932,784  shares at December 31, 2003 and 2002, respectively                                                                           |   | (49,584  | )          | (48,318  | )          |
|                                                                                                                                                                               |   |     |       |     |       |
| Total stockholders’ equity                                                                                                                                                    |   | 75,078   |       | 69,266   |       |
|                                                                                                                                                                               |   |     |       |     |       |
| TOTAL                                                                                                                                                                              |   | $        | 690,653    |     | $          | 679,896 |   |

 

Seenotes to consolidated financial statements.

 

46

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**FIRST FEDERAL BANCSHARES OF ARKANSAS, INC**

 

**CONSOLIDATED STATEMENTS OF INCOME**

**YEARS ENDED DECEMBER 31, 2003, 2002, 2001**

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

 
|                                                 |   | **2003** |   | **2002** |   | **2001** |   |
|------------------------------------------------------|--------|----------|--------|----------|--------|----------|--------|
| INTEREST INCOME:                                     |   |     |   |     |   |     |   |
| Loans receivable                                     |   | $        | 34,188 |     | $      | 36,859   |   | $ | 39,678 |   |
| Investment securities:                               |   |     |   |     |   |     |   |
| Taxable                                              |   | 3,422    |   | 6,143    |   | 9,363    |   |
| Nontaxable                                           |   | 516      |   | 307      |   | 198      |   |
| Other                                                |   | 619      |   | 785      |   | 913      |   |
| Total interest income                                |   | 38,745   |   | 44,094   |   | 50,152   |   |
|                                                 |   |     |   |     |   |     |   |
| INTEREST EXPENSE:                                    |   |     |   |     |   |     |   |
| Deposits                                             |   | 14,607   |   | 19,446   |   | 27,497   |   |
| Federal Home Loan Bank advances                      |   | 1,379    |   | 2,187    |   | 4,365    |   |
|                                                 |   |     |   |     |   |     |   |
| Total interest expense                               |   | 15,986   |   | 21,633   |   | 31,862   |   |
|                                                 |   |     |   |     |   |     |   |
| NET INTEREST INCOME                                  |   | 22,759   |   | 22,461   |   | 18,290   |   |
|                                                 |   |     |   |     |   |     |   |
| PROVISION FOR LOAN LOSSES                            |   | 690      |   | 1,500    |   | 452      |   |
|                                                 |   |     |   |     |   |     |   |
| NET INTEREST INCOME AFTER PROVISION FOR LOAN  LOSSES |   | 22,069   |   | 20,961   |   | 17,838   |   |
|                                                 |   |     |   |     |   |     |   |
| NONINTEREST INCOME:                                  |   |     |   |     |   |     |   |
| Deposit fee income                                   |   | 2,611    |   | 2,375    |   | 1,394    |   |
| Earnings on life insurance policies                  |   | 848      |   | 881      |   | 373      |   |
| Gain on sale of loans                                |   | 1,696    |   | 888      |   | 748      |   |
| Other                                                |   | 1,834    |   | 1,202    |   | 1,230    |   |
|                                                 |   |     |   |     |   |     |   |
| Total noninterest income                             |   | 6,989    |   | 5,346    |   | 3,745    |   |
|                                                 |   |     |   |     |   |     |   |
| NONINTEREST EXPENSES:                                |   |     |   |     |   |     |   |
| Salaries and employee benefits                       |   | 10,399   |   | 8,575    |   | 8,488    |   |
| Net occupancy expense                                |   | 1,874    |   | 1,297    |   | 1,136    |   |
| Data processing                                      |   | 1,559    |   | 1,240    |   | 1,031    |   |
| Professional fees                                    |   | 329      |   | 404      |   | 284      |   |
| Advertising and public relations                     |   | 613      |   | 596      |   | 489      |   |
| Postage and supplies                                 |   | 737      |   | 598      |   | 620      |   |
| Contributions                                        |   | 526      |   | 120      |   | 38       |   |
| Other                                                |   | 2,226    |   | 1,694    |   | 1,510    |   |
|                                                 |   |     |   |     |   |     |   |
| Total noninterest expenses                           |   | 18,263   |   | 14,524   |   | 13,596   |   |
|                                                 |   |     |   |     |   |     |   |
| INCOME BEFORE INCOME TAXES                           |   | 10,795   |   | 11,783   |   | 7,987    |   |
|                                                 |   |     |   |     |   |     |   |
| INCOME TAX PROVISION                                 |   | 3,339    |   | 4,005    |   | 2,527    |   |
|                                                 |   |     |   |     |   |     |   |
| NET INCOME                                           |   | $        | 7,456  |     | $      | 7,778    |   | $ | 5,460 |   |
|                                                 |   |     |   |     |   |     |   |
| EARNINGS PER SHARE:                                  |   |     |   |     |   |     |   |
| Basic                                                |   | $        | 1.46   |     | $      | 1.44     |   | $ | 0.88 |   |
|                                                 |   |     |   |     |   |     |   |
| Diluted                                              |   | $        | 1.38   |     | $      | 1.38     |   | $ | 0.87 |   |

 

Seenotes to consolidated financial statements.

 

47

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

 

**CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY**

**YEARS ENDED DECEMBER 31, 2003, 2002 AND 2001**

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

 
|                                                       |   | **Issued  Common Stock** |   | **Additional  Paid-In** |   | **Employee  Stock** |   | **Retained**       |   | **Treasury  Stock** |   | **Total  Stockholders’** |   |
|------------------------------------------------------------|--------|--------------------------|--------|-------------------------|--------|---------------------|--------|--------------------|--------|---------------------|--------|-------------------------------|--------|
|                                                       |   | **Shares**               |   | **Amount**              |   | **Capital**         |   | **Benefit  Plans** |   | **Earnings**        |   | **Shares**                    |   | **Amount** |   | **Equity** |   |
|                                                       |   |                     |   |                    |   |                |   |               |   |                |   |                          |   |   |   |   |   |
| BALANCE—January 1, 2001                               |   | 10,307,502               |   | $                       | 103    |                | $      | 51,045             |   | $                   | (2,680 | )                             | $      | 56,662 |   | 3,199,540 |   | $ | (28,508 | ) | $ | 76,622 |   |
|                                                       |   |                     |   |                    |   |                |   |               |   |                |   |                          |   |   |   |   |   |
| Net income                                                 |   | —                   |   | —                  |   | —              |   | —             |   | 5,460               |   | —                        |   | — |   | 5,460 |   |
| Release of ESOP shares                                     |   | —                   |   | —                  |   | 434                 |   | 416                |   | —              |   | —                        |   | — |   | 850 |   |
| Stock compensation expense                                 |   | —                   |   | —                  |   | —              |   | 297                |   | —              |   | —                        |   | — |   | 297 |   |
| Tax effect of stock compensation plans                     |   | —                   |   | —                  |   | (45                 | )      | —             |   | —              |   | —                        |   | — |   | (45 | ) |
| Purchase of treasury stock—at cost                    |   | —                   |   | —                  |   | —              |   | —             |   | —              |   | 1,006,044                     |   | (10,682 | ) | (10,682 | ) |
| Dividends paid                                             |   | —                   |   | —                  |   | —              |   | —             |   | (1,437              | )      | —                        |   | — |   | (1,437 | ) |
|                                                       |   |                     |   |                    |   |                |   |               |   |                |   |                          |   |   |   |   |   |
| BALANCE—December 31, 2001                             |   | 10,307,502               |   | 103                     |   | 51,434              |   | (1,967             | )      | 60,685              |   | 4,205,584                     |   | (39,190 | ) | 71,065 |   |
|                                                       |   |                     |   |                    |   |                |   |               |   |                |   |                          |   |   |   |   |   |
| Net income                                                 |   | —                   |   | —                  |   | —              |   | —             |   | 7,778               |   | —                        |   | — |   | 7,778 |   |
| Release of ESOP shares                                     |   | —                   |   | —                  |   | 600                 |   | 416                |   | —              |   | —                        |   | — |   | 1,016 |   |
| Stock options exercised                                    |   | —                   |   | —                  |   | 3                   |   | —             |   | —              |   | (43,800                       | )      | 419 |   | 422 |   |
| Tax effect of stock compensation plans                     |   | —                   |   | —                  |   | 3                   |   | —             |   | —              |   | —                        |   | — |   | 3 |   |
| Purchase of treasury stock—at cost                    |   | —                   |   | —                  |   | —              |   | —             |   | —              |   | 771,000                       |   | (9,547 | ) | (9,547 | ) |
| Dividends paid                                             |   | —                   |   | —                  |   | —              |   | —             |   | (1,471              | )      | —                        |   | — |   | (1,471 | ) |
|                                                       |   |                     |   |                    |   |                |   |               |   |                |   |                          |   |   |   |   |   |
| BALANCE—December 31, 2002                             |   | 10,307,502               |   | 103                     |   | 52,040              |   | (1,551             | )      | 66,992              |   | 4,932,784                     |   | (48,318 | ) | 69,266 |   |
|                                                       |   |                     |   |                    |   |                |   |               |   |                |   |                          |   |   |   |   |   |
| Net income                                                 |   | —                   |   | —                  |   | —              |   | —             |   | 7,456               |   | —                        |   | — |   | 7,456 |   |
| Release of ESOP shares                                     |   | —                   |   | —                  |   | 906                 |   | 416                |   | —              |   | —                        |   | — |   | 1,322 |   |
| Management recognition and retention plan shares           |   | —                   |   | —                  |   | 35                  |   | 110                |   | —              |   | (10,000                       | )      | 99 |   | 244 |   |
| Tax effect of stock compensation plans                     |   | —                   |   | —                  |   | (9                  | )      | —             |   | —              |   | —                        |   | — |   | (9 | ) |
| Purchase of treasury stock—at cost                    |   | —                   |   | —                  |   | —              |   | —             |   | —              |   | 190,400                       |   | (2,805 | ) | (2,805 | ) |
| Treasury shares reissued due to exercise of stock  options |   | —                   |   | —                  |   | (22                 | )      | —             |   | —              |   | (145,768                      | )      | 1,440 |   | 1,418 |   |
| Dividends paid                                             |   | —                   |   | —                  |   | —              |   | —             |   | (1,814              | )      | —                        |   | — |   | (1,814 | ) |
|                                                       |   |                     |   |                    |   |                |   |               |   |                |   |                          |   |   |   |   |   |
| BALANCE—December 31, 2003                             |   | 10,307,502               |   | $                       | 103    |                | $      | 52,950             |   | $                   | (1,025 | )                             | $      | 72,634 |   | 4,967,416 |   | $ | (49,584 | ) | $ | 75,078 |   |

 

Seenotes to consolidated financial statements.

 

48

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

 

**CONSOLIDATED STATEMENTS OF CASH FLOWS**

**YEARS ENDED DECEMBER 31, 2003, 2002 AND 2001**

**(In thousands)**

 
|                                                                               |   | **2003** |       | **2002** |       | **2001** |       |
|------------------------------------------------------------------------------------|--------|----------|------------|----------|------------|----------|------------|
|                                                                               |   |     | ** ** |     | ** ** |     | ** ** |
| OPERATING ACTIVITIES:                                                              |   |     |       |     |       |     |       |
| Net income                                                                         |   | $        | 7,456      |     | $          | 7,778    |       | $ | 5,460 |   |
| Adjustments to reconcile net income to net cash  provided by operating activities: |   |     |       |     |       |     |       |
| Provision for loan losses                                                          |   | 690      |       | 1,500    |       | 452      |       |
| Provision for real estate losses                                                   |   | 35       |       | 16       |       | 8        |       |
| Deferred tax provision (benefit)                                                   |   | 60       |       | (80      | )          | 22       |       |
| Accretion of discounts on investment  securities—net                          |   | (111     | )          | (157     | )          | (18      | )          |
| Federal Home Loan Bank stock dividends                                             |   | (110     | )          | (146     | )          | (206     | )          |
| Loss (gain) on disposition of fixed assets                                         |   | 98       |       | (3       | )          | (27      | )          |
| Loss on sale of repossessed assets—net                                        |   | 17       |       | 13       |       | 15       |       |
| Originations of loans held for sale                                                |   | (119,833 | )          | (69,631  | )          | (64,655  | )          |
| Proceeds from sales of loans originated to sell                                    |   | 128,106  |       | 67,815   |       | 60,633   |       |
| Gain on sale of mortgage loans originated to sell                                  |   | (1,696   | )          | (888     | )          | (748     | )          |
| Depreciation                                                                       |   | 1,167    |       | 819      |       | 704      |       |
| Accretion of deferred loan fees—net                                           |   | (384     | )          | (606     | )          | (673     | )          |
| Release of ESOP shares                                                             |   | 1,322    |       | 1,016    |       | 850      |       |
| Earnings on life insurance policies                                                |   | (848     | )          | (881     | )          | (373     | )          |
| Stock compensation expense                                                         |   | 45       |       | —   |       | 297      |       |
| Changes in operating assets and liabilities:                                       |   |     |       |     |       |     |       |
| Accrued interest receivable                                                        |   | 291      |       | 40       |       | 2,490    |       |
| Prepaid expenses and other assets                                                  |   | (585     | )          | (350     | )          | (97      | )          |
| Other liabilities                                                                  |   | (660     | )          | (1,891   | )          | (171     | )          |
|                                                                               |   |     |       |     |       |     |       |
| Net cash provided by operating activities                                          |   | 15,060   |       | 4,364    |       | 3,963    |       |
|                                                                               |   |     |       |     |       |     |       |
| INVESTING ACTIVITIES:                                                              |   |     |       |     |       |     |       |
| Purchases of investment securities—held to  maturity                          |   | (304,089 | )          | (147,958 | )          | (55,655  | )          |
| Proceeds from maturities of investment  securities—held to maturity           |   | 338,292  |       | 134,522  |       | 141,105  |       |
| Federal Home Loan Bank stock redeemed                                              |   | 1,425    |       | —   |       | 385      |       |
| Purchase of bank owned life insurance                                              |   |     |       | —   |       | (15,000  | )          |
| Loan originations—net of repayments                                           |   | (37,458  | )          | (7,909   | )          | 28,081   |       |
| Loan purchases                                                                     |   | (3,140   | )          | —   |       | —   |       |
| Loan participations sold                                                           |   | 3,124    |       | —   |       | —   |       |
| Proceeds from sales of repossessed assets                                          |   | 773      |       | 833      |       | 472      |       |
| Proceeds from sales of office properties and  equipment                            |   | 38       |       | 4        |       | 40       |       |
| Purchases of office properties and equipment                                       |   | (4,851   | )          | (4,504   | )          | (539     | )          |
|                                                                               |   |     |       |     |       |     |       |
| Net cash provided by (used in) investing  activities                               |   | (5,886   | )          | (25,012  | )          | 98,889   |       |
|                                                                               |   |     |       |     |       |     |       |
| FINANCING ACTIVITIES:                                                              |   |     |       |     |       |     |       |
| Net increase in deposits                                                           |   | $        | 4,818      |     | $          | 12,829   |       | $ | 15,606 |   |
| Advances from Federal Home Loan Bank                                               |   | 23,000   |       | 26,000   |       | 2,450    |       |
| Repayment of advances from Federal Home Loan Bank                                  |   | (22,048  | )          | (35,234  | )          | (47,965  | )          |
| Net decrease in advance payments by borrowers for  taxes and insurance             |   | (35      | )          | (169     | )          | (77      | )          |
| Purchase of treasury stock                                                         |   | (2,805   | )          | (9,547   | )          | (10,682  | )          |
| Dividends paid                                                                     |   | (1,814   | )          | (1,471   | )          | (1,437   | )          |
| Stock options exercised                                                            |   | 1,418    |       | 422      |       | —   |       |
|                                                                               |   |     |       |     |       |     |       |
| Net cash provided by (used in) financing  activities                               |   | 2,534    |       | (7,170   | )          | (42,105  | )          |
|                                                                               |   |     |       |     |       |     |       |
| NET INCREASE (DECREASE) IN CASH AND CASH  EQUIVALENTS                              |   | 11,708   |       | (27,818  | )          | 60,747   |       |
|                                                                               |   |     |       |     |       |     |       |
| CASH AND CASH EQUIVALENTS:                                                         |   |     |       |     |       |     |       |
| Beginning of year                                                                  |   | 44,493   |       | 72,311   |       | 11,564   |       |
|                                                                               |   |     |       |     |       |     |       |
| End of year                                                                        |   | $        | 56,201     |     | $          | 44,493   |       | $ | 72,311 |   |
|                                                                               |   |     |       |     |       |     |       |
| SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION—                            |   |     |       |     |       |     |       |
| Cash paid for:                                                                     |   |     |       |     |       |     |       |
| Interest                                                                           |   | $        | 16,073     |     | $          | 22,020   |       | $ | 32,469 |   |
|                                                                               |   |     |       |     |       |     |       |
| Income taxes                                                                       |   | $        | 3,394      |     | $          | 4,016    |       | $ | 2,587 |   |
|                                                                               |   |     |       |     |       |     |       |
| SUPPLEMENTAL SCHEDULE OF NONCASH INVESTING  ACTIVITIES:                            |   |     |       |     |       |     |       |
| Real estate and other assets acquired in  settlement of loans                      |   | $        | 1,933      |     | $          | 1,017    |       | $ | 642 |   |
|                                                                               |   |     |       |     |       |     |       |
| Loans to facilitate sales of real estate owned                                     |   | $        | 620        |     | $          | 272      |       | $ | 18 |   |
|                                                                               |   |     |       |     |       |     |       |
| Investment securities purchased—not settled                                   |   | $        | —     |     | $          | —   |       | $ | 2,000 |   |

 

Seenotes to consolidated financial statements.

 

49

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

 

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**YEARS ENDED DECEMBER 31, 2003, 2002, AND 2001**

 

**1.****                                      SUMMARYOF SIGNIFICANT ACCOUNTING POLICIES**

 

***Nature of Operationsand Principles of Consolidation—***First FederalBancshares of Arkansas, Inc. (the “Company”) is a unitary holding company whichowns all of the stock of First Federal Bank of Arkansas, FA (the “Bank”). TheBank provides a broad line of financial products to individuals and small tomedium-sized businesses. The consolidated financial statements also include theaccounts of the Bank’s wholly-owned subsidiary, First Harrison ServiceCorporation (“FHSC”), which is inactive. All material intercompany transactionshave been eliminated in consolidation.

 

***Use of Estimates—***Thepreparation of financial statements in conformity with accounting principlesgenerally accepted in the United States of America requires management to makeestimates and assumptions that affect the reported amounts of assets andliabilities and disclosure of contingent assets and liabilities at the date ofthe financial statements and the reported amounts of revenues and expensesduring the reporting period. Actual results could differ from those estimatesand such differences could be significant. The allowance for loan losses is amaterial estimate that is particularly susceptible to significant change in thenear term.

 

***Cash and CashEquivalents—***For the purpose of presentation in theconsolidated statements of cash flows, cash and cash equivalents includes cashon hand and amounts due from depository institutions, which includesinterest-bearing amounts available upon demand.

 

***InvestmentSecurities—***The Company classifies investmentsecurities into one of two categories: held to maturity or available for sale.The Company does not engage in trading activities. Debt securities that theCompany has the positive intent and ability to hold to maturity are classifiedas held to maturity and recorded at cost, adjusted for the amortization ofpremiums and the accretion of discounts.

 

Investment securities that the Company intends to hold for indefiniteperiods of time are classified as available for sale and are recorded at fairvalue. Unrealized holding gains and losses are excluded from earnings andreported net of tax in other comprehensive income. Investment securities in theavailable for sale portfolio may be used as part of the Company’s asset andliability management practices and may be sold in response to changes ininterest rate risk, prepayment risk, or other economic factors. AtDecember 31, 2003 and 2002, the Company did not own any investmentsecurities classified as available for sale.

 

Premiums are amortized into interest income using the interest methodto the earlier of maturity or call date. Discounts are accreted into interestincome using the interest method over the period to maturity. The specificidentification method of accounting is used to compute gains or losses on thesales of investment securities.

 

Declines in the fair value of held to maturity and available for salesecurities below their cost that are deemed to be other than temporary arereflected in earnings as realized losses. In estimating other than temporaryimpairment losses, management considers independent price quotations and thefinancial condition of the issuer.

 

***Loans Receivable—***TheBank originates and maintains loans receivable which are substantiallyconcentrated in its lending territory (primarily Northwest and NorthcentralArkansas). The majority of the Bank’s loans are residential mortgage loans,commercial loans, and construction loans for residential property. The Bank’spolicy calls for collateral or other forms of repayment assurance to bereceived from the borrower at the time of loan origination. Such collateral orother form of repayment assurance is subject to changes in economic value dueto various factors beyond the control of the Bank.

 

Loans receivable that management has the intent and ability to hold forthe foreseeable future or until maturity or pay-off are stated at unpaidprincipal balances adjusted for any charge-offs, the allowance for loan losses,and any deferred loan fees or costs. Deferred loan fees or costs and discountson first mortgage loans are amortized or accreted to income using thelevel-yield method over the remaining period to contractual maturity.

 

50

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Mortgage loans originated and committed for sale in the secondarymarket are carried at the lower of cost or estimated market value in theaggregate. Such loans are carried at cost due to the short period of timebetween funding and sale, generally two to three weeks.

 

The accrual of interest on impaired loans is discontinued when, inmanagement’s opinion, the borrower may be unable to meet payments as theybecome due or when the loan becomes 90 days past due, whichever occurs first.When interest accrual is discontinued, all unpaid accrued interest is reversedagainst interest income. The interest on these loans is accounted for on thecash basis until qualifying for return to accrual. Loans are returned toaccrual status when all the principal and interest amounts contractually dueare brought current and future payments are reasonably assured.

 

***Allowance for LoanLosses—***The allowance for loan losses isestablished as losses are estimated to have occurred through a provision forloan losses charged to earnings. Loan losses are charged against the allowancewhen management believes the uncollectibility of a loan balance is confirmed.Subsequent recoveries, if any, are credited to the allowance.

 

The allowance for loan losses is evaluated on a regular basis bymanagement and is based upon management’s periodic review of the collectibilityof the loans in light of historical experience, the nature and volume of theloan portfolio, adverse situations that may affect the borrower’s ability torepay, estimated value of any underlying collateral and prevailing economicconditions. This evaluation is inherently subjective as it requires estimatesthat are susceptible to significant revision as more information becomesavailable or conditions change.

 

The allowance consists of specific, general and unallocated components.The specific component relates to loans that are classified as loss, doubtful,substandard or special mention. For such loans that are also classified asimpaired, an allowance is established when the discounted cash flows (orcollateral value or observable market price) of the impaired loan is lower thanthe carrying value of that loan. The general component covers non-classifiedloans and is based primarily on historical loss experience. An unallocatedcomponent is maintained to cover uncertainties that could affect management’sestimate of probable losses. The unallocated component of the allowancereflects the margin of imprecision inherent in the underlying assumptions usedin the methodologies for estimating specific and general losses in theportfolio. A loan is considered impaired when, based on current information andevents, it is probable that the Bank will be unable to collect the scheduledpayments of principal or interest when due according to the contractual termsof the loan agreement. Factors considered by management in determiningimpairment include payment status, collateral value, and the probability ofcollecting scheduled principal and interest payments when due. Loans thatexperience insignificant payment delays and payment shortfalls generally arenot classified as impaired. Management determines the significance of paymentdelays and payment shortfalls on a case-by-case basis, taking intoconsideration all of the circumstances surrounding the loan and the borrower,including the length of the delay, the reasons for the delay, the borrower’sprior payment record, and the amount of the short fall in relation to theprincipal and interest owed. Impairment is measured on a loan by loan basis byeither the present value of expected future cash flows discounted at the loan’seffective interest rate, the loan’s obtainable market price, or the fair valueof the collateral if the loan is collateral dependent.

 

Large groups of smaller balance homogeneous loans are collectivelyevaluated for impairment. Accordingly, the Bank does not separately identifyindividual consumer and residential loans for impairment disclosures.

 

Homogeneous loans are those that are considered to have commoncharacteristics that provide for evaluation on an aggregate or pool basis. TheBank considers the characteristics of (1) one- to four-family residential firstmortgage loans; (2) unsecured consumer loans; and (3) collateralized consumerloans to permit consideration of the appropriateness of the allowance forlosses of each group of loans on a pool basis. The primary methodology used todetermine the appropriateness of the allowance for losses includes segregatingcertain specific, poorly performing loans based on their performancecharacteristics from the pools of loans as to type, valuing these loans, andthen applying a loss factor to the remaining pool balance based on severalfactors including past loss experience, inherent risks, and economic conditionsin the primary market areas.

 

***Rate LockCommitments—***On March 13, 2002, the FinancialAccounting Standards Board (“FASB”) determined that loan commitments related tothe origination or acquisition of mortgage loans that will be held for salemust be accounted for as derivative instruments, effective for fiscal quartersbeginning after April 10, 2002. Accordingly, the Company adopted suchaccounting on July 1, 2002.

 

51

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The Bank enters into commitments to originate loans whereby theinterest rate on the loan is determined prior to funding (rate lockcommitments). Rate lock commitments on mortgage loans that are intended to besold are considered to be derivatives. Accordingly, such commitments, alongwith any related fees received from potential borrowers, are recorded at fairvalue in derivative assets or liabilities, with changes in fair value recordedin the net gain or loss on sale of mortgage loans. Fair value is based on feescurrently charged to enter into similar agreements, and for fixed-ratecommitments also considers the difference between current levels of interestrates and the committed rates. Prior to July 1, 2002, such commitmentswere recorded to the extent of fees received. Fees received were subsequentlyincluded in the net gain or loss on sale of mortgage loans.

 

The cumulative effect of adopting SFAS No. 133, *Accounting for Derivative Instruments and HedgingActivities,* for rate lock commitments as of July 1, 2002 wasnot material, nor was its effect material at December 31, 2003 or 2002.

 

***Real Estate Acquiredin Settlement of Loans—***Real estate acquired insettlement of loans is initially recorded at estimated fair value lessestimated costs to sell, establishing a new cost basis. Subsequent toforeclosure, valuations are periodically performed by management and the assetsare carried at the lower of carrying amount or fair value less costs to sell. Revenueand expenses from operations and changes in the valuation allowance areincluded in other noninterest expenses.

 

***Office Propertiesand Equipment—***Land is carried at cost. Buildingsand equipment are stated at cost less accumulated depreciation and amortization.The Company computes depreciation using the straight-line method over theestimated useful lives of the individual assets which range from 3 to 40 years.

 

***Income Taxes—***Deferred income tax assets and liabilities are determined using the liability(or balance sheet) method. Under this method, the net deferred tax asset orliability is determined based on the tax effects of the temporary differencesbetween the book and tax bases of the various statement of financial conditionassets and liabilities and gives current recognition to changes in tax ratesand laws.

 

***Interest Rate Risk—***TheBank’s asset base is exposed to risk including the risk resulting from changesin interest rates and changes in the timing of cash flows. The Bank monitorsthe effect 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—***Compensation expense for theEmployee Stock Ownership Plan (“ESOP”) is determined based on the average fairvalue of shares committed to be released during the period and is recognized asthe shares are committed to be released. For the purpose of earnings per share,ESOP shares are included in weighted-average common shares outstanding as theshares are committed to be released.

 

***Stock CompensationPlans—***Statement of Financial Accounting StandardsNo. 123, *Accounting for Stock-BasedCompensation* (“SFAS 123”), provides that entities may adopt a fairvalue based method of accounting for employee stock compensation plans, wherebycompensation cost is measured at the grant date based on the value of the awardand is recognized over the service period, which is usually the vesting period.However, it also provides that an entity may measure compensation cost forthose plans using the intrinsic value based method of accounting prescribed byAccounting Principles Board (“APB”) Opinion No. 25, *Accounting for Stock Issued to Employees*,whereby compensation cost is the excess, if any, of the quoted market price ofthe stock at the grant date (or other measurement date) over the amount anemployee must pay to acquire the stock. The Company applies the provisions ofAPB Opinion No. 25 in accounting for its stock option plan. No compensationcost has been recognized for options granted to employees as all optionsgranted had an exercise price equal to the market price of the underlying stockon the grant date. Had compensation cost for these plans been determined basedon the fair value at the grant dates for awards under those plans consistentwith the methods of SFAS 123, the Company’s pro forma net income and proforma earnings per share would have been as follows:

 

52

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|                      |   | **2003**        |   | **2002**      |   | **2001**        |   |
|---------------------------|--------|-----------------|--------|---------------|--------|-----------------|--------|
|                      |   | **As Reported** |   | **Pro forma** |   | **As Reported** |   | **Pro forma** |   | **As Reported** |   | **Pro forma** |   |
|                      |   |            |   |          |   |            |   |   |   |   |   |   |   |
| Net income (in thousands) |   | $               | 7,456  |          | $      | 7,438           |   | $ | 7,778 |   | $ | 7,748 |   | $ | 5,460 |   | $ | 4,934 |   |
| Earnings per share:       |   |            |   |          |   |            |   |   |   |   |   |   |   |
| Basic                     |   | $               | 1.46   |          | $      | 1.46            |   | $ | 1.44 |   | $ | 1.43 |   | $ | 0.88 |   | $ | 0.80 |   |
|                      |   |            |   |          |   |            |   |   |   |   |   |   |   |
| Diluted                   |   | $               | 1.38   |          | $      | 1.38            |   | $ | 1.38 |   | $ | 1.38 |   | $ | 0.87 |   | $ | 0.79 |   |

 

The proforma effects are computed using the Binomial option-pricingmodel, with the following weighted-average assumptions at the grant date:

 
|                            |   | **2003**       |   | **2002**       |   | **2001**       |   |
|---------------------------------|--------|----------------|--------|----------------|--------|----------------|--------|
|                            |   |           |   |           |   |           |   |
| Risk-free interest rate         |   | 3.18% to 3.82% |   | 4.43% to 5.22% |   | 4.89% to 5.11% |   |
| Expected option life (years)    |   | 7.00           |   | 7.00           |   | 7.00           |   |
| Expected stock price volatility |   | 11% - 14%      |   | 17% - 18%      |   | 18% - 22%      |   |
| Dividend yield                  |   | 2.02% to 2.50% |   | 2.30%          |   | 1.90% to 2.10% |   |

 

***Earnings Per CommonShare—***Basic earnings per share represents incomeavailable to common stockholders divided by the weighted-average number ofcommon shares outstanding during the period. Diluted earnings per sharereflects additional common shares that would have been outstanding if dilutivepotential common shares had been issued, as well as any adjustment to incomethat would result from the assumed issuance. Potential common shares that maybe issued by the Company relate solely to outstanding stock options, and aredetermined using the treasury stock method.

 

***Stock Split—***OnNovember 25, 2003, the Board of Directors of the Company declared a two-for-onestock split payable December 31, 2003, to the stockholders of record December17, 2003. Stockholders’ equity, including shares, has been retroactivelyrestated to reflect the stock split as of the earliest date presented in thisreport. All per share amounts and weighted average shares outstanding have beenrestated to reflect the stock split.

 

***Recent AccountingPronouncements—***In December 2003, the FASB issuedSFAS No. 132 (revised 2003), *Employers’Disclosures about Pensions and Other Postretirement Benefits*, whichrequires additional disclosures about the assets, obligations, cash flows andnet periodic benefit costs of defined benefit pension plans and other defined benefitpostretirement plans. The Company adopted this statement on December 31,2003. See the disclosures in Note 11.

 

In April 2003, theFASB issued SFAS No. 149, *Amendments ofStatement 133 on Derivative Instruments and Hedging Activities*(“SFAS 149”). SFAS 149 amends and clarifies financial accounting and reportingfor derivative instruments, including certain derivative instruments embeddedin other contracts and for hedging activities under FASB Statement No. 133, *Accounting for Derivative Instruments and HedgingActivities*. SFAS 149 requires that contracts with comparablecharacteristics be accounted for similarly. In particular, SFAS 149 (1)clarifies under what circumstances a contract with an initial net investmentmeets the characteristic of a derivative discussed in paragraph 6(b) ofStatement 133, (2) clarifies when a derivative contains a financing component,(3) amends the definition of an underlying to conform it to language used inFIN 45, *Guarantor’s Accounting andDisclosure Requirements for Guarantees, Including Indirect Guarantees ofIndebtedness of Others*, and (4) amends certain other existingpronouncements. SFAS 149 is effective for contracts entered into or modifiedafter June 30, 2003, with certain exceptions. The adoptionof SFAS 149 on July 1, 2003 did not have a material effect on thefinancial statements of the Company.

 

In May 2003, theFASB issued SFAS No. 150, *Accounting forCertain Financial Instruments with Characteristics of both Liabilities andEquity* (“SFAS 150”). SFAS 150 establishes standards for how anissuer classifies and measures certain financial instruments withcharacteristics of both liabilities and equity. SFAS 150 is effective forfinancial instruments entered into or modified after May 31, 2003, andotherwise is effective at the beginning of the first interim period beginningafter June 15, 2003, with certain exceptions. The adoption of SFAS 150 onJuly 1, 2003 did not have a material effect on the financial statements ofthe Company.

 

53

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FASB InterpretationNo. 46, *Consolidation of Variable InterestEntities, an Interpretation of Accounting Research Bulletin No. 51*(revised December 2003)**(“FIN46R”) establishes accounting guidance for consolidation of variable interestentities (“VIE”) that function to support the activities of the primarybeneficiary. The primary beneficiary of the VIE entity is the entity thatabsorbs a majority of expected losses, receives a majority of its expectedresidual returns, or both, as a result of holding variable interests, which arethe ownership, contractual, or other pecuniary interests in an entity thatchange with changes in the fair value of the entity’s net assets excludingvariable interests. Prior to the implementation of FIN 46R, VIEs were generallyconsolidated by an enterprise when the enterprise had a controlling financialinterest through ownership of a majority of voting interest in the entity. Theprovisions of FIN 46R were effective for public entities that have interests invariable interest entities or potential variable interest entities commonlyreferred to as special-purpose entities for periods ending afterDecember 15, 2003. Application for all other types of entities is requiredin financial statements for periods ending after March 15, 2004. FIN 46Rdoes not have an effect on the Company because the Company is not involved withany such entities.

 

***Reclassifications—***Certain amounts in the 2002 and 2001 consolidated financialstatements have been reclassified to conform to the classifications adopted forreporting in 2003.

 

**2.****                                      RESTRICTIONSON CASH AND AMOUNTS DUE FROM BANKS**

 

The Bank is required to maintain average balances on hand or with theFederal Reserve Bank. At December 31, 2003 and 2002, these reserve balancesamounted to $520,000 and $4,875,000, respectively.

 

**3.****                                      INVESTMENTSECURITIES**

 

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

 
|                                   |   | **2003**            |   |
|----------------------------------------|--------|---------------------|--------|
| **Held To Maturity**                   |   | **Amortized  Cost** |   | **Gross  Unrealized  Gains** |   | **Gross  Unrealized  Losses** |   | **Fair  Value** |   |
|                                   |   |                |   |   |   |   |   |   |   |
| Certificates of deposit                |   | $                   | 9,000  |   | $ | — |   | $ | — |   | $ | 9,000 |   |
| Municipal securities                   |   | 14,303              |   | 426 |   | 31 |   | 14,698 |   |
| U.S. Government and Agency obligations |   | 57,076              |   | 266 |   | 877 |   | 56,465 |   |
|                                   |   |                |   |   |   |   |   |   |   |
| Total                                  |   | $                   | 80,379 |   | $ | 692 |   | $ | 908 |   | $ | 80,163 |   |

 
|                                   |   | **2002**            |    |
|----------------------------------------|--------|---------------------|---------|
| **Held To Maturity**                   |   | **Amortized  Cost** |    | **Gross  Unrealized  Gains** |   | **Gross  Unrealized  Losses** |   | **Fair  Value** |   |
|                                   |   |                |    |   |   |   |   |   |   |
| Certificates of deposit                |   | $                   | 40,341  |   | $ | 54 |   | $ | — |   | $ | 40,395 |   |
| Municipal securities                   |   | 8,728               |    | 183 |   | 25 |   | 8,886 |   |
| U.S. Government and Agency obligations |   | 65,402              |    | 1,064 |   | 13 |   | 66,453 |   |
|                                   |   |                |    |   |   |   |   |   |   |
| Total                                  |   | $                   | 114,471 |   | $ | 1,301 |   | $ | 38 |   | $ | 115,734 |   |

 

54

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The following table shows gross unrealized losses and fair valueaggregated by investment category and length of time that individual securitieshave been in a continuous unrealized loss position, at December 31, 2003:

 
|                                   |   | **Less than 12 Months** |   | **12 Months or More**  |   | **Total**       |   |
|----------------------------------------|--------|-------------------------|--------|------------------------|--------|-----------------|--------|
|                                   |   | **Fair  Value**         |   | **Unrealized  Losses** |   | **Fair  Value** |   | **Unrealized  Losses** |   | **Fair  Value** |   | **Unrealized  Losses** |   |
|                                   |   |                    |   |                   |   |            |   |   |   |   |   |   |   |
| Municipal securities                   |   | $                       | 1,824  |                   | $      | 31              |   | $ | — |   | $ | — |   | $ | 1,824 |   | $ | 31 |   |
| U.S. Government and Agency obligations |   | 22,229                  |   | 877                    |   | —          |   | — |   | 22,229 |   | 877 |   |
|                                   |   |                    |   |                   |   |            |   |   |   |   |   |   |   |
|                                   |   | $                       | 24,053 |                   | $      | 908             |   | $ | — |   | $ | — |   | $ | 24,053 |   | $ | 908 |   |

 

The Company has pledged investment securities held to maturity withcarrying values of approximately $15.5 million and $22.4 million atDecember 31, 2003 and 2002, respectively, as collateral for certaindeposits in excess of $100,000.

 

The scheduled maturities of debt securities at December 31, 2003,by contractual maturity are shown below (in thousands). Expected maturities maydiffer from contractual maturities because borrowers may have the right to callor prepay obligations with or without call or prepayment penalties.

 
|                             |   | **2003**            |   |
|----------------------------------|--------|---------------------|--------|
|                             |   | **Amortized  Cost** |   | **Fair  Value** |   |
|                             |   |                |   |   |   |
| Within one year                  |   | $                   | 9,500  |   | $ | 9,508 |   |
| Due from one year to five years  |   | 2,100               |   | 2,134 |   |
| Due from five years to ten years |   | 9,610               |   | 9,665 |   |
| Due after ten years              |   | 59,169              |   | 58,856 |   |
|                             |   |                |   |   |   |
| Total                            |   | $                   | 80,379 |   | $ | 80,163 |   |

 

As of December 31, 2003 and 2002, investments with carrying valuesof approximately $70 million and $80 million, respectively, have call optionsheld by the issuer, of which approximately $55 million and $68 million,respectively, are callable within one year.

 

55

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**4.****                                      LOANSRECEIVABLE**

 

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

 
|                            |   | **2003** |       | **2002** |       |
|---------------------------------|--------|----------|------------|----------|------------|
|                            |   |     | ** ** |     | ** ** |
| First mortgage loans:           |   |     |       |     |       |
| One-to four-family residences   |   | $        | 256,796    |     | $          | 289,106 |   |
| Commercial                      |   | 82,895   |       | 64,888   |       |
| Multi-family                    |   | 9,998    |       | 5,821    |       |
| Other                           |   | 2,234    |       | 1,735    |       |
| Construction                    |   | 89,332   |       | 49,144   |       |
| Less:                           |   |     |       |     |       |
| Unearned discounts              |   | (119     | )          | (178     | )          |
| Undisbursed loan funds          |   | (35,181  | )          | (20,618  | )          |
| Deferred loan fees—net     |   | (784     | )          | (1,414   | )          |
|                            |   |     |       |     |       |
| Total first mortgage loans      |   | 405,171  |       | 388,484  |       |
|                            |   |     |       |     |       |
| Consumer and other loans:       |   |     |       |     |       |
| Commercial loans                |   | 33,672   |       | 28,213   |       |
| Automobile                      |   | 22,087   |       | 22,570   |       |
| Consumer loans                  |   | 10,167   |       | 7,741    |       |
| Home equity and second mortgage |   | 36,332   |       | 31,670   |       |
| Savings loans                   |   | 2,353    |       | 2,158    |       |
| Other                           |   | 4,349    |       | 3,907    |       |
| Deferred loan costs—net    |   | 246      |       | 254      |       |
|                            |   |     |       |     |       |
| Total consumer and other loans  |   | 109,206  |       | 96,513   |       |
|                            |   |     |       |     |       |
| Allowance for loan losses       |   | (1,621   | )          | (1,529   | )          |
|                            |   |     |       |     |       |
| Loans receivable—net       |   | $        | 512,756    |     | $          | 483,468 |   |

 

At December 31, 2003 and 2002, loans receivable included loanscommitted to be sold with net book values of $1.7 and $8.3 million,respectively.

 

The following is a summary of information pertaining to impaired andnon-accrual loans:

 
|                                                         |   | **December 31** |       |
|--------------------------------------------------------------|--------|-----------------|------------|
|                                                         |   | **2003**        |       | **2002** |   |
|                                                         |   |            | ** ** |   | ** ** |
| Impaired loans without a valuation allowance                 |   | $               | 1,352      |   | $ | — |   |
| Impaired loans with a valuation allowance                    |   | —          |       | 4,219 |   |
|                                                         |   |            |       |   |   |
| Total impaired loans                                         |   | $               | 1,352      |   | $ | 4,219 |   |
|                                                         |   |            |       |   |   |
| Valuation allowance related to impaired loans                |   | $               | —     |   | $ | 442 |   |
|                                                         |   |            |       |   |   |
| Total non-accrual loans                                      |   | $               | 2,331      |   | $ | 2,728 |   |
|                                                         |   |            |       |   |   |
| Total loans past-due ninety days or more and still  accruing |   | $               | 400        |   | $ | — |   |

 

56

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|                                                          |   | **Year Ended  December 31** |   |
|---------------------------------------------------------------|--------|-----------------------------|--------|
|                                                          |   | **2003**                    |   | **2002** |   |
|                                                          |   |                        |   |   |   |
| Average investment in impaired loans                          |   | $                           | 4,660  |   | $ | 4,351 |   |
|                                                          |   |                        |   |   |   |
| Interest income recognized on impaired loans                  |   | $                           | 401    |   | $ | 332 |   |
|                                                          |   |                        |   |   |   |
| Interest income recognized on a cash basis on  impaired loans |   | $                           | 88     |   | $ | — |   |

 

No additional funds are committed to be advanced in connection withimpaired loans.

 

**5.****                                      ACCRUEDINTEREST RECEIVABLE**

 

Accrued interest receivable consisted of the following atDecember 31 (in thousands):

 
|                  |   | **2003** |   | **2002** |   |
|-----------------------|--------|----------|--------|----------|--------|
|                  |   |     |   |     |   |
| Loans                 |   | $        | 3,229  |     | $      | 2,992 |   |
| Investment securities |   | 860      |   | 1,388    |   |
|                  |   |     |   |     |   |
| Total                 |   | $        | 4,089  |     | $      | 4,380 |   |

 

**6.****                                      ALLOWANCESFOR LOAN AND REAL ESTATE LOSSES**

 

A summary of the activity in the allowances for loan and real estatelosses is as follows for the years ended December 31 (in thousands):

 
|                            |   | **2003**  |   | **2002**        |   | **2001**  |   |
|---------------------------------|--------|-----------|--------|-----------------|--------|-----------|--------|
|                            |   | **Loans** |   | **Real Estate** |   | **Loans** |   | **Real Estate** |   | **Loans** |   | **Real Estate** |   |
|                            |   |      |   |            |   |      |   |   |   |   |   |   |   |
| Balance—beginning of year  |   | $         | 1,529  |            | $      | —    |   | $ | 923 |   | $ | — |   | $ | 691 |   | $ | — |   |
|                            |   |      |   |            |   |      |   |   |   |   |   |   |   |
| Provisions for estimated losses |   | 690       |   | 35              |   | 1,500     |   | 16 |   | 452 |   | 8 |   |
| Recoveries                      |   | 80        |   |            |   | 92        |   |   |   | 17 |   |   |   |
| Losses charged off              |   | (678      | )      | (35             | )      | (986      | )      | (16 | ) | (237 | ) | (8 | ) |
|                            |   |      |   |            |   |      |   |   |   |   |   |   |   |
| Balance—end of year        |   | $         | 1,621  |            | $      | —    |   | $ | 1,529 |   | $ | — |   | $ | 923 |   | $ | — |   |

 

57

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**7.****                                      OFFICEPROPERTIES AND EQUIPMENT**

 

Office properties and equipment consisted of the following atDecember 31 (in thousands):

 
|                                     |   | **2003** |   | **2002** |   |
|------------------------------------------|--------|----------|--------|----------|--------|
|                                     |   |     |   |     |   |
| Land and land improvements               |   | $        | 3,143  |     | $      | 2,508 |   |
| Buildings and improvements               |   | 11,544   |   | 5,152    |   |
| Furniture and equipment                  |   | 4,895    |   | 5,273    |   |
| Automobiles                              |   | 754      |   | 680      |   |
| Construction in progress                 |   | —   |   | 2,986    |   |
|                                     |   |     |   |     |   |
| Total                                    |   | 20,336   |   | 16,599   |   |
|                                     |   |     |   |     |   |
| Accumulated depreciation                 |   | (6,098   | )      | (5,909   | )      |
|                                     |   |     |   |     |   |
| Office properties and equipment—net |   | $        | 14,238 |     | $      | 10,690 |   |

 

Depreciation expense for the years ended December 31, 2003, 2002,and 2001, amounted to approximately $1,167,000, $819,000, and $704,000,respectively.

 

**8.****                                      DEPOSITS**

 

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

 
|                                                                                                                    |   | **2003** |       | **2002** |       |
|-------------------------------------------------------------------------------------------------------------------------|--------|----------|------------|----------|------------|
|                                                                                                                    |   |     | ** ** |     | ** ** |
| Demand and NOW accounts, including  noninterest-bearing deposits of $23,821 and $22,890 in 2003 and 2002,  respectively |   | $        | 96,090     |     | $          | 86,851 |   |
| Money market                                                                                                            |   | 108,400  |       | 80,020   |       |
| Regular savings                                                                                                         |   | 29,269   |       | 27,772   |       |
| Certificates of deposit                                                                                                 |   | 339,821  |       | 374,119  |       |
|                                                                                                                    |   |     |       |     |       |
| Total                                                                                                                   |   | $        | 573,580    |     | $          | 568,762 |   |

 

The aggregate amount of time deposits in denominations of $100 thousandor more was approximately $80 million and $88 million at December 31, 2003and 2002, respectively.

 

At December 31, 2003, scheduled maturities of certificates ofdeposit are as follows (in thousands):

 
| **Year Ending  December 31** |   |   |       |
|------------------------------|--------|--------|------------|
|                         |   |   | ** ** |
| 2004                         |   | $      | 187,585    |   |
| 2005                         |   | 47,689 |       |
| 2006                         |   | 36,082 |       |
| 2007                         |   | 34,587 |       |
| 2008                         |   | 7,062  |       |
| 2009 and thereafter          |   | 26,816 |       |
|                         |   |   |       |
| Total                        |   | $      | 339,821    |   |

 

58

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Interest expense on deposits consisted of the following (in thousands):

 
|                                     |   | **Year Ended December 31** |   |
|------------------------------------------|--------|----------------------------|--------|
|                                     |   | **2003**                   |   | **2002** |   | **2001** |   |
|                                     |   |                       |   |   |   |   |   |
| NOW and demand deposits                  |   | $                          | 454    |   | $ | 760 |   | $ | 1,189 |   |
| Money market                             |   | 1,703                      |   | 1,641 |   | 734 |   |
| Regular savings and certificate accounts |   | 12,536                     |   | 17,106 |   | 25,662 |   |
| Early withdrawal penalties               |   | (86                        | )      | (61 | ) | (88 | ) |
|                                     |   |                       |   |   |   |   |   |
| Total                                    |   | $                          | 14,607 |   | $ | 19,446 |   | $ | 27,497 |   |

 

Eligible deposits of the Bank are insured up to $100 thousand by theSavings Association Insurance Fund (“SAIF”) of the Federal Deposit InsuranceCorporation (“FDIC”).

 

**9.****                                      FEDERALHOME LOAN BANK STOCK AND ADVANCES**

 

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 Federal Home Loan Bank (“FHLB”) in an amount equal to the sum of .20% oftotal assets as of the previous December 31 and 4.25% of outstandingadvances. No ready market exists for such stock and it has no quoted marketvalue. The carrying value of the stock is its cost.

 

The Bank pledges eligible collateral for its FHLB advances as definedin its blanket lien agreement with the FHLB as well as its FHLB demand depositaccount and FHLB stock. Eligible collateral under the blanket lien includesFirst Mortgage Collateral (as defined), multi-family residential mortgagesmeeting the requirements for eligibility as First Mortgage Collateral, U.S.Government and Agency Securities (as defined), privately issued mortgage-backedsecurities that qualify as eligible collateral under applicable regulations,Federal Home Loan Bank Term Deposit Accounts, and other non-securitized realestate related collateral. Advances at December 31, 2003 and 2002,consisted of the following (in thousands):

 
|                                             |   | **2003**                    |       | **2002**   |       |
|--------------------------------------------------|--------|-----------------------------|------------|------------|------------|
| **Amounts Maturing in Year Ending  December 31** |   | **Weighted  Average  Rate** |       | **Amount** |       | **Weighted  Average  Rate** |   | **Amount** |   |
|                                             |   |                        | ** ** |       | ** ** |   | ** ** |   | ** ** |
| 2003                                             |   |                        |       | $          | —     |   | 3.46 | % | $ | 20,896 |   |
| 2004                                             |   | 2.22                        | %          | 15,456     |       | 3.56 | % | 4,035 |   |
| 2005                                             |   | 4.79                        | %          | 9,503      |       | 5.49 | % | 6,998 |   |
| 2006                                             |   | 2.93                        | %          | 4,740      |       | 3.06 | % | 2,163 |   |
| 2007                                             |   | 3.53                        | %          | 5,551      |       | 4.17 | % | 2,900 |   |
| 2008                                             |   | 2.96                        | %          | 1,677      |       | 3.26 | % | 191 |   |
| Thereafter                                       |   | 4.06                        | %          | 2,635      |       | 3.65 | % | 1,427 |   |
|                                             |   |                        |       |       |       |   |   |   |   |
| Total                                            |   | 3.26                        | %          | $          | 39,562     |   | 3.86 | % | $ | 38,610 |   |

 

**10.****                               INCOMETAXES**

 

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

 
|                            |   | **Year Ended December 31** |   |
|---------------------------------|--------|----------------------------|--------|
|                            |   | **2003**                   |   | **2002** |   | **2001** |   |
|                            |   |                       |   |   |   |   |   |
| Income tax provision (benefit): |   |                       |   |   |   |   |   |
| Current                         |   | $                          | 3,279  |   | $ | 4,085 |   | $ | 2,505 |   |
| Deferred                        |   | 60                         |   | (80 | ) | 22 |   |
|                            |   |                       |   |   |   |   |   |
| Total                           |   | $                          | 3,339  |   | $ | 4,005 |   | $ | 2,527 |   |

 

59

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The reasons for the differences between the statutory federal incometax rates and the effective tax rates are summarized as follows (in thousands):

 
|                                |   | **Year Ended December 31** |   |
|-------------------------------------|--------|----------------------------|--------|
|                                |   | **2003**                   |   | **2002** |   | **2001** |   |
|                                |   |                       |   |   |   |   |   |   |   |   |   |   |   |
| Taxes at statutory rate             |   | $                          | 3,670  |   | 34.0 | % | $ | 4,006 |   | 34.0 | % | $ | 2,715 |   | 34.0 | % |
| Increase (decrease) resulting from: |   |                       |   |   |   |   |   |   |   |   |   |   |   |
| State income tax—net           |   | 276                        |   | 2.5 | % | 244 |   | 2.1 | % | — |   | — |   |
| Earnings on life insurance policies |   | (288                       | )      | (2.7 | )% | (299 | ) | (2.5 | )% | (127 | ) | (1.6 | )% |
| Nontaxable investments              |   | (153                       | )      | (1.4 | )% | (89 | ) | (0.8 | )% | (67 | ) | (0.8 | )% |
| Other—net                      |   | (166                       | )      | (1.5 | )% | 143 |   | 1.2 | % | 6 |   |   |   |
|                                |   |                       |   |   |   |   |   |   |   |   |   |   |   |
| Total                               |   | $                          | 3,339  |   | 30.9 | % | $ | 4,005 |   | 34.0 | % | $ | 2,527 |   | 31.6 | % |

 

The Company’s net deferred tax liability account was comprised of thefollowing at December 31 (in thousands):

 
|                           |   | **2003** |   | **2002** |   |
|--------------------------------|--------|----------|--------|----------|--------|
|                           |   |     |   |     |   |
| Deferred tax assets:           |   |     |   |     |   |
| Stock based compensation       |   | $        | 119    |     | $      | 146 |   |
| Allowance for loan losses      |   | 621      |   | 500      |   |
|                           |   |     |   |     |   |
| Total deferred tax assets      |   | 740      |   | 646      |   |
|                           |   |     |   |     |   |
| Deferred tax liabilities:      |   |     |   |     |   |
| Office properties              |   | (561     | )      | (285     | )      |
| Federal Home Loan Bank stock   |   | (700     | )      | (923     | )      |
| Pension plan contribution      |   | (142     | )      | (41      | )      |
|                           |   |     |   |     |   |
| Total deferred tax liabilities |   | (1,403   | )      | (1,249   | )      |
|                           |   |     |   |     |   |
| Net deferred tax liability     |   | $        | (663   | )        | $      | (603 | ) |

 

Specifically exempted from deferred tax recognition requirements arebad debt reserves for tax purposes of U.S. savings and loans in theinstitution’s base year, as defined. Base year reserves totaled approximately$4.2 million. Consequently, a deferred tax liability of approximately $1.6million related to such reserves was not provided for in the consolidatedstatements of financial condition at December 31, 2003 and 2002. Paymentof dividends to shareholders out of retained earnings deemed to have been madeout of earnings previously set aside as bad debt reserves may create taxableincome to the Bank. No provision has been made for income tax on such adistribution as the Bank does not anticipate making such distributions.

 

**11.****                               BENEFITPLANS**

 

***Stock Option Plan***—TheStock Option Plan (“SOP”) provides for a committee of the Company’s Board ofDirectors to award incentive stock options, non-qualified or compensatory stockoptions and stock appreciation rights representing up to 1,030,750 shares ofCompany stock. One-fifth of the options granted vested immediately upon grant,with the balance vesting in equal amounts on the four subsequent anniversarydates of the grant. Options granted vest immediately in the event ofretirement, disability, or death. Stock options granted expire in ten years.

 

60

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Under the SOP, options have been granted to directors and key employeesto purchase common stock of the Company. The exercise price in each case equalsthe fair market value of the Company’s stock at the date of grant. Optionsgranted are summarized as follows:

 
| **Year Granted** |   | **Range of  Exercise Prices** |       | **Weighted Average  Remaining  Contract Life** |       |
|------------------|--------|-------------------------------|------------|------------------------------------------------|------------|
|             |   |                          | ** ** |                                           | ** ** |
| 1997             |   | $ 9.63 - 10.19                |       | 3.2 years                                      |       |
| 1998             |   | 11.63 - 12.00                 |       | 3.7 years                                      |       |
| 1999             |   | 8.53 - 9.32                   |       | 3.4 years                                      |       |
| 2000             |   | 7.38 - 9.13                   |       | 6.7 years                                      |       |
| 2001             |   | 9.35 - 11.35                  |       | 7.6 years                                      |       |
| 2002             |   | 12.20 - 12.32                 |       | 8.6 years                                      |       |
| 2003             |   | 12.93 - 16.11                 |       | 9.3 years                                      |       |

 

A summary of the status of the Company’s SOP as of December 31,2003, 2002, and 2001, and changes during the years ending on those dates arepresented below:

 
|                                       |   | **Shares** |       | **Weighted  Average  Exercise  Price** |       |
|--------------------------------------------|--------|------------|------------|----------------------------------------|------------|
|                                       |   |       | ** ** |                                   | ** ** |
| Outstanding—January 1, 2001           |   | 1,001,130  |       | $                                      | 9.67       |   |
|                                       |   |       |       |                                   |       |
| Granted                                    |   | 16,000     |       | 10.27                                  |       |
|                                       |   |       |       |                                   |       |
| Outstanding—December 31, 2001         |   | 1,017,130  |       | 9.68                                   |       |
|                                       |   |       |       |                                   |       |
| Exercised                                  |   | (43,800    | )          | 9.65                                   |       |
| Granted                                    |   | 10,000     |       | 12.29                                  |       |
| Forfeited                                  |   | (800       | )          | 8.53                                   |       |
|                                       |   |       |       |                                   |       |
| Outstanding—December 31, 2002         |   | 982,530    |       | 9.71                                   |       |
|                                       |   |       |       |                                   |       |
| Exercised                                  |   | (145,768   | )          | 9.73                                   |       |
| Granted                                    |   | 8,000      |       | 14.19                                  |       |
| Expired                                    |   | (3,200     | )          | 9.91                                   |       |
| Forfeited                                  |   | (2,000     | )          | 11.71                                  |       |
|                                       |   |       |       |                                   |       |
| Outstanding—December 31, 2003         |   | 839,562    |       | $                                      | 9.74       |   |
|                                       |   |       |       |                                   |       |
| Options exercisable—December 31, 2003 |   | 819,962    |       | $                                      | 9.69       |   |

 

***ManagementRecognition and Retention Plan—***The ManagementRecognition and Retention Plan (“MRR Plan”) provides for a committee of theCompany’s Board of Directors to award restricted stock to key officers as wellas non-employee directors. The MRR Plan authorizes the Company to grant up to412,300 shares of the Company stock, of which 401,688 shares have been grantedthrough December 31, 2003. 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 $45,000 and $297,000 in compensation expense was recognizedduring the years ended December 31, 2003 and 2001, respectively. Nocompensation expense was recognized during the year ended December 31,2002.

 

61

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***Employee StockOwnership Plan—***The Company established an EmployeeStock Ownership Plan on May 3, 1996. During 1996, the ESOP borrowed $4.1million from the Company to purchase shares of Company stock. The loan iscollateralized by the shares that were purchased with the proceeds of the loan.As the loan is repaid, ESOP shares will be allocated to participants of theESOP and are available for release to the participants subject to the vestingprovisions of the ESOP.

 

Forfeitures of nonvested benefits will be reallocated among remainingparticipating employees in the same proportion as contributions. During each ofthe years ended December 31, 2003, 2002, and 2001, 83,208 shares werereleased by the ESOP to participant accounts. At December 31, 2003, therewere 563,875 shares allocated to participant accounts and 187,217 unallocatedshares. The fair value of the unallocated shares amounted to approximately $3.8million at December 31, 2003.

 

During the years ended December 31, 2003, 2002, and 2001, ESOPexpense was approximately $1.2 million, $924,000, and $754,000,respectively.

 

***Other PostretirementBenefits—***The Bank is a participant in amulti-employer retirement plan and therefore separate information is notavailable. The plan is noncontributory and covers substantially all employees.The plan provides a retirement benefit and a death benefit. Retirement benefitsare payable in monthly installments for life and must begin not later than thefirst day of the month coincident with or the next month following theseventieth birthday or the participant may elect a lump-sum distribution. Deathbenefits are paid in a lump-sum distribution, the amount of which depends onyears of service. Net pension expense was approximately $480,000 and $108,000for the years ended December 31, 2003 and 2002, respectively. There was nonet pension cost for the year ended December 31, 2001.

 

**12.****                               EARNINGSPER SHARE**

 
|                                                                              |   | **Year Ended December 31, 2003**        |   |
|-----------------------------------------------------------------------------------|--------|-----------------------------------------|--------|
|                                                                              |   | **Income  (In Thousands)  (Numerator)** |   | **Shares  (Denominator)** |   | **Per Share  Amount** |   |
| Basic EPS—Income available to common stockholders                            |   | $                                       | 7,456  |   | 5,099,844 |   | $ | 1.46 |   |
|                                                                              |   |                                    |   |   |   |   |   |
| Effect of dilutive securities—Stock options                                  |   | —                                  |   | 286,983 |   |   |   |
|                                                                              |   |                                    |   |   |   |   |   |
| Diluted EPS—Income available to common  stockholders and assumed conversions |   | $                                       | 7,456  |   | 5,386,827 |   | $ | 1.38 |   |

 
|                                                                              |   | **Year Ended December 31, 2002**        |   |
|-----------------------------------------------------------------------------------|--------|-----------------------------------------|--------|
|                                                                              |   | **Income  (In Thousands)  (Numerator)** |   | **Shares  (Denominator)** |   | **Per Share  Amount** |   |
| Basic EPS—Income available to common stockholders                            |   | $                                       | 7,778  |   | 5,413,076 |   | $ | 1.44 |   |
|                                                                              |   |                                    |   |   |   |   |   |
| Effect of dilutive securities—Stock options                                  |   | —                                  |   | 207,362 |   |   |   |
|                                                                              |   |                                    |   |   |   |   |   |
| Diluted EPS—Income available to common  stockholders and assumed conversions |   | $                                       | 7,778  |   | 5,620,438 |   | $ | 1.38 |   |

 

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|                                                                              |   | **Year Ended December 31, 2001**        |   |
|-----------------------------------------------------------------------------------|--------|-----------------------------------------|--------|
|                                                                              |   | **Income  (In Thousands)  (Numerator)** |   | **Shares  (Denominator)** |   | **Per Share  Amount** |   |
| Basic EPS—Income available to common stockholders                            |   | $                                       | 5,460  |   | 6,195,754 |   | $ | 0.88 |   |
|                                                                              |   |                                    |   |   |   |   |   |
| Effect of dilutive securities-Stock options                                       |   | —                                  |   | 58,040 |   |   |   |
|                                                                              |   |                                    |   |   |   |   |   |
| Diluted EPS—Income available to common  stockholders and assumed conversions |   | $                                       | 5,460  |   | 6,253,794 |   | $ | 0.87 |   |

 

**13.****                               OFF-BALANCESHEET ARRANGEMENTS AND COMMITMENTS**

 

The Bank is a party to financial instruments with off-balance sheetrisk in the normal course of business to meet the financing needs of itscustomers. These financial instruments include commitments to extend credit andstandby letters of credit. Those instruments involve, to varying degrees,elements of credit risk in excess of the amount recognized in the consolidatedstatements of financial condition.

 

The Bank does not use financial instruments with off-balance sheet riskas part of its asset/liability management program or for trading purposes. TheBank’s exposure to credit loss in the event of nonperformance by the otherparty to the financial instrument for commitments to extend credit and standbyletters of credit is represented by the contractual amounts of thoseinstruments. The Bank uses the same credit policies in making commitments andconditional obligations as it does for on-balance sheet instruments.

 

Commitments to extend credit are agreements to lend to a customer aslong as there is no violation of any condition established in the contract.Commitments generally have fixed expiration dates or other termination clauses.The Bank evaluates each customer’s creditworthiness on a case-by-case basis.The amount of collateral obtained, if deemed necessary by the Bank uponextension of credit, is based on management’s credit evaluation of thecounterparty. Such collateral consists primarily of residential properties.Standby letters of credit are conditional commitments issued by the Bank toguarantee the performance of a customer to a third party. The credit riskinvolved in issuing letters of credit is essentially the same as that involvedin extending loan facilities to customers.

 

The funding period for construction loans is generally six-totwelve-months and commitments to originate mortgage loans are generallyoutstanding for 60 days or less.

 

The Company, in the normal course of business, makes commitments to buyor sell assets or to incur or fund liabilities. Commitments include, but arenot limited to:

 

•                  the origination,purchase or sale of loans;

•                  the purchase ofinvestment securities;

•                  the fulfillmentof commitments under letters-of-credit, extensions of credit on home equitylines of credit, construction loans, and under predetermined overdraftprotection limits; and

•                  the commitmentto fund withdrawals of certificates of deposit at maturity.

 

At December 31, 2003, the Bank’s off-balance sheet arrangementsprincipally included lending commitments, which are described below. AtDecember 31, 2003, the Company had no interests in non-consolidated specialpurpose entities.

 

At December 31, 2003, commitments included:

 

•                  total approvedloan origination commitments outstanding amounting to $14.2 million, including$4.3 million of loans committed to sell;

•                  commitments topurchase loans of $3.9 million;

•                  rate lockagreements with customers of $4.3 million, all of which have been locked withan investor;

•                  funded mortgageloans committed to sell of $1.7 million;

•                  unadvancedportion of construction loans of $35.2 million;

 

63

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•                  unused lines ofcredit of $20.8 million;

•                  outstandingstandby letters of credit of $1.7 million;

•                  totalpredetermined overdraft protection limits of $9.7 million; and

•                  certificates ofdeposit scheduled to mature in one year or less totaling $187.6 million.

 

Total unfunded commitments to originate loans for sale and the relatedcommitments to sell of $4.3 million meet the definition of a derivativefinancial instrument. The related asset and liability are considered immaterialat December 31, 2003.

 

Historically, a very small percentage of predetermined overdraft limitshave been used. At December 31, 2003, overdrafts of accounts with BounceProtectionä represented usageof 2.1% of the limit.

 

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

 

**14.****                               FAIRVALUE OF FINANCIAL INSTRUMENTS**

 

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 acurrent market exchange. The use of different market assumptions and/orestimation methodologies may have a material effect on the estimated fair valueamounts. The estimated fair values of financial instruments are as follows (inthousands):

 
|                                                   |   | **December 31, 2003** |   | **December 31, 2002**      |   |
|--------------------------------------------------------|--------|-----------------------|--------|----------------------------|--------|
|                                                   |   | **Carrying  Value**   |   | **Estimated  Fair  Value** |   | **Carrying  Value** |   | **Estimated  Fair  Value** |   |
| ASSETS:                                                |   |                  |   |                       |   |   |   |   |   |
| Cash and cash equivalents                              |   | $                     | 56,201 |                       | $      | 56,201 |   | $ | 44,493 |   | $ | 44,493 |   |
| Investment securities—held to maturity            |   | 80,379                |   | 80,163                     |   | 114,471 |   | 115,734 |   |
| Federal Home Loan Bank stock                           |   | 3,749                 |   | 3,749                      |   | 5,064 |   | 5,064 |   |
| Loans receivable—net                              |   | 512,756               |   | 518,666                    |   | 483,468 |   | 492,750 |   |
| Cash surrender value of life insurance                 |   | 17,102                |   | 17,102                     |   | 16,254 |   | 16,254 |   |
| Accrued interest receivable                            |   | 4,089                 |   | 4,089                      |   | 4,380 |   | 4,380 |   |
| Commitments                                            |   | 1                     |   | 1                          |   | 85 |   | 85 |   |
|                                                   |   |                  |   |                       |   |   |   |   |   |
| LIABILITIES:                                           |   |                  |   |                       |   |   |   |   |   |
| Deposits:                                              |   |                  |   |                       |   |   |   |   |   |
| Demand, NOW, money market and regular savings          |   | 233,759               |   | 233,759                    |   | 194,643 |   | 194,643 |   |
| Certificates of deposit                                |   | 339,821               |   | 348,208                    |   | 374,119 |   | 380,574 |   |
| Federal Home Loan Bank advances                        |   | 39,562                |   | 40,062                     |   | 38,610 |   | 39,664 |   |
| Accrued interest payable                               |   | 244                   |   | 244                        |   | 331 |   | 331 |   |
| Advance payments by borrowers for taxes and  insurance |   | 725                   |   | 725                        |   | 760 |   | 760 |   |
| Commitments                                            |   | 1                     |   | 1                          |   | 85 |   | 85 |   |
|                                                        |        |                       |        |                            |        |  |  |  |  |  |  |  |  |

 

For cash and cash equivalents, Federal Home Loan Bank stock, cashsurrender value of life insurance and accrued interest receivable, the carryingvalue is a reasonable estimate of fair value, primarily because of theshort-term nature of the instruments or, as to Federal Home Loan Bank stock,the ability to sell the stock back to the Federal Home Loan Bank at cost. Thefair value of investment securities is based on quoted market prices, dealerquotes and prices obtained from independent pricing services. The fair value ofvariable rate loans is based on repricing dates. Fixed-rate loans were valuedusing discounted cash flows. The discount rates used to determine the presentvalue of these loans were based on interest rates currently being charged bythe Bank on comparable loans as to credit risk and term.

 

64

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The fair value of demand deposit accounts, NOW accounts, savingsaccounts and money market deposits is the amount payable on demand at thereporting date. The fair value of fixed-maturity certificates of deposit andFederal Home Loan Bank advances is estimated using the rates currently offeredfor deposits of similar terms and advances of similar remaining maturities atthe reporting date. For advance payments by borrowers, for taxes and insuranceand for accrued interest payable the carrying value is a reasonable estimate offair value, primarily because of the short-term nature of the instruments.

 

The fair value estimates presented herein are based on pertinentinformation available to management as of December 31, 2003 and 2002.Although management is not aware of any factors that would significantly affectthe estimated 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.

 

**15.****                               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.

 

**16.****                               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 liquidation (and only in suchevent), each eligible and supplemental eligible account holder will be entitledto receive a liquidation distribution from the liquidation account in an amountproportionate to the current adjusted qualifying balances for accounts thenheld.

 

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.

 

**17.****                               REGULATORYMATTERS**

 

The Bank is subject to various regulatory capital requirementsadministered by the Office of Thrift Supervision (“OTS”). Failure to meetminimum capital requirements can initiate certain mandatory—and possibleadditional discretionary—actions by regulators that, if undertaken, could havea direct and material effect on the Bank’s financial statements. Under capitaladequacy guidelines and the regulatory framework for prompt corrective action,the Bank must meet specific capital guidelines that involve quantitativemeasures of the Bank’s assets, liabilities, and certain off-balance sheet itemsas calculated under regulatory accounting practices. The Bank’s capital amountsand classification are also subject to qualitative judgments by the regulatorsabout components, risk weightings, and other factors.

 

Quantitative measures established by regulation to ensure capitaladequacy require the Bank to maintain minimum amounts and ratios (set forth inthe table below) of tangible capital (as defined in the regulations) totangible assets (as defined) and core capital (as defined) to adjusted tangibleassets (as defined), and of total risk-based capital (as defined) torisk-weighted assets (as defined). Management believes, as of December 31,2003, that the Bank meets all capital adequacy requirements to which it issubject.

 

At December 31, 2003 and 2002, 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 Bankmust maintain 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.

 

65

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

 
|                                     |   | **Actual** |       | **For Capital  Adequacy Purposes** |       | **To be Categorized  as Well  Capitalized Under  Prompt Corrective  Action Provisions** |       |
|------------------------------------------|--------|------------|------------|------------------------------------|------------|-----------------------------------------------------------------------------------------|------------|
|                                     |   | **Amount** |       | **Ratio**                          |       | **Amount**                                                                              |       | **Ratio** |   | **Amount** |   | **Ratio** |   |
|                                     |   |       | ** ** |                               | ** ** |                                                                                    | ** ** |   | ** ** |   | ** ** |   | ** ** |
| As of December 31, 2003:                 |   |       |       |                               |       |                                                                                    |       |   |   |   |   |   |   |
|                                     |   |       |       |                               |       |                                                                                    |       |   |   |   |   |   |   |
| Tangible Capital to Tangible Assets      |   | $          | 70,868     |                               | 10.27      | %                                                                                       | $          | 10,353 |   | 1.50 | % | N/A |   | N/A |   |
|                                     |   |       |       |                               |       |                                                                                    |       |   |   |   |   |   |   |
| Core Capital to Adjusted Tangible Assets |   | 70,868     |       | 10.27                              | %          | 27,608                                                                                  |       | 4.00 | % | $ | 34,509 |   | 5.00 | % |
|                                     |   |       |       |                               |       |                                                                                    |       |   |   |   |   |   |   |
| Total Capital to Risk-Weighted Assets    |   | 72,237     |       | 16.25                              | %          | 35,557                                                                                  |       | 8.00 | % | 44,447 |   | 10.00 | % |
|                                     |   |       |       |                               |       |                                                                                    |       |   |   |   |   |   |   |
| Tier I Capital to Risk-Weighted Assets   |   | 70,868     |       | 15.94                              | %          | N/A                                                                                     |       | N/A |   | 26,668 |   | 6.00 | % |
|                                     |   |       |       |                               |       |                                                                                    |       |   |   |   |   |   |   |
| As of December 31, 2002:                 |   |       |       |                               |       |                                                                                    |       |   |   |   |   |   |   |
|                                     |   |       |       |                               |       |                                                                                    |       |   |   |   |   |   |   |
| Tangible Capital to Tangible Assets      |   | 66,509     |       | 9.78                               | %          | 10,196                                                                                  |       | 1.50 | % | N/A |   | N/A |   |
|                                     |   |       |       |                               |       |                                                                                    |       |   |   |   |   |   |   |
| Core Capital to Adjusted Tangible Assets |   | 66,509     |       | 9.78                               | %          | 27,190                                                                                  |       | 4.00 | % | $ | 33,988 |   | 5.00 | % |
|                                     |   |       |       |                               |       |                                                                                    |       |   |   |   |   |   |   |
| Total Capital to Risk-Weighted Assets    |   | 67,413     |       | 17.03                              | %          | 31,675                                                                                  |       | 8.00 | % | 39,593 |   | 10.00 | % |
|                                     |   |       |       |                               |       |                                                                                    |       |   |   |   |   |   |   |
| Tier I Capital to Risk-Weighted Assets   |   | 66,509     |       | 16.80                              | %          | N/A                                                                                     |       | N/A |   | 23,756 |   | 6.00 | % |
|                                          |        |            |            |                                    |            |                                                                                         |            |  |  |  |  |  |  |  |  |  |

 

**18.****                               RELATEDPARTY 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$2.5 and $3.0 million at December 31, 2003 and 2002, respectively.

 

Deposits from related parties held by the Bank at December 31,2003 and 2002 amounted to $3.9 and $3.7 million, respectively.

 

66

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**19.****                               PARENTCOMPANY ONLY FINANCIAL INFORMATION**

 

The following condensed statements of financial condition, as ofDecember 31, 2003 and 2002, and condensed statements of income and of cashflows for each of the three years in the period ended December 31, 2003,for First Federal Bancshares of Arkansas, Inc. should be read in conjunctionwith the consolidated financial statements and the notes herein.

 

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

**(Parent Company Only)**

 

**CONDENSED STATEMENTS OF FINANCIAL CONDITION**

**DECEMBER 31, 2003 AND 2002**

**(In thousands)**

 
|                                           |   | **2003** |       | **2002** |       |
|------------------------------------------------|--------|----------|------------|----------|------------|
| **ASSETS**                                     |   |     | ** ** |     | ** ** |
|                                           |   |     |       |     |       |
| Cash and cash equivalents (deposits in Bank)   |   | $        | 236        |     | $          | 391 |   |
| Loan to Bank subsidiary                        |   | 3,195    |       | 1,967    |       |
| Accrued interest receivable                    |   | 2        |       | 2        |       |
| Investment in Bank                             |   | 71,122   |       | 66,509   |       |
| Other assets                                   |   | 938      |       | 747      |       |
|                                           |   |     |       |     |       |
| TOTAL                                          |   | $        | 75,493     |     | $          | 69,616 |   |
|                                           |   |     |       |     |       |
| **LIABILITIES AND STOCKHOLDERS’  EQUITY** |   |     |       |     |       |
|                                           |   |     |       |     |       |
| Accrued expenses and other liabilities         |   | $        | 415        |     | $          | 350 |   |
| Stockholders’ equity                      |   | 75,078   |       | 69,266   |       |
|                                           |   |     |       |     |       |
| TOTAL                                          |   | $        | 75,493     |     | $          | 69,616 |   |

 

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

**(Parent Company Only)**

 

**CONDENSED STATEMENTS OF INCOME**

**YEARS ENDED DECEMBER 31, 2003, 2002, AND 2001**

**(In thousands)**

 
|                                                                                             |   | **2003** |       | **2002** |       | **2001** |       |
|--------------------------------------------------------------------------------------------------|--------|----------|------------|----------|------------|----------|------------|
|                                                                                             |   |     | ** ** |     | ** ** |     | ** ** |
| INCOME:                                                                                          |   |     |       |     |       |     |       |
| Dividends from the Bank                                                                          |   | $        | 3,000      |     | $          | 8,000    |       | $ | 12,900 |   |
| Interest income—loan to the Bank                                                            |   | 24       |       | 34       |       | 139      |       |
|                                                                                             |   |     |       |     |       |     |       |
| Total income                                                                                     |   | 3,024    |       | 8,034    |       | 13,039   |       |
|                                                                                             |   |     |       |     |       |     |       |
| EXPENSES:                                                                                        |   |     |       |     |       |     |       |
| Management fees                                                                                  |   | 66       |       | 66       |       | 66       |       |
| Other operating expenses                                                                         |   | 228      |       | 184      |       | 144      |       |
|                                                                                             |   |     |       |     |       |     |       |
| Total expenses                                                                                   |   | 294      |       | 250      |       | 210      |       |
|                                                                                             |   |     |       |     |       |     |       |
| INCOME BEFORE INCOME TAX BENEFIT AND EQUITY IN  UNDISTRIBUTED EARNINGS (LOSS) OF BANK SUBSIDIARY |   | 2,730    |       | 7,784    |       | 12,829   |       |
|                                                                                             |   |     |       |     |       |     |       |
| INCOME TAX BENEFIT                                                                               |   | 103      |       | 82       |       | 24       |       |
|                                                                                             |   |     |       |     |       |     |       |
| INCOME BEFORE EQUITY IN UNDISTRIBUTED EARNINGS (LOSS)  OF BANK SUBSIDIARY                        |   | 2,833    |       | 7,866    |       | 12,853   |       |
|                                                                                             |   |     |       |     |       |     |       |
| EQUITY IN UNDISTRIBUTED EARNINGS (LOSS) OF BANK  SUBSIDIARY                                      |   | 4,623    |       | (88      | )          | (7,393   | )          |
|                                                                                             |   |     |       |     |       |     |       |
| NET INCOME                                                                                       |   | $        | 7,456      |     | $          | 7,778    |       | $ | 5,460 |   |

 

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

**(Parent Company Only)**

 

**CONDENSED STATEMENTS OF CASH FLOWS**

**YEARS ENDED DECEMBER 31, 2003, 2002, AND 2001**

**(In thousands)**

 
|                                                                               |   | **2003** |       | **2002** |       | **2001** |       |
|------------------------------------------------------------------------------------|--------|----------|------------|----------|------------|----------|------------|
|                                                                               |   |     | ** ** |     | ** ** |     | ** ** |
| OPERATING ACTIVITIES:                                                              |   |     |       |     |       |     |       |
| Net income                                                                         |   | $        | 7,456      |     | $          | 7,778    |       | $ | 5,460 |   |
| Adjustments to reconcile net income to net cash  provided by operating activities: |   |     |       |     |       |     |       |
| Equity in undistributed net (earnings) loss of  Bank                               |   | (4,623   | )          | 88       |       | 7,393    |       |
| Release of ESOP shares                                                             |   | 1,322    |       | 1,016    |       | 850      |       |
| Stock compensation expense                                                         |   | 45       |       |     |       | 297      |       |
| Changes in operating assets and liabilities:                                       |   |     |       |     |       |     |       |
| Accrued interest receivable                                                        |   |     |       | 4        |       | 5        |       |
| Other assets                                                                       |   | (190     | )          | (236     | )          | 297      |       |
| Accrued expenses and other liabilities                                             |   | 264      |       | 30       |       | 114      |       |
|                                                                               |   |     |       |     |       |     |       |
| Net cash provided by operating activities                                          |   | 4,274    |       | 8,680    |       | 14,416   |       |
|                                                                               |   |     |       |     |       |     |       |
| INVESTING ACTIVITIES—Loan to bank—net of  repayments                     |   | (1,228   | )          | 2,129    |       | (2,278   | )          |
|                                                                               |   |     |       |     |       |     |       |
| Net cash provided by (used in) investing  activities                               |   | (1,228   | )          | 2,129    |       | (2,278   | )          |
|                                                                               |   |     |       |     |       |     |       |
| FINANCING ACTIVITIES:                                                              |   |     |       |     |       |     |       |
| Purchase of treasury stock                                                         |   | (2,805   | )          | (9,547   | )          | (10,682  | )          |
| Dividends paid                                                                     |   | (1,814   | )          | (1,471   | )          | (1,437   | )          |
| Stock options exercised                                                            |   | 1,418    |       | 422      |       |     |       |
|                                                                               |   |     |       |     |       |     |       |
| Net cash used in financing activities                                              |   | (3,201   | )          | (10,596  | )          | (12,119  | )          |
|                                                                               |   |     |       |     |       |     |       |
| NET INCREASE (DECREASE) IN CASH AND CASH  EQUIVALENTS                              |   | (155     | )          | 213      |       | 19       |       |
|                                                                               |   |     |       |     |       |     |       |
| CASH AND CASH EQUIVALENTS:                                                         |   |     |       |     |       |     |       |
| Beginning of period                                                                |   | 391      |       | 178      |       | 159      |       |
|                                                                               |   |     |       |     |       |     |       |
| End of period                                                                      |   | $        | 236        |     | $          | 391      |       | $ | 178 |   |

 

******

 

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**SELECTED QUARTERLY OPERATING RESULTS**

(IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)

 
| **YEAR ENDED DECEMBER 31, 2003**                     |   | **FOURTH  QUARTER** |   | **THIRD  QUARTER** |   | **SECOND  QUARTER** |   | **FIRST  QUARTER** |   |
|------------------------------------------------------|--------|---------------------|--------|--------------------|--------|---------------------|--------|--------------------|--------|
| Interest income                                      |   | $                   | 9,463  |               | $      | 9,475               |   | $                  | 9,716  |   | $ | 10,091 |   |
| Interest expense                                     |   | 3,681               |   | 3,799              |   | 4,118               |   | 4,388              |   |
| Net interest  income                                 |   | 5,782               |   | 5,676              |   | 5,598               |   | 5,703              |   |
| Provision for  loan losses                           |   | 71                  |   | 204                |   | 136                 |   | 279                |   |
| Net interest  income after provision for loan losses |   | 5,711               |   | 5,472              |   | 5,462               |   | 5,424              |   |
| Noninterest  income                                  |   | 1,441               |   | 1,861              |   | 2,145               |   | 1,542              |   |
| Noninterest expense                                  |   | 4,689               |   | 4,547              |   | 4,994               |   | 4,033              |   |
| Income before  income taxes                          |   | 2,463               |   | 2,786              |   | 2,613               |   | 2,933              |   |
| Provision for  income taxes                          |   | 750                 |   | 914                |   | 726                 |   | 949                |   |
| Net income                                           |   | $                   | 1,713  |               | $      | 1,872               |   | $                  | 1,887  |   | $ | 1,984 |   |
|                                                 |   |                |   |               |   |                |   |               |   |
| Earnings per  share(1):                              |   |                |   |               |   |                |   |               |   |
| Basic                                                |   | $                   | 0.33   |               | $      | 0.37                |   | $                  | 0.37   |   | $ | 0.39 |   |
| Diluted                                              |   | $                   | 0.31   |               | $      | 0.35                |   | $                  | 0.35   |   | $ | 0.38 |   |
|                                                 |   |                |   |               |   |                |   |               |   |
| Selected Ratios  (Annualized):                       |   |                |   |               |   |                |   |               |   |
| Net interest  margin                                 |   | 3.59                | %      | 3.50               | %      | 3.45                | %      | 3.55               | %      |
| Return on average  assets                            |   | 0.99                |   | 1.08               |   | 1.09                |   | 1.16               |   |
| Return on average  equity                            |   | 9.16                |   | 10.19              |   | 10.48               |   | 11.24              |   |

 
| **YEAR  ENDED DECEMBER 31, 2002**                    |   | **FOURTH  QUARTER** |   | **THIRD  QUARTER** |   | **SECOND  QUARTER** |   | **FIRST  QUARTER** | ** ** |
|------------------------------------------------------|--------|---------------------|--------|--------------------|--------|---------------------|--------|--------------------|------------|
| Interest income                                      |   | $                   | 10,678 |               | $      | 11,070              |   | $                  | 11,142     |   | $ | 11,204 |   |
| Interest expense                                     |   | 4,757               |   | 5,122              |   | 5,708               |   | 6,046              |       |
| Net interest  income                                 |   | 5,921               |   | 5,948              |   | 5,434               |   | 5,158              |       |
| Provision for  loan losses                           |   | 518                 |   | 247                |   | 373                 |   | 362                |       |
| Net interest  income after provision for loan losses |   | 5,403               |   | 5,701              |   | 5,061               |   | 4,796              |       |
| Noninterest  income                                  |   | 1,477               |   | 1,323              |   | 1,259               |   | 1,287              |       |
| Noninterest  expense                                 |   | 3,920               |   | 3,617              |   | 3,570               |   | 3,417              |       |
| Income before  income taxes                          |   | 2,960               |   | 3,407              |   | 2,750               |   | 2,666              |       |
| Provision for  income taxes                          |   | 996                 |   | 1,183              |   | 916                 |   | 910                |       |
| Net income                                           |   | $                   | 1,964  |               | $      | 2,224               |   | $                  | 1,834      |   | $ | 1,756 |   |
|                                                 |   |                |   |               |   |                |   |               |       |
| Earnings per  share(1):                              |   |                |   |               |   |                |   |               |       |
| Basic                                                |   | $                   | 0.38   |               | $      | 0.42                |   | $                  | 0.33       |   | $ | 0.31 |   |
| Diluted                                              |   | $                   | 0.36   |               | $      | 0.40                |   | $                  | 0.32       |   | $ | 0.30 |   |
|                                                 |   |                |   |               |   |                |   |               |       |
| Selected Ratios  (Annualized):                       |   |                |   |               |   |                |   |               |       |
| Net interest  margin                                 |   | 3.73                | %      | 3.73               | %      | 3.35                | %      | 3.21               | %          |
| Return on average  assets                            |   | 1.16                |   | 1.32               |   | 1.07                |   | 1.03               |       |
| Return on average  equity                            |   | 11.33               |   | 12.78              |   | 10.26               |   | 9.73               |       |

 

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(1)    Basic and diluted earnings per share, aswell as basic and diluted shares outstanding, have been restated for the effectof the two-for-one stock split paid on December 31, 2003.  Basic and diluted shares outstanding aresummarized below.

 

 
|                                    |   | **FOURTH  QUARTER** |   | **THIRD  QUARTER** |   | **SECOND  QUARTER** |   | **FIRST  QUARTER** |   |
|-----------------------------------------|--------|---------------------|--------|--------------------|--------|---------------------|--------|--------------------|--------|
| YEAR ENDED  DECEMBER 31, 2003           |   |                |   |               |   |                |   |               |   |
| Basic weighted — average  shares   |   | 5,119,672           |   | 5,105,834          |   | 5,088,516           |   | 5,084,904          |   |
| Effect of dilutive  securities          |   | 348,725             |   | 306,971            |   | 255,572             |   | 202,249            |   |
| Diluted weighted — average  shares |   | 5,468,397           |   | 5,412,805          |   | 5,344,088           |   | 5,287,153          |   |
|                                    |   |                |   |               |   |                |   |               |   |
| YEAR ENDED  DECEMBER 31, 2002           |   |                |   |               |   |                |   |               |   |
| Basic weighted — average  shares   |   | 5,118,728           |   | 5,270,438          |   | 5,553,300           |   | 5,717,988          |   |
| Effect of dilutive  securities          |   | 219,984             |   | 221,698            |   | 213,474             |   | 170,526            |   |
| Diluted weighted — average  shares |   | 5,338,712           |   | 5,492,136          |   | 5,766,774           |   | 5,888,514          |   |

 

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

 

NotApplicable.

 

**Item 9A.  Controls andProcedures**

 

Our management evaluated, with the participation of our Chief ExecutiveOfficer and Chief Financial Officer, the effectiveness of the design andoperation of our disclosure controls and procedures (as defined in Rules13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934) as of theend of the period covered by this report. Based on such evaluation, our Chief Executive Officer and ChiefFinancial Officer have concluded that our disclosure controls and proceduresare designed to ensure that information required to be disclosed by us in thereports that we file or submit under the Securities Exchange Act of 1934 isrecorded, processed, summarized and reported within the time periods specifiedin the SEC’s rules and regulations and are operating in an effective manner.

 

No change in our internal control over financial reporting (as definedin Rules 13a-15(f) and 15(d)-15(f) under the Securities Exchange Act of 1934)occurred during the most recent fiscal quarter that has materially affected, oris reasonably likely to materially affect, our internal control over financialreporting.

 

**PART III.**

 

**Item 10.  Directors andExecutive Officers of the Registrant.**

 

Theinformation required herein is incorporated by reference from pages 4 to 9 ofthe definitive proxy statement of the Company for the Annual Meeting ofStockholders to be held on April 28, 2004 (“Definitive Proxy Statement”).

 

**Item 11.  ExecutiveCompensation.**

 

Theinformation required herein is incorporated by reference from pages 13 to 17and page 19 of the Definitive Proxy Statement.

 

**Item 12.  SecurityOwnership of Certain Beneficial Owners and Management and Related StockholderMatters.**

 

Theinformation required herein is incorporated by reference from pages 10 to 12 ofthe Definitive Proxy Statement.

 

**Item 13.  CertainRelationships and Related Transactions.**

 

Theinformation required herein is incorporated by reference from page 16 of theDefinitive Proxy Statement.

 

**Item 14.  PrincipalAccountant Fees and Services.**

 

Theinformation required herein is incorporated by reference from pages 17 and 18of the Definitive Proxy Statement.

 

**PART IV.**

 

**Item 15. Exhibits, Financial Statement Schedules and Reportson Form 8-K.**

 

**(a)  DocumentsFiled as Part of this Report**

 

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

 

(2) All schedules for which provision is made in theapplicable accounting regulation of the SEC are omitted because of the absenceof conditions under which they are required or because the required informationis included in the financial statements and related notes thereto.

 

(3)The following exhibits are filed as part of this Form 10-K and this listincludes the Exhibit Index.

 

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Exhibit Index

 

 
| 2.1*    |   | Plan  of Conversion                                                                                                                                         |
|---------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.1*    |   | Articles  of Incorporation of First Federal Bancshares of Arkansas, Inc.                                                                                    |
| 3.2*    |   | Bylaws  of First Federal Bancshares of Arkansas, Inc.                                                                                                       |
| 4.0**   |   | Stock  Certificate of First Federal Bancshares of Arkansas, Inc.                                                                                            |
| 10.6*   |   | Employment  Agreement between the Company, the Bank and Larry J. Brandt                                                                                     |
| 10.7*** |   | Employment  Agreement between the Company, the Bank and Tommy W. Richardson                                                                                 |
| 10.8*** |   | Employment  Agreement between the Company, the Bank and Sherri R. Billings                                                                                  |
| 21.0    |   | Subsidiaries  of the Registrant - Reference is made to “Item 1 Business - Subsidiaries” for  the required information                             |
| 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                                                                                                                       |

 

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(*)        Incorporated herein by reference from the Company’sRegistration Statement on Form S-1 (File No. 333-612) filed with the SEC.

 

(**)      Incorporated herein by reference from the Company’sRegistration Statement on Form 8-A filed with the SEC.

 

(***)   Incorporated herein by reference from the Company’s Annual Reporton Form 10-K for the fiscal year ended December 31, 2002 filed with the SEC.

 

**(b)****         ****Reports on Form 8-K**

 

On October 29, 2003, a Form 8-K was filed forthe Company’s October 29, 2003 press release announcing results of operationsfor the quarter ended September 30, 2003.

 

On November 5, 2003, a Form 8-K was filed forthe Company’s November 5, 2003, press release announcing stock repurchaseprogram activity.

 

On November 25, 2003, a Form 8-K was filedfor the Company’s November 25, 2003, press release announcing a quarterly cashdividend.

 

On December 9, 2003, a Form 8-K was filed forthe Company’s December 8, 2003, press release announcing a two-for-one stocksplit.

 

72

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**SIGNATURES**

 

 

Pursuantto the requirements of Section 13 or 15(d) of the Securities Exchange Act of1934, the Registrant has duly caused this report to be signed on its behalf bythe undersigned, thereunto duly authorized.

 

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

 

 

Pursuantto the requirements of the Securities Exchange Act of 1934, this report hasbeen signed below by the following persons on behalf of the Registrant and inthe capacities and on the dates indicated.

 

 

 
| /s/  Larry J. Brandt                                       |   | March  5, 2004 |   |
|------------------------------------------------------------|--------|----------------|--------|
| Larry  J. Brandt                                           |   |           |
| President  and Chief Executive Officer                |   |           |
|                                                       |   |           |
| /s/  John P. Hammerschmidt                                 |   | March  5, 2004 |   |
| John  P. Hammerschmidt                                     |   |           |
| Chairman                                                   |   |           |
|                                                       |   |           |
| /s/  James D. Heuer                                        |   | March  5, 2004 |   |
| James  D. Heuer                                            |   |           |
| Director                                                   |   |           |
|                                                       |   |           |
| /s/  Kenneth C. Savells                                    |   | March  5, 2004 |   |
| Kenneth  C. Savells                                        |   |           |
| Director                                                   |   |           |
|                                                       |   |           |
| /s/  Frank Conner                                          |   | March  5, 2004 |   |
| Frank  Conner                                              |   |           |
| Director                                                   |   |           |
|                                                       |   |           |
| /s/  Sherri R. Billings                                    |   | March  5, 2004 |   |
| Sherri  R. Billings                                        |   |           |
| Executive  Vice President and Chief Financial Officer |   |           |
|                                                            |        |                |        |  |  |  |  |  |

 

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