# ** **

# **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,  2004**                                                                                                                                                                          |
|                                                                                                                                                                                                                           |
| **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**

 

**FirstFederal Bancshares of Arkansas, Inc.**

(Exact name of registrant as specified in itscharter)

 
| **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’s telephone  number, including area code:**(870) 741-7641** |
|                                                                        |       |                                     |
| Securities registered  pursuant to Section 12(b) of the Act:           |
| **Not  Applicable**                                                         |
|                                                                        |       |                                     |
| Securities registered  pursuant to Section 12(g) of the Act            |
|                                                                        |       |                                     |
| **Common  Stock (par value $.01 per share)**                                |
| (Title of Class)                                                            |

 

Indicate by check mark whether the Registrant (1) has filed all reportsrequired by Section 13 or 15(d) of the Securities Exchange Act of 1934during the preceding 12 months (or for such shorter period that the Registrantwas required to file such reports), and (2) has been subject to such filingrequirements for the past 90 days.

Yes  ý  No  o

 

Indicate by check mark if disclosure of delinquent filers pursuant toItem 405 of Regulation S-K is not contained herein, and will not be contained,to the best of Registrant’s knowledge, in definitive proxy or informationstatements incorporated by reference in Part III of this Form 10-K or anyamendment to this Form 10-K.  ý

 

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

 

Yes  ý  No  o

 

As of June 30, 2004, the aggregate value of the 4,647,899 sharesof Common Stock of the Registrant issued and outstanding on such date, whichexcludes 547,583 shares held by directors and officers of the Registrant as agroup, was approximately $90.7 million. This figure is based on the last sales price of $19.51 per share of theRegistrant’s Common Stock on June 30, 2004.

 

Number of shares of Common Stock outstanding as of February 22,2005:  5,079,408

 

**DOCUMENTS INCORPORATED BY REFERENCE**

 

List hereunder the followingdocuments incorporated by reference and the Part of the Form 10-K into whichthe document is incorporated.

 

Portions of the definitiveproxy statement for the 2005 Annual Meeting of Stockholders are incorporatedinto Part III, Items 10 through 14 of this Form 10-K.

 

 

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**PART I.**

 

**Item 1.****  Business**

 

**General**

 

**First Federal Bancshares ofArkansas, Inc.**** **First Federal Bancshares of Arkansas, Inc.(the “Company”) is a Texas corporation organized in January 1996 by FirstFederal Bank of Arkansas, FA (“First Federal” or the “Bank”) for the purpose ofbecoming a unitary holding company of the Bank. The only significant assets of the Company are the capital stock of theBank, the Company’s loan to the Employee Stock Ownership Plan (“ESOP”), andcash.  The business and management of theCompany consists of the business and management of the Bank.  The Company does not presently own or leaseany property, but instead uses the premises, equipment and furniture of theBank.  At the present time, the Companydoes not employ any persons other than officers of the Bank, and the Companyutilizes the support staff of the Bank from time to time.  Additional employees will be hired asappropriate to the extent the Company expands or changes its business in thefuture.  At December 31, 2004, theCompany had $751.7 million in total assets, $582.4 million in total depositsand $75.3 million in stockholders’ equity.

 

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

 

**First Federal Bank of Arkansas, FA.**** **The Bank is a federally chartered stock savings and loan associationformed in 1934.  First Federal conductsbusiness from its main office and fourteen full service branch offices, all ofwhich are located in a six county area in Northcentral and Northwest Arkansascomprised of Benton, Marion, Washington, Carroll, Baxter and Boonecounties.  First Federal’s deposits areinsured by the Savings Association Insurance Fund (“SAIF”), which isadministered by the Federal Deposit Insurance Corporation (“FDIC”), to themaximum extent permitted by law.

 

The Bank is a community-orientedfinancial institution offering a wide range of retail and small business 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 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 reserverequirements established by the Board of Governors of the Federal ReserveSystem (“FRB”) and is a member of the Federal Home Loan Bank (“FHLB”) ofDallas, which is one of the 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, inthose 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 they relate tothe Company or the Company’s management, are intended to identifyforward-looking statements.  Suchstatements reflect the current views of the Company with respect to futurelooking events and are subject to certain risks, uncertainties andassumptions.  Should one or more of theserisks 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 229 full-time employees and 38 part-time employees at December 31,2004, compared to 237 full-time employees and 37 part-time employees at December 31,2003.  None of these employees isrepresented by a collective bargaining agent, and the Bank believes that itenjoys good relations with its personnel.

 

1

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## **AvailableInformation**

## ** **

The Company makes available free of charge its annual report on Form10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and allamendments to such reports filed pursuant to Sections 13(a) or 15(d) of theSecurities Exchange Act of 1934, as soon as reasonably practicable on orthrough its website located at www.ffbh.com after filing with the United StatesSecurities and Exchange Commission.

 

## **Competition**

## ** **

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

 

TheBank experiences strong competition for loans principally from savingsassociations, community banks, commercial banks and mortgage companies.  In 2004, several new community banks andseveral well-established financial institutions have begun to establishbranches in the Washington-Benton county area, providing for increasedcompetition. The Bank competes for loans principally through the interest ratesand loan fees it charges and the efficiency and quality of services it providesborrowers.  Competition has increased asa result of the continuing reduction of restrictions on the interstateoperations of financial institutions.

 

**Lending Activities**

 

**General.**** **At December 31, 2004, the Bank’s portfolio of net loans receivableamounted to $634.2 million or 84.4% of the Company’s total assets.  The Bank has traditionally concentrated itslending activities on loans collateralized by real estate.  Consistent with such approach, $596.6 millionor 85.3% of the Bank’s total portfolio of loans receivable (“total loanportfolio”) consisted of loans collateralized by first mortgage loans at December 31,2004.

 

Inrecent years, the Bank has placed an increased emphasis on commercial realestate lending, construction lending, and commercial lending in order tobetter utilize excess cash and to transition to more of a full-servicecommunity bank.  The table below summarizes the changes in thecomposition of the loan portfolio between December 31, 2000, which is theearliest year presented in the loan composition table on page 4, and December 31,2004 (dollars in millions):

 
| ** **                | ** ** | **2004 vs 2000**        | ** ** | **Year Ended December 31,** | ** ** |
|---------------------------|------------|-------------------------|------------|----------------------------------|------------|
| ** **                | ** ** | **Increase (Decrease)** | ** ** | **2004**                         | ** ** | **2000** | ** ** |
| ** **                | ** ** | **Amount**              | ** ** | **Percentage  of Loans**         | ** ** | **Amount** | ** ** | **Percentage  of Loans** | ** ** | **Amount** | ** ** | **Percentage  of Loans** | ** ** |
| Real estate  loans:       |       |                    |       |                             |       |   |   |   |   |   |   |   |   |
| 1-4 family  residential   |       | $                       | (95.2      | )                                | (33.52     | )% | $ | 282.1 |   | 40.35 | % | $ | 377.3 |   | 73.87 | % |
| Multi-family  residential |       | 5.8                     |       | 0.63                             |       | 9.5 |   | 1.35 |   | 3.7 |   | 0.72 |   |
| Commercial  real estate   |       | 103.6                   |       | 12.60                            |       | 145.9 |   | 20.87 |   | 42.3 |   | 8.27 |   |
| Construction              |       | 134.2                   |       | 17.88                            |       | 159.1 |   | 22.76 |   | 24.9 |   | 4.88 |   |
| Total real  estate loans  |       | 148.4                   |       | (2.41                            | )          | 596.6 |   | 85.33 |   | 448.2 |   | 87.74 |   |
|                      |       |                    |       |                             |       |   |   |   |   |   |   |   |   |
| Commercial  loans         |       | 11.5                    |       | 0.79                             |       | 27.6 |   | 3.94 |   | 16.1 |   | 3.15 |   |
|                      |       |                    |       |                             |       |   |   |   |   |   |   |   |   |
| Consumer  loans           |       | 28.5                    |       | 1.62                             |       | 75.0 |   | 10.73 |   | 46.5 |   | 9.11 |   |
|                      |       |                    |       |                             |       |   |   |   |   |   |   |   |   |
| Total (1)                 |       | $                       | 188.4      |                             | 0.00       | % | $ | 699.2 |   | 100.00 | % | $ | 510.8 |   | 100.00 | % |

 

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

 

2

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Commercial real estate, construction and commerciallending are generally considered to involve a higher degree of risk thanresidential real estate lending due to the relatively larger loan amounts andthe effect of general economic conditions on the successful operation of therelated business and/or income producing properties.  The Bank has attempted to reduce such risk byevaluating the credit history and past performance of the borrower, the qualityof the borrowers’ management, the debt service ratio, the quality andcharacteristics of the income stream generated by the business or the propertyand appraisals supporting the property’s valuation as applicable.  See “Asset Quality”.

 

3

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**Loan Composition.**** **The following table sets forth certain data relating to the compositionof the Bank’s loan portfolio by type of loan at the dates indicated.

 
| ** **                                     | ** ** | **December 31,**      | ** ** |
|------------------------------------------------|------------|----------------------------|------------|
| ** **                                     | ** ** | **2004**                   | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** | **2000** | ** ** |
| ** **                                     | ** ** | **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:                             |       |                       |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| 1-4 family  residential                        |       | $                          | 282,144    |   | 40.35 | % | $ | 259,121 |   | 47.09 | % | $ | 289,106 |   | 57.03 | % | $ | 330,844 |   | 67.85 | % | $ | 377,341 |   | 73.87 | % |
| Multi-family  residential                      |       | 9,454                      |       | 1.35 |   | 7,673 |   | 1.39 |   | 5,821 |   | 1.15 |   | 4,386 |   | 0.90 |   | 3,666 |   | 0.72 |   |
| Commercial real  estate                        |       | 145,909                    |       | 20.87 |   | 97,310 |   | 17.69 |   | 75,234 |   | 14.84 |   | 51,592 |   | 10.58 |   | 42,257 |   | 8.27 |   |
| Construction                                   |       | 159,111                    |       | 22.76 |   | 89,332 |   | 16.24 |   | 49,144 |   | 9.69 |   | 24,842 |   | 5.09 |   | 24,937 |   | 4.88 |   |
| Total first mortgage  loans                    |       | 596,618                    |       | 85.33 |   | 453,436 |   | 82.41 |   | 419,305 |   | 82.71 |   | 411,664 |   | 84.42 |   | 448,201 |   | 87.74 |   |
|                                           |       |                       |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Commercial loans                               |       | 27,545                     |       | 3.94 |   | 21,491 |   | 3.91 |   | 19,601 |   | 3.87 |   | 18,755 |   | 3.85 |   | 16,067 |   | 3.15 |   |
|                                           |       |                       |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Consumer loans:                                |       |                       |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Home equity and  second mortgage loans         |       | 45,256                     |       | 6.47 |   | 42,421 |   | 7.71 |   | 35,856 |   | 7.07 |   | 28,798 |   | 5.91 |   | 22,849 |   | 4.47 |   |
| Automobile                                     |       | 19,101                     |       | 2.73 |   | 22,087 |   | 4.01 |   | 22,570 |   | 4.45 |   | 20,506 |   | 4.20 |   | 16,051 |   | 3.14 |   |
| Other                                          |       | 10,685                     |       | 1.53 |   | 10,780 |   | 1.96 |   | 9,621 |   | 1.90 |   | 7,916 |   | 1.62 |   | 7,651 |   | 1.50 |   |
| Total consumer loans                           |       | 75,042                     |       | 10.73 |   | 75,288 |   | 13.68 |   | 68,047 |   | 13.42 |   | 57,220 |   | 11.73 |   | 46,551 |   | 9.11 |   |
|                                           |       |                       |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Total loans  receivable                        |       | 699,205                    |       | 100.00 | % | 550,215 |   | 100.00 | % | 506,953 |   | 100.00 | % | 487,639 |   | 100.00 | % | 510,819 |   | 100.00 | % |
|                                           |       |                       |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Less:                                          |       |                       |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Undisbursed loan  funds                        |       | (62,661                    | )          |   |   | (35,181 | ) |   |   | (20,618 | ) |   |   | (10,144 | ) |   |   | (9,126 | ) |   |   |
| Unearned discounts  and net deferred loan fees |       | (481                       | )          |   |   | (657 | ) |   |   | (1,338 | ) |   |   | (2,078 | ) |   |   | (2,697 | ) |   |   |
| Allowance for loan  losses                     |       | (1,846                     | )          |   |   | (1,621 | ) |   |   | (1,529 | ) |   |   | (923 | ) |   |   | (691 | ) |   |   |
| Total loans  receivable, net                   |       | $                          | 634,217    |   |   |   | $ | 512,756 |   |   |   | $ | 483,468 |   |   |   | $ | 474,494 |   |   |   | $ | 498,305 |   |   |   |

 

4

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**Loan Maturity and Interest Rates.**** **The following table sets forth certain information at December 31,2004 regarding the dollar amount of loans maturing in the Bank’s loan portfoliobased on their contractual terms to maturity. Demand loans and loans having no stated schedule of repayments andno stated maturity are reported as due in one year or less.  All other loans are included in the period inwhich the final contractual repayment is due.

 
| ** **               | ** ** | **Within  One Year** | ** ** | **One  Year  Through  Five Years** | ** ** | **After  Five  Years** | ** ** | **Total** | ** ** |
|--------------------------|------------|----------------------|------------|------------------------------------|------------|------------------------|------------|-----------|------------|
| ** **               | ** ** | **(In  Thousands)**  | ** ** |
| Real estate loans:       |       |                 |       |                               |       |                   |       |      |       |
| 1-4 family residential   |       | $                    | 2,203      |                               | $          | 19,591                 |       | $         | 260,350    |   | $ | 282,144 |   |
| Multi-family residential |       | 939                  |       | 3,392                              |       | 5,123                  |       | 9,454     |       |
| Commercial real estate   |       | 33,914               |       | 81,245                             |       | 30,750                 |       | 145,909   |       |
| Construction             |       | 97,311               |       | 20,173                             |       | 41,627                 |       | 159,111   |       |
| Commercial loans         |       | 16,133               |       | 9,535                              |       | 1,877                  |       | 27,545    |       |
| Consumer loans           |       | 22,428               |       | 46,627                             |       | 5,987                  |       | 75,042    |       |
| Total(1)                 |       | $                    | 172,928    |                               | $          | 180,563                |       | $         | 345,714    |   | $ | 699,205 |   |

 

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

 

Thefollowing table sets forth the dollar amount of the Bank’s loans at December 31,2004 due after one year from such date which have fixed interest rates or whichhave floating or adjustable interest rates.

 
| ** **                | ** ** | **Fixed-Rates**    | ** ** | **Floating or  Adjustable-Rates** | ** ** | **Total** | ** ** |
|---------------------------|------------|--------------------|------------|-----------------------------------|------------|-----------|------------|
| ** **                | ** ** | **(In Thousands)** | ** ** |
| Real estate  loans:       |       |               |       |                              |       |      |       |
| 1-4 family  residential   |       | $                  | 69,119     |                              | $          | 210,822   |       | $ | 279,941 |   |
| Multi-family  residential |       | 7,788              |       | 727                               |       | 8,515     |       |
| Commercial  real estate   |       | 92,441             |       | 19,554                            |       | 111,995   |       |
| Construction              |       | 32,426             |       | 29,374                            |       | 61,800    |       |
| Commercial  loans         |       | 10,442             |       | 970                               |       | 11,412    |       |
| Consumer  loans           |       | 41,243             |       | 11,371                            |       | 52,614    |       |
| Total                     |       | $                  | 253,459    |                              | $          | 272,818   |       | $ | 526,277 |   |

 

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, when currentmortgage loan rates substantially exceed rates on existing mortgage loans and,conversely, decrease when rates on existing mortgage loans substantially exceedcurrent mortgage loan rates.

 

**Origination, Purchase and Sale ofLoans.**  The lending activities of the Bank aresubject to the written, non-discriminatory underwriting standards and policiesestablished by the Bank’s board of directors and management.  Loan originations are obtained from a varietyof sources, including realtor referrals, walk-in customers to the Bank’s branchlocations, solicitation by loan officers, radio, television and newspaperadvertising, and to a lesser extent, through the Bank’s Internet website.  The Bank continually emphasizes its communityties and its practice of quick and efficient underwriting and loan approvalprocesses, made possible in part through the use of automated underwritingsoftware.  The Bank believes it providesexceptional personalized service to its customers.  The Bank requires hazard insurance, titleinsurance, and to the extent applicable, flood insurance on all secured realproperty.

 

5

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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 Vice President/Chief Lending Officer and the SeniorVice President/Commercial Lending Manager as well as the appropriate loancommittee members as described herein.  Allloans are 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.  Various membersof the loan committee may approve loans based upon an aggregate approvalauthority 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 Officer, 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 ormore, commercial real estate loans of $1,000,000 or more, and non-real estateloans of $500,000 or more require approval by the Bank’s board of directors.  All loans are reviewed, subsequent to theloan being closed, by the board of directors.

 

During 2004, the Bank purchased participations in five commercialconstruction loans with a total commitment amount of $13.8 million as well as a$1.2 million participation in a commercial real estate loan.  During 2003, the Bank purchased twocommercial loan participations totaling $3.1 million.  No loans were purchased during 2002.  All participations purchased were current asof December 31, 2004.

 

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 originated subjectto Fannie Mae and/or Freddie Mac underwriting guidelines and are typicallyunderwritten and validated by a third party prior to loan closing.  The Secondary Market Department of the Banktypically locks and confirms the purchase price of the loan on the day of theloan application which protects the Bank from market price movements andensures that the Bank will receive a fair and reasonable price on the sale ofthe respective loan.  Due to the loansbeing underwritten by a third party, the repurchase risk associated with theseloans is substantially assumed by the underwriter.  The Bank believes it has minimal risk ofrepurchase of these loans based upon the contracts with the specificinvestors.  This risk typically involvespotential early prepayments of the mortgage or an early default of a loan.  In 2004, 2003, and 2002, the Bank was notrequired to repurchase any loans.  In2004, 2003, and 2002, the Bank’s secondary market loan sales amounted to $45.8million, $123.5 million, and $65.5 million, respectively.  The significant amount of loan sales in 2003was primarily due to refinancing activity during a period of historically lowinterest rates. The Bank is not involved in loan hedging or other speculativemortgage loan origination activities.

 

In addition to sales of loans on the secondary market, the Bankperiodically sells larger commercial loans or participations in such loans inorder to comply with the Bank’s loans-to-one borrower limit.  In such situations the loans are typicallysold with servicing retained.  During theyears ended December 31, 2004, 2003, and 2002, such loans sold amounted toapproximately $21.5 million, $6.6 million, and $1.8 million, respectively.  At December 31, 2004, 2003, and 2002,the balances of loans sold with servicing retained were approximately $18.9million, $8.4 million, and $2.0 million, respectively.  Loan servicing fee income for the years endedDecember 31, 2004, 2003, and 2002, was approximately $159,000, $36,000,and $5,000, respectively.

 

6

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Followingis a table showing the Bank’s originations, sales, purchases, and repayments ofloans during the periods indicated.

 
| ** **                               | ** ** | **Year Ended December 31,** | ** ** |
|------------------------------------------|------------|----------------------------------|------------|
| ** **                               | ** ** | **2004**                         | ** ** | **2003** | ** ** | **2002** | ** ** |
| ** **                               | ** ** | **(In Thousands)**               | ** ** |
|                                     |       |                             |       |   |   |   |   |
| Loans  receivable at beginning of period |       | $                                | 550,215    |   | $ | 506,953 |   | $ | 487,639 |   |
| Loan  originations:                      |       |                             |       |   |   |   |   |
| Real estate:                             |       |                             |       |   |   |   |   |
| 1-4 family  residential                  |       | 135,584                          |       | 199,984 |   | 136,154 |   |
| Multi-family  residential                |       | 11,303                           |       | 6,103 |   | 2,756 |   |
| Commercial  real estate                  |       | 83,677                           |       | 44,958 |   | 31,878 |   |
| Construction                             |       | 158,929                          |       | 94,105 |   | 54,504 |   |
| Commercial  loans                        |       | 31,295                           |       | 24,646 |   | 16,880 |   |
| Consumer:                                |       |                             |       |   |   |   |   |
| Home equity  and second mortgage loans   |       | 41,012                           |       | 27,507 |   | 24,653 |   |
| Automobile                               |       | 12,511                           |       | 15,245 |   | 17,348 |   |
| Other                                    |       | 12,474                           |       | 15,029 |   | 15,207 |   |
| Total loan  originations                 |       | 486,785                          |       | 427,577 |   | 299,380 |   |
| Loan  purchases                          |       | 15,000                           |       | 3,140 |   | — |   |
| Repayments                               |       | (284,830                         | )          | (254,015 | ) | (212,166 | ) |
| Loan sales                               |       | (67,301                          | )          | (130,169 | ) | (67,350 | ) |
| Transfers to  real estate owned          |       | (894                             | )          | (1,771 | ) | (1,029 | ) |
| Other                                    |       | 230                              |       | (1,500 | ) | 479 |   |
| Net loan  activity                       |       | 148,990                          |       | 43,262 |   | 19,314 |   |
| Loans  receivable at end of period(1)    |       | $                                | 699,205    |   | $ | 550,215 |   | $ | 506,953 |   |
|                                          |            |                                  |            |  |  |  |  |  |  |  |  |  |

 

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

 

**Loans-to-One Borrower.**** **A savings institution generally may not make loans-to-one borrower andrelated entities in an amount which exceeds 15% of its unimpaired capital andsurplus, although loans in an amount equal to an additional 10% of unimpairedcapital and surplus may be made to a borrower if the loans are fully secured byreadily marketable securities.  At December 31,2004, the Bank’s limit on loans-to-one borrower was approximately $11.2million.  At December 31, 2004, theBank’s largest loan or group of loans-to-one borrower, including persons orentities related to the borrower, amounted to $10.6million.  Such amount consists of fourcommercial real estate loans.  The Bank’sten largest loans or groups of loans-to-one borrower, including persons orentities related to the borrower, including unfunded commitments, totaled $84.9million at December 31, 2004.  Noneof these loans were 90 days or more past due at December 31, 2004.

 

**One- to Four-Family ResidentialReal Estate Loans.**** **The Bank has historically concentrated itslending activities on the origination of loans collateralized by first mortgageliens on existing one- to four-family residences.  At December 31, 2004, $282.1 million or40.4% of the Bank’s total loan portfolio consisted of one- to four-familyresidential real estate loans.  Of the$282.1 million of such loans at December 31, 2004, $210.8 million or 74.7%had adjustable rates of interest (including $64.3 million of seven-yearadjustable-rate loans) and $71.3 million or 25.3% 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.

 

7

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

 

The Bank’s residential mortgage loans generally 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 and areonly approved on loans with exceptional credit scores, sizeable asset reserves,or other compensating factors.  At December 31,2004, the Bank had $2.6 million of nonperforming, one- to four-familyresidential loans.  See “Asset Quality”.

 

**Multi-Family Residential RealEstate Loans.**** **The Bank offers mortgage loans for theacquisition and refinancing of multi-family residential properties.  At December 31, 2004, $9.5 million or1.4% of the Bank’s total loan portfolio consisted of loans collateralized byexisting multi-family residential real estate properties.

 

TheBank currently originates both fixed- and adjustable- rate multi-familyloans.  Fixed-rate loans are generallyoriginated with amortization periods not to exceed 20 years, and typically haveballoon periods of three, five or seven years. Adjustable-rate loans are typically amortized over terms up to 30 years,with interest rate adjustments every 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.  The paymentexperience on such loans is typically dependent on the successful operation ofthe real estate project.  The success ofsuch projects is sensitive to changes in supply and demand conditions in themarket for multi-family real estate as well as regional and economic conditionsgenerally.  At December 31, 2004,the Bank did not have any nonperforming multi-family real estate loans.  See “Asset Quality”.

 

**Commercial Real Estate Loans.**** **The Bank originates mortgage loans for the acquisition and refinancingof commercial real estate properties.  AtDecember 31, 2004, $145.9 million or 20.9% of the Bank’s total loanportfolio consisted of loans collateralized by existing commercial real estateproperties and developed as well as undeveloped land.  In recent years, the Bank has placed anincreased emphasis on commercial real estate lending in order to transitionto a more full-service community bank as well as to take advantage of the highdemand for this type of property in some of the markets we serve.

 

Many of the Bank’s commercial real estate loans are collateralized byproperties such as office buildings, convenience stores, service stations,mini-storage facilities, motels, churches, small shopping malls, and stripcenters.  The Bank has experienced anincrease in this type of lending over the last few years and underwritescommercial real estate loans specifically in relation to the type of propertybeing collateralized.  Cash flows andvacancy rates are primary considerations when underwriting loans collateralizedby office buildings, mini-storage facilities and motels.  Loans with borrowers that are corporations,limited liability companies, trusts, or other such legal entities are alsotypically

 

8

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personally guaranteed by the principals of therespective entity.  The financialstrength of the individuals who are personally guaranteeing the loan is also aprimary underwriting factor.

 

Commercial real estate loans include loans for the acquisition anddevelopment of land.  This segment of theportfolio totaled $30.9 million, $7.0 million, $5.5 million, $2.7 million, and$1.4 million as of December 31, 2004, 2003, 2002, 2001, and 2000,respectively.  The Bank has experienced asignificant increase in this type of lending during 2004, primarily due toopportunities resulting from the growth and development of the Benton andWashington county areas discussed below. These loans are typically made to borrowers with whom the Bank has hadprevious favorable experience and whose personal financial position isstrong.  These loans include landpurchased for development into single-family subdivision lots, condominiumlots, and commercial lots.  Generally,these loans are collateralized by properties in the Bank’s market areas.

 

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 worthiness of the borrower, the cash flow of the project, and thequality of management involved with the property.  The Bank’s commercial real estate loans aregenerally originated with amortizations not to exceed 20-25 years and typicallyhave balloon periods of three-, five-, or seven-year terms.  The Bank has originated some loans withvariable rate terms based upon Wall Street Journal prime.  To a lesser degree, the Bank has in the pastoffered a limited number of fixed rate commercial real estate loans with termsnot to exceed 15 years subject to then current interest rate scenarios.  As part of the criteria for underwritingmulti-family and commercial real estate loans, the Bank generally estimates acash flow analysis that includes a vacancy rate projection, expenses for taxes,insurance, maintenance and repair reserves as well as debt coverageratios.  This information is alsoestimated and obtained from commercial real estate appraisals.

 

Commercial real estate lending entails additional risks, as compared tothe Bank’s one- to four-family residential property loans. Commercial realestate loans generally involve larger loan balances to single borrowers orgroups of related borrowers.  The paymentexperience on such loans is typically dependent on the successful operation ofthe real estate project. The success 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.  The Bank believes it has mitigated some ofthese additional risks by focusing its commercial real estate lendingactivities in the economically strong Washington/Benton County, Arkansasmarket.  This region is the home of theworld’s largest retailer, Wal-Mart, as well as the nation’s largest meatcompany, Tyson Foods, the trucking firm J. B. Hunt, and the University ofArkansas.  Reports have ranked the regionas one of the top performing economic areas in the country since 2003.  Low unemployment rates, population growth,and job growth in this market add additional support to the Bank’s growth inthe area of commercial real estate loans. At December 31, 2004, the Bank had one impaired commercial realestate loan relationship of $3.9 million for which an estimated $62,000allowance for loan losses was recorded. At December 31, 2004, none of the loans in this relationship wereover 90 days past due.  See “AssetQuality”.

 

**Construction Loans.**** **The Bank originates one- tofour-family residential, multi-family, and commercial real estate constructionloans.  However, the Bank’s primaryemphasis has been residential construction lending.  The Bank’s construction lending activitiesare typically limited to the Bank’s primary market areas.  At December 31, 2004, construction loansamounted to $159.1 million or 22.8% of the Bank’s total loan portfolio, ofwhich, $111.7 million consisted of one- to four-family residential constructionloans, $25.5 million consisted of commercial real estate construction loans,and $21.9 million consisted of multi-family residential constructionloans.  As discussed above in thecommercial real estate section, our market areas of Benton and Washington countieshave experienced tremendous prosperity and growth and provided the Bank withincreased lending opportunities, which can be demonstrated by the significantgrowth in construction lending.  However,as stated previously, our primary focus in construction lending has been andremains residential construction lending. The Bank has been successful in marketing its lending products to theresidential construction market, including involvement in homebuilders’associations and maintaining established relationships with builders.

 

The Bank’s construction loans generally have fixed interest rates andare typically issued for terms of six- to twelve-months. However, the Bank ispermitted to originate construction loans with terms up to two years under itsloan policy.  This practice is generallylimited to larger projects that cannot be completed in the typical six- totwelve-month period.  Construction loansare typically made with a maximum loan-to-value ratio of 80% on an as-completedbasis.

 

9

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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 originated for multi-family andcommercial properties.  The Banktypically requires that permanent financing with the Bank or some other lenderbe in place prior to closing any non-speculative construction loan.  Interest on construction/permanent loans isdue upon completion of the construction phase of the loan.  At such time, the loan automatically convertsto a permanent loan at the interest rate established at the initial closing ofthe 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 one- to four-family homes.  These loans are subject to credit review,analysis of personal and, if applicable, corporate financial statements, and anappraisal of the property to be constructed. The Bank also reviews and inspects the project prior to the disbursementof funds (draws) during the construction term. Loan proceeds are disbursed after a satisfactory inspection of theproject has been made based upon percentage of completion.  Interest on these construction loans is dueupon maturity.  The Bank may extend theterm of a construction loan upon payment of interest accrued if the propertyhas not been sold by the maturity date. The Bank has not experienced any material credit or delinquency problemsin 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 concentration ofprincipal 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 potential riskto the Bank than construction loans to individuals on their personal residencesor on houses that are pre-sold prior to the inception of the loan.  In addition, the Bank analyzes eachborrower involved in speculative building and limits the principal amount andnumber of unsold speculative homes at any one time with such borrower.  At December 31, 2004, the Bank hadnonperforming construction loans totaling $634,000.  See “Asset Quality”.

 

**Commercial Loans.**** **The Bank also offers commercial loans which primarily consist ofequipment and inventory loans which are typically cross-collateralized bycommercial real estate.  At December 31,2004, such loans amounted to $27.5 million or 3.9% of the total loanportfolio.  At December 31, 2004,the Bank had nonperforming commercial loans totaling $186,000.  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 to provide a full range offinancial services to its customers while increasing the yield on its overallloan portfolio and decreasing its interest rate risk due to the relativelyshorter term nature of consumer loans. 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 $75.0 million or10.7% of the total loan portfolio at December 31, 2004, of which $45.3million, $19.1 million and $10.6 million consisted of home equity and secondmortgage loans, automobile loans, and other consumer loans, respectively.  The Bank intends to continue its emphasis onconsumer loans in furtherance of its role as a community-oriented financialinstitution.

 

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 totalloan-to-value on 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.

 

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Otherconsumer loans consist primarily of deposit account loans and unsecuredloans.  Loans secured by deposit accountsare originated for up to 95% of the account balance, with a hold placed on theaccount 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 fora defaulted consumer loan may not provide an adequate source of repayment ofthe outstanding loan balance as a result of the greater likelihood of damage,loss or depreciation.  In addition,consumer loan 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 the amountwhich can be recovered on such loans.  AtDecember 31, 2004, the Bank had $723,000 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, late noticesare sent and/or personal contacts are made. In most cases, deficiencies arecured promptly.  While the Bank generallyprefers to work with borrowers to resolve such problems, when a mortgage loanbecomes 90 days delinquent, the Bank generally institutes foreclosure or otherproceedings, 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 generally doesnot accrue interest on loans past due 90 days or more.  Loans may be reinstated to accrual statuswhen payments are made to bring the loan under 90 dayspast due and, in the opinion of management, collection of the remaining balancecan be reasonably expected.

 

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 information concerning delinquent loansat December 31, 2004, in dollar amounts and as a percentage of the Bank’stotal loan portfolio.  The amountspresented represent the total outstanding principal balances of the relatedloans, rather than the actual payment amounts which are past due.

 
| ** **        | ** ** | **One- to four-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        |       | $                                    | 3,550      |                            | 0.51       | %                           | $          | 1,026                           |       | 0.15         | %          | $ | 31 |   | — | % | $ | 157 |   | 0.02 | % | $ | 688 |   | 0.10 | % |
|              |       |                                 |       |                            |       |                        |       |                            |       |         |       |   |   |   |   |   |   |   |   |   |   |
| 60-89 days        |       | 1,711                                |       | 0.24                            |       | 75                          |       | 0.01                            |       | 1,175        |       | 0.17 |   | 62 |   | 0.01 |   | 189 |   | 0.03 |   |
|              |       |                                 |       |                            |       |                        |       |                            |       |         |       |   |   |   |   |   |   |   |   |   |   |
| 90 days and over  |       | 1,716                                |       | 0.25                            |       | 593                         |       | 0.08                            |       | —       |       | — |   | 139 |   | 0.02 |   | 564 |   | 0.08 |   |
|              |       |                                 |       |                            |       |                        |       |                            |       |         |       |   |   |   |   |   |   |   |   |   |   |
| Total             |       | $                                    | 6,977      |                            |       |                        | $          | 1,694                           |       |         |       | $ | 1,206 |   |   |   | 358 |   |   |   | 1,441 |   |   |   |
|                   |            |                                      |            |                                 |            |                             |            |                                 |            |              |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Interest income that would have been recorded under the original termsof the Bank’s nonaccruing loans for the year ended December 31, 2004amounted to $243,000, and the interest recognizedduring this period amounted to $85,000.

 

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

 
| ** **                                                                         | ** ** | **December 31,**      | ** ** |
|------------------------------------------------------------------------------------|------------|----------------------------|------------|
| ** **                                                                         | ** ** | **2004**                   | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** | **2000** | ** ** |
| ** **                                                                         | ** ** | **(Dollars in Thousands)** | ** ** |
| Nonaccrual  loans:                                                                 |       |                       |       |   |   |   |   |   |   |   |   |
| One- to  four-family residential                                                   |       | $                          | 2,619      |   | $ | 1,537 |   | $ | 2,184 |   | $ | 2,024 |   | $ | 1,438 |   |
| Multi-family  residential                                                          |       | —                     |       | — |   | — |   | — |   | — |   |
| Construction  loans                                                                |       | 634                        |       | — |   | — |   | 350 |   | — |   |
| Commercial  real estate                                                            |       | —                     |       | 99 |   | 124 |   | 269 |   | 48 |   |
| Commercial  loans                                                                  |       | 186                        |       | 131 |   | 245 |   | 54 |   | 20 |   |
| Consumer  loans                                                                    |       | 723                        |       | 564 |   | 175 |   | 409 |   | 140 |   |
| Total  nonaccrual loans                                                            |       | 4,162                      |       | 2,331 |   | 2,728 |   | 3,106 |   | 1,646 |   |
|                                                                               |       |                       |       |   |   |   |   |   |   |   |   |
| Restructured  loans                                                                |       | 3,790                      |       | 1,352 |   | 4,219 |   | — |   | — |   |
| Real estate  owned                                                                 |       | 563                        |       | 822 |   | 320 |   | 455 |   | 261 |   |
|                                                                               |       |                       |       |   |   |   |   |   |   |   |   |
| Total  nonperforming assets                                                        |       | $                          | 8,515      |   | $ | 4,505 |   | $ | 7,267 |   | $ | 3,561 |   | $ | 1,907 |   |
|                                                                               |       |                       |       |   |   |   |   |   |   |   |   |
| Total  nonaccrual and restructured loans as a percentage of total loans receivable |       | 1.14                       | %          | 0.67 | % | 1.37 | % | 0.64 | % | 0.32 | % |
|                                                                               |       |                       |       |   |   |   |   |   |   |   |   |
| Total  nonperforming assets as a percentage of total assets                        |       | 1.13                       | %          | 0.65 | % | 1.07 | % | 0.53 | % | 0.27 | % |

 

The increase in nonaccrual one- to four- family residential loans,construction loans, and consumer loans is due to a single relationship with aspeculative homebuilder of approximately $1.7 million.  We became aware in early January 2005that this builder filed for bankruptcy protection and reviewed our collateralposition on all of this builder’s loans and placed all of the borrower’s loanson nonaccrual status as of December 31, 2004.  At December 31, 2004, a specific reserveof approximately $59,000 was recorded for these loans.

 

Restructured loans at December 31, 2004,consists of a commercial real estaterelationship.  This relationship wascurrent as of December 31, 2004.  Wealso reviewed our collateral position on all of this borrower’s loans and haverecorded a specific reserve of approximately $62,000 at December 31, 2004.

 

**Classified Assets.**** **Federal regulations require that each insured savings associationclassify its assets on a regular basis. In addition, in connection with examinations of insured institutions,federal examiners have authority to identify problem assets and, ifappropriate, classify them.  There arethree classifications for problem assets: “substandard,” “doubtful” and “loss.”  Substandard assets have one or more definedweaknesses and are characterized by the distinct possibility that the insuredinstitution will sustain some loss if the deficiencies are not corrected.  Doubtful assets have the weaknesses ofsubstandard assets with the additional characteristic that the weaknesses makecollection or liquidation in full on the basis of currently existing facts,conditions and values questionable, and there is a high possibility ofloss.  An asset classified loss isconsidered uncollectible and of such little value that continuance as an assetof the institution is not warranted.  At December 31,2004, the Bank had $8.5 million of classified assets, $8.2 million of whichwere classified as substandard and $300,000 of which were classified asloss.  In addition, at such date, theBank had $3.2 million of assets designated as special mention.  Special mention assets have potentialweaknesses that deserve management’s close attention.  If left uncorrected, these potentialweaknesses may result in deterioration of the repayment prospects for the assetor the institution’s credit position at some future date.

 

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

 

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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.

 

Theallowance consists of specific, general and unallocated components. Thespecific 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.

 

TheBank reviews its non-homogeneous loans for impairment on a quarterlybasis.  The Bank considers commercialreal estate, construction, multi-family, and commercial loans to benon-homogeneous loans.  A loan isconsidered impaired when, based on current information and events, it isprobable that the Bank will be unable to collect the scheduled payments ofprincipal or interest when due according to the contractual terms of the loanagreement.  Factors considered bymanagement in determining impairment include payment status, collateral value,and the probability of collecting scheduled principal and interest paymentswhen due.  Loans that experienceinsignificant payment delays and payment shortfalls generally are not classifiedas impaired.  Management determines thesignificance of payment delays and payment shortfalls on a case-by-case basis,taking into consideration all of the circumstances surrounding the loan and theborrower, including the length of the delay, the reasons for the delay, theborrower’s prior payment record, and the amount of the shortfall in relation tothe principal and interest owed. Impairment is measured on a loan-by-loan basis by either the presentvalue of expected future cash flows discounted at the loan’s effective interestrate, the loan’s obtainable market price, or the fair value of the collateralif 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 determine theappropriateness 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 a lossfactor to the remaining pool balance based on several factors including pastloss experience, inherent risks, and economic conditions in the primary marketareas.

 

In estimating theamount of credit losses inherent in our loan portfolio, various judgments andassumptions are made.  For example, whenassessing the condition of the overall economic environment, assumptions aremade regarding future market conditions and their impact on the loan portfolio.  In the event the national or local economywere to sustain a prolonged downturn, the loss factors applied to ourportfolios may need to be revised, which may significantly impact themeasurement of the allowance for loan losses. For impaired loans that are collateral-dependent, the estimated fairvalue of the collateral may deviate significantly from the proceeds receivedwhen the collateral is sold.

 

Although we considerthe allowance for loan losses of approximately $1.8 million adequate to coverlosses inherent in our loan portfolio at December 31, 2004, no assurancecan be given that we will not sustain loan losses that are significantlydifferent from the amount recorded, or that subsequent evaluations of the loanportfolio, in light of factors then prevailing, would not result in asignificant change in the allowance for loan losses.

 

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

 
| ** **                                                                             | ** ** | **Year Ended December 31,** | ** ** |
|----------------------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                                             | ** ** | **2004**                         | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** | **2000** | ** ** |
| ** **                                                                             | ** ** | **(Dollars in Thousands)**       |       |
| Total loans  outstanding at end of period                                              |       | $                                | 699,205    |   | $ | 550,215 |   | $ | 506,953 |   | $ | 487,639 |   | $ | 510,819 |   |
| Average  loans outstanding                                                             |       | $                                | 573,520    |   | $ | 492,492 |   | $ | 481,330 |   | $ | 488,942 |   | $ | 481,112 |   |
| Allowance at  beginning of period                                                      |       | $                                | 1,621      |   | $ | 1,529 |   | $ | 923 |   | $ | 691 |   | $ | 752 |   |
| Charge-offs:                                                                           |       |                             |       |   |   |   |   |   |   |   |   |
| One- to  four-family residential                                                       |       | (152                             | )          | (73 | ) | (54 | ) | (75 | ) | (28 | ) |
| Commercial  real estate                                                                |       | (71                              | )          | — |   | (56 | ) | — |   | — |   |
| Commercial  loans                                                                      |       | (184                             | )          | (109 | ) | (415 | ) | (41 | ) | (20 | ) |
| Consumer  loans (1)                                                                    |       | (491                             | )          | (496 | ) | (461 | ) | (121 | ) | (40 | ) |
| Total  charge-offs                                                                     |       | (898                             | )          | (678 | ) | (986 | ) | (237 | ) | (88 | ) |
| Recoveries:                                                                            |       |                             |       |   |   |   |   |   |   |   |   |
| One- to  four-family residential                                                       |       | 2                                |       | 1 |   | 6 |   | — |   | — |   |
| Commercial  real estate                                                                |       | —                           |       | — |   | 2 |   | — |   | — |   |
| Commercial  loans                                                                      |       | 2                                |       | — |   | — |   | — |   | — |   |
| Consumer  loans (1)                                                                    |       | 99                               |       | 79 |   | 84 |   | 17 |   | 27 |   |
| Total  recoveries                                                                      |       | 103                              |       | 80 |   | 92 |   | 17 |   | 27 |   |
| Net  charge-offs                                                                       |       | (795                             | )          | (598 | ) | (894 | ) | (220 | ) | (61 | ) |
| Total  provisions for losses                                                           |       | 1,020                            |       | 690 |   | 1,500 |   | 452 |   | — |   |
| Allowance at  end of period                                                            |       | $                                | 1,846      |   | $ | 1,621 |   | $ | 1,529 |   | $ | 923 |   | $ | 691 |   |
|                                                                                   |       |                             |       |   |   |   |   |   |   |   |   |
| Allowance  for loan losses as a percentage of total loans outstanding at end of period |       | 0.26                             | %          | 0.29 | % | 0.30 | % | 0.19 | % | 0.14 | % |
| Net loans  charged-off as a percentage of average loans outstanding                    |       | 0.14                             | %          | 0.12 | % | 0.19 | % | 0.05 | % | 0.01 | % |

 

----

(1)Consumer loan charge-offs include overdraft charge-offs of $323,000, $182,000and $214,000 for the years ended December 31, 2004, 2003, and 2002,respectively.  Consumer loan recoveriesinclude recoveries of overdraft charge-offs of $85,000, $50,000, and $53,000for the years ended December 21, 2004, 2003, and 2002, respectively.Overdraft charge-offs and recoveries for the years ended December 31, 2001and 2000 were not significant.

 

14

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The following table presents the allocation of the Bank’s allowance forloan losses by the type of loan at each of the dates indicated.

 
| ** **                  | ** ** | **December 31,**      | ** ** |
|-----------------------------|------------|----------------------------|------------|
| ** **                  | ** ** | **2004**                   | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** | **2000** | ** ** |
| ** **                  | ** ** | **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)** |       |
| 1-4  family residential     |       | $                          | 318        |   | 40.35 | % | $ | 239 |   | 47.09 | % | $ | 128 |   | 57.03 | % | $ | 66 |   | 67.85 | % | $ | 57 |   | 73.87 | % |
| Multi-family  residential   |       | 39                         |       | 1.35 |   | 31 |   | 1.39 |   | 1 |   | 1.15 |   | 1 |   | 0.90 |   | — |   | 0.72 |   |
| Commercial  real estate (1) |       | 420                        |       | 20.87 |   | 256 |   | 17.69 |   | 719 |   | 14.84 |   | 240 |   | 10.58 |   | 190 |   | 8.27 |   |
| Construction  loans         |       | —                     |       | 22.76 |   | — |   | 16.24 |   | — |   | 9.69 |   | 25 |   | 5.09 |   | — |   | 4.88 |   |
| Commercial  loans           |       | 509                        |       | 3.94 |   | 404 |   | 3.91 |   | 209 |   | 3.87 |   | 133 |   | 3.85 |   | 101 |   | 3.15 |   |
| Consumer  loans             |       | 508                        |       | 10.73 |   | 628 |   | 13.68 |   | 463 |   | 13.42 |   | 327 |   | 11.73 |   | 158 |   | 9.11 |   |
| Unallocated                 |       | 52                         |       | — |   | 63 |   | — |   | 9 |   | — |   | 131 |   | — |   | 185 |   | — |   |
| Total                       |       | $                          | 1,846      |   | 100.00 | % | $ | 1,621 |   | 100.00 | % | $ | 1,529 |   | 100.00 | % | $ | 923 |   | 100.00 | % | $ | 691 |   | 100.00 | % |

 

----

(1)The allowance allocated to commercial real estate loans decreased between 2003and 2002 primarily due to two factors. At December 31, 2002, there was a valuation allowance on animpaired loan that is not recorded in 2003 and the loss experience factor wasrevised downward in 2003 due to a more established history of low levels ofcharge-offs.  The allowance increased in this categorybetween 2003 and 2004 due primarily to****loan growth.

 

15

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**Investment Activities**

 

**Investment Securities. **The investmentpolicy of the Bank, as established by the board of directors, is designed primarilyto provide and maintain liquidity, to complement the Bank’s interest rate riskstrategy and to generate a favorable return on investments.  The Bank’s investment policy is currentlyimplemented by the Bank’s President/Chief Executive Officer within theparameters set by the investment committee and the board of directors.  The Bank is authorized to invest inobligations issued or fully guaranteed by the U.S. Government, certain federalagency obligations, certain time deposits, negotiable certificates of depositissued by commercial banks and other insured financial institutions, municipalsecurities, investment grade corporate debt securities and other specifiedinvestments.

 

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 andlosses excluded from earnings and reported net of tax in other comprehensiveincome.  At December 31, 2004, theBank held no investment securities classified as available for sale.  At December 31, 2004, approximately$19.5 million of the Bank’s investment securities were pledged as collateralfor certain deposits in excess of $100,000. In addition, certain U.S. Government and agency securities are pledgedas collateral for Federal Home Loan Bank of Dallas (“FHLB”) advances under theFHLB’s blanket lien.  At December 31,2004, investments in the debt and/or equity securities of any one issuer, otherthan those issued by U.S. Government agencies, did not exceed more than 10% ofthe Company’s stockholders’ equity.

 

Thefollowing table sets forth the amount of investment securities held to maturitywhich contractually mature during each of the periods indicated and theweighted average yields for each range of maturities at December 31,2004.  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                |       | $                        | 3,000      |                    | 1.58       | %                       | $          | —                |       | —     |       | $ | — |   | — |   | $ | — |   | — |   | $ | 3,000 |   | 1.58 | % |
| Municipal  securities                   |       | 100                      |       | 4.45                    |       | —                  |       | —                |       | 3,130      |       | 4.51 | % | 12,609 |   | 4.59 | % | 15,839 |   | 4.58 |   |
| U.S.  Government and agency obligations |       | —                   |       | —                  |       | 200                     |       | 3.63                  | %          | 9,000      |       | 4.79 |   | 28,621 |   | 4.99 |   | 37,821 |   | 4.94 |   |
| Total                                   |       | $                        | 3,100      |                    | 1.68       | %                       | $          | 200                   |       | 3.63       | %          | $ | 12,130 |   | 4.72 | % | $ | 41,230 |   | 4.87 | % | $ | 56,660 |   | 4.66 | % |

 

Asof December 31, 2004, there were approximately $55.8 million of investmentsecurities at an average interest rate of 4.65% with issuer call options, ofwhich approximately $41.8 million at an average interest rate of 4.70% arecallable within one year.  In a risinginterest rate environment, the Company believes that the issuers would not callthese investment securities.

 

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

 
| ** **                              | ** ** | **December 31,** | ** ** |
|-----------------------------------------|------------|-----------------------|------------|
| ** **                              | ** ** | **2004**              | ** ** | **2003** | ** ** | **2002** | ** ** |
| ** **                              | ** ** | **(In Thousands)**    | ** ** |
| Investment securities held to maturity: |       |                  |       |   |   |   |   |
| Certificates of deposit                 |       | $                     | 3,000      |   | $ | 9,000 |   | $ | 40,341 |   |
| Municipal securities                    |       | 15,839                |       | 14,303 |   | 8,728 |   |
| U.S. Government and agency obligations  |       | 37,821                |       | 57,076 |   | 65,402 |   |
| Total                                   |       | $                     | 56,660     |   | $ | 80,379 |   | $ | 114,471 |   |

 

Asa member of the FHLB of Dallas, the Bank is required to maintain an investmentin FHLB stock.  At December 31,2004, the Bank’s investment in FHLB stock amounted to $4.9 million.  No ready market exists for such stock and ithas no quoted market value.

 

16

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**Sources of Funds**

 

**General. **Deposits are the primary source of the Bank’sfunds for lending and other investment purposes.  In addition to deposits, the Bank derivesfunds from loan principal repayments and prepayments and interest payments,maturities and calls of investment securities and advances from the FHLB ofDallas.  Loan repayments are a relativelystable source of funds, while deposit inflows and outflows are significantlyinfluenced by general interest rates and money market conditions.  Borrowings are used when funds from depositsources are insufficient to meet funding needs. They may also be used on a longer term basis for general businesspurposes.  FHLB advances are the primarysource of borrowings.

 

**Deposits. **The Bank’s deposit products include a broadselection of deposit instruments, including negotiable order of withdrawal (“NOW”)accounts, demand deposit accounts (“DDA”), money market accounts, regularsavings accounts and term certificate accounts. Deposit account terms vary, with the principal differences being theminimum balance required, the time period the funds must remain on deposit,early withdrawal penalties and the interest rate.

 

TheBank considers its primary market area to be Northcentral and NorthwestArkansas.  The Bank utilizes traditionalmarketing methods to attract new customers and savings deposits.  In the second quarter of 2004, theBank began a direct mail campaign to solicit checking accounts.  Thisprogram was instrumental in attaining 14.2% growth in checking account balancesin 2004.  The Bank will continue to focus much of its marketing resourceson cross-selling checking accounts and developing new checking accountrelationships with the Bank.  The Bank does not advertise for depositsoutside of its primary market area and management believes that aninsignificant number of deposit accounts were held by non-residents of Arkansasat December 31, 2004.  Services ofdeposit brokers have been used on a limited basis with less than 1% ofcertificates of deposit at December 31, 2004 obtained through a broker.

 

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

 

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

 
| ** **                 | ** ** | **December 31,**      | ** ** |
|----------------------------|------------|----------------------------|------------|
| ** **                 | ** ** | **2004**                   | ** ** | **2003** | ** ** | **2002** | ** ** |
| ** **                 | ** ** | **Amount**                 | ** ** | **%** | ** ** | **Amount** | ** ** | **%** | ** ** | **Amount** | ** ** | **%** | ** ** |
| ** **                 | ** ** | **(Dollars in Thousands)** | ** ** |
| Certificate accounts:      |       |                       |       |   |   |   |   |   |   |   |   |   |   |
| Less than 3.00%            |       | $                          | 168,779    |   | 29.0 | % | $ | 180,301 |   | 31.4 | % | $ | 136,015 |   | 23.9 | % |
| 3.00% - 3.99%              |       | 68,140                     |       | 11.7 |   | 38,057 |   | 6.6 |   | 78,571 |   | 13.8 |   |
| 4.00% - 5.99%              |       | 81,725                     |       | 14.0 |   | 99,801 |   | 17.4 |   | 118,401 |   | 20.8 |   |
| 6.00% - 7.99%              |       | 15,911                     |       | 2.7 |   | 21,271 |   | 3.7 |   | 34,547 |   | 6.1 |   |
| 8.00% and over             |       | 423                        |       | 0.1 |   | 391 |   | 0.1 |   | 6,585 |   | 1.2 |   |
| Total certificate accounts |       | 334,978                    |       | 57.5 |   | 339,821 |   | 59.2 |   | 374,119 |   | 65.8 |   |
|                       |       |                       |       |   |   |   |   |   |   |   |   |   |   |
| Transaction accounts:      |       |                       |       |   |   |   |   |   |   |   |   |   |   |
| Savings                    |       | 31,611                     |       | 5.4 |   | 29,269 |   | 5.1 |   | 27,772 |   | 4.9 |   |
| Money market accounts      |       | 106,063                    |       | 18.2 |   | 108,400 |   | 18.9 |   | 80,020 |   | 14.1 |   |
| NOW accounts/DDA           |       | 109,772                    |       | 18.9 |   | 96,090 |   | 16.8 |   | 86,851 |   | 15.2 |   |
| Total transaction accounts |       | 247,446                    |       | 42.5 |   | 233,759 |   | 40.8 |   | 194,643 |   | 34.2 |   |
| Total deposits             |       | $                          | 582,424    |   | 100.0 | % | $ | 573,580 |   | 100.0 | % | $ | 568,762 |   | 100.0 | % |

 

17

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The following table presents the average balance ofeach type of deposit and the average rate paid on each type of deposit and/ortotal deposits for the periods indicated.

 
| ** **              | ** ** | **Year  Ended****December 31,** | ** ** |
|-------------------------|------------|--------------------------------------|------------|
| ** **              | ** ** | **2004**                             | ** ** | **2003** | ** ** | **2002** | ** ** |
| ** **              | ** ** | **Average  Balance**                 | ** ** | **Average  Rate  Paid** | ** ** | **Average  Balance** | ** ** | **Average  Rate  Paid** | ** ** | **Average  Balance** | ** ** | **Average  Rate  Paid** | ** ** |
| ** **              | ** ** | **(Dollars in Thousands)**           | ** ** |
| ** **              | ** ** | ** **                           | ** ** |
| Savings accounts        |       | $                                    | 31,096     |   | 0.41 | % | $ | 28,664 |   | 0.66 | % | $ | 27,955 |   | 1.04 | % |
| Money market accounts   |       | 113,842                              |       | 1.46 |   | 99,426 |   | 1.71 |   | 67,814 |   | 2.42 |   |
| NOW accounts            |       | 75,416                               |       | 0.37 |   | 69,168 |   | 0.73 |   | 61,532 |   | 1.26 |   |
| Demand deposit accounts |       | 29,263                               |       | — |   | 23,969 |   | — |   | 19,619 |   | — |   |
| Certificates of deposit |       | 331,662                              |       | 3.20 |   | 350,180 |   | 3.49 |   | 389,127 |   | 4.30 |   |
| Total deposits          |       | $                                    | 581,279    |   | 2.18 | % | $ | 571,407 |   | 2.56 | % | $ | 566,047 |   | 3.44 | % |

 

The following table presents, by various interest ratecategories, the amount of certificates of deposit at December 31, 2004and 2003 and the amounts at December 31, 2004 which mature during theperiods indicated.

 
| ** **                 | ** ** | **December 31,** | ** ** | **Balance at December 31, 2004  Maturing in the 12 Months Ending December 31,** | ** ** |
|----------------------------|------------|-----------------------|------------|-------------------------------------------------------------------------------------------|------------|
| ** **                 | ** ** | **2004**              | ** ** | **2003**                                                                                  | ** ** | **2005** | ** ** | **2006** | ** ** | **2007** | ** ** | **Thereafter** | ** ** |
| ** **                 | ** ** | **(In Thousands)**    | ** ** |
| Certificate accounts:      |       |                  |       |                                                                                      |       |   |   |   |   |   |   |   |   |
| Less than 3.00%            |       | $                     | 168,779    |                                                                                      | $          | 180,301 |   | $ | 115,483 |   | $ | 49,500 |   | $ | 3,280 |   | $ | 516 |   |
| 3.00% - 3.99%              |       | 68,140                |       | 38,057                                                                                    |       | 770 |   | 14,847 |   | 21,055 |   | 31,468 |   |
| 4.00% - 5.99%              |       | 81,725                |       | 99,801                                                                                    |       | 12,768 |   | 18,115 |   | 26,601 |   | 24,241 |   |
| 6.00% - 7.99%              |       | 15,911                |       | 21,271                                                                                    |       | 8,114 |   | 4,051 |   | 22 |   | 3,724 |   |
| 8.00% and over             |       | 423                   |       | 391                                                                                       |       | — |   | 423 |   | — |   | — |   |
| Total certificate accounts |       | $                     | 334,978    |                                                                                      | $          | 339,821 |   | $ | 137,135 |   | $ | 86,936 |   | $ | 50,958 |   | $ | 59,949 |   |

 

The following table sets forth maturities of the Bank’s certificates ofdeposit of $100,000 or more at December 31, 2004 by time remaining tomaturity.

 
| ** **                                                       | ** ** | **Amount**         | ** ** |
|------------------------------------------------------------------|------------|--------------------|------------|
| ** **                                                       | ** ** | **(In Thousands)** | ** ** |
| Period Ending:                                                   | ** ** | ** **         | ** ** |
| March 31, 2005                                              |       | $                  | 12,638     |   |
| June 30, 2005                                               |       | 12,971             |       |
| September 30, 2005                                          |       | 4,292              |       |
| December 31, 2005                                           |       | 3,797              |       |
| After December 31, 2005                                     |       | 53,683             |       |
| Total certificates of deposit with balances  of $100,000 or more |       | $                  | 87,381     |   |

 

**Borrowed funds.**  The Bank utilizes FHLB advances in its normaloperating and investing activities.  TheBank pledges as collateral for FHLB advances its FHLB stock and FHLB demanddeposit account and has entered into a blanket collateral agreement with theFHLB.  Eligible collateral under theblanket lien includes First Mortgage Collateral (as defined), multi-familyresidential mortgages meeting the requirements for eligibility as FirstMortgage Collateral, U.S. Government and Agency Securities (as defined by theFHLB), privately issued mortgage-backed securities that qualify as eligiblecollateral under applicable regulations, FHLB Term Deposit Accounts, and othernon-securitized real estate related collateral.

 

18

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Advancesat December 31, 2004, have maturity dates and weighted average rates asfollows:

 
| **Year  Ending December 31,** | ** ** | **Weighted  Average  Rate** | ** ** | **Amount**                 | ** ** |
|------------------------------------|------------|-----------------------------|------------|----------------------------|------------|
| ** **                         | ** ** | ** **                  | ** ** | **(Dollars in Thousands)** | ** ** |
| 2005                               |       | 3.34                        | %          | $                          | 31,187     |   |
| 2006                               |       | 2.68                        |       | 28,363                     |       |
| 2007                               |       | 3.46                        |       | 15,786                     |       |
| 2008                               |       | 3.35                        |       | 5,029                      |       |
| 2009                               |       | 3.62                        |       | 3,006                      |       |
| Thereafter                         |       | 4.25                        |       | 6,385                      |       |
| Total                              |       | 3.23                        | %          | $                          | 89,756     |   |

 

Thefollowing table sets forth information with respect to the Company’s FHLBadvances at and during the periods indicated.

 
| ** **                      | ** ** | **At or For the Year Ended December 31,** | ** ** |
|---------------------------------|------------|------------------------------------------------|------------|
| ** **                      | ** ** | **2004**                                       | ** ** | **2003** | ** ** | **2002** | ** ** |
| ** **                      | ** ** | **(Dollars in Thousands)**                     | ** ** |
| Maximum balance                 |       | $                                              | 89,756     |   | $ | 49,458 |   | $ | 47,844 |   |
|                            |       |                                           |       |   |   |   |   |
| Average balance                 |       | 53,299                                         |       | 43,321 |   | 38,434 |   |
|                            |       |                                           |       |   |   |   |   |
| Year end balance                |       | 89,756                                         |       | 39,562 |   | 38,610 |   |
|                            |       |                                           |       |   |   |   |   |
| Weighted average interest rate: |       |                                           |       |   |   |   |   |
|                            |       |                                           |       |   |   |   |   |
| At end of year                  |       | 3.23                                           | %          | 3.26 | % | 3.86 | % |
|                            |       |                                           |       |   |   |   |   |
| During the year                 |       | 3.09                                           | %          | 3.18 | % | 5.69 | % |
|                                 |            |                                                |            |  |  |  |  |  |  |  |

 

## **Subsidiaries**

 

TheBank is permitted to invest up to 2% of its assets in the capital stock of, orsecured or unsecured loans to, subsidiary corporations, with an additionalinvestment of 1% of assets when such additional investment is utilizedprimarily for community development purposes. The Bank’s only subsidiary, First Harrison Service Corporation (the “ServiceCorporation”), was formed in 1971.  At December 31,2004, the Service Corporation was inactive.

 

**REGULATION**

 

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

 

19

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**The Company**

 

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

 

**Holding Company Acquisitions. **Federal lawgenerally prohibits a savings and loan holding company, without prior OTSapproval, from acquiring the ownership or control of any other savingsinstitution or savings and loan holding company, or all, or substantially all,of the assets or more than 5% of the voting shares thereof which is not asubsidiary.  These provisions also prohibit,among other things, any director or officer of a savings and loan holdingcompany, or any individual who owns or controls more than 25% of the votingshares of such holding company, from acquiring control of any savingsinstitution not a subsidiary of such savings and loan holding company, unlessthe acquisition is approved by the OTS.

 

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

 

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

 

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

 

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

 

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

 

•                  engage in activities determined by 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.

 

Theactivities financial holding companies may 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;

 

20

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

 

•                  issuing orselling interests in pooled assets that a bank could hold directly;

 

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

 

•                  merchant banking activities.

 

Everysavings institution subsidiary of a savings and loan holding company is requiredto give the OTS at least 30 days’ advance notice of any proposed dividends tobe made on its guaranteed, permanent or other non-withdrawable stock, or elsesuch dividend will be invalid.

 

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

 

In addition, Sections 22(g) and (h) of the Federal Reserve Act placerestrictions on loans to executive officers, directors and principalstockholders.  Under Section 22(h),loans to a director, an executive officer and to a greater than 10% stockholderof a savings institution (“a principal stockholder”), and certain affiliatedinterests of either, may not exceed, together with all other outstanding loansto such person and affiliated interests, the savings institution’s loans to oneborrower limit (generally equal to 15% of the institution’s unimpaired capitaland surplus).  Section 22(h) alsorequires that loans to directors, executive officers and principal stockholdersbe made on terms substantially the same as offered in comparable transactionsto other persons unless the loans are made pursuant to a benefit orcompensation program that (i) is widely available to employees of theinstitution and (ii) does not give preference to any director, executiveofficer or principal stockholder, or certain affiliated interests of either,over other employees of the savings institution.  Section 22(h) also requires prior boardapproval for certain loans.  In addition,the aggregate amount of extensions of credit by a savings institution to allinsiders cannot exceed the institution’s unimpaired capital and surplus.  Furthermore, Section 22(g) placesadditional restrictions on loans to executive officers.  At December 31, 2004, the Bank was incompliance with the above restrictions.

 

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

 

Thelegislation creates a public company accounting oversight board which isempowered to set auditing, quality control and ethics standards, to inspectregistered public accounting firms, to conduct investigations and to takedisciplinary actions, subject to SEC oversight and review.  The board will be funded by mandatory feespaid by all public companies. The legislation also improves the FinancialAccounting Standards Board, giving it full financial independence from theaccounting industry.

 

Thelegislation strengthens auditor independence from corporate management by,among other things, limiting the scope of consulting services that auditors canoffer their public company audit clients.

 

21

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Thelegislation heightens the responsibility of public company directors and seniormanagers for the quality of the financial reporting and disclosure made bytheir companies.  Among other things, thelegislation provides for a strong public company audit committee that will bedirectly responsible for the appointment, compensation and oversight of thework of the public company auditors.

 

Thelegislation contains a number of provisions to deter wrongdoing.  CEOs and CFOs will have to certify thatcompany financial statements fairly present the company’s financialcondition.  If a misleading financialstatement later resulted in a restatement, the CEO and CFO must forfeit andreturn to the company any bonus, stock or stock option compensation received inthe twelve months following the misleading financial report.  The legislation also prohibits any companyofficer or director from attempting to mislead or coerce an auditor.  Among other reforms, the legislation empowersthe SEC to bar certain persons from serving as officers or directors of apublic company; prohibits insider trades during pension fund “blackout periods;”directs the SEC to adopt rules requiring attorneys to report securities lawviolations; and requires that civil penalties imposed by the SEC go into adisgorgement fund to benefit harmed investors.

 

Thelegislation imposes a range of corporate disclosure requirements.  Among other things, the legislation requirespublic companies to report all off-balance-sheet transactions and conflicts, aswell as to present any pro forma disclosures in a way that is not misleadingand in accordance with requirements to be established by the SEC.  The legislation also accelerated the requiredreporting of insider transactions, which now generally must be reported by theend of the second business day following a covered transaction; requires thatannual reports filed with the SEC include a statement by management assertingthat it is responsible for creating and maintaining adequate internal controlsand assessing 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, basedon certain enumerated factors, to regularly and systematically review corporatefilings.

 

Thelegislation contains provisions which generally seek to limit and expose topublic view possible conflicts of interest affecting securities analysts.

 

Finally, thelegislation imposes a range of criminal penalties for fraud and other wrongfulacts, as well as extends the period during which certain types of lawsuits canbe brought against a company or its insiders.

 

**The Bank**

 

**General. **The OTS has extensive authority over theoperations of federally chartered savings institutions.  As part of this authority, savingsinstitutions are required to file periodic reports with the OTS and are subjectto periodic examinations by the OTS and the FDIC.  The last regulatory examination of the Bankby the OTS was completed in February 2004. The Bank was not required to make any material changes to its operationsas a result of such examination.  Theinvestment and lending authority of savings institutions are prescribed byfederal laws and regulations, and such institutions are prohibited fromengaging in any activities not permitted by such laws and regulations.

 

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

 

**Insurance of Accounts. **The depositsof the Bank are insured to the maximum extent permitted by the SAIF, which isadministered by the FDIC, and are backed by the full faith and credit of theU.S. Government.  As insurer, the FDIC isauthorized to conduct examinations of, and to require reporting by,FDIC-insured institutions.  It also mayprohibit any FDIC-insured institution from engaging in any activity the FDICdetermines by regulation or order to pose a serious threat to the FDIC.  The FDIC also has the authority to initiateenforcement actions against savings institutions, after giving the OTS anopportunity to take such action.

 

Currently,FDIC deposit insurance rates generally range from zero basis points to 27 basispoints, depending on the assessment risk classification assigned to thedepository institution.  The FDIC alsoassesses depository institutions the Financing Corporation (“FICO”) debtservice assessment which became applicable to all insured institutions as of January 1,1997, in accordance with the Deposit Insurance Funds Act of 1996.  SAIF and Bank Insurance Fund (“BIF”)

 

22

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membersboth paid quarterly FICO debt service assessments ranging from 1.46 basispoints to 1.54 basis points in 2004.  Thecurrent assessment rate is 1.44 basis points and is adjusted quarterly.

 

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

 

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

 

CurrentOTS capital standards require savings institutions to satisfy three differentcapital requirements.  Under thesestandards, savings institutions must maintain “tangible” capital equal to atleast 1.5% of adjusted total assets, “core” capital equal to at least 4.0% ofadjusted total assets and “total” capital (a combination of core and “supplementary”capital) equal to at least 8.0% of “risk-weighted” assets.  For purposes of the regulation, core capitalgenerally consists of common stockholders’ equity (including retainedearnings), noncumulative perpetual preferred stock and related surplus,minority interests in the equity accounts of fully consolidated subsidiaries,certain nonwithdrawable accounts and pledged deposits and “qualifying supervisorygoodwill.”  Tangible capital is given thesame definition as core capital but does not include qualifying supervisorygoodwill and is reduced by the amount of all the savings institution’sintangible assets, with only a limited exception for purchased mortgageservicing rights.  Both core and tangiblecapital are further reduced by an amount equal to a savings institution’s debtand equity 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, 2004, theBank exceeded its tangible, core and risk-based capital requirements.

 

Indetermining compliance with the risk-based capital requirement, a savingsinstitution is allowed to include both core capital and supplementary capitalin its total capital, provided that the amount of supplementary capitalincluded does not exceed the savings institution’s core capital.  Supplementary capital generally consists ofhybrid capital instruments; perpetual preferred stock which is not eligible tobe included as core capital; subordinated debt and intermediate-term preferredstock; and general allowances for loan losses up to a maximum of 1.25% ofrisk-weighted assets.  In determining therequired amount of risk-based capital, total assets, including certainoff-balance sheet items, are multiplied by a risk weight based on the risksinherent in the type of assets.  The riskweights assigned by the OTS for principal categories of assets are (i) 0% forcash and securities issued by the U.S. Government or unconditionally backed bythe full faith and credit of the U.S. Government; (ii) 20% for securities(other than equity securities) issued by U.S. Government-sponsored agencies andmortgage-backed securities issued by, or fully guaranteed as to principal andinterest by, the FNMA or the FHLMC, except for those classes with residualcharacteristics or stripped mortgage-related securities; (iii) 50% forprudently underwritten permanent one- to four-family first lien mortgage loansnot more than 90 days delinquent and having a loan-to-value ratio of not morethan 90% at origination unless insured to such ratio by an insurer approved bythe FNMA or the FHLMC, qualifying residential bridge loans made directly forthe construction of one- to four-family residences and qualifying multi-familyresidential loans; and (iv) 100% for all other loans and investments, includingconsumer loans, commercial loans, and one- to four-family residential realestate loans more than 90 days delinquent, and for repossessed assets.

 

23

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**Qualified Thrift Lender Test. **All savings institutions are required to meet a QTLtest to avoid certain restrictions on their operations.  A savingsinstitution that does not meet the QTL test must either convert to a bank charteror comply with the following restrictions on its operations: (i) theinstitution may not engage in any new activity or make any new investment,directly or indirectly, unless such activity or investment is permissible for anational bank; (ii) the branching powers of the institution shall be restrictedto those of a national bank; and (iii) payment of dividends by the institutionshall be subject to the rules regarding payment of dividends by a nationalbank.  Upon the expiration of three years from the date the savingsinstitution ceases to be a QTL, it must cease any activity and not retain anyinvestment not permissible for a national bank.

 

Currently, the QTL test requires either (i) that a savings associationqualifies as a domestic building and loan association as defined in Section 7701(a)(19) of the Internal Revenue Code of 1986, as amended, (“Code”) or (ii) that65% of an institution’s “portfolio assets” (as defined) consist of certainhousing and consumer-related assets on a monthly average basis in nine out ofevery 12 months.  Assets that qualifywithout limit for inclusion as part of the 65% requirement are loans made topurchase, refinance, construct, improve or repair domestic residential housingand manufactured housing; home equity loans; educational loans; small businessloans; loans made through credit cards or credit card accounts; mortgage-backedsecurities (where the mortgages are secured by domestic residential housing ormanufactured housing); stock issued by the FHLB of Dallas; and direct orindirect obligations of the FDIC.  Inaddition, the following assets, among others, may be included in meeting thetest subject to an overall limit of 20% of the savings institution’s portfolioassets: 50% of residential mortgage loans originated and sold within 90 days oforigination; investments in a service corporation that derives at least 80% ofits gross revenues from activities related to domestic or manufacturedresidential housing; 200% of the amount of loans and investments in “starter homes”;200% of the amount of certain loans in “credit-needy” areas; loans for thepurchase, construction, development, or improvements of “community servicefacilities” not in credit-needy areas; loans for personal, family, or householdpurchases (other than those in the includable without limit category); andstock issued by the FHLMC or the FNMA. Portfolio assets consist of total assets minus the sum of(i) goodwill and other intangible assets, (ii) property used by thesavings institution to conduct its business, and (iii) liquid assets up to20% of the institution’s total assets. At December 31, 2004, the qualified thrift investments of the Bankwere approximately 81.2% of its portfolio assets.

 

**Federal Home Loan Bank System. **The Bank is a member of the FHLB of Dallas, which is one of 12 regionalFHLBs that administers the home financing credit function of savingsinstitutions.  Each FHLB serves as areserve or central bank for its members within its assigned region.  It is funded primarily from proceeds derivedfrom the sale of consolidated obligations of the FHLB System.  It makes loans to members (i.e., advances) inaccordance with policies and procedures established by the board of directorsof the FHLB.  At December 31, 2004,the Bank had $89.8 million of outstanding FHLB advances.

 

Asa member, the Bank is required to purchase and maintain stock in the FHLB ofDallas in an amount equal to the sum of 0.15% of total assets as of theprevious December 31 and 4.25% of outstanding advances.  At December 31, 2004, the Bank had $4.9million in FHLB stock, which was in compliance with this requirement.  No ready market exists for such stock and ithas no quoted market value.

 

TheFHLBs are required to provide funds for the resolution of troubled savings institutionsand to contribute to affordable housing programs through direct loans orinterest subsidies on advances targeted for community investment and low- andmoderate-income housing projects.  Thesecontributions have adversely affected the level of FHLB dividends paid in thepast and could continue to do so in the future. These contributions also could have an adverse effect on the value ofFHLB stock in the future.

 

**Federal Reserve System. **The FRBrequires all depository institutions to maintain reserves against theirtransaction accounts and non-personal time deposits.  As of December 31, 2004, no reserveswere required to be maintained on the first $7.0 million of transactionaccounts, reserves of 3% were required to be maintained against the next $40.6million of net transaction accounts (with such dollar amounts subject toadjustment by the FRB), and a reserve of 10% (which is subject to adjustment bythe FRB to a level between 8% and 14%) against all remaining net transactionaccounts.  Because required reserves mustbe maintained in the form of vault cash or a noninterest-bearing account at aFederal Reserve Bank, the effect of this reserve requirement is to reduce aninstitution’s earning assets.

 

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## **TAXATION**

 

**Federal Taxation**

 

**General. **The Company and Bank are subject to thegenerally applicable corporate tax provisions of the Code, and the Bank issubject to certain additional provisions of the Code which apply to thrift andother 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 onthe basis of a fiscal year ending on December 31.  The Company filed a consolidated federalincome tax return with both the Bank and the Service Corporation.

 

**Bad Debt Reserves. **Prior to 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 deductionsfor bad debts under methods more favorable than those granted to othertaxpayers.  Qualified thrift institutionscould compute deductions for bad debts using either the specific charge-offmethod of Section 166 of the Code or the reserve method of Section 593of the Code.

 

UnderSection 593, a thrift institution annually could elect to deduct bad debtsunder either (i) the “percentage of taxable income” method applicable only tothrift institutions, or (ii) the “experience” method that also was available tosmall banks.  Under the percentage oftaxable income method, a thrift institution generally was allowed a deductionfor an addition to its bad debt reserve equal to 8% of its taxable income(determined without regard to this deduction and with additionaladjustments).  Under the experiencemethod, a thrift institution was generally allowed a deduction for an additionto its bad debt reserve equal to the greater of (i) an amount based on itsactual average experience for losses in the current and five preceding taxableyears, or (ii) an amount necessary to restore the reserve to its balance as ofthe close of the base year.  A thriftinstitution could elect annually to compute its allowable addition to bad debtreserves for qualifying loans either under the experience method or thepercentage of taxable income method.

 

Section 1616(a)of the Act repealed the Section 593 reserve method of accounting for baddebts by thrift institutions, effective for taxable years beginning after1995.  Thrift institutions that aretreated as “small banks” are allowed to utilize the experience methodapplicable to such institutions, while thrift institutions that are treated as “largebanks” are required to use only the specific charge-off method.  The percentage of taxable income method ofaccounting for bad debts is no longer available for any financial institution.

 

Athrift institution required to change its method of computing reserves for baddebts will treat such change as a change in the method of accounting, initiatedby the taxpayer and having been made with the consent of the Secretary of theTreasury.  Section 481(a) of theCode requires certain amounts to be recaptured with respect to suchchange.  Generally, the amounts to berecaptured will be determined solely with respect to the “applicable excessreserves” of the taxpayer.  The amount ofthe applicable excess reserves will be taken into account ratably over a periodof six taxable years, beginning with the first taxable year after 1995, subjectto the residential loan requirement described below.  In the case of a thrift institution that istreated as a large bank, the amount of the institution’s applicable excessreserves generally is the excess of (i) the balance of its reserve for losseson qualifying real property loans (generally loans secured by improved realestate) and its reserve for losses on nonqualifying loans (all other types ofloans) as of the close of its last taxable year beginning before January 1,1996, over (ii) the balances of such reserves as of the close of its lasttaxable year beginning before January 1, 1988 (i.e., the “pre-1988reserves”).  In the case of a thriftinstitution that is treated as a small bank, the amount of the institution’sapplicable excess reserves generally is the excess of (i) the balance of itsreserve for losses on qualifying real property loans and its reserve for losseson nonqualifying loans as of the close of its last taxable year beginningbefore January 1, 1996, over (ii) the greater of the balance of (a) itspre-1988 reserves or, (b) what the thrift’s reserves would have been at theclose of its last year beginning before January 1, 1996, had the thriftalways used the experience method.

 

Fortaxable years that begin after December 31, 1995, and before January 1,1998, if a thrift meets the residential loan requirement for a tax year, therecapture of the applicable excess reserves otherwise required to be taken intoaccount as a Code Section 481(a) adjustment for the year will besuspended.  A thrift meets theresidential 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 asdescribed in Section 7701(a) (19)

 

25

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(C)(v) (generally a loan secured by residential or churchproperty and certain mobile homes), but only to the extent that the loan ismade to the owner of the property.  TheBank’s applicable excess reserves were fully recaptured ratably over a periodof six taxable years, beginning with taxable year 1998 and concluding withtaxable year 2003.

 

Thebalance of the pre-1988 reserves is subject to the provisions of Section 593(e),as modified by the Act, which requires recapture in the case of certainexcessive distributions to shareholders. The pre-1988 reserves may not be utilized for payment of cash dividendsor other distributions to a shareholder (including distributions in dissolutionor liquidation) or for any other purpose (except to absorb bad debtlosses).  Distribution of a cash dividendby a thrift institution to a shareholder is treated as made:  first, out of the institution’s post-1951accumulated earnings and profits; second, out of the pre-1988 reserves; andthird, out of such other accounts as may be proper.  To the extent a distribution by the Bank tothe Company is deemed paid out of its pre-1988 reserves under these rules, thepre-1988 reserves would be reduced and the Bank’s gross income for tax purposeswould be increased by the amount which, when reduced by the income tax, if any,attributable to the inclusion of such amount in its gross income, equals theamount deemed paid out of the pre-1988 reserves.  As of December 31, 2004, the Bank’spre-1988 reserves for tax purposes totaled approximately $4.2 million.

 

**Minimum Tax. **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.  Items of tax preference that constitute AMTIinclude (a) tax-exempt interest on newly issued (generally, issued on or after August 8, 1986)private activity bonds other than certain qualified bonds and (b) 75% of theexcess (if any) of (i) adjusted current earnings as defined in the Code, over(ii) AMTI (determined without regard to this preference and prior to reductionby net operating losses).

 

**Net Operating Loss Carryovers. **A financial institution may, for federal income tax purposes, carryback net operating losses (“NOLs”) to the preceding two taxable years andforward to the succeeding 20 taxable years. This provision applies to losses incurred in taxable years beginningafter 1997.  The Job Creation and WorkerAssistance Act of 2002 temporarily increased the general NOL carryback periodfrom two years to five years for NOLs arising in taxable years ending in 2001and 2002.  At December 31, 2004, theBank had no NOL carryforwards for federal income tax purposes.

 

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

 

**Other Matters. **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 or furtherrestrictions on the deductibility of mortgage interest could adversely affectthe Bank.

 

TheBank’s federal income tax returns for the tax years ended December 31,2001 forward are open under the statute of limitations and are subject toreview by the IRS.

 

**State Taxation**

 

TheBank is subject to the Arkansas corporation income tax, which is a progressiverate up to a maximum of 6.7% of all taxable earnings.

 

TheCompany is incorporated under Texas law and, accordingly, is subject to Texasfranchise tax in an amount equal to 4.5% of net income allocated to Texaspursuant to apportionments of gross receipts based upon where the Companyconducts business.

 

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

 

AtDecember 31, 2004, the Bank conducted its business from its executiveoffice in Harrison, Arkansas, and fourteen full service offices, all of whichare located in Northcentral and Northwest Arkansas.

 

Thefollowing table sets forth information with respect to the offices and otherproperties of the Bank at December 31, 2004.

 
| **Description/Address**                              | ** ** | **Leased/  Owned** |
|------------------------------------------------------|------------|--------------------|
| ** **                                           | ** ** | ** **         |
| 1401 Highway 62-65 North  Harrison, AR 72601         |       | Owned              |
|                                                 |       |               |
| 200 West Stephenson  Harrison, AR 72601              |       | Owned              |
|                                                 |       |               |
| Corner Central & Willow  Harrison, AR 72601      |       | Owned              |
|                                                 |       |               |
| 324 Hwy. 62-65 Bypass  Harrison, AR 72601            |       | Owned              |
|                                                 |       |               |
| 210 South Main  Berryville, AR 72616                 |       | Owned              |
|                                                 |       |               |
| 668 Highway 62 East  Mountain Home, AR 72653         |       | Owned              |
|                                                 |       |               |
| 1337 Highway 62 SW  Mountain Home, AR 72653          |       | Owned              |
|                                                 |       |               |
| 301 Highway 62 West  Yellville, AR 72687             |       | Owned              |
|                                                 |       |               |
| 307 North Walton Blvd.  Bentonville, AR 72712        |       | Owned              |
|                                                 |       |               |
| 2501 E. Central Ave., Suite 2  Bentonville, AR 72712 |       | Leased(1)          |
|                                                 |       |               |
| 3460 North College  Fayetteville, AR 72703           |       | Owned              |
|                                                 |       |               |
| 1303 West Hudson  Rogers, AR 72756                   |       | Owned              |
|                                                 |       |               |
| 201 East Henri De Tonti Blvd.  Tontitown, AR 72764   |       | Owned              |
|                                                 |       |               |
| 2025 North Crossover Road  Fayetteville, AR 72703    |       | Owned              |
|                                                 |       |               |
| 249 West Main Street  Farmington, AR 72730           |       | Leased(2)          |
|                                                 |       |               |
| 2030 West Elm  Rogers, AR 72756                      |       | Owned              |
|                                                 |       |               |
| 1023 East Millsap Road  Fayetteville, AR 72703       |       | Owned              |

 

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

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

 

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**Item 3.  LegalProceedings.**

 

Neitherthe Company nor the Bank is involved in any pending legal proceedings otherthan nonmaterial legal proceedings occurring in the ordinary course ofbusiness.

 

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

 

Nomatters were submitted to a vote of security holders during the fourth quarterof 2004.

 

**PART II.**

 

**Item 5.  Market forRegistrant’s Common Equity, Related Stockholder Matters, and Issuer Purchasesof Equity Securities.**

 

Shares of the Company’s common stock aretraded under the symbol “FFBH” on the Nasdaq National Market System.  At February 22, 2005, the Company had5,079,408 shares of common stock outstanding and had approximately 1,985 beneficialholders of common stock.

 

The following table sets forth the dividendsdeclared and the reported high and low end of day closing prices of a share ofthe Company’s common 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, 2004** | ** ** | **Year Ended  December 31, 2003** | ** ** |
|-----------------------|------------|----------------------------------------|------------|----------------------------------------|------------|
| **Ended**             | ** ** | **High**                               | ** ** | **Low**                                | ** ** | **Dividend** | ** ** | **High** | ** ** | **Low** | ** ** | **Dividend** | ** ** |
| **March 31**     |       | $                                      | 21.03      |                                   | $          | 19.89 |   | $ | 0.10 |   | $ | 13.11 |   | $ | 12.66 |   | $ | 0.08 |   |
|                  |       |                                   |       |                                   |       |   |   |   |   |   |   |   |   |
| **June 30**      |       | $                                      | 20.85      |                                   | $          | 18.34 |   | $ | 0.10 |   | $ | 16.75 |   | $ | 12.87 |   | $ | 0.08 |   |
|                  |       |                                   |       |                                   |       |   |   |   |   |   |   |   |   |
| **September 30** |       | $                                      | 21.28      |                                   | $          | 18.89 |   | $ | 0.11 |   | $ | 18.95 |   | $ | 15.86 |   | $ | 0.09 |   |
|                  |       |                                   |       |                                   |       |   |   |   |   |   |   |   |   |
| **December 31**  |       | $                                      | 23.50      |                                   | $          | 20.21 |   | $ | 0.11 |   | $ | 20.50 |   | $ | 18.39 |   | $ | 0.09 |   |
|                       |            |                                        |            |                                        |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

 
| **ISSUER PURCHASES OF EQUITY SECURITIES**  | ** ** |
|--------------------------------------------|------------|
| **Period**                                 | ** ** | **(a) Total  Number of  Shares  Purchased** | ** ** | **(b)  Average  Price Paid  per Share** | ** ** | **(c) Total Number of  Shares Purchased as  Part of Publicly  Announced Plans or  Programs** | ** ** | **(d) Maximum Number  of Shares that May  Yet Be Purchased  Under the Plans or  Programs** | ** ** |
| ** **                                 | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| October 1 to  October 31, 2004   |       | 60,000 |   | $ | 21.65 |   | 60,000 |   | 87,591 |   |
| November 1 to  November 30, 2004 |       | 18,000 |   | $ | 22.05 |   | 18,000 |   | 69,591 |   |
| December 1 to  December 31, 2004 |       | 20,600 |   | $ | 22.59 |   | 20,600 |   | 48,991 |   |

 

The Company is in its 16th announced repurchase program,which was approved by the board of directors on May 26, 2004, and publiclyannounced on June 8, 2004. Total shares approved to be purchased in thisprogram are 260,257, of which 211,266 have been purchased as of December 31,2004.  All treasury stock purchases aremade under publicly announced repurchase programs.

 

28

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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, themore detailed information, including the Consolidated Financial Statements andrelated Notes, appearing elsewhere herein.

 
| ** **                                           | ** ** | **At or For the  Year Ended December 31,** | ** ** |
|------------------------------------------------------|------------|-------------------------------------------------|------------|
| ** **                                           | ** ** | **2004**                                        | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** | **2000** | ** ** |
| ** **                                           | ** ** | **(In Thousands, Except  Per Share Data)**      | ** ** |
|                                                 |       |                                            |       |   |   |   |   |   |   |   |   |
| **Selected Financial Condition Data:**               |       |                                            |       |   |   |   |   |   |   |   |   |
| Total  assets                                        |       | $                                               | 751,665    |   | $ | 690,653 |   | $ | 679,896 |   | $ | 680,255 |   | $ | 713,902 |   |
| Cash  and cash equivalents                           |       | 16,003                                          |       | 56,201 |   | 44,493 |   | 72,326 |   | 11,564 |   |
| Investment  securities                               |       | 56,660                                          |       | 80,379 |   | 114,471 |   | 100,878 |   | 184,310 |   |
| Loans  receivable, net                               |       | 634,217                                         |       | 512,756 |   | 483,468 |   | 474,494 |   | 498,305 |   |
| Allowance  for loan losses                           |       | 1,846                                           |       | 1,621 |   | 1,529 |   | 923 |   | 691 |   |
| Deposits                                             |       | 582,424                                         |       | 573,580 |   | 568,762 |   | 555,933 |   | 540,327 |   |
| Federal  Home Loan Bank advances                     |       | 89,756                                          |       | 39,562 |   | 38,610 |   | 47,844 |   | 93,359 |   |
| Stockholders’  equity                           |       | 75,301                                          |       | 75,078 |   | 69,266 |   | 71,065 |   | 76,622 |   |
|                                                 |       |                                            |       |   |   |   |   |   |   |   |   |
| **Selected Operating Data:**                         |       |                                            |       |   |   |   |   |   |   |   |   |
| Interest  income                                     |       | $                                               | 39,370     |   | $ | 38,745 |   | $ | 44,094 |   | $ | 50,152 |   | $ | 51,982 |   |
| Interest  expense                                    |       | 14,338                                          |       | 15,986 |   | 21,633 |   | 31,862 |   | 33,243 |   |
| Net  interest income                                 |       | 25,032                                          |       | 22,759 |   | 22,461 |   | 18,290 |   | 18,739 |   |
| Provision  for loan losses                           |       | 1,020                                           |       | 690 |   | 1,500 |   | 452 |   | — |   |
| Net  interest income after provision for loan losses |       | 24,012                                          |       | 22,069 |   | 20,961 |   | 17,838 |   | 18,739 |   |
| Noninterest  income                                  |       | 6,274                                           |       | 6,989 |   | 5,346 |   | 3,745 |   | 1,998 |   |
| Noninterest  expense                                 |       | 18,783                                          |       | 18,263 |   | 14,524 |   | 13,596 |   | 12,398 |   |
| Income  before income taxes                          |       | 11,503                                          |       | 10,795 |   | 11,783 |   | 7,987 |   | 8,339 |   |
| Provision  for income taxes                          |       | 3,698                                           |       | 3,339 |   | 4,005 |   | 2,527 |   | 2,747 |   |
| Net  income                                          |       | $                                               | 7,805      |   | $ | 7,456 |   | $ | 7,778 |   | $ | 5,460 |   | $ | 5,592 |   |
|                                                 |       |                                            |       |   |   |   |   |   |   |   |   |
| **Earnings per Share (1):**                          |       |                                            |       |   |   |   |   |   |   |   |   |
| Basic                                                |       | $                                               | 1.54       |   | $ | 1.46 |   | $ | 1.44 |   | $ | 0.88 |   | $ | 0.80 |   |
| Diluted                                              |       | 1.45                                            |       | 1.38 |   | 1.38 |   | 0.87 |   | 0.80 |   |
|                                                 |       |                                            |       |   |   |   |   |   |   |   |   |
| **Cash Dividends Declared per Share (1)**            |       | $                                               | 0.42       |   | $ | 0.34 |   | $ | 0.26 |   | $ | 0.22 |   | $ | 0.20 |   |

 

----

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

 

29

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| ** **                                                                  | ** ** | **At  or For the Year Ended December 31,** | ** ** |
|-----------------------------------------------------------------------------|------------|-------------------------------------------------|------------|
| ** **                                                                  | ** ** | **2004**                                        | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** | **2000** | ** ** |
| **Selected Operating Ratios(1):**                                           |       |                                            |       |   |   |   |   |   |   |   |   |
| Return on average assets                                                    |       | 1.09                                            | %          | 1.08 | % | 1.14 | % | .79 | % | .80 | % |
| Return on average equity                                                    |       | 10.37                                           |       | 10.25 |   | 11.01 |   | 7.36 |   | 7.21 |   |
| Average equity to average assets                                            |       | 10.53                                           |       | 10.52 |   | 10.39 |   | 10.74 |   | 11.07 |   |
| Interest rate spread(2)                                                     |       | 3.64                                            |       | 3.40 |   | 3.30 |   | 2.35 |   | 2.29 |   |
| Net interest margin(2)                                                      |       | 3.75                                            |       | 3.52 |   | 3.50 |   | 2.76 |   | 2.77 |   |
| Net interest income after provision for loan  losses to noninterest expense |       | 127.84                                          |       | 120.84 |   | 144.32 |   | 131.20 |   | 151.14 |   |
| Noninterest expense to average assets                                       |       | 2.63                                            |       | 2.64 |   | 2.14 |   | 1.97 |   | 1.77 |   |
| Average interest-earning assets to average  interest-bearing liabilities    |       | 105.12                                          |       | 105.08 |   | 106.10 |   | 108.61 |   | 109.77 |   |
| Operating efficiency(3)                                                     |       | 60.00                                           |       | 61.39 |   | 52.23 |   | 61.70 |   | 59.79 |   |
|                                                                        |       |                                            |       |   |   |   |   |   |   |   |   |
| **Asset Quality Ratios(4):**                                                |       |                                            |       |   |   |   |   |   |   |   |   |
| Nonaccrual and restructured loans to total  loans(5)                        |       | 1.14                                            |       | 0.67 |   | 1.37 |   | 0.64 |   | 0.32 |   |
| Nonperforming assets to total assets(5)                                     |       | 1.13                                            |       | 0.66 |   | 1.07 |   | 0.53 |   | 0.27 |   |
| Allowance for loan losses to non-performing  loans(5)                       |       | 23.21                                           |       | 44.01 |   | 22.01 |   | 29.71 |   | 41.96 |   |
| Allowance for loan losses to total loans                                    |       | 0.26                                            |       | 0.29 |   | 0.30 |   | 0.19 |   | 0.14 |   |
|                                                                        |       |                                            |       |   |   |   |   |   |   |   |   |
| **Capital Ratios(6):**                                                      |       |                                            |       |   |   |   |   |   |   |   |   |
| Tangible capital to adjusted total assets                                   |       | 9.74                                            |       | 10.27 |   | 9.78 |   | 9.79 |   | 10.37 |   |
| Core capital to adjusted total assets                                       |       | 9.74                                            |       | 10.27 |   | 9.78 |   | 9.79 |   | 10.37 |   |
| Risk-based capital to risk-weighted assets                                  |       | 13.75                                           |       | 16.25 |   | 17.03 |   | 17.29 |   | 19.69 |   |
|                                                                        |       |                                            |       |   |   |   |   |   |   |   |   |
| **Other Data:**                                                             |       |                                            |       |   |   |   |   |   |   |   |   |
| Dividend payout ratio(7)                                                    |       | 27.91                                           | %          | 24.32 | % | 18.91 | % | 26.33 | % | 26.39 | % |
| Full service offices at end of period                                       |       | 15                                              |       | 15 |   | 14 |   | 14 |   | 14 |   |

 

----

| (1)    |   | Ratios are based on average daily  balances.                                                                                                                                                                                                                                                            |
|--------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                                                    |
| (2)    |   | Interest rate spread represents the  difference between the weighted average yield on average interest-earning  assets and the weighted average cost of average interest-bearing liabilities,  and net interest margin represents net interest income as a percent of  average interest-earning assets. |
|   |   |                                                                                                                                                                                                                                                                                                    |
| (3)    |   | Noninterest expense to net interest  income plus noninterest income.                                                                                                                                                                                                                                    |
|   |   |                                                                                                                                                                                                                                                                                                    |
| (4)    |   | Asset quality ratios are end of  period ratios.                                                                                                                                                                                                                                                         |
|   |   |                                                                                                                                                                                                                                                                                                    |
| (5)    |   | Nonperforming assets consist of  nonperforming loans and real estate owned (“REO”). Nonperforming loans  consist of nonaccrual loans and restructured loans while REO consists of real  estate acquired in settlement of loans.                                                               |
|   |   |                                                                                                                                                                                                                                                                                                    |
| (6)    |   | Capital  ratios are end of period ratios for First Federal Bank.                                                                                                                                                                                                                                        |
|   |   |                                                                                                                                                                                                                                                                                                    |
| (7)    |   | Dividend payout ratio is the total dividends declared divided by net  income.                                                                                                                                                                                                                           |

 

30

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**Item 7. Management’s Discussion and Analysis of Financial Condition and Resultsof Operations.**

 

**GENERAL**

 

Management’s discussion andanalysis of financial condition and results of operations is intended to assista reader inunderstandingthe consolidated financial condition and results of operations of the Companyfor the periods presented.  Theinformation contained in this section should be read in conjunction withthe Consolidated Financial Statements and the accompanying Notes toConsolidated Financial Statements and the other sections contained herein.

 

The Bank is a federallychartered stock savings and loan association formed in 1934.  First Federal conducts business from its mainoffice and fourteen full-service branch offices, all of which are located in asix county area in Northcentral and Northwest Arkansas comprised of Benton,Marion, Washington, Carroll, Baxter and Boone counties. The Bank will continueto focus its growth and expansion efforts in this six county area, especiallyin Benton and Washington counties, one of the fastest growing areas of thestate.  The Bank is a community-oriented financialinstitution offering a wide range of retail and commercial deposit accounts,including non-interest bearing and interest bearing checking, savings and moneymarket 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 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.

 

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 November 2004,unemployment in the Fayetteville/Springdale/Rogers metro area was 2.7%,compared to the Arkansas rate of 5.5% and the U.S. rate of 5.4%.

 

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 emphasiswill continue with plans to attract checking accounts through the utilizationof targeted direct mail throughout our market area.  Checking accounts offer low interestdeposits, fee income potential, and the opportunity to cross-sell otherfinancial 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 also affectedby the provision for loan losses, the level of its noninterest income andexpenses, 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.

 

Like most banks, First Federal Bank’s twogreatest challenges are managing interest rate risk and asset quality.  The Bank’s current interest rate riskposition as measured by our regulator, the Office of Thrift Supervision (“OTS”),is at a minimal level as defined by Thrift Bulletin 13a.  The level of interest rate risk is impactedby the movement of interest rates and the timing and magnitude of assetsrepricing compared to liabilities repricing. The Bank attempts to reduce the impact of changes in interest rates onits net interest income by managing the repricing gap as described in the “Assetand Liability Management” section.  Westrive to maintain the asset quality of our loan portfolio at acceptable levelsthrough sound underwriting procedures, including the use of credit scoring; anindependent large loan review function; active collection procedures fordelinquent loans; and, in the event of repossession, prompt and efficient liquidationof real estate, automobiles and other forms of collateral.  Both the board of directors and seniormanagement place a high priority on managing interest rate risk and assetquality.

 

31

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### **CRITICAL ACCOUNTINGPOLICIES**

### ** **

Variouselements of our accounting policies, by their nature, are inherently subject toestimation techniques, valuation assumptions and other subjectiveassessments.  In particular, themethodology for the determination of our allowance for loan losses, due to thejudgments, estimates and assumptions inherent in that policy, is critical topreparation of our financial statements. This policy and the judgments, estimates and assumptions are described ingreater detail in subsequent sections of Management’s Discussion and Analysisand in the Notes to the Consolidated Financial Statements included herein.  In particular, Note 1 to the ConsolidatedFinancial Statements – “Summary of Significant Accounting Policies” describesgenerally our accounting policies.  Webelieve that the judgments, estimates and assumptions used in the preparationof our Consolidated Financial Statements are appropriate given the factualcircumstances at the time.  However,given the sensitivity of our Consolidated Financial Statements to this criticalaccounting policy, the use of other judgments, estimates and assumptions couldresult in material differences in our results of operations or financialcondition.

 

Inestimating the amount of credit losses inherent in our loan portfolio, variousjudgments and assumptions are made.  Forexample, when assessing the condition of the overall economic environment,assumptions are made regarding future market conditions and their impact on theloan portfolio.  In the event the nationaleconomy were to sustain a prolonged downturn, the loss factors applied to ourportfolios may need to be revised, which may significantly impact themeasurement of the allowance for loan losses. For impaired loans that are collateral-dependent, the estimated fairvalue of the collateral may deviate significantly from the proceeds receivedwhen the collateral is sold.

 

## **CHANGESIN FINANCIAL CONDITION**

## ** **

Changes in financial condition between December 31,2004 and 2003 are presented in the following table (dollars in thousands).  Material changes between periods will bediscussed in the sections which follow the table.

 
| ** **                                     | ** ** | **December 31,** | ** ** | **Increase** | ** ** | ** **     | ** ** |
|------------------------------------------------|------------|-----------------------|------------|--------------|------------|----------------|------------|
| ** **                                     | ** ** | **2004**              | ** ** | **2003**     | ** ** | **(Decrease)** | ** ** | **%****Change** | ** ** |
|                                           |       |                  |       |         |       |           |       |   |   |
| **ASSETS**                                     |       |                  |       |         |       |           |       |   |   |
| Cash and  cash equivalents                     |       | $                     | 16,003     |         | $          | 56,201         |       | $ | (40,198 | ) | (71.5 | )% |
| Investment  securities held to maturity        |       | 56,660                |       | 80,379       |       | (23,719        | )          | (29.5 | ) |
| Loans  receivable, net                         |       | 634,217               |       | 512,756      |       | 121,461        |       | 23.7 |   |
| Office  properties and equipment, net          |       | 15,295                |       | 14,238       |       | 1,057          |       | 7.4 |   |
| Prepaid expenses  and other assets             |       | 29,490                |       | 27,079       |       | 2,411          |       | 8.9 |   |
|                                           |       |                  |       |         |       |           |       |   |   |
| TOTAL                                          |       | $                     | 751,665    |         | $          | 690,653        |       | $ | 61,012 |   | 8.8 | % |
|                                           |       |                  |       |         |       |           |       |   |   |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY** | ** ** | ** **            | ** ** | ** **   | ** ** | ** **     | ** ** | ** ** | ** ** |
| LIABILITIES:                                   |       |                  |       |         |       |           |       |   |   |
| Deposits                                       |       | $                     | 582,424    |         | $          | 573,580        |       | $ | 8,844 |   | 1.5 | % |
| FHLB  advances                                 |       | 89,756                |       | 39,562       |       | 50,194         |       | 126.9 |   |
| Other  liabilities                             |       | 4,184                 |       | 2,433        |       | 1,751          |       | 72.0 |   |
| Total  liabilities                             |       | 676,364               |       | 615,575      |       | 60,789         |       | 9.9 |   |
|                                           |       |                  |       |         |       |           |       |   |   |
| STOCKHOLDERS’  EQUITY                     |       | 75,301                |       | 75,078       |       | 223            |       | 0.3 |   |
| TOTAL                                          |       | $                     | 751,665    |         | $          | 690,653        |       | $ | 61,012 |   | 8.8 | % |
|                                           |       |                  |       |         |       |           |       |   |   |
| BOOK VALUE  PER SHARE                          |       | $                     | 14.78      |         | $          | 14.06          |       |   |   |   |   |
|                                           |       |                  |       |         |       |           |       |   |   |
| EQUITY TO  ASSETS                              |       | 10.0                  | %          | 10.9         | %          |           |       |   |   |

 

32

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**Loans Receivable. **Changes in loan composition between December 31,2004 and 2003 are presented in the following table (dollars in thousands).

 
| ** **                                     | ** ** | **December 31,** | ** ** | **Increase** | ** ** | ** **     | ** ** |
|------------------------------------------------|------------|-----------------------|------------|--------------|------------|----------------|------------|
| ** **                                     | ** ** | **2004**              | ** ** | **2003**     | ** ** | **(Decrease)** | ** ** | **%****Change** | ** ** |
|                                           |       |                  |       |         |       |           |       |   |   |
| One- to  four- family residences               |       | $                     | 282,144    |         | $          | 259,121        |       | $ | 23,023 |   |   |   |
| Multi-family                                   |       | 9,454                 |       | 7,673        |       | 1,781          |       |   |   |
| Commercial  real estate                        |       | 145,909               |       | 97,310       |       | 48,599         |       |   |   |
| Construction                                   |       | 159,111               |       | 89,332       |       | 69,779         |       |   |   |
| Total first  mortgage loans                    |       | 596,618               |       | 453,436      |       | 143,182        |       | 31.6 | % |
|                                           |       |                  |       |         |       |           |       |   |   |
| Commercial                                     |       | 27,545                |       | 21,491       |       | 6,054          |       | 28.2 | % |
|                                           |       |                  |       |         |       |           |       |   |   |
| Home equity  and second mortgage               |       | 45,256                |       | 42,421       |       | 2,835          |       |   |   |
| Automobile                                     |       | 19,101                |       | 22,087       |       | (2,986         | )          |   |   |
| Other                                          |       | 10,685                |       | 10,780       |       | (95            | )          |   |   |
| Total  consumer                                |       | 75,042                |       | 75,288       |       | (246           | )          | (0.3 | )% |
|                                           |       |                  |       |         |       |           |       |   |   |
| Total loans  receivable                        |       | 699,205               |       | 550,215      |       | 148,990        |       | 27.1 | % |
| Less:                                          |       |                  |       |         |       |           |       |   |   |
| Undisbursed  loan funds                        |       | (62,661               | )          | (35,181      | )          | (27,480        | )          |   |   |
| Unearned  discounts and net deferred loan fees |       | (481                  | )          | (657         | )          | 176            |       |   |   |
| Allowance  for loan losses                     |       | (1,846                | )          | (1,621       | )          | (225           | )          |   |   |
|                                           |       |                  |       |         |       |           |       |   |   |
| Total loans receivable,  net                   |       | $                     | 634,217    |         | $          | 512,756        |       | $ | 121,461 |   | 23.7 | % |
|                                                |            |                       |            |              |            |                |            |  |  |  |  |  |  |

 

The Bank continued to experience increased demand for commercial realestate loans, construction loans, and commercial loans.  Generally, the Bank’s construction loans werefor the purpose of constructing single-family residential properties.  The interest rate environment and robusteconomy of our market area provided increased demand and opportunity for ourother loan products as well.  In recentyears, the Bank has placed an increased emphasis on commercial real estatelending, construction lending, and commercial lending to diversify its loanportfolio, take advantage of market opportunities in these types of loans, andhelp the Bank transition to a more full-service community bank, as well as toprovide opportunities to cross-sell its other banking products.

 

**Allowance for LoanLosses**.  Changes in the compositionof the allowance for loan losses between December 31, 2004 and 2003 arepresented in the following table (in thousands).

 
| ** **  | ** ** | **December 31,** | ** ** | **Increase** | ** ** |
|-------------|------------|-----------------------|------------|--------------|------------|
| ** **  | ** ** | **2004**              | ** ** | **2003**     | ** ** | **(Decrease)** | ** ** |
| General     |       | $                     | 1,476      |         | $          | 1,306 |   | $ | 170 |   |
|        |       |                  |       |         |       |   |   |
| Specific    |       | 318                   |       | 252          |       | 66 |   |
|        |       |                  |       |         |       |   |   |
| Unallocated |       | 52                    |       | 63           |       | (11 | ) |
|        |       |                  |       |         |       |   |   |
|        |       | $                     | 1,846      |         | $          | 1,621 |   | $ | 225 |   |

 

The increase in the general loan lossallowance was primarily due to loan portfolio growth as well as an increase incharge-off experience related to overdrafts on demand deposit accounts.  The increase in the specific allowance forloan losses was due to a valuation allowance recorded at December 31,2004, related to a single commercial loan relationship that was not required atDecember 31, 2003.

 

The allowance for loan losses isevaluated on a regular basis by management and is based upon management’speriodic review of the collectibility of the loans in light of historicalexperience, the nature and volume of the loan portfolio, adverse situationsthat may affect the borrower’s ability to repay, estimated value of anyunderlying collateral and prevailing economic conditions.  This evaluation is inherently subjective asit requires estimates that are susceptible to significant revision asconditions change and more information becomes available.

 

33

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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 the portfolio.

 

The Bank reviews its non-homogeneous loansfor impairment on a quarterly basis.  TheBank considers commercial real estate, construction, multi-family, 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.  Factors consideredby management in determining impairment include payment status, collateralvalue, and the probability of collecting scheduled principal and interestpayments when due.  Loans that experienceinsignificant payment delays and payment shortfalls generally are notclassified 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.

 

Large groups of smaller balance homogeneousloans are collectively evaluated for impairment.  Accordingly, the Bank does not separatelyidentify individual consumer and residential loans for impairmentdisclosures.  Homogeneous loans are thosethat are considered to have common characteristics that provide for evaluationon an aggregate or pool basis.  The 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 $1.8 million appropriate and adequate to cover losses inherent in ourloan portfolio at December 31, 2004, no assurance can be given that wewill not sustain loan losses that are significantly different from the amountrecorded, or that subsequent evaluations of the loan portfolio, in light offactors then prevailing, would not result in a significant change in theallowance for loan losses.

 

34

----

 

**Investment Securities. **Changes in the composition ofinvestment securities held to maturity between December 31, 2004 and 2003are presented in the following table (dollars in thousands).

 
| ** **                              | ** ** | **December 31,** | ** ** | **Increase** | ** ** |
|-----------------------------------------|------------|-----------------------|------------|--------------|------------|
| ** **                              | ** ** | **2004**              | ** ** | **2003**     | ** ** | **(Decrease)** | ** ** |
| Certificates  of deposit                |       | $                     | 3,000      |         | $          | 9,000 |   | $ | (6,000 | ) |
| U.S.  Government and agency obligations |       | 37,821                |       | 57,076       |       | (19,255 | ) |
| Municipal  securities                   |       | 15,839                |       | 14,303       |       | 1,536 |   |
| Total                                   |       | $                     | 56,660     |         | $          | 80,379 |   | $ | (23,719 | ) |
|                                         |            |                       |            |              |            |  |  |  |  |  |  |  |

 

During 2004, investment securities totaling approximately$88 million were purchased and $112 million matured or were called.  The majority of these purchases andmaturities were shorter-term certificates of deposit and U.S. Government andagency obligations.  The decreases incertificates of deposit and U.S. Government and agency obligations were due tocalls and maturities in excess of purchases.

 

**Office Properties and Equipment. **The increasein office properties and equipment of $1.1million was due primarily to thepurchase of land for future branch expansion.

 

**Deposits. **Changes in the composition of depositsbetween December 31, 2004 and 2003 are presented in the following table(dollars in thousands).

 
| ** **               | ** ** | **December 31,** | ** ** | **Increase** | ** ** | ** **     | ** ** |
|--------------------------|------------|-----------------------|------------|--------------|------------|----------------|------------|
| ** **               | ** ** | **2004**              | ** ** | **2003**     | ** ** | **(Decrease)** | ** ** | **%****Change** | ** ** |
|                     |       |                  |       |         |       |           |       |   |   |
| DDA and NOW  accounts    |       | $                     | 109,772    |         | $          | 96,090         |       | $ | 13,682 |   | 14.2 | % |
| Money market  accounts   |       | 106,063               |       | 108,400      |       | (2,337         | )          | (2.2 | )% |
| Savings  accounts        |       | 31,611                |       | 29,269       |       | 2,342          |       | 8.0 | % |
| Certificates  of deposit |       | 334,978               |       | 339,821      |       | (4,843         | )          | (1.4 | )% |
|                     |       |                  |       |         |       |           |       |   |   |
| Total  deposits          |       | $                     | 582,424    |         | $          | 573,580        |       | $ | 8,844 |   | 1.5 | % |
|                          |            |                       |            |              |            |                |            |  |  |  |  |  |  |  |

 

The Bank experienced a change in the mix ofdeposits due to the low interest rate environment during the year.  Certificates of deposit and money marketaccounts decreased while demand and NOW deposit accounts increased.  During the second quarter of 2004, the Banklaunched a new marketing program aimed at increasing checking accounts.  As part of this program, the Bank changed itschecking account offerings to make them more attractive to potential customersas well as offering “thank you” gifts with account openings and referrals.  The promotion and marketing ofchecking accounts will continue to be emphasized since they are a veryattractive source of funds for the Bank as they offer low-interest deposits,fee income potential, and the opportunity to cross-sell other financialservices.  Checking account growth was14.2% during 2004 with the average balance of checking accounts during 2004 of$104.7 million with an average cost of 0.27%.  Deposit fee incomeincreased 27.0% during 2004 primarily through an increase in clearing andhonoring checks for customers who did not have sufficient funds in theirchecking account.

 

**FHLB Advances.**  The Bank experienced $50.2 million or 126.9%growth in FHLB of Dallas advances during the year.  The advances were used to fund loan growth in2004.  The balance of advances at December 31,2004 of $89.8 million consisted of $51.6 million of fixed rate advances with anaverage cost of 3.77% and $38.2 million of floating rate advances with anaverage cost of 2.49%.

 

**Stockholders’ Equity. **Stockholders’ equity increased approximately$200,000 from December 31, 2003 to December 31, 2004.  The increase in stockholders’ equity wasprimarily due to net income of $7.8 million, the reissuance of 210,918shares of treasury stock totaling $2.0 million resulting from the exercise ofstock options, and the release of ESOP shares totaling $1.7 million, offset bythe purchase of treasury stock totaling $9.5 million and payment of dividendstotaling $2.2 million during 2004.  Seethe Consolidated Statements of Stockholders’ Equity for the years ended December 31,2004, 2003 and 2002 for more detail.

 

35

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**Average BalanceSheets**

 

The following table sets forth certain informationrelating to the Company’s average balance sheets and reflects the average yieldon assets and average cost of liabilities for the periods indicated and theyields earned and rates paid at December 31, 2004.  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 December 31,2004.  Average balances are based ondaily balances during the periods. 

 
| ** **                                                        | ** ** | **December 31,**      | ** ** | **Year Ended December 31,** | ** ** |
|-------------------------------------------------------------------|------------|----------------------------|------------|----------------------------------|------------|
| ** **                                                        | ** ** | **2004**                   | ** ** | **2004**                         | ** ** | **2003** | ** ** | **2002** | ** ** |
| ** **                                                        | ** ** | **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)                                               |       | 6.14                       | %          | $                                | 573,520    |   | $ | 35,685 |   | 6.22 | % | $ | 492,492 |   | $ | 34,188 |   | 6.94 | % | $ | 481,330 |   | $ | 36,859 |   | 7.66 | % |
| Investment  securities(2)                                         |       | 4.50                       |       | 78,468                           |       | 3,533 |   | 4.50 |   | 92,564 |   | 3,938 |   | 4.25 |   | 111,189 |   | 6,450 |   | 5.80 |   |
| Other  interest-earning assets                                    |       | 1.81                       |       | 15,053                           |       | 152 |   | 1.01 |   | 60,881 |   | 619 |   | 1.02 |   | 48,839 |   | 785 |   | 1.61 |   |
| Total  interest-earning assets                                    |       | 5.97                       |       | 667,041                          |       | 39,370 |   | 5.90 |   | 645,937 |   | 38,745 |   | 6.00 |   | 641,358 |   | 44,094 |   | 6.88 |   |
| Noninterest-earning  assets                                       |       |                       |       | 47,793                           |       |   |   |   |   | 45,383 |   |   |   |   |   | 38,336 |   |   |   |   |   |
| Total assets                                                      |       |                       |       | $                                | 714,834    |   |   |   |   |   | $ | 691,320 |   |   |   |   |   | $ | 679,694 |   |   |   |   |   |
| Interest-bearing  liabilities:                                    |       |                       |       |                             |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Deposits                                                          |       | 2.26                       |       | 581,279                          |       | 12,690 |   | 2.18 |   | $ | 571,407 |   | 14,607 |   | 2.56 |   | $ | 566,047 |   | 19,446 |   | 3.44 |   |
| FHLB advances                                                     |       | 3.23                       |       | 53,299                           |       | 1,648 |   | 3.09 |   | 43,321 |   | 1,379 |   | 3.18 |   | 38,434 |   | 2,187 |   | 5.69 |   |
| Total  interest-bearing liabilities                               |       | 2.39                       |       | 634,578                          |       | 14,338 |   | 2.26 |   | 614,728 |   | 15,986 |   | 2.60 |   | 604,481 |   | 21,633 |   | 3.58 |   |
| Noninterest-bearing  liabilities                                  |       |                       |       | 5,002                            |       |   |   |   |   | 3,886 |   |   |   |   |   | 4,562 |   |   |   |   |   |
| Total liabilities                                                 |       |                       |       | 639,580                          |       |   |   |   |   | 618,614 |   |   |   |   |   | 609,043 |   |   |   |   |   |
| Stockholders’ equity                                         |       |                       |       | 75,254                           |       |   |   |   |   | 72,706 |   |   |   |   |   | 70,651 |   |   |   |   |   |
| Total liabilities  and stockholders’ equity                  |       |                       |       | $                                | 714,834    |   |   |   |   |   | $ | 691,320 |   |   |   |   |   | $ | 679,694 |   |   |   |   |   |
|                                                              |       |                       |       |                             |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Net interest income                                               |       |                       |       |                             |       | $ | 25,032 |   |   |   |   |   | $ | 22,759 |   |   |   |   |   | $ | 22,461 |   |   |   |
| Net earning assets                                                |       |                       |       | $                                | 32,463     |   |   |   |   |   | $ | 31,209 |   |   |   |   |   | $ | 36,877 |   |   |   |   |   |
| Interest rate spread                                              |       | 3.58                       | %          |                             |       |   |   | 3.64 | % |   |   |   |   | 3.40 | % |   |   |   |   | 3.30 | % |
| Net interest margin                                               |       |                       |       |                             |       |   |   | 3.75 | % |   |   |   |   | 3.52 | % |   |   |   |   | 3.50 | % |
| Ratio of  interest-earning assets to interest-bearing liabilities |       |                       |       |                             |       |   |   | 105.12 | % |   |   |   |   | 105.08 | % |   |   |   |   | 106.10 | % |

 

----

(1) Includes nonaccrual loans.

(2) Includes FHLB of Dallas stock.

 

36

----

 

## **Rate/Volume Analysis**

## ** **

The table below setsforth certain information regarding changes in interest income and interestexpense of the Company for the periods indicated.  For each category of interest-earning assetsand interest-bearing liabilities, information is provided on changes attributableto (i) changes in volume (changes in average volume multiplied by prior rate);(ii) changes in rate (change in rate multiplied by prior average volume); (iii)changes in rate-volume (changes in rate multiplied by the change in averagevolume); and (iv) the net change.

 
| ** **                         | ** ** | **Year  Ended December 31,** | ** ** |
|------------------------------------|------------|-----------------------------------|------------|
| ** **                         | ** ** | **2004  vs. 2003**                | ** ** | **2003  vs. 2002** | ** ** |
| ** **                         | ** ** | **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                   |       | $                                 | 5,624      |   | $ | (3,544 | ) | $ | (583 | ) | $ | 1,497 |   | $ | 855 |   | $ | (3,446 | ) | $ | (80 | ) | $ | (2,671 | ) |
| Investment securities              |       | (600                              | )          | 230 |   | (35 | ) | (405 | ) | (1,080 | ) | (1,720 | ) | 288 |   | (2,512 | ) |
| Other interest-earning assets      |       | (466                              | )          | (5 | ) | 4 |   | (467 | ) | 193 |   | (288 | ) | (71 | ) | (166 | ) |
| Total interest-earning assets      |       | 4,558                             |       | (3,319 | ) | (614 | ) | 625 |   | (32 | ) | (5,454 | ) | 137 |   | (5,349 | ) |
|                               |       |                              |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Interest expense:                  |       |                              |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Deposits                           |       | 252                               |       | (2,132 | ) | (37 | ) | (1,917 | ) | 184 |   | (4,976 | ) | (47 | ) | (4,839 | ) |
| FHLB advances                      |       | 317                               |       | (39 | ) | (9 | ) | 269 |   | 278 |   | (964 | ) | (122 | ) | (808 | ) |
| Total interest-bearing liabilities |       | 569                               |       | (2,171 | ) | (46 | ) | (1,648 | ) | 462 |   | (5,940 | ) | (169 | ) | (5,647 | ) |
| Net change in net interest income  |       | $                                 | 3,989      |   | $ | (1,148 | ) | $ | (568 | ) | $ | 2,273 |   | $ | (494 | ) | $ | 486 |   | $ | 306 |   | $ | 298 |   |

 

37

----

 

**CHANGES IN RESULTS OFOPERATIONS**

 

The table below presents a comparison ofresults of operations for the years ended December 31, 2004, 2003, and2002 (dollars in thousands).  Specificchanges in captions will be discussed below the table.

 
| ** **                                            | ** ** | **Year Ended December 31,** | ** ** | **Dollar Change** | ** ** | **Percentage Change** | ** ** |
|-------------------------------------------------------|------------|----------------------------------|------------|-------------------|------------|-----------------------|------------|
| ** **                                            | ** ** | **2004**                         | ** ** | **2003**          | ** ** | **2002**              | ** ** | **2004 vs 2003** | ** ** | **2003 vs 2002** | ** ** | **2004 vs 2003** | ** ** | **2003 vs 2002** | ** ** |
| Interest  income:                                     |       |                             |       |              |       |                  |       |   |   |   |   |   |   |   |   |
| Loans receivable                                      |       | $                                | 35,685     |              | $          | 34,188                |       | $ | 36,859 |   | $ | 1,497 |   | $ | (2,671 | ) |   |   |   |   |
| Investment  securities                                |       | 3,533                            |       | 3,938             |       | 6,450                 |       | (405 | ) | (2,512 | ) |   |   |   |   |
| Other                                                 |       | 152                              |       | 619               |       | 785                   |       | (467 | ) | (166 | ) |   |   |   |   |
| Total  interest income                                |       | 39,370                           |       | 38,745            |       | 44,094                |       | 625 |   | (5,349 | ) | 1.6 | % | (12.1 | )% |
| Interest  expense:                                    |       |                             |       |              |       |                  |       |   |   |   |   |   |   |   |   |
| Deposits                                              |       | 12,690                           |       | 14,607            |       | 19,446                |       | (1,917 | ) | (4,839 | ) |   |   |   |   |
| FHLB  advances                                        |       | 1,648                            |       | 1,379             |       | 2,187                 |       | 269 |   | (808 | ) |   |   |   |   |
| Total  interest expense                               |       | 14,338                           |       | 15,986            |       | 21,633                |       | (1,648 | ) | (5,647 | ) | (10.3 | )% | (26.1 | )% |
| Net interest  income before provision for loan losses |       | 25,032                           |       | 22,759            |       | 22,461                |       | 2,273 |   | 298 |   |   |   |   |   |
| Provision  for loan losses                            |       | 1,020                            |       | 690               |       | 1,500                 |       | 330 |   | (810 | ) | 47.8 | % | (54.0 | )% |
| Net interest  income after provision for loan losses  |       | 24,012                           |       | 22,069            |       | 20,961                |       | 1,943 |   | 1,108 |   | 8.8 | % | 5.3 | % |
| Noninterest  income:                                  |       |                             |       |              |       |                  |       |   |   |   |   |   |   |   |   |
| Deposit fee  income                                   |       | 3,674                            |       | 2,893             |       | 2,620                 |       | 781 |   | 273 |   |   |   |   |   |
| Gain on sale  of loans                                |       | 607                              |       | 1,696             |       | 888                   |       | (1,089 | ) | 808 |   |   |   |   |   |
| Other                                                 |       | 1,993                            |       | 2,400             |       | 1,838                 |       | (407 | ) | 562 |   |   |   |   |   |
| Total  noninterest income                             |       | 6,274                            |       | 6,989             |       | 5,346                 |       | (715 | ) | 1,643 |   | (10.2 | )% | 30.7 | % |
| Noninterest  expenses:                                |       |                             |       |              |       |                  |       |   |   |   |   |   |   |   |   |
| Salaries and  employee benefits                       |       | 11,094                           |       | 10,417            |       | 8,575                 |       | 677 |   | 1,842 |   |   |   |   |   |
| Net  occupancy expense                                |       | 2,009                            |       | 1,926             |       | 1,359                 |       | 83 |   | 567 |   |   |   |   |   |
| Data  processing                                      |       | 1,546                            |       | 1,507             |       | 1,178                 |       | 39 |   | 329 |   |   |   |   |   |
| Advertising  and public relations                     |       | 972                              |       | 613               |       | 596                   |       | 359 |   | 17 |   |   |   |   |   |
| Contributions                                         |       | 30                               |       | 526               |       | 120                   |       | (496 | ) | 406 |   |   |   |   |   |
| Other                                                 |       | 3,132                            |       | 3,274             |       | 2,696                 |       | (142 | ) | 578 |   |   |   |   |   |
| Total noninterest  expenses                           |       | 18,783                           |       | 18,263            |       | 14,524                |       | 520 |   | 3,739 |   | 2.9 | % | 25.7 | % |
| Income  before provision for income taxes             |       | 11,503                           |       | 10,795            |       | 11,783                |       | 708 |   | (988 | ) |   |   |   |   |
| Income tax  provision                                 |       | 3,698                            |       | 3,339             |       | 4,005                 |       | 359 |   | (666 | ) |   |   |   |   |
| Net income                                            |       | $                                | 7,805      |              | $          | 7,456                 |       | $ | 7,778 |   | $ | 349 |   | $ | (322 | ) | 4.7 | % | (4.1 | )% |
|                                                  |       |                             |       |              |       |                  |       |   |   |   |   |   |   |   |   |
| Basic  earnings per share                             |       | $                                | 1.54       |              | $          | 1.46                  |       | $ | 1.44 |   | $ | 0.08 |   | $ | 0.02 |   | 5.5 | % | 1.4 | % |
| Diluted  earnings per share                           |       | $                                | 1.45       |              | $          | 1.38                  |       | $ | 1.38 |   | $ | 0.07 |   | $ | — |   | 5.1 | % | 0.0 | % |
|                                                  |       |                             |       |              |       |                  |       |   |   |   |   |   |   |   |   |
| Interest  rate spread                                 |       | 3.64                             | %          | 3.40              | %          | 3.30                  | %          |   |   |   |   |   |   |   |   |
| Net interest  margin                                  |       | 3.75                             | %          | 3.52              | %          | 3.50                  | %          |   |   |   |   |   |   |   |   |
|                                                  |       |                             |       |              |       |                  |       |   |   |   |   |   |   |   |   |
| Full-time  equivalents                                |       | 243                              |       | 252               |       | 235                   |       |   |   |   |   |   |   |   |   |
| Full-service  offices                                 |       | 15                               |       | 15                |       | 14                    |       |   |   |   |   |   |   |   |   |

 

38

----

 

**Net Interest Income. **Net interest incomeis determined by the Company’s interest rate spread (i.e., the differencebetween the yields earned on its interest-earning assets and the rates paid onits interest-bearing liabilities) and the relative amounts of interest-earningassets and interest-bearing liabilities. The Company’s net interest income increased in both comparison periodsdue to increases in interest rate spread and interest rate margin.  Inthe 2003 vs. 2002 period, the average rates paid on interest-bearingliabilities declined by 98 basis points compared to the decline in the averageyield on earning assets of 88 basis points. This resulted in a 10 basis pointimprovement in the interest rate spread from 2002 to 2003. In the 2004 vs. 2003period the increases in the interest rate spread and interest rate margin wereprimarily the result of the shift in composition of interest-earning assets.  Interest-earning cash balances and proceedsfrom maturing and called investment securities were used to fund loan growthresulting in a higher yield being earned on the funds.

 

**Interest Income and Interest Expense**

 

Dollar and percentage changes in interestincome and interest expense for the comparison periods are presented in therate/volume analysis table which appears on page 37.

 

**Interest Income. **The increasein the 2004 vs. 2003 period was primarily due to an increase in the averagebalance of loans and an increase in the average yield earned on investment securities,offset by decreases in the average balances of investment securities and otherinterest-earning assets and decreases in the average yields earned on loans andother interest-earning assets.  Thedecrease in the average yield earned on loans was primarily due to an overalldecline in rates during the periods and customers’ refinancing to lowerrates.  The decrease in the averagebalances of investment securities held to maturity and other interest-earningassets was due to proceeds from called or matured investments andinterest-earning cash balances being used to fund loan growth.  The average balance of loans increasedprimarily due to construction and commercial real estate loan growth in 2004.

 

The decrease in the 2003 vs. 2002 period was primarilydue to a decrease in the average yield earned on loans, investment securities,and other interest-earning assets and a decrease in the average balance ofinvestment securities, offset by an increase in the average balance of loans.  The decrease in the average yield earned onloans, investment securities, and other interest-earning assets was primarilydue 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 loans increased primarily due to constructionloan growth in 2003.

 

**Interest Expense. **The decreasein interest expense in the 2004 vs. 2003 period was primarily due to decreasesin the average rates paid on deposit accounts and FHLB advances, offset byincreases in the average balances of deposits and FHLB advances.  The decrease in the average interest ratepaid on deposits was primarily the result of maturing certificates and variableinterest-bearing deposits being repriced to lower interest rates.  The increase in FHLB advances was due to theuse of FHLB advances to fund loan growth.

 

Thedecrease in interest expense in the 2003 vs. 2002 period was primarily due to adecrease in the average rate paid on deposit accounts and FHLB advances.  The decrease in the average interest ratepaid on deposits was primarily the result of maturing certificates and variableinterest-bearing deposits being reinvested at lower interest rates.

 

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

 

Factors influencing management’s decision to increasethe provision in the 2004 vs. 2003 period include an increase in the loanportfolio, particularly commercial real estate and construction loans, as wellas an increase in nonaccrual and restructured loans.

 

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

 

**Noninterest Income. **Deposit feeincome increased as a result of the Bank’s continued promotion of BounceProtectionTM overdraft service as well as an increase in the number of checking accounts and a changein the insufficient funds fee structure. The number of checking accounts increased approximately 8.0% from December 31,2003 to December 31, 2004 and increased 7.4% from December 31, 2002to December 31, 2003.  The Bankplans to continue to aggressively promote

 

39

----

 

checkingaccounts in 2005 through direct mail campaigns to further expand its checkingaccounts and increase deposit fee income.

 

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

 
| ** **                                | ** ** | **Year Ended December 31,** | ** ** |
|-------------------------------------------|------------|----------------------------------|------------|
| ** **                                | ** ** | **2004**                         | ** ** | **2003** | ** ** | **2002** | ** ** |
| Loans held  for sale, beginning of period |       | $                                | 1,687      |   | $ | 8,264 |   | $ | 5,560 |   |
| Originations                              |       | 45,763                           |       | 119,833 |   | 69,631 |   |
| Sales                                     |       | (45,827                          | )          | (126,410 | ) | (66,927 | ) |
| Loans held  for sale, end of period       |       | $                                | 1,623      |   | $ | 1,687 |   | $ | 8,264 |   |
|                                      |       |                             |       |   |   |   |   |
| Gain on sale  of loans                    |       | $                                | 607        |   | $ | 1,696 |   | $ | 888 |   |

 

Sales of loans peaked in2003 due to record low interest rates in 2003 and the resulting refinancingactivity.

 

Other noninterest income decreased during the 2004 vs. 2003 period andincreased in the 2003 vs. 2002 period primarily due to an adjustment of thecarrying value of donated real estate from its cost to its estimated fairvalue.  The gain on contribution wasrecognized during the year ended December 31, 2003.  A corresponding expense in the amount of$500,000, the fair value of the donated real estate, was also recorded duringthe year ended December 31, 2003, and is included in the balance ofcontributions expense.

 

**Noninterest Expense**

 

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

 
| ** **                         | ** ** | **Year Ended December 31,** | ** ** | **Change** | ** ** |
|------------------------------------|------------|----------------------------------|------------|------------|------------|
| ** **                         | ** ** | **2004**                         | ** ** | **2003**   | ** ** | **2002** | ** ** | **2004 vs 2003** | ** ** | **2003 vs 2002** | ** ** |
| Salaries                           |       | $                                | 7,635      |       | $          | 7,315 |   | $ | 6,374 |   | $ | 320 |   | $ | 941 |   |
| Payroll  taxes                     |       | 701                              |       | 638        |       | 540 |   | 63 |   | 98 |   |
| Insurance                          |       | 572                              |       | 579        |       | 510 |   | (7 | ) | 69 |   |
| ESOP expense  (1)                  |       | 1,661                            |       | 1,230      |       | 924 |   | 431 |   | 306 |   |
| MRP expense  (2)                   |       | 27                               |       | 45         |       | — |   | (18 | ) | 45 |   |
| Defined  benefit plan contribution |       | 358                              |       | 480        |       | 108 |   | (122 | ) | 372 |   |
| Other                              |       | 140                              |       | 130        |       | 119 |   | 10 |   | 11 |   |
| Total                              |       | $                                | 11,094     |       | $          | 10,417 |   | $ | 8,575 |   | $ | 677 |   | $ | 1,842 |   |

 

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(1)          Employee Stock Ownership Plan

(2)          Management Recognition and Retention Plan

 

2004 vs. 2003

 

The increase in salaries was due to normal salary and merit increasesand an increase in bonuses paid to loan officers related to loan quality andproduction.  Payroll taxes increased dueto the increase in salaries.  Theincrease in employee stock ownership plan expense was due to an increase in theCompany’s average stock price from $15.89 in 2003 to $20.58 in 2004.

 

2003 vs. 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 planexpense was due to an increase in the Company’s average stock price from $12.21in 2002 to $15.89 in 2003.  The definedbenefit plan expense increased due to an increase in the Bank’s requiredcontribution to the multiemployer pension plan as a result of decreased yieldson plan assets.

 

40

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

 
| ** **                                  | ** ** | **Year Ended December 31,** | ** ** | **Change** | ** ** |
|---------------------------------------------|------------|----------------------------------|------------|------------|------------|
| ** **                                  | ** ** | **2004**                         | ** ** | **2003**   | ** ** | **2002** | ** ** | **2004 vs 2003** | ** ** | **2003 vs 2002** | ** ** |
| Depreciation                                |       | $                                | 1,103      |       | $          | 1,053 |   | $ | 719 |   | $ | 50 |   | $ | 334 |   |
| Furniture,  fixtures, and equipment expense |       | 183                              |       | 290        |       | 157 |   | (107 | ) | 133 |   |
| Utilities                                   |       | 219                              |       | 190        |       | 131 |   | 29 |   | 59 |   |
| Building  repairs and maintenance           |       | 258                              |       | 190        |       | 174 |   | 68 |   | 16 |   |
| Taxes and  insurance                        |       | 179                              |       | 137        |       | 103 |   | 42 |   | 34 |   |
| Rent                                        |       | 67                               |       | 66         |       | 75 |   | 1 |   | (9 | ) |
| Total                                       |       | $                                | 2,009      |       | $          | 1,926 |   | $ | 1,359 |   | $ | 83 |   | $ | 567 |   |

 

2004 vs. 2003

 

The increases in depreciation, utilities, and taxes and insurance arerelated to the new corporate headquarters being open a full year in 2004compared to seven months in 2003.  Theincrease in building repairs and maintenance can be partially attributed toexpenses related to the new corporate office, but also relates to remodelingand refurbishing of other branch locations. The decrease in furniture, fixtures, and equipment expense was due tofurnishings purchased in 2003 for the new building with unit costs below theCompany’s capitalization level.

 

2003 vs. 2002

 

Theincrease in net occupancy expense was primarily due to an increase indepreciation expense on buildings and equipment.  This increase in depreciation was due tocompletion of the new corporate headquarters in Harrison in June 2003.  Furniture, fixtures, and equipment expensealso increased for the same reason and represents furnishings for the newbuilding with unit costs below the Company’s capitalization level.

 

**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.

 

**Advertising and public relations.** Advertising and public relations increased for the year ended December 31,2004 compared to the same period in 2003 primarily due to costs associated withthe new checking account marketing program, including direct mail, “thank you”gifts, marketing brochures, posters and billboards.

 

**Contributions.** Contributions decreased between the 2004 and 2003 periods and increasedbetween the 2003 and 2002 periods mainly due to the contribution of real estateduring the year ended December 31, 2003, discussed above in thenoninterest income narrative.  The$526,000 balance of contributions expense for the year ended December 31,2003, includes the fair value of the donated real estate of $500,000.

 

**Other expenses.**  Thechanges in the composition of this line item are presented below (inthousands):

 
| ** **                      | ** ** | **Year Ended December 31,** | ** ** | **Change** | ** ** |
|---------------------------------|------------|----------------------------------|------------|------------|------------|
| ** **                      | ** ** | **2004**                         | ** ** | **2003**   | ** ** | **2002** | ** ** | **2004 vs 2003** | ** ** | **2003 vs 2002** | ** ** |
| Consultant  and management fees |       | $                                | 234        |       | $          | 382 |   | $ | 98 |   | $ | (148 | ) | $ | 284 |   |
| Professional  fees              |       | 466                              |       | 329        |       | 404 |   | 137 |   | (75 | ) |
| Postage and  supplies           |       | 695                              |       | 737        |       | 598 |   | (42 | ) | 139 |   |
| Loan related  expenses          |       | 152                              |       | 194        |       | 153 |   | (42 | ) | 41 |   |
| Real estate  owned expenses     |       | 109                              |       | 135        |       | 88 |   | (26 | ) | 47 |   |
| Telephone                       |       | 214                              |       | 228        |       | 190 |   | (14 | ) | 38 |   |
| Other                           |       | 1,262                            |       | 1,269      |       | 1,165 |   | (7 | ) | 104 |   |
| Total                           |       | $                                | 3,132      |       | $          | 3,274 |   | $ | 2,696 |   | $ | (142 | ) | $ | 578 |   |

 

2004 vs. 2003 

 

Otherexpenses decreased slightly overall for the year ended December 31, 2004compared to the year ended December 31, 2003.  Consultant and management fees decreased in2004 primarily due to fees paid to a consulting firm in 2003 related topreparation for internal control assertion and attestation under therequirements of Section 404 of the Sarbanes-Oxley Act of

 

41

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2002.  Fees paid to a third party vendor related tothe Bounce ProtectionTM program also decreased during the year ended December 31, 2004 dueto the end of the contractual payment period during the year. Offsetting thesedecreases were fees paid to a consultant in 2004 related to our new checkingaccount marketing program.  The increasein professional fees was primarily due to increased fees paid to our audit firmrelated to the requirements of Sarbanes-Oxley.

 

2003 vs. 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 Section 404of the Sarbanes-Oxley Act of 2002, which will require management to report onits 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 thedeposit reclassification program and fees paid to a consultant for workperformed in the area of human resources. The deposit reclassification program allows the Bank to reduce itsreserve requirement, thereby freeing up funds to be invested ininterest-earning assets.

 

**Income Taxes.**

 

2004 vs. 2003

 

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 tax rate from30.9% in 2003 to 32.1% in 2004 was attributable to the tax benefit of thecontribution of the real estate made in 2003.

 

2003 vs. 2002

 

The decrease in income tax expense wasprimarily due to a decrease in taxable income and, to a lesser extent, adecrease in the effective tax rate.  Thedecrease in the effective tax rate from 34.0% in 2002 to 30.9% in 2003 wasattributable to the tax benefit of the contribution of real estate and anincrease in nontaxable interest income.

 

# **OFF-BALANCESHEET ARRANGEMENTS**

# ** **

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

 

**•**                  the origination,purchase, or sale of loans;

**•**                  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, 2004, the Bank’soff-balance sheet arrangements principally included lending commitments, whichare described below.  At December 31,2004, the Company had no interests in non-consolidated special purposeentities. At December 31, 2004, commitments included:

 

**•**                  total approvedloan origination commitments outstanding amounting to $20.6 million, including$1.9 million of loans committed to sell;

**•**                  rate lockagreements with customers of $6.4 million, all of which have been locked withan investor;

**•**                  funded mortgageloans committed to sell of $1.6 million;

**•**                  unadvancedportion of construction loans of $62.7 million;

**•**                  unused lines ofcredit of $22.4 million;

**•**                  outstandingstandby letters of credit of $1.6 million;

**•**                  totalpredetermined overdraft protection limits of $10.4 million; and

**•**                  certificates ofdeposit scheduled to mature in one year or less totaling $137.1 million.

 

Total unfunded commitments to originate loans for sale and the relatedcommitments to sell of $6.4 million meet the definition of a derivativefinancial instrument.  The related assetand liability are considered immaterial at December 31, 2004.

 

Historically, a very small percentage of predetermined overdraft limitshave been used.  At December 31,2004, overdrafts of accounts with Bounce ProtectionTMrepresented usage of 2.3% of the limit. We expect this trend to continue in the future.

 

42

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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.

 

### **CONTRACTUALOBLIGATIONS**

### ** **

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 |       | $                     | 137,135    |          | $          | 137,894         |       | $                      | 39,909     |      | $          | 20,040 |   | $ | 334,978 |   |
| FHLB  advances maturities           |       | $                     | 31,187     |          | $          | 44,149          |       | $                      | 8,035      |      | $          | 6,385 |   | $ | 89,756 |   |
|                                     |            |                       |            |               |            |                 |            |                        |            |           |            |  |  |  |  |  |  |  |  |  |

 

### **LIQUIDITY ANDCAPITAL 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, borrowings, collectionson outstanding 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.  Inaddition, the Bank invests excess funds in overnight deposits and othershort-term interest-earning assets which provide liquidity to meet lendingrequirements.  The Bank has generallybeen able to generate enough cash through the retail deposit market, itstraditional funding source, to offset the cash utilized in investingactivities.  As an additional source offunds, the Bank has borrowed from the FHLB of Dallas.  During 2004, the use of FHLB advancesincreased due to increased demand for the Bank’s loan products.  At December 31, 2004, availableborrowing capacity with the FHLB was approximately $169 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 of investing invarious lending products.  The Bank usesits sources of funds primarily to meet its ongoing commitments, to pay maturingsavings certificates and savings withdrawals, to repay maturing FHLB of Dallasadvances, and to fund loan commitments.

 

As of December 31, 2004, the Bank’sregulatory capital was in excess of all applicable regulatoryrequirements.  At December 31, 2004,the Bank’s tangible, core and risk-based capital ratios amounted to 9.74%, 9.74%and 13.75%, respectively, compared to regulatory requirements of 1.5%, 4.0% and8.0%, respectively.

 

### **IMPACT OFINFLATION 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 NEWACCOUNTING STANDARDS**

### ** **

See Note 1 to the Consolidated Financial Statements.

 

43

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### **FORWARD-LOOKINGSTATEMENTS**

### ** **

TheCompany’s Annual Report on Form 10-K contains certain forward-looking statementsand information relating to the Company that are based on the beliefs ofmanagement as well as assumptions made by and information currently availableto management.  In addition, in thisdocument, 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 intend toupdate these forward-looking statements.

 

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

 

**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 of thedifference 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-rate sensitiveliabilities exceeds the amount of interest-rate sensitive assets.  Generally, during a period of rising interestrates, a negative gap within shorter maturities would adversely affect netinterest income, while a positive gap within shorter maturities would result inan increase in net interest income, and during a period of falling interestrates, a negative gap within shorter maturities would result in an increase innet interest income while a positive gap within shorter maturities would have theopposite effect.  As of December 31,2004, the Bank estimates that the ratio of its one-year gap to total assets wasa negative 18.3% and its ratio of interest-earning assets to interest-bearingliabilities maturing or repricing within one year was 67.2%.

 

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 involvecertain risks, including increased payments and the potential for default in anincreasing interest rate environment, such loans decrease the risks associatedwith changes in interest rates.  As of December 31,2004, $210.8 million or 74.7% of the Bank’s portfolio of one- to four-familyresidential mortgage loans consisted of ARMs, including $64.3 million inseven-year ARMs.

 

The Company’s investment portfolio amountedto $56.7 million or 7.5% of the Company’s total assets at December 31, 2004.  Of such amount, $3.1 million or 5.5% iscontractually due within one year and $200,000 or .4% is contractually dueafter one year to five years.  However,actual maturities can be shorter than contractual maturities due to the abilityof borrowers to call or prepay such obligations without call or prepaymentpenalties.  As of December 31, 2004,there was approximately $55.8 million of investment securities at an averageinterest rate of 4.65% with call options held by the issuer, of whichapproximately $41.8 million, at an average interest rate of 4.70%, are callablewithin one year. To the extent that these higher yielding securities arecalled, the Company may reinvest such funds at prevailing interest rates whichmay have a downward impact 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 offering 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, 2004 the Bank had $335.0million in certificates of deposit of which $137.1 million mature in one yearor less.  At December 31, 2004, theBank had $89.8 million of FHLB advances of which $31.2 million is due in oneyear or less.

 

44

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### **NetPortfolio Value**

 

The value ofthe Bank’s loan and investment portfolio will change as interest rateschange.  As a result of the Bank’sinterest rate repricing gap, rising interest rates will generally decrease theBank’s net portfolio value (“NPV”), while falling interest rates will generallyincrease the value of that portfolio. NPV is the difference between incoming and outgoing discounted cashflows from assets, liabilities, and off-balance sheet contracts.  The following tables set forth, quantitatively,as of December 31, 2004 and 2003, the OTS estimate of the projected changes inNPV in the event of a 100, 200 and 300 basis point instantaneous and permanentincrease and a 100 basis point instantaneous and permanent decrease in marketinterest rates.  Due to the current lowprevailing interest rate environment the changes in NPV are not estimated for adecrease in interest rates of 200 or 300 basis points.

 
| **2004**                                      | ** ** |
|-----------------------------------------------|------------|
| **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                                          |       | $ | 82,803 |   | 11.04 | % | $ | (22,317 | ) | (21 | )% |
| +200                                          |       | 91,891 |   | 12.05 |   | (13,229 | ) | (13 | ) |
| +100                                          |       | 99,446 |   | 12.85 |   | (5,674 | ) | (5 | ) |
| 0                                             |       | 105,120 |   | 13.41 |   | — |   | — |   |
| -100                                          |       | 106,737 |   | 13.49 |   | 1,617 |   | 2 |   |
|                                          |
| **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 |   |

 

Computationsof prospective effects of hypothetical interest rate changes are calculated bythe OTS from data provided by the Bank and are based on numerous assumptions,including relative levels of market interest rates, loan repayments, anddeposit runoffs, and should not be relied upon as indicative of actualresults.  Further, the computations donot contemplate any actions the Bank may undertake in response to changes ininterest rates.

 

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 interestrates, prepayment and early withdrawal levels could deviate significantly fromthose assumed in the table.  Finally, theability of many borrowers to service their adjustable-rate debt may decrease inthe event of an interest rate increase.

 

45

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

 

**MANAGEMENT REPORT ON INTERNAL CONTROL**

 

**Financial Statements**

 

The management of FirstFederal Bancshares of Arkansas, Inc. and its subsidiary, First Federal Bank ofArkansas, FA (the “Bank”), (collectively referred to as the “Company”) isresponsible for the preparation, integrity, and fair presentation of itspublished financial statements and all other information presented in thisannual report on Form 10-K.  Thefinancial statements have been prepared in accordance with accountingprinciples generally accepted in the United States of America (“GAAP”) and, assuch, include amounts based on informed judgments and estimates made bymanagement.

 

**Internal Control**

 

Managementis responsible for establishing and maintaining adequate internal control overfinancial reporting for financial presentations in conformity with both GAAPand the Office of Thrift Supervision Instructions for Schedules SC, SO, and theReconciliation of Equity Capital included on Schedule SI of the ThriftFinancial Reports (“TFR Instructions”). Pursuant to the rules and regulationsof the Securities and Exchange Commission, internal control over financialreporting is a process designed by, or under the supervision of, the company’sprincipal executive and principal financial officers, or persons performingsimilar functions, and effected by the company’s board of directors, managementand other personnel, to provide reasonable assurance regarding the reliabilityof financial reporting and the preparation of financial statements for externalpurposes in accordance with GAAP and includes those policies and proceduresthat:

 

Pertain to themaintenance of records that in reasonable detail accurately and fairly reflectthe transactions and dispositions of the assets of the Company;

 

Provide reasonableassurance that transactions are recorded as necessary to permit preparation offinancial statements in accordance with GAAP, and that receipts andexpenditures of the company are being made only in accordance withauthorizations of management and directors of the Company; and

 

Provide reasonableassurance regarding prevention or timely detection of unauthorized acquisition,use or disposition of the company’s assets that could have a material effect onthe financial statements.

 

Managementhas evaluated the effectiveness of its internal control over financialreporting for financial presentations in conformity with both GAAP and the TFRInstructions as of December 31, 2004 based on the control criteria establishedin a report entitled *InternalControl—Integrated Framework*, issued by the Committee of SponsoringOrganizations of the Treadway Commission. Based on such evaluation, we haveconcluded that the Company’s internal control over financial reporting iseffective as of December 31, 2004.

 

**Compliance With Laws andRegulations**

 

Managementis also responsible for ensuring compliance with the federal laws andregulations concerning loans to insiders and the federal and state laws andregulations concerning dividend restrictions, both of which are designated bythe Federal Deposit Insurance Corporation (“FDIC”) as safety and soundness lawsand regulations.  Management assessed itscompliance with the designated safety and soundness laws and regulations andhas maintained records of its determinations and assessments as required by theFDIC.  Based on this assessment,management believes that the Bank has complied, in all material respects, withthe designated safety and soundness laws and regulations for the year endedDecember 31, 2004.

 

Theindependent registered public accounting firm of Deloitte & Touche LLP, asauditors of the Company’s consolidated financial statements, has issued anattestation report on management’s assessment of the Company’s internal controlover financial reporting.

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

 

46

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**REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**

 

Tothe Board of Directors and Stockholders of

FirstFederal Bancshares of Arkansas, Inc.

Harrison,Arkansas

 

Wehave audited the accompanying consolidated statements of financial condition ofFirst Federal Bancshares of Arkansas, Inc. and its subsidiary (the “Company”)as of December 31, 2004 and 2003, and the related statements of income,stockholders’ equity, and cash flows for each of the three years in the periodended December 31, 2004.  These financial statements are theresponsibility of the Company’s management.  Our responsibility is toexpress an opinion on these financial statements based on our audits.

 

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

 

Inour opinion, such financial statements present fairly, in all materialrespects, the financial position of First Federal Bancshares of Arkansas, Inc.and its subsidiary as of December 31, 2004 and 2003, and the results of theiroperations and their cash flows for each of the three years in the period endedDecember 31, 2004, in conformity with accounting principles generally acceptedin the United States of America.

 

Wehave also audited, in accordance with the standards of the Public CompanyAccounting Oversight Board (United States), the effectiveness of the Company’sinternal control over financial reporting as of December 31, 2004, based on thecriteria established in *InternalControl—Integrated Framework* issued by the Committee of SponsoringOrganizations of the Treadway Commission and our report dated February 28, 2005expressed an unqualified opinion on management’s assessment of theeffectiveness of the Company’s internal control over financial reporting and anunqualified opinion on the effectiveness of the Company’s internal control overfinancial reporting.

 
| /s/  DELOITTE & TOUCHE LLP |   |   |
|--------------------------------|--------|--------|
|                           |
| Little  Rock, Arkansas         |
| February  28, 2005             |

 

47

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**REPORT OFINDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**

 

To the Board of Directors andStockholders of

First Federal Bancshares ofArkansas, Inc.

Harrison, Arkansas

 

Wehave audited management’s assessment, included in the accompanying ManagementReport on Internal Control, that First Federal Bancshares of Arkansas, Inc. andits subsidiary (the “Company”) maintained effective internal control overfinancial reporting as of December 31, 2004, based on criteria established in *Internal Control—Integrated Framework*issued by the Committee of Sponsoring Organizations of the TreadwayCommission.  Because management’sassessment and our audit were conducted to meet the reporting requirements ofSection 112 of the Federal Deposit Insurance Corporation Improvement Act(FDICIA), management’s assessment and our audit of the Company’s internalcontrol over financial reporting included controls over the preparation of theschedules equivalent to the basic financial statements in accordance with theOffice of Thrift Supervision Instructions for Thrift Financial Reports forSchedules SC, SO, and the Reconciliation of Equity Capital included on ScheduleSI.  The Company’s management isresponsible for maintaining effective internal control over financial reportingand for its assessment of the effectiveness of internal control over financialreporting.  Our responsibility is to expressan opinion on management’s assessment and an opinion on the effectiveness ofthe Company’s internal control over financial reporting based on our audit.

 

Weconducted our audit in accordance with the standards of the Public CompanyAccounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtainreasonable assurance about whether effective internal control over financialreporting was maintained in all material respects.  Our audit included obtaining an understandingof internal control over financial reporting, evaluating management’sassessment, testing, and evaluating the design and operating effectiveness ofinternal control, and performing such other procedures as we considerednecessary in the circumstances.  We believethat our audit provides a reasonable basis for our opinions.

 

Acompany’s internal control over financial reporting is a process designed by,or under the supervision of, the company’s principal executive and principalfinancial officers, or persons performing similar functions, and effected bythe company’s board of directors, management, and other personnel to providereasonable assurance regarding the reliability of financial reporting and thepreparation of financial statements for external purposes in accordance withgenerally accepted accounting principles. A company’s internal control over financial reporting includes thosepolicies and procedures that (1) pertain to the maintenance of records that, inreasonable detail, accurately and fairly reflect the transactions anddispositions of the assets of the company; (2) provide reasonable assurancethat transactions are recorded as necessary to permit preparation of financialstatements in accordance with generally accepted accounting principles, andthat receipts and expenditures of the company are being made only in accordancewith authorizations of management and directors of the company; and (3) providereasonable assurance regarding prevention or timely detection of unauthorizedacquisition, use, or disposition of the company’s assets that could have amaterial effect on the financial statements.

 

Becauseof the inherent limitations of internal control over financial reporting,including the possibility of collusion or improper management override ofcontrols, material misstatements due to error or fraud may not be prevented ordetected on a timely basis.  Also,projections of any evaluation of the effectiveness of the internal control overfinancial reporting to future periods are subject to the risk that the controlsmay become inadequate because of changes in conditions, or that the degree ofcompliance with the policies or procedures may deteriorate.

 

Inour opinion, management’s assessment that the Company maintained effectiveinternal control over financial reporting as of December 31, 2004, is fairlystated, in all material respects, based on the criteria established in *Internal Control—Integrated Framework*issued by the Committee of Sponsoring Organizations of the TreadwayCommission.  Also, in our opinion, theCompany maintained, in all material respects, effective internal control overfinancial reporting as of December 31, 2004, based on the criteriaestablished in *Internal Control—IntegratedFramework* issued by the Committee of Sponsoring Organizations of theTreadway Commission.

 

Wehave not examined, and accordingly, we do not express an opinion or any otherform of assurance on management’s statement referring to compliance with lawsand regulations.

 

48

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Wehave also audited, in accordance with the standards of the Public CompanyAccounting Oversight Board (United States) the consolidated financialstatements as of and for the year ended December 31, 2004 of the Company, andour report dated February 28, 2005 expressed an unqualified opinion on thosefinancial statements.

 
| /s/  DELOITTE & TOUCHE LLP |   |   |
|--------------------------------|--------|--------|
|                           |
| Little  Rock, AR               |
| February  28, 2005             |

 

49

----

 

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

 

**CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION**

**DECEMBER 31, 2004 AND 2003**

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

 
| ** **                                                                                                                                                                                                                                                       | ** ** | **2004**   | ** ** | **2003**   | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------|------------|------------|------------|
| **ASSETS**                                                                                                                                                                                                                                                       | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                                                                                                                                                                                                                                       | ** ** | ** ** | ** ** | ** ** | ** ** |
| Cash and cash equivalents:                                                                                                                                                                                                                                       |       |       |       |       |       |
| Cash and collection items                                                                                                                                                                                                                                        |       | $          | 12,080     |       | $          | 11,376 |   |
| Interest-bearing deposits with banks                                                                                                                                                                                                                             |       | 3,923      |       | 44,825     |       |
|                                                                                                                                                                                                                                                             |       |       |       |       |       |
| Total cash and cash equivalents                                                                                                                                                                                                                                  |       | 16,003     |       | 56,201     |       |
|                                                                                                                                                                                                                                                             |       |       |       |       |       |
| Investment securities—                                                                                                                                                                                                                                      |       |       |       |       |       |
| Held to maturity, at amortized cost (fair  value at December 31, 2004 and 2003, of $56,426 and $80,163, respectively)                                                                                                                                            |       | 56,660     |       | 80,379     |       |
| Federal Home Loan Bank stock—at cost                                                                                                                                                                                                                        |       | 4,876      |       | 3,749      |       |
| Loans receivable, net of allowance at  December 31, 2004 and 2003, of $1,846 and $1,621, respectively                                                                                                                                                            |       | 634,217    |       | 512,756    |       |
| Accrued interest receivable                                                                                                                                                                                                                                      |       | 4,427      |       | 4,089      |       |
| Real estate acquired in settlement of loans—net                                                                                                                                                                                                             |       | 563        |       | 822        |       |
| Office properties and equipment—net                                                                                                                                                                                                                         |       | 15,295     |       | 14,238     |       |
| Cash surrender value of life insurance                                                                                                                                                                                                                           |       | 17,897     |       | 17,102     |       |
| Prepaid expenses and other assets                                                                                                                                                                                                                                |       | 1,727      |       | 1,317      |       |
|                                                                                                                                                                                                                                                             |       |       |       |       |       |
| TOTAL                                                                                                                                                                                                                                                            |       | $          | 751,665    |       | $          | 690,653 |   |
|                                                                                                                                                                                                                                                             |       |       |       |       |       |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                                                                                                                                    |       |       |       |       |       |
|                                                                                                                                                                                                                                                             |       |       |       |       |       |
| LIABILITIES:                                                                                                                                                                                                                                                     |       |       |       |       |       |
| Deposits:                                                                                                                                                                                                                                                        |       |       |       |       |       |
| Interest-bearing                                                                                                                                                                                                                                                 |       | $          | 551,405    |       | $          | 549,759 |   |
| Noninterest-bearing                                                                                                                                                                                                                                              |       | 31,019     |       | 23,821     |       |
|                                                                                                                                                                                                                                                             |       |       |       |       |       |
| Total deposits                                                                                                                                                                                                                                                   |       | 582,424    |       | 573,580    |       |
|                                                                                                                                                                                                                                                             |       |       |       |       |       |
| Federal Home Loan Bank advances                                                                                                                                                                                                                                  |       | 89,756     |       | 39,562     |       |
| Advance payments by borrowers for taxes and  insurance                                                                                                                                                                                                           |       | 757        |       | 725        |       |
| Other liabilities                                                                                                                                                                                                                                                |       | 3,427      |       | 1,708      |       |
|                                                                                                                                                                                                                                                             |       |       |       |       |       |
| Total liabilities                                                                                                                                                                                                                                                |       | 676,364    |       | 615,575    |       |
|                                                                                                                                                                                                                                                             |       |       |       |       |       |
| 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; 5,094,020 and 5,340,086 shares  outstanding at December 31, 2004 and 2003, respectively |       | 103        |       | 103        |       |
| Additional paid-in capital                                                                                                                                                                                                                                       |       | 54,427     |       | 52,950     |       |
| Employee stock benefit plans                                                                                                                                                                                                                                     |       | (582       | )          | (1,025     | )          |
| Retained earnings—substantially restricted                                                                                                                                                                                                                  |       | 78,261     |       | 72,634     |       |
|                                                                                                                                                                                                                                                             |       | 132,209    |       | 124,662    |       |
| Treasury stock—at cost; 5,213,482 and  4,967,416 shares at December 31, 2004 and 2003, respectively                                                                                                                                                         |       | (56,908    | )          | (49,584    | )          |
|                                                                                                                                                                                                                                                             |       |       |       |       |       |
| Total stockholders’ equity                                                                                                                                                                                                                                  |       | 75,301     |       | 75,078     |       |
|                                                                                                                                                                                                                                                             |       |       |       |       |       |
| TOTAL                                                                                                                                                                                                                                                            |       | $          | 751,665    |       | $          | 690,653 |   |

 

Seenotes to consolidated financial statements.

 

50

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**FIRST FEDERAL BANCSHARES OF ARKANSAS, INC**

 

**CONSOLIDATED STATEMENTS OF INCOME**

**YEARS ENDED DECEMBER 31, 2004, 2003, 2002**

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

 
| ** **                                           | ** ** | **2004**   | ** ** | **2003**   | ** ** | **2002**   | ** ** |
|------------------------------------------------------|------------|------------|------------|------------|------------|------------|------------|
| INTEREST  INCOME:                                    | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Loans receivable                                     |       | $          | 35,685     |       | $          | 34,188     |       | $ | 36,859 |   |
| Investment securities:                               |       |       |       |       |       |       |       |
| Taxable                                              |       | 2,837      |       | 3,422      |       | 6,143      |       |
| Nontaxable                                           |       | 696        |       | 516        |       | 307        |       |
| Other                                                |       | 152        |       | 619        |       | 785        |       |
| Total interest income                                |       | 39,370     |       | 38,745     |       | 44,094     |       |
|                                                 |       |       |       |       |       |       |       |
| INTEREST EXPENSE:                                    |       |       |       |       |       |       |       |
| Deposits                                             |       | 12,690     |       | 14,607     |       | 19,446     |       |
| Federal Home Loan Bank advances                      |       | 1,648      |       | 1,379      |       | 2,187      |       |
|                                                 |       |       |       |       |       |       |       |
| Total interest expense                               |       | 14,338     |       | 15,986     |       | 21,633     |       |
|                                                 |       |       |       |       |       |       |       |
| NET INTEREST INCOME                                  |       | 25,032     |       | 22,759     |       | 22,461     |       |
|                                                 |       |       |       |       |       |       |       |
| PROVISION FOR LOAN LOSSES                            |       | 1,020      |       | 690        |       | 1,500      |       |
|                                                 |       |       |       |       |       |       |       |
| NET INTEREST INCOME AFTER PROVISION FOR  LOAN LOSSES |       | 24,012     |       | 22,069     |       | 20,961     |       |
|                                                 |       |       |       |       |       |       |       |
| NONINTEREST INCOME:                                  |       |       |       |       |       |       |       |
| Deposit fee income                                   |       | 3,674      |       | 2,893      |       | 2,620      |       |
| Earnings on life insurance policies                  |       | 795        |       | 848        |       | 881        |       |
| Gain on sale of loans                                |       | 607        |       | 1,696      |       | 888        |       |
| Other                                                |       | 1,198      |       | 1,552      |       | 957        |       |
|                                                 |       |       |       |       |       |       |       |
| Total noninterest income                             |       | 6,274      |       | 6,989      |       | 5,346      |       |
|                                                 |       |       |       |       |       |       |       |
| NONINTEREST EXPENSES:                                |       |       |       |       |       |       |       |
| Salaries and employee benefits                       |       | 11,094     |       | 10,417     |       | 8,575      |       |
| Net occupancy expense                                |       | 2,009      |       | 1,926      |       | 1,359      |       |
| Data processing                                      |       | 1,546      |       | 1,507      |       | 1,178      |       |
| Professional fees                                    |       | 466        |       | 329        |       | 404        |       |
| Advertising and public relations                     |       | 972        |       | 613        |       | 596        |       |
| Postage and supplies                                 |       | 695        |       | 737        |       | 598        |       |
| Contributions                                        |       | 30         |       | 526        |       | 120        |       |
| Other                                                |       | 1,971      |       | 2,208      |       | 1,694      |       |
|                                                 |       |       |       |       |       |       |       |
| Total noninterest expenses                           |       | 18,783     |       | 18,263     |       | 14,524     |       |
|                                                 |       |       |       |       |       |       |       |
| INCOME BEFORE INCOME TAXES                           |       | 11,503     |       | 10,795     |       | 11,783     |       |
|                                                 |       |       |       |       |       |       |       |
| INCOME TAX PROVISION                                 |       | 3,698      |       | 3,339      |       | 4,005      |       |
|                                                 |       |       |       |       |       |       |       |
| NET INCOME                                           |       | $          | 7,805      |       | $          | 7,456      |       | $ | 7,778 |   |
|                                                 |       |       |       |       |       |       |       |
| EARNINGS PER SHARE:                                  |       |       |       |       |       |       |       |
| Basic                                                |       | $          | 1.54       |       | $          | 1.46       |       | $ | 1.44 |   |
|                                                 |       |       |       |       |       |       |       |
| Diluted                                              |       | $          | 1.45       |       | $          | 1.38       |       | $ | 1.38 |   |

 

See notes to consolidated financial statements.

 

51

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**FIRSTFEDERAL BANCSHARES OF ARKANSAS, INC.**

 

## **CONSOLIDATED STATEMENTS OFSTOCKHOLDERS’ EQUITY**

## **YEARS ENDED DECEMBER 31, 2004,2003, AND 2002**

**(Inthousands, 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, 2002                            |       | 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 |   |
| Treasury shares  reissued due to exercise of stock options |       | —                   |       | —                  |       | 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  ($0.26 per share)                          |       | —                   |       | —                  |       | —              |       | —             |       | (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 |   |
| Stock  compensation expense                                |       | —                   |       | —                  |       | 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  ($0.34 per share)                          |       | —                   |       | —                  |       | —              |       | —             |       | (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 |   |
|                                                       |       |                     |       |                    |       |                |       |               |       |                |       |                          |       |   |   |   |   |
| Net income                                                 |       | —                   |       | —                  |       | —              |       | —             |       | 7,805               |       | —                        |       | — |   | 7,805 |   |
| Release of ESOP  shares                                    |       | —                   |       | —                  |       | 1,296               |       | 416                |       | —              |       | —                        |       | — |   | 1,712 |   |
| Stock  compensation expense                                |       | —                   |       | —                  |       | 14                  |       | 27                 |       | —              |       | (1,316                        | )          | 15 |   | 56 |   |
| Tax effect of  stock compensation plans                    |       | —                   |       | —                  |       | 327                 |       | —             |       | —              |       | —                        |       | — |   | 327 |   |
| Purchase of  treasury stock – at cost                 |       | —                   |       | —                  |       |                |       | —             |       | —              |       | 458,300                       |       | (9,534 | ) | (9,534 | ) |
| Treasury shares  reissued due to exercise of stock options |       | —                   |       | —                  |       | (160                | )          | —             |       | —              |       | (210,918                      | )          | 2,195 |   | 2,035 |   |
| Dividends paid  ($0.42 per share)                          |       | —                   |       | —                  |       | —              |       | —             |       | (2,178              | )          | —                        |       | — |   | (2,178 | ) |
|                                                       |       |                     |       |                    |       |                |       |               |       |                |       |                          |       |   |   |   |   |
| BALANCE –  December 31, 2004                          |       | 10,307,502               |       | $                       | 103        |                | $          | 54,427             |       | $                   | (582       | )                             | $          | 78,261 |   | 5,213,482 |   | $ | (56,908 | ) | $ | 75,301 |   |

 

52

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

 

**CONSOLIDATED STATEMENTS OF CASH FLOWS**

**YEARS ENDED DECEMBER 31, 2004, 2003 AND 2002**

**(In thousands)**

 
| ** **                                                                         | ** ** | **2004**   | ** ** | **2003**   | ** ** | **2002**   | ** ** |
|------------------------------------------------------------------------------------|------------|------------|------------|------------|------------|------------|------------|
| ** **                                                                         | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| OPERATING ACTIVITIES:                                                              |       |       |       |       |       |       |       |
| Net income                                                                         |       | $          | 7,805      |       | $          | 7,456      |       | $ | 7,778 |   |
| Adjustments to reconcile net income to net  cash provided by operating activities: |       |       |       |       |       |       |       |
| Provision for loan losses                                                          |       | 1,020      |       | 690        |       | 1,500      |       |
| Provision for real estate losses                                                   |       | 45         |       | 35         |       | 16         |       |
| Deferred tax provision (benefit)                                                   |       | 350        |       | 60         |       | (80        | )          |
| Accretion of discounts on investment  securities—net                          |       | (40        | )          | (111       | )          | (157       | )          |
| Federal Home Loan Bank stock dividends                                             |       | (69        | )          | (110       | )          | (146       | )          |
| Loss (gain) on disposition of fixed assets                                         |       | (70        | )          | 98         |       | (3         | )          |
| Loss (gain) on sale of repossessed assets—net                                 |       | (42        | )          | 17         |       | 13         |       |
| Originations of loans held for sale                                                |       | (63,041    | )          | (119,833   | )          | (69,631    | )          |
| Proceeds from sales of loans originated to  sell                                   |       | 63,712     |       | 128,106    |       | 67,815     |       |
| Gain on sale of mortgage loans originated  to sell                                 |       | (607       | )          | (1,696     | )          | (888       | )          |
| Depreciation                                                                       |       | 1,185      |       | 1,167      |       | 819        |       |
| Amortization (accretion) of deferred loan  fees—net                           |       | 91         |       | (384       | )          | (606       | )          |
| Release of ESOP shares                                                             |       | 1,712      |       | 1,322      |       | 1,016      |       |
| Earnings on life insurance policies                                                |       | (795       | )          | (848       | )          | (881       | )          |
| Stock compensation expense                                                         |       | 56         |       | 45         |       | —     |       |
| Changes in operating assets and  liabilities:                                      |       |       |       |       |       |       |       |
| Accrued interest receivable                                                        |       | (338       | )          | 291        |       | 40         |       |
| Prepaid expenses and other assets                                                  |       | (427       | )          | (585       | )          | (350       | )          |
| Other liabilities                                                                  |       | 351        |       | (660       | )          | (1,891     | )          |
|                                                                               |       |       |       |       |       |       |       |
| Net cash provided by operating activities                                          |       | 10,898     |       | 15,060     |       | 4,364      |       |
|                                                                               |       |       |       |       |       |       |       |
| INVESTING ACTIVITIES:                                                              |       |       |       |       |       |       |       |
| Purchases of investment securities—held to  maturity                          |       | (87,039    | )          | (304,089   | )          | (147,958   | )          |
| Proceeds from maturities of investment  securities—held to maturity           |       | 111,798    |       | 338,292    |       | 134,522    |       |
| Purchase of Federal Home Loan Bank stock                                           |       | (1,737     | )          | —     |       | —     |       |
| Federal Home Loan Bank stock redeemed                                              |       | 679        |       | 1,425      |       | —     |       |
| Loan originations—net of repayments                                           |       | (121,946   | )          | (37,458    | )          | (7,909     | )          |
| Loan purchases                                                                     |       | (5,172     | )          | (3,140     | )          | —     |       |
| Loan participations sold                                                           |       | 3,970      |       | 3,124      |       | —     |       |
| Proceeds from sales of repossessed assets                                          |       | 801        |       | 773        |       | 833        |       |
| Proceeds from sales of office properties  and equipment                            |       | 632        |       | 38         |       | 4          |       |
| Purchases of office properties and  equipment                                      |       | (2,475     | )          | (4,851     | )          | (4,504     | )          |
|                                                                               |       |       |       |       |       |       |       |
| Net cash used in investing activities                                              |       | (100,489   | )          | (5,886     | )          | (25,012    | )          |
|                                                                                    |            |            |            |            |            |            |            |  |  |  |

 

(Continued)

 

53

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| ** **                                                                        | ** ** | **2004**   | ** ** | **2003**   | ** ** | **2002**   | ** ** |
|-----------------------------------------------------------------------------------|------------|------------|------------|------------|------------|------------|------------|
| ** **                                                                        | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| FINANCING  ACTIVITIES:                                                            | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net increase in deposits                                                          |       | $          | 8,844      |       | $          | 4,818      |       | $ | 12,829 |   |
| Advances from Federal Home Loan Bank                                              |       | 81,578     |       | 23,000     |       | 26,000     |       |
| Repayment of advances from Federal Home  Loan Bank                                |       | (31,384    | )          | (22,048    | )          | (35,234    | )          |
| Net increase (decrease) in advance payments  by borrowers for taxes and insurance |       | 32         |       | (35        | )          | (169       | )          |
| Purchase of treasury stock                                                        |       | (9,534     | )          | (2,805     | )          | (9,547     | )          |
| Dividends paid                                                                    |       | (2,178     | )          | (1,814     | )          | (1,471     | )          |
| Stock options exercised                                                           |       | 2,035      |       | 1,418      |       | 422        |       |
|                                                                              |       |       |       |       |       |       |       |
| Net cash provided by (used in) financing  activities                              |       | 49,393     |       | 2,534      |       | (7,170     | )          |
|                                                                              |       |       |       |       |       |       |       |
| NET INCREASE (DECREASE) IN CASH AND CASH  EQUIVALENTS                             |       | (40,198    | )          | 11,708     |       | (27,818    | )          |
|                                                                              |       |       |       |       |       |       |       |
| CASH AND CASH EQUIVALENTS:                                                        |       |       |       |       |       |       |       |
| Beginning of year                                                                 |       | 56,201     |       | 44,493     |       | 72,311     |       |
|                                                                              |       |       |       |       |       |       |       |
| End of year                                                                       |       | $          | 16,003     |       | $          | 56,201     |       | $ | 44,493 |   |
|                                                                              |       |       |       |       |       |       |       |
| SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION—                           |       |       |       |       |       |       |       |
| Cash paid for:                                                                    |       |       |       |       |       |       |       |
| Interest                                                                          |       | $          | 14,238     |       | $          | 16,073     |       | $ | 22,020 |   |
|                                                                              |       |       |       |       |       |       |       |
| Income taxes                                                                      |       | $          | 2,990      |       | $          | 3,394      |       | $ | 4,016 |   |
|                                                                              |       |       |       |       |       |       |       |
| SUPPLEMENTAL SCHEDULE OF NONCASH INVESTING  ACTIVITIES:                           |       |       |       |       |       |       |       |
| Real estate and other assets acquired in  settlement of loans                     |       | $          | 709        |       | $          | 1,933      |       | $ | 1,017 |   |
|                                                                              |       |       |       |       |       |       |       |
| Loans to facilitate sales of real estate  owned                                   |       | $          | 197        |       | $          | 620        |       | $ | 272 |   |
|                                                                              |       |       |       |       |       |       |       |
| Investment securities purchased—not settled                                  |       | $          | 1,000      |       | $          | —     |       | $ | — |   |

 

(Concluded)

 

Seenotes to consolidated financial statements.

 

54

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

 

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**YEARS ENDED DECEMBER 31, 2004, 2003, AND 2002**

 

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

 

***Nature of Operations and Principlesof Consolidation—***FirstFederal Bancshares of Arkansas, Inc. (the “Company”) is a unitary holdingcompany which owns all of the stock of First Federal Bank of Arkansas, FA (the “Bank”).The Bank provides a broad line of financial products to individuals and smallto medium-sized businesses. The consolidated financial statements also includethe accounts 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.

 

***Investment Securities—***The Company classifies investment securitiesinto one of two categories: held to maturity or available for sale. The Companydoes not engage in trading activities. Debt securities that the Company has thepositive intent and ability to hold to maturity are classified as held tomaturity and recorded at cost, adjusted for the amortization of premiums andthe accretion of discounts.

 

Investmentsecurities that the Company intends to hold for indefinite periods of time areclassified as available for sale and are recorded at fair value. Unrealizedholding gains and losses are excluded from earnings and reported net of tax inother comprehensive income. Investment securities in the available for saleportfolio may be used as part of the Company’s asset and liability managementpractices and may be sold in response to changes in interest rate risk,prepayment risk, or other economic factors. At December 31, 2004 and 2003,the Company did not own any investment securities classified as available forsale.

 

Premiumsare amortized into interest income using the interest method to the earlier ofmaturity or call date. Discounts are accreted into interest income using theinterest method over the period to maturity. The specific identification methodof accounting is used to compute gains or losses on the sales of investmentsecurities.

 

Declinesin the fair value of held to maturity and available for sale securities belowtheir cost that are deemed to be other than temporary are reflected in earningsas realized losses. In estimating other than temporary impairment losses,management considers independent price quotations and the financial conditionof the issuer.

 

***Loans Receivable—***The Bank originates and maintains loansreceivable which are substantially concentrated in its lending territory(primarily Northwest and Northcentral Arkansas). The majority of the Bank’sloans are residential mortgage loans, commercial real estate loans, commercialloans, and construction loans for residential property. The Bank’s policy callsfor collateral or other forms of repayment assurance to be received from theborrower at the time of loan origination. Such collateral or other form ofrepayment assurance is subject to changes in economic value due to variousfactors beyond the control of the Bank.

 

Loansreceivable that management has the intent and ability to hold for theforeseeable future or until maturity or pay-off are stated at unpaid principalbalances adjusted for any charge-offs, the allowance for loan losses, and anydeferred loan fees or costs. Deferred loan fees or costs and discounts on firstmortgage loans are amortized or accreted to income using the level-yield methodover the remaining period to contractual maturity.

 

55

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Mortgageloans originated and committed for sale in the secondary market are carried atthe lower of cost or estimated market value in the aggregate. Such loans aregenerally carried at cost due to the short period of time between funding andsale, generally two to three weeks.

 

Theaccrual of interest on impaired loans is discontinued when, in management’sopinion, the borrower may be unable to meet payments as they become due or whenthe loan becomes 90 days past due, whichever occurs first. When interestaccrual is discontinued, all unpaid accrued interest is reversed againstinterest income. The interest on these loans is accounted for on the cash basisuntil qualifying for return to accrual. Loans are returned 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 reasonably expected.

 

***Allowance for Loan Losses—***The allowance for loan losses is establishedas losses are estimated to have occurred through a provision for loan lossescharged to earnings. Loan losses are charged against the allowance whenmanagement believes it is likely that a loan balance is uncollectible.  Subsequent recoveries, if any, are creditedto 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. Thisevaluation is inherently subjective as it requires estimates that aresusceptible to significant revision as more information becomes available orconditions change.

 

Theallowance consists of specific, general and unallocated components. Thespecific 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.

 

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

 

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

 

***Rate Lock Commitments—***On March 13, 2002, the Financial AccountingStandards Board (“FASB”) determined that loan commitments related to theorigination or acquisition of mortgage loans that will be held for sale must beaccounted for as derivative instruments, effective for fiscal quartersbeginning after April 10, 2002. Accordingly, the Company adopted suchaccounting on July 1, 2002.

 

56

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TheBank enters into commitments to originate loans whereby the interest rate onthe loan is determined prior to funding (rate lock commitments). Rate lockcommitments on mortgage loans that are intended to be sold are considered to bederivatives. Accordingly, such commitments, along with any related feesreceived from potential borrowers, are recorded at fair value in derivativeassets or liabilities, with changes in fair value recorded in the net gain orloss on sale of mortgage loans. Fair value is based on fees currently chargedto enter into similar agreements, and for fixed-rate commitments also considersthe difference between current levels of interest rates and the committedrates. Prior to July 1, 2002, such commitments were recorded to the extentof fees received. Fees received were subsequently included in the net gain orloss on sale of mortgage loans.

 

Thecumulative effect of adopting SFAS No. 133, *Accounting for Derivative Instruments and Hedging Activities,*for rate lock commitments as of July 1, 2002 was not material, nor was itseffect material at December 31, 2004 or 2003.

 

***Real Estate Acquired in Settlementof Loans—***Realestate acquired in settlement of loans is initially recorded at estimated fairvalue less estimated costs to sell, establishing a new cost basis. Subsequentto foreclosure, valuations are periodically performed by management and theassets are carried at the lower of carrying amount or fair value less costs tosell. Revenue and expenses from operations and changes in the valuationallowance are included in other noninterest expenses.

 

***Office Properties and Equipment—***Land is carried at cost. Buildings andequipment 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 liabilitiesare determined using the liability (or balance sheet) method. Under thismethod, the net deferred tax asset or liability is determined based on the taxeffects of the temporary differences between the book and tax bases of thevarious statement of financial condition assets and liabilities and givescurrent recognition to changes in tax rates and laws.

 

***Interest Rate Risk—***The Bank’s asset base is exposed to riskincluding the risk resulting from changes in interest rates and changes in thetiming of cash flows. The Bank monitors the effect of such risks by consideringthe mismatch of the maturities of its assets and liabilities in the currentinterest rate environment and the sensitivity of assets and liabilities tochanges in interest rates. The Bank’s management has considered the effect ofsignificant increases and decreases in interest rates and believes suchchanges, if they occurred, would be manageable and would not affect the abilityof the Bank to hold its assets as planned. However, the Bank is exposed tosignificant market risk in the event of significant and prolonged interest ratechanges.

 

***Employee Stock Ownership Plan—***Compensation expense for the Employee StockOwnership Plan (“ESOP”) is determined based on the average fair value of sharescommitted to be released during the period and is recognized as the shares arecommitted to be released. For the purpose of earnings per share, ESOP sharesare included in weighted-average common shares outstanding as the shares arecommitted to be released.

 

***Stock Compensation Plans—***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 effect on the Company’s pro forma netincome and pro forma earnings per share would not have been significant.

 

***Earnings Per Common Share—***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

 

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beenissued, as well as any adjustment to income that would result from the assumedissuance. Potential common shares that may be issued by the Company relatesolely to outstanding stock options, and are determined using the treasurystock method.

 

***Stock Split—***On November 25, 2003, the Board of Directorsof the Company declared a two-for-one stock split payable December 31, 2003, tothe stockholders of record on December 17, 2003. Stockholders’ equity,including shares, has been retroactively restated to reflect the stock split asof the earliest date presented in this report. All per share amounts andweighted average shares outstanding have been restated to reflect the stocksplit.

 

***Recent Accounting Pronouncements—***In December 2004, the FASB issued SFAS No.123(R),*Share-Based Payment*,which establishes accounting standards for all transactions in which an entityexchanges its equity instruments for goods and services. SFAS No. 123(R)focuses primarily on accounting for transactions with employees, and carriesforward without change prior guidance for share-based payments for transactionswith non-employees. SFAS No. 123(R) eliminates the intrinsic value measurementobjective in APB Opinion 25 and generally requires measurement of the cost ofemployee services received in exchange for an award of equity instruments basedon the fair value of the award on the date of the grant. The standard requiresgrant date fair value to be estimated using either an option-pricing modeladjusted for the unique characteristics of the award or an observable marketprice, if such a price exists. Such cost must be recognized over the periodduring which an employee is required to provide service in exchange for theaward - the requisite service period (which is usually the vestingperiod).  We will be required to applySFAS No. 123(R) to all awards granted, modified or settled in our firstreporting period after June 15, 2005.  Asof the required effective date, all public entities will apply this Statementusing a modified version of prospective application. Under that transitionmethod, compensation cost is recognized on or after the required effective datefor the portion of outstanding awards for which the requisite service has notyet been rendered, based on the grant-date fair value of those awardscalculated under Statement 123 for either recognition or pro forma disclosures.For periods before the required effective date, entities may elect to apply amodified version of retrospective application under which financial statementsfor prior periods are adjusted on a basis consistent with the pro formadisclosures required for those periods by Statement 123.  We will adopt SFAS No. 123(R) in the thirdquarter of 2005 using the modified prospective application.  Based on our current activities, we estimatethat the adoption of this Statement will not have a material effect on thefinancial statements of the Company.

 

InDecember 2004, the FASB issued SFAS No. 153, Exchanges of Nonmonetary Assets anamendment of APB No. 29.  This Statement amends Opinion 29 to eliminatethe exception for nonmonetary exchanges of similar productive assets andreplaces it with a general exception for exchanges of nonmonetary assets thatdo not have commercial substance.  The Statement specifies that anonmonetary exchange has commercial substance if the future cash flows of theentity are expected to change significantly as a result of the exchange. This Statement is effective for nonmonetary asset exchanges occurring in fiscalperiods beginning after June 15, 2005.  Earlier application is permittedfor nonmonetary asset exchanges occurring in fiscal periods beginning after thedate this Statement is issued.  Retroactive application is not permitted. Based on our current activities, we estimate that the adoption of thisStatement will not have a material effect on the financial statements of theCompany.

 

***Reclassifications—***Certain amounts in the 2003 and 2002consolidated financial statements have been reclassified to conform to theclassifications adopted for reporting in 2004.

 

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

 

TheBank is required to maintain average balances on hand or with the FederalReserve Bank. At December 31, 2004 and 2003, these reserve balancesamounted to $571,000 and $520,000, respectively.

 

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

 

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

 
| ** **                              | ** ** | **2004**            | ** ** |
|-----------------------------------------|------------|---------------------|------------|
| ** **                              | ** ** | **Amortized  Cost** | ** ** | **Gross  Unrealized  Gains** | ** ** | **Gross  Unrealized  Losses** | ** ** | **Fair  Value** | ** ** |
| ** **                              |       |                |       |   |   |   |   |   |   |
| **Held To Maturity**                    |       |                |       |   |   |   |   |   |   |
| Certificates of deposit                 |       | $                   | 3,000      |   | $ | — |   | $ | — |   | $ | 3,000 |   |
| Municipal securities                    |       | 15,839              |       | 299 |   | 80 |   | 16,058 |   |
| U.S. Government and  Agency obligations |       | 37,821              |       | 22 |   | 475 |   | 37,368 |   |
|                                    |       |                |       |   |   |   |   |   |   |
| Total                                   |       | $                   | 56,660     |   | $ | 321 |   | $ | 555 |   | $ | 56,426 |   |

 
| ** **                              | ** ** | **2003**            | ** ** |
|-----------------------------------------|------------|---------------------|------------|
| ** **                              | ** ** | **Amortized  Cost** | ** ** | **Gross  Unrealized  Gains** | ** ** | **Gross  Unrealized  Losses** | ** ** | **Fair  Value** | ** ** |
| ** **                              |       |                |       |   |   |   |   |   |   |
| **Held To Maturity**                    |       |                |       |   |   |   |   |   |   |
| 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 |   |

 

Thefollowing table shows gross unrealized losses and fair value aggregated byinvestment category and length of time that individual securities have been ina continuous unrealized loss position, at December 31, 2004:

 
| ** **                              | ** ** | **Less than 12 Months** | ** ** | **12 Months or More**  | ** ** | **Total**       | ** ** |
|-----------------------------------------|------------|-------------------------|------------|------------------------|------------|-----------------|------------|
| ** **                              | ** ** | **Fair  Value**         | ** ** | **Unrealized  Losses** | ** ** | **Fair  Value** | ** ** | **Unrealized  Losses** | ** ** | **Fair  Value** | ** ** | **Unrealized  Losses** | ** ** |
|                                    |       |                    |       |                   |       |            |       |   |   |   |   |   |   |
| Municipal securities                    |       | $                       | 2,504      |                   | $          | 47              |       | $ | 1,407 |   | $ | 33 |   | $ | 3,911 |   | $ | 80 |   |
| U.S. Government and  Agency obligations |       | 12,619                  |       | 73                     |       | 16,290          |       | 402 |   | 28,909 |   | 475 |   |
|                                    |       |                    |       |                   |       |            |       |   |   |   |   |   |   |
|                                    |       | $                       | 15,123     |                   | $          | 120             |       | $ | 17,697 |   | $ | 435 |   | $ | 32,820 |   | $ | 555 |   |

 

TheCompany has pledged investment securities held to maturity with carrying valuesof approximately $19.5 million and $15.5 million at December 31, 2004 and2003, respectively, as collateral for certain deposits in excess of $100,000.

 

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The scheduledmaturities of debt securities at December 31, 2004, by contractualmaturity are shown below (in thousands). Expected maturities may differ fromcontractual maturities because borrowers may have the right to call or prepayobligations with or without call or prepayment penalties.

 
| ** **                       | ** ** | **2004**            | ** ** |
|----------------------------------|------------|---------------------|------------|
| ** **                       | ** ** | **Amortized  Cost** | ** ** | **Fair  Value** | ** ** |
|                             |       |                |       |   |   |
| Within one year                  |       | $                   | 3,100      |   | $ | 3,101 |   |
| Due from one year to five years  |       | 200                 |       | 199 |   |
| Due from five years to ten years |       | 12,130              |       | 12,184 |   |
| Due after ten years              |       | 41,230              |       | 40,942 |   |
|                             |       |                |       |   |   |
| Total                            |       | $                   | 56,660     |   | $ | 56,426 |   |

 

As ofDecember 31, 2004 and 2003, investments with carrying values ofapproximately $55.8 million and $70.0 million, respectively, have call optionsheld by the issuer, of which approximately $41.8 million and $55.4 million,respectively, are callable within one year.

 

**4.**                                      LOANS RECEIVABLE

 

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

 
| ** **                      | ** ** | **2004**   | ** ** | **2003**   | ** ** |
|---------------------------------|------------|------------|------------|------------|------------|
| ** **                      | ** ** | ** ** | ** ** | ** ** | ** ** |
| First mortgage loans:           |       |       |       |       |       |
| One- to four-family residences  |       | $          | 282,144    |       | $          | 259,121 |   |
| Commercial                      |       | 114,986    |       | 90,274     |       |
| Multi-family                    |       | 9,454      |       | 7,673      |       |
| Other                           |       | 30,923     |       | 7,036      |       |
| Construction                    |       | 159,111    |       | 89,332     |       |
| Less:                           |       |       |       |       |       |
| Unearned discounts              |       | (92        | )          | (119       | )          |
| Undisbursed loan funds          |       | (62,661    | )          | (35,181    | )          |
| Deferred loan fees—net     |       | (623       | )          | (784       | )          |
|                            |       |       |       |       |       |
| Total first mortgage loans      |       | 533,242    |       | 417,352    |       |
|                            |       |       |       |       |       |
| Commercial loans                |       | 27,545     |       | 21,491     |       |
|                            |       |       |       |       |       |
| Consumer loans:                 |       |       |       |       |       |
| Home equity and second mortgage |       | 45,256     |       | 42,421     |       |
| Automobile                      |       | 19,101     |       | 22,087     |       |
| Other                           |       | 10,685     |       | 10,780     |       |
| Deferred loan costs—net    |       | 234        |       | 246        |       |
|                            |       |       |       |       |       |
| Total consumer and other loans  |       | 75,276     |       | 75,534     |       |
|                            |       |       |       |       |       |
| Allowance for loan losses       |       | (1,846     | )          | (1,621     | )          |
|                            |       |       |       |       |       |
| Loans receivable—net       |       | $          | 634,217    |       | $          | 512,756 |   |

 

AtDecember 31, 2004 and 2003, loans receivable included loans committed tobe sold with net book values of $1.6 million and $1.7 million, respectively.

 

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Mortgage loans serviced for others are not included in the accompanyingconsolidated statements of financial condition. The unpaid principal balances of such loans at December 31, 2004 and2003 were $18.9 million and $8.4 million, respectively.  Servicing loans for others generally consistsof collecting mortgage payments, maintaining escrow accounts, disbursingpayments to investors, and foreclosure processing.  Servicing income for the years ended December31, 2004, 2003, and 2002 was $159,000, $36,000 and $5,000, respectively.

 

The following is asummary of information pertaining to impaired and non-accrual loans:

 
| ** **                                                   | ** ** | **December 31** | ** ** |
|--------------------------------------------------------------|------------|-----------------|------------|
| ** **                                                   | ** ** | **2004**        | ** ** | **2003** | ** ** |
| ** **                                                   | ** ** | ** **      | ** ** | ** ** | ** ** |
| Impaired loans without a valuation  allowance                |       | $               | 3,370      |   | $ | 1,352 |   |
| Impaired loans with a valuation allowance                    |       | 420             |       | — |   |
|                                                         |       |            |       |   |   |
| Total impaired loans                                         |       | $               | 3,790      |   | $ | 1,352 |   |
|                                                         |       |            |       |   |   |
| Valuation allowance related to impaired  loans               |       | $               | 62         |   | $ | — |   |
|                                                         |       |            |       |   |   |
| Total non-accrual loans                                      |       | $               | 4,162      |   | $ | 2,331 |   |
|                                                         |       |            |       |   |   |
| Total loans past-due ninety days or more  and still accruing |       | $               | —     |   | $ | 400 |   |

 
| ** **                                                    | ** ** | **Year Ended  December 31** | ** ** |
|---------------------------------------------------------------|------------|-----------------------------|------------|
| ** **                                                    | ** ** | **2004**                    | ** ** | **2003** | ** ** |
| ** **                                                    | ** ** | ** **                  | ** ** | ** ** | ** ** |
| Average investment in impaired loans                          |       | $                           | 1,298      |   | $ | 4,660 |   |
|                                                          |       |                        |       |   |   |
| Interest income recognized on impaired  loans                 |       | $                           | 270        |   | $ | 401 |   |
|                                                          |       |                        |       |   |   |
| Interest income recognized on a cash basis  on impaired loans |       | $                           | —     |   | $ | 88 |   |

 

Interest incomerecorded during the years ended December 31, 2004, 2003 and 2002 for nonaccrualloans was $85,000, $112,000, and $413,000, respectively.  Under the original terms, these loans wouldhave reported approximately $243,000, $274,000, and $525,000, of interestincome for the years ended December 31, 2004, 2003, and 2002, respectively.

 

**5.**                                      ACCRUED INTEREST RECEIVABLE

 

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

 
| ** **            | ** ** | **2004**   | ** ** | **2003**   | ** ** |
|-----------------------|------------|------------|------------|------------|------------|
| ** **            | ** ** | ** ** | ** ** | ** ** | ** ** |
| Loans                 |       | $          | 3,861      |       | $          | 3,229 |   |
| Investment securities |       | 566        |       | 860        |       |
|                  |       |       |       |       |       |
| Total                 |       | $          | 4,427      |       | $          | 4,089 |   |

 

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**6.**                                      ALLOWANCES FOR LOAN AND REAL ESTATELOSSES

** **

A summary of the activityin the allowances for loan and real estate losses is as follows for the yearsended December 31 (in thousands):

 
| ** **                      | ** ** | **2004**  | ** ** | **2003**         | ** ** | **2002**  | ** ** |
|---------------------------------|------------|-----------|------------|------------------|------------|-----------|------------|
| ** **                      | ** ** | **Loans** | ** ** | **Real  Estate** | ** ** | **Loans** | ** ** | **Real  Estate** | ** ** | **Loans** | ** ** | **Real  Estate** | ** ** |
|                            |       |      |       |             |       |      |       |   |   |   |   |   |   |
| Balance—beginning of year  |       | $         | 1,621      |             | $          | —    |       | $ | 1,529 |   | $ | — |   | $ | 923 |   | $ | — |   |
|                            |       |      |       |             |       |      |       |   |   |   |   |   |   |
| Provisions for estimated losses |       | 1,020     |       | 45               |       | 690       |       | 35 |   | 1,500 |   | 16 |   |
| Recoveries                      |       | 103       |       | —           |       | 80        |       |   |   | 92 |   |   |   |
| Losses charged off              |       | (898      | )          | (45              | )          | (678      | )          | (35 | ) | (986 | ) | (16 | ) |
|                            |       |      |       |             |       |      |       |   |   |   |   |   |   |
| Balance—end of year        |       | $         | 1,846      |             | $          | —    |       | $ | 1,621 |   | $ | — |   | $ | 1,529 |   | $ | — |   |

 

**7.**                                      OFFICE PROPERTIES AND EQUIPMENT

** **

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

 
| ** **                               | ** ** | **2004** | ** ** | **2003** | ** ** |
|------------------------------------------|------------|----------|------------|----------|------------|
|                                     |       |     |       |     |       |
| Land and land improvements               |       | $        | 4,001      |     | $          | 3,143 |   |
| Buildings and improvements               |       | 11,712   |       | 11,544   |       |
| Furniture and equipment                  |       | 5,007    |       | 4,895    |       |
| Automobiles                              |       | 391      |       | 754      |       |
| Construction in progress                 |       | 303      |       | —   |       |
|                                     |       |     |       |     |       |
| Total                                    |       | 21,414   |       | 20,336   |       |
|                                     |       |     |       |     |       |
| Accumulated depreciation                 |       | (6,119   | )          | (6,098   | )          |
|                                     |       |     |       |     |       |
| Office properties and equipment—net |       | $        | 15,295     |     | $          | 14,238 |   |
|                                          |            |          |            |          |            |  |  |  |  |

 

Depreciation expense forthe years ended December 31, 2004, 2003, and 2002, amounted toapproximately $1,185,000, $1,167,000, and, $819,000, respectively.

 

**8.**                                      DEPOSITS

** **

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

 
| ** **                                                                                                              | ** ** | **2004** | ** ** | **2003** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|
|                                                                                                                    |       |     |       |     |       |
| Demand and NOW accounts, including  noninterest-bearing deposits of $31,019 and $23,821 in 2004 and 2003,  respectively |       | $        | 109,772    |     | $          | 96,090 |   |
| Money market                                                                                                            |       | 106,063  |       | 108,400  |       |
| Regular  savings                                                                                                        |       | 31,611   |       | 29,269   |       |
| Certificates of deposit                                                                                                 |       | 334,978  |       | 339,821  |       |
|                                                                                                                    |       |     |       |     |       |
| Total                                                                                                                   |       | $        | 582,424    |     | $          | 573,580 |   |
|                                                                                                                         |            |          |            |          |            |  |  |  |

 

Overdrafts of demanddeposit accounts of $574,000 and $240,000 at December 31, 2004 and 2003,respectively, have been reclassified for financial reporting and are reflectedin net loans receivable on the consolidated statements of financial condition.

 

62

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The aggregate amount oftime deposits in denominations of $100 thousand or more was approximately $87million and $80 million at December 31, 2004 and 2003, respectively.

 

At December 31,2004, scheduled maturities of certificates of deposit are as follows (inthousands):

 
| **Year Ending**     | ** ** | ** ** | ** ** |
|---------------------|------------|------------|------------|
| **December 31**     | ** ** | ** ** | ** ** |
|                |       |       |       |
| 2005                |       | $          | 137,135    |   |
| 2006                |       | 86,936     |       |
| 2007                |       | 50,958     |       |
| 2008                |       | 31,005     |       |
| 2009                |       | 8,904      |       |
| 2010 and thereafter |       | 20,040     |       |
|                |       |       |       |
| Total               |       | $          | 334,978    |   |
|                     |            |            |            |  |  |

 

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

 
| ** **                               | ** ** | **Year Ended December 31** | ** ** |
|------------------------------------------|------------|----------------------------|------------|
| ** **                               | ** ** | **2004**                   | ** ** | **2003** | ** ** | **2002** | ** ** |
|                                     |       |                       |       |   |   |   |   |
| NOW accounts                             |       | $                          | 281        |   | $ | 454 |   | $ | 760 |   |
| Money market                             |       | 1,665                      |       | 1,703 |   | 1,641 |   |
| Regular savings and certificate accounts |       | 10,812                     |       | 12,536 |   | 17,106 |   |
| Early withdrawal penalties               |       | (68                        | )          | (86 | ) | (61 | ) |
|                                     |       |                       |       |   |   |   |   |
| Total                                    |       | $                          | 12,690     |   | $ | 14,607 |   | $ | 19,446 |   |

 

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

 

**9.**                                      FEDERAL HOME LOAN BANK STOCK AND ADVANCES

** **

The Bank is a member ofthe Federal Home Loan Bank System. As a member of this system, it is requiredto maintain an investment in capital stock of the Federal Home Loan Bank(“FHLB”) in an amount equal to the sum of 0.15% of total assets as of theprevious December 31 and 4.25% of outstanding advances. No ready marketexists for such stock and it has no quoted market value. The carrying value ofthe stock is its cost.

 

63

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The Bank pledges eligiblecollateral for its FHLB advances as defined in its blanket lien agreement withthe FHLB as well as its FHLB demand deposit account and FHLB stock. Eligiblecollateral under the blanket lien includes First Mortgage Collateral (asdefined), multi-family residential mortgages meeting the requirements foreligibility as First Mortgage Collateral, U.S. Government and Agency Securities(as defined), privately issued mortgage-backed securities that qualify aseligible collateral under applicable regulations, Federal Home Loan Bank TermDeposit Accounts, and other non-securitized real estate related collateral.Advances at December 31, 2004 and 2003, consisted of the following (inthousands):

 
| ** **                          | ** ** | **2004**     | ** ** | **2003**   | ** ** |
|-------------------------------------|------------|--------------|------------|------------|------------|
| ** **                          | ** ** | **Weighted** | ** ** | ** ** | ** ** | **Weighted** | ** ** | ** ** | ** ** |
| **Amounts Maturing in Year Ending** | ** ** | **Average**  | ** ** | ** ** | ** ** | **Average** | ** ** | ** ** | ** ** |
| **December 31**                     | ** ** | **Rate**     | ** ** | **Amount** | ** ** | **Rate** | ** ** | **Amount** | ** ** |
|                                |       |         |       |       |       |   |   |   |   |
| 2004                                |       | —       | %          | $          | —     |   | 2.22 | % | $ | 15,456 |   |
| 2005                                |       | 3.34         |       | 31,187     |       | 4.79 |   | 9,503 |   |
| 2006                                |       | 2.68         |       | 28,363     |       | 2.93 |   | 4,740 |   |
| 2007                                |       | 3.46         |       | 15,786     |       | 3.53 |   | 5,551 |   |
| 2008                                |       | 3.35         |       | 5,029      |       | 2.96 |   | 1,677 |   |
| 2009                                |       | 3.62         |       | 3,006      |       | 3.58 |   | 289 |   |
| Thereafter                          |       | 4.25         |       | 6,385      |       | 4.12 |   | 2,346 |   |
|                                |       |         |       |       |       |   |   |   |   |
| Total                               |       | 3.23         | %          | $          | 89,756     |   | 3.26 | % | $ | 39,562 |   |

** **

**10.**                               INCOME TAXES

** **

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

 
| ** **                      | ** ** | **Year Ended December 31** | ** ** |
|---------------------------------|------------|----------------------------|------------|
| ** **                      | ** ** | **2004**                   | ** ** | **2003** | ** ** | **2002** | ** ** |
|                            |       |                       |       |   |   |   |   |
| Income tax provision (benefit): |       |                       |       |   |   |   |   |
| Current:                        |       |                       |       |   |   |   |   |
| Federal                         |       | $                          | 2,924      |   | $ | 2,882 |   | $ | 3,714 |   |
| State                           |       | 424                        |       | 397 |   | 371 |   |
| Total Current                   |       | $                          | 3,348      |   | $ | 3,279 |   | $ | 4,085 |   |
|                            |       |                       |       |   |   |   |   |
| Deferred:                       |       |                       |       |   |   |   |   |
| Federal                         |       | $                          | 317        |   | $ | 84 |   | $ | (140 | ) |
| State                           |       | 33                         |       | (24 | ) | 60 |   |
| Total Deferred                  |       | $                          | 350        |   | $ | 60 |   | $ | (80 | ) |
|                            |       |                       |       |   |   |   |   |
| Total                           |       | $                          | 3,698      |   | $ | 3,339 |   | $ | 4,005 |   |

 

64

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The reasons for thedifferences between the statutory federal income tax rates and the effectivetax rates are summarized as follows (in thousands):

 
| ** **

** **              | ** ** | **Year Ended December 31** | ** ** |
|-------------------------------------|------------|----------------------------|------------|
| ** **                          | ** ** | **2004**                   | ** ** | **2003** | ** ** | **2002** | ** ** |
|                                |       |                       |       |   |   |   |   |   |   |   |   |   |   |
| Taxes at statutory rate             |       | $                          | 3,911      |   | 34.0 | % | $ | 3,670 |   | 34.0 | % | $ | 4,006 |   | 34.0 | % |
| Increase (decrease) resulting from: |       |                       |       |   |   |   |   |   |   |   |   |   |   |
| State income tax—net           |       | 287                        |       | 2.5 | % | 263 |   | 2.4 | % | 244 |   | 2.1 | % |
| Earnings on life insurance policies |       | (271                       | )          | (2.4 | )% | (288 | ) | (2.7 | )% | (299 | ) | (2.5 | )% |
| Nontaxable investments              |       | (208                       | )          | (1.8 | )% | (154 | ) | (1.4 | )% | (89 | ) | (0.8 | )% |
| Other—net                      |       | (21                        | )          | (0.2 | )% | (152 | ) | (1.4 | )% | 143 |   | 1.2 | % |
|                                |       |                       |       |   |   |   |   |   |   |   |   |   |   |
| Total                               |       | $                          | 3,698      |   | 32.1 | % | $ | 3,339 |   | 30.9 | % | $ | 4,005 |   | 34.0 | % |

 

The Company’s netdeferred tax liability account was comprised of the following atDecember 31 (in thousands):

 
| ** **                     | ** ** | **2004** | ** ** | **2003** | ** ** |
|--------------------------------|------------|----------|------------|----------|------------|
|                           |       |     |       |     |       |
| Deferred tax assets:           |       |     |       |     |       |
| Stock based compensation       |       | $        | 77         |     | $          | 119 |   |
| Allowance for loan losses      |       | 709      |       | 621      |       |
|                           |       |     |       |     |       |
| Total deferred tax assets      |       | 786      |       | 740      |       |
|                           |       |     |       |     |       |
| Deferred tax liabilities:      |       |     |       |     |       |
| Office properties              |       | (762     | )          | (561     | )          |
| Federal Home Loan Bank stock   |       | (601     | )          | (700     | )          |
| Pension plan contribution      |       | (436     | )          | (142     | )          |
|                           |       |     |       |     |       |
| Total deferred tax liabilities |       | (1,799   | )          | (1,403   | )          |
|                           |       |     |       |     |       |
| Net deferred tax liability     |       | $        | (1,013     | )        | $          | (663 | ) |

 

Specifically exemptedfrom deferred tax recognition requirements are bad debt reserves for taxpurposes of U.S. savings and loans in the institution’s base year, as defined.Base year reserves totaled approximately $4.2 million. Consequently, a deferredtax liability of approximately $1.6 million related to such reserves was notprovided for in the consolidated statements of financial condition atDecember 31, 2004 and 2003. Payment of dividends to shareholders out ofretained earnings deemed to have been made out of earnings previously set asideas bad debt reserves may create taxable income to the Bank. No provision hasbeen made for income tax on such a distribution as the Bank does not anticipatemaking such distributions.

 

**11.**                               BENEFIT PLANS

** **

***Stock Option Plan***—The Stock OptionPlan (“SOP”) provides for a committee of the Company’s Board of Directors toaward incentive stock options, non-qualified or compensatory stock options andstock appreciation rights representing up to 1,030,750 shares of Company stock.One-fifth of the options granted vested immediately upon grant, with thebalance vesting in equal amounts on the four subsequent anniversary dates ofthe grant. Options granted vest immediately in the event of retirement,disability, or death. Stock options granted expire in ten years unless granteeterminates employment, in which case the award expires five years aftertermination date or ten years after grant date, whichever comes first.

 

65

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Under the SOP, optionshave been granted to directors and key employees to purchase common stock ofthe Company. The exercise price in each case equals the fair market value ofthe Company’s stock at the date of grant. Options granted are summarized asfollows:

 
| ** **  | ** ** | ** **             | ** **        | **Weighted Average** | ** ** |
|-------------|------------|------------------------|-------------------|----------------------|------------|
| **Year**    | ** ** | **Range of**           | ** **        | **Remaining**        | ** ** |
| **Granted** | ** ** | **Exercise Prices**    | ** **        | **Contract Life**    | ** ** |
|        |       |                   |              |                 |       |
| 1997        |       | $                      | 9.63 — 10.19 |                 | 2.2 years  |   |
| 1998        |       | 11.63 —12.00      |              | 3.1 years            |       |
| 1999        |       | 8.53  — 9.32 |              | 2.4 years            |       |
| 2000        |       | 7.38  — 9.13 |              | 5.6 years            |       |
| 2001        |       | 9.35 —11.35       |              | 6.4 years            |       |
| 2002        |       | 12.20 —12.32      |              | 7.6 years            |       |
| 2003        |       | 12.93 —16.11      |              | 8.3 years            |       |
| 2004        |       | 19.25 —21.50      |              | 9.1 years            |       |
|             |            |                        |                   |                      |            |  |

 

A summary of the statusof the Company’s SOP as of December 31, 2004, 2003, and 2002, and changesduring the years ending on those dates are presented below:

 
| ** **                                   | ** ** | ** ** | ** ** | **Weighted** | ** ** |
|----------------------------------------------|------------|------------|------------|--------------|------------|
| ** **                                   | ** ** | ** ** | ** ** | **Average**  | ** ** |
| ** **                                   | ** ** | ** ** | ** ** | **Exercise** | ** ** |
| ** **                                   | ** ** | **Shares** | ** ** | **Price**    | ** ** |
|                                         |       |       |       |         |       |
| Outstanding—January 1, 2002             |       | 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       |   |
|                                         |       |       |       |         |       |
| Exercised                                    |       | (210,918   | )          | 9.65         |       |
| Granted                                      |       | 3,720      |       | 20.15        |       |
| Expired                                      |       | (1,600     | )          | 11.63        |       |
| Forfeited                                    |       | (1,040     | )          | 15.96        |       |
|                                         |       |       |       |         |       |
| Outstanding—December 31, 2004           |       | 629,724    |       | $            | 9.82       |   |
| Options exercisable – December 31, 2004 |       | 616,588    |       | $            | 9.73       |   |

* *

***Management Recognition and Retention Plan—***TheManagement Recognition and Retention Plan (“MRR Plan”) provides for a committeeof the Company’s Board of Directors to award restricted stock to key officersas well as non-employee directors. The MRR Plan authorizes the Company to grantup to 412,300 shares of the Company stock, of which 401,688 shares have beengranted through December 31, 2004. Compensation expense has beenrecognized over the vesting period based on the fair market value of the shareson the grant date. Shares granted will be deemed vested in the event ofdisability or death. Approximately $27,000 and $45,000 in compensation expensewas recognized during the years ended December 31, 2004 and 2003,respectively. No compensation expense was recognized during the year endedDecember 31, 2002.

 

66

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***Employee Stock Ownership Plan—***TheCompany established an Employee Stock Ownership Plan on May 3, 1996. During1996, the ESOP borrowed $4.1 million from the Company to purchase shares ofCompany stock. The loan is collateralized by the shares that were purchasedwith the proceeds of the loan. As the loan is repaid, ESOP shares will beallocated to participants of the ESOP and are available for release to theparticipants subject to the vesting provisions of the ESOP.

 

Forfeitures of nonvestedbenefits will be reallocated among remaining participating employees in thesame proportion as contributions. During each of the years endedDecember 31, 2004, 2003, and 2002, 83,208 shares were released by the ESOPto participant accounts. At December 31, 2004, there were 600,091 sharesallocated to participant accounts and 104,009 unallocated shares. The fairvalue of the unallocated shares amounted to approximately $2.3 million atDecember 31, 2004.

 

During the years endedDecember 31, 2004, 2003, and 2002, ESOP expense was approximately$1.7 million, $1.2 million, and $924,000, respectively.

 

***Other PostretirementBenefits—***The Bank is a participant in a multi-employerretirement plan and therefore separate information is not available. The planis noncontributory and covers substantially all employees. The plan provides aretirement benefit and a death benefit. Retirement benefits are payable inmonthly installments for life and must begin not later than the first day ofthe month coincident with or the next month following the seventieth birthdayor the participant may elect a lump-sum distribution. Death benefits are paidin a lump-sum distribution, the amount of which depends on years of service.Net pension expense was approximately $358,000, $480,000 and $108,000 for theyears ended December 31, 2004, 2003, and 2002 respectively.

 

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

 
| ** **                                                                          | ** ** | **Year Ended December 31, 2004** | ** ** |
|-------------------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                                          | ** ** | **Income**                       | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                                                          | ** ** | **(In Thousands)**               | ** ** | **Shares** | ** ** | **Per Share** | ** ** |
| ** **                                                                          | ** ** | **(Numerator)**                  | ** ** | **(Denominator)** | ** ** | **Amount** | ** ** |
| Basic EPS — Income available to common stockholders                            |       | $                                | 7,805      |   | 5,066,682 |   | $ | 1.54 |   |
|                                                                                |       |                             |       |   |   |   |   |
| Effect of dilutive securities — Stock  options                                 |       | —                           |       | 314,228 |   |   |   |
|                                                                                |       |                             |       |   |   |   |   |
| Diluted EPS — Income available to common stockholders  and assumed conversions |       | $                                | 7,805      |   | 5,380,910 |   | $ | 1.45 |   |

 
| ** **                                                                          | ** ** | **Year Ended December 31, 2003** | ** ** |
|-------------------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                                          | ** ** | **Income**                       | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                                                          | ** ** | **(In Thousands)**               | ** ** | **Shares** | ** ** | **Per Share** | ** ** |
| ** **                                                                          | ** ** | **(Numerator)**                  | ** ** | **(Denominator)** | ** ** | **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 |   |

 

67

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| ** **                                                                        | ** ** | **Year Ended December 31, 2002** | ** ** |
|-----------------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                                        | ** ** | **Income**                       | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                                                        | ** ** | **(In Thousands)**               | ** ** | **Shares** | ** ** | **Per Share** | ** ** |
| ** **                                                                        | ** ** | **(Numerator)**                  | ** ** | **(Denominator)** | ** ** | **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 |   |

** **

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

** **

The Bank is a party tofinancial instruments with off-balance sheet risk in the normal course ofbusiness to meet the financing needs of its customers. These financialinstruments include commitments to extend credit and standby letters of credit.Those instruments involve, to varying degrees, elements of credit risk inexcess of the amount recognized in the consolidated statements of financialcondition.

 

The Bank does not usefinancial instruments with off-balance sheet risk as part of itsasset/liability management program or for trading purposes. The Bank’s exposureto credit loss in the event of nonperformance by the other party to thefinancial instrument for commitments to extend credit and standby letters ofcredit is represented by the contractual amounts of those instruments. The Bankuses the same credit policies in making commitments and conditional obligationsas it does for on-balance sheet instruments.

 

Commitments to extendcredit are agreements to lend to a customer as long as there is no violation ofany condition established in the contract. Commitments generally have fixedexpiration dates or other termination clauses. The Bank evaluates eachcustomer’s creditworthiness on a case-by-case basis. The amount of collateralobtained, if deemed necessary by the Bank upon extension of credit, is based onmanagement’s credit evaluation of the counterparty. Such collateral consistsprimarily of residential properties. Standby letters of credit are conditionalcommitments issued by the Bank to guarantee the performance of a customer to athird party. The credit risk involved in issuing letters of credit is essentiallythe same as that involved in extending loan facilities to customers.

 

The funding period forconstruction loans is generally six- to twelve-months and commitments tooriginate mortgage loans are generally outstanding for 60 days or less.

 

The Company, in thenormal course of business, makes commitments to buy or sell assets or to incuror fund liabilities. Commitments include, but are not limited to:

 

•                    theorigination, purchase or sale of loans;

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

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

 

At December 31, 2004, theBank’s off-balance sheet arrangements principally included lending commitments,which are described below. At December 31, 2004, the Company had no interestsin non-consolidated special purpose entities.

 

At December 31, 2004,commitments included:

 

•                  totalapproved loan origination commitments outstanding amounting to $20.6 million,including $1.9 million of loans committed to sell;

•                  ratelock agreements with customers of $6.4 million, all of which have been lockedwith an investor;

•                  fundedmortgage loans committed to sell of $1.6 million;

•                  unadvancedportion of construction loans of $62.7 million;

•                  unusedlines of credit of $22.4 million;

 

68

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•                  outstandingstandby letters of credit of $1.6 million;

•                  totalpredetermined overdraft protection limits of $10.4 million; and

•                  certificatesof deposit scheduled to mature in one year or less totaling $137.1 million.

 

Total unfundedcommitments to originate loans for sale and the related commitments to sell of$6.4 million meet the definition of a derivative financial instrument. Therelated asset and liability are considered immaterial at December 31, 2004.

 

Historically, a verysmall percentage of predetermined overdraft limits have been used. AtDecember 31, 2004, overdrafts of accounts with Bounce Protectionärepresented usage of 2.3% of the limit.

 

Based on historicalexperience, management believes that a significant portion of maturing depositswill remain with the Bank. Management anticipates that the Bank will continueto have sufficient funds, through repayments, deposits and borrowings, to meetour current commitments.

 

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

 

The estimated fair valueamounts have been determined by the Company using available market informationand appropriate valuation methodologies. However, considerable judgment isrequired to interpret market data to develop the estimates of fair value.Accordingly, the estimates presented herein are not necessarily indicative ofthe amounts the Company could realize in a current market exchange. The use ofdifferent market assumptions and/or estimation methodologies may have amaterial effect on the estimated fair value amounts. The estimated fair valuesof financial instruments are as follows (in thousands):

 
| ** **                                             | ** ** | **December 31, 2004** | ** ** | **December 31, 2003** | ** ** |
|--------------------------------------------------------|------------|-----------------------|------------|-----------------------|------------|
| ** **                                             | ** ** | ** **            | ** ** | **Estimated**         | ** ** | ** ** | ** ** | **Estimated** | ** ** |
| ** **                                             | ** ** | **Carrying**          | ** ** | **Fair**              | ** ** | **Carrying** | ** ** | **Fair** | ** ** |
| ** **                                             | ** ** | **Value**             | ** ** | **Value**             | ** ** | **Value** | ** ** | **Value** | ** ** |
| ASSETS:                                                |       |                  |       |                  |       |   |   |   |   |
| Cash and cash equivalents                              |       | $                     | 16,003     |                  | $          | 16,003 |   | $ | 56,201 |   | $ | 56,201 |   |
| Investment securities—held to maturity            |       | 56,660                |       | 56,426                |       | 80,379 |   | 80,163 |   |
| Federal Home Loan Bank stock                           |       | 4,876                 |       | 4,876                 |       | 3,749 |   | 3,749 |   |
| Loans receivable—net                              |       | 634,217               |       | 636,424               |       | 512,756 |   | 518,666 |   |
| Cash surrender value of life insurance                 |       | 17,897                |       | 17,897                |       | 17,102 |   | 17,102 |   |
| Accrued interest receivable                            |       | 4,427                 |       | 4,427                 |       | 4,089 |   | 4,089 |   |
| Commitments                                            |       | 2                     |       | 2                     |       | 1 |   | 1 |   |
|                                                   |       |                  |       |                  |       |   |   |   |   |
| LIABILITIES:                                           |       |                  |       |                  |       |   |   |   |   |
| Deposits:                                              |       |                  |       |                  |       |   |   |   |   |
| Demand, NOW, money market and regular  savings         |       | 247,446               |       | 247,446               |       | 233,759 |   | 233,759 |   |
| Certificates of deposit                                |       | 334,978               |       | 336,508               |       | 339,821 |   | 348,208 |   |
| Federal Home Loan Bank advances                        |       | 89,756                |       | 89,670                |       | 39,562 |   | 40,062 |   |
| Accrued interest payable                               |       | 344                   |       | 344                   |       | 244 |   | 244 |   |
| Advance payments by borrowers for taxes and  insurance |       | 757                   |       | 757                   |       | 725 |   | 725 |   |
| Commitments                                            |       | 2                     |       | 2                     |       | 1 |   | 1 |   |
|                                                        |            |                       |            |                       |            |  |  |  |  |  |  |  |  |

 

For cash and cashequivalents, Federal Home Loan Bank stock, cash surrender value of lifeinsurance and accrued interest receivable, the carrying value is a reasonableestimate of fair value, primarily because of the short-term nature of theinstruments or, as to Federal Home Loan Bank stock, the ability to sell thestock back to the Federal Home Loan Bank at cost. The fair value of investmentsecurities is based on quoted market prices, dealer quotes and prices obtainedfrom independent pricing services. The fair value of variable rate loans isbased on repricing dates. Fixed-rate loans were valued using discounted cashflows. The discount rates used to determine the present value of these loanswere based on interest rates currently being charged by the Bank on comparableloans as to credit risk and term.

 

69

----

 

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

 

The fair value estimatespresented herein are based on pertinent information available to management asof December 31, 2004 and 2003. Although management is not aware of anyfactors that would significantly affect the estimated fair value amounts, suchamounts have not been comprehensively revalued for purposes of these financialstatements since the reporting date and, therefore, current estimates of fairvalue may differ significantly from the amounts presented herein.

 

**15.          CONTINGENCIES**

 

The Company is adefendant in certain claims and legal actions arising in the ordinary course ofbusiness. In the opinion of management, after consultation with legal counsel,the ultimate disposition of these matters is not expected to have a materialadverse effect on the consolidated financial statements of the Company.

 

**16.          RETAINED EARNINGS—SUBSTANTIALLYRESTRICTED**

 

Upon conversion, theCompany established a special liquidation account for the benefit of eligibleaccount holders and the supplemental eligible account holders in an amountequal to the net worth of the Bank as of the date of its latest statement offinancial condition contained in the final offering circular used in connectionwith the conversion. The liquidation account will be maintained for the benefitof eligible account holders and supplemental eligible account holders whocontinue to maintain their accounts in the Bank after conversion. In the eventof a complete liquidation (and only in such event), each eligible andsupplemental eligible account holder will be entitled to receive a liquidationdistribution from the liquidation account in an amount proportionate to thecurrent adjusted qualifying balances for accounts then held.

 

The Company may notdeclare or pay cash dividends on its shares of common stock if the effectthereof would cause the Company’s stockholders’ equity to be reduced belowapplicable regulatory capital maintenance requirements for insured institutionsor below the special liquidation account referred to above.

 

**17.          REGULATORY MATTERS**

 

The Bank is subject tovarious regulatory capital requirements administered by the Office of ThriftSupervision (“OTS”). Failure to meet minimum capital requirements can initiatecertain mandatory—and possible additional discretionary—actions by regulatorsthat, if undertaken, could have a direct and material effect on the Bank’sfinancial statements. Under capital adequacy guidelines and the regulatoryframework for prompt corrective action, the Bank must meet specific capitalguidelines that involve quantitative measures of the Bank’s assets,liabilities, and certain off-balance sheet items as calculated under regulatoryaccounting practices. The Bank’s capital amounts and classification are alsosubject to qualitative judgments by the regulators about components, riskweightings, and other factors.

 

Quantitative measuresestablished by regulation to ensure capital adequacy require the Bank tomaintain minimum amounts and ratios (set forth in the following table) oftangible capital (as defined) to tangible assets (as defined) and core capital(as defined) to adjusted tangible assets (as defined), and of total risk-basedcapital (as defined) to risk-weighted assets (as defined). Management believes,as of December 31, 2004, that the Bank meets all capital adequacyrequirements to which it is subject.

 

At December 31, 2004and 2003, the most recent notification from the OTS categorized the Bank aswell capitalized under the regulatory framework for prompt corrective action.To be categorized as well capitalized the Bank must maintain minimum core (TierI leverage), Tier I risk-based, and total risk-based ratios as set forth in thetable. There are no conditions or events since that notification thatmanagement believes have changed the Bank’s category.

 

70

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The Bank’s actual capitalamounts (in thousands) and ratios are also presented in the table:

 
| ** **                               | ** ** | ** ** | ** ** | ** **            | ** ** | ** **            | ** ** | ** **            | ** ** | **To be Categorized** | ** ** |
|------------------------------------------|------------|------------|------------|-----------------------|------------|-----------------------|------------|-----------------------|------------|-----------------------|------------|
| ** **                               | ** ** | ** ** | ** ** | ** **            | ** ** | ** **            | ** ** | ** **            | ** ** | **as Well**           | ** ** |
| ** **                               | ** ** | ** ** | ** ** | ** **            | ** ** | ** **            | ** ** | ** **            | ** ** | **Capitalized Under** | ** ** |
| ** **                               | ** ** | ** ** | ** ** | ** **            | ** ** | **For Capital**       | ** ** | **Prompt Corrective** | ** ** |
| ** **                               | ** ** | **Actual** | ** ** | **Adequacy Purposes** | ** ** | **Action Provisions** | ** ** |
| ** **                               | ** ** | **Amount** | ** ** | **Ratio**             | ** ** | **Amount**            | ** ** | **Ratio**             | ** ** | **Amount**            | ** ** | **Ratio** | ** ** |
|                                     |       |       |       |                  |       |                  |       |                  |       |                  |       |   |   |
| As of December 31, 2004:                 |       |       |       |                  |       |                  |       |                  |       |                  |       |   |   |
|                                     |       |       |       |                  |       |                  |       |                  |       |                  |       |   |   |
| Tangible Capital to Tangible Assets      |       | $          | 73,177     |                  | 9.74       | %                     | $          | 11,268                |       | 1.50                  | %          | N/A |   | N/A |   |
|                                     |       |       |       |                  |       |                  |       |                  |       |                  |       |   |   |
| Core Capital to Adjusted Tangible Assets |       | 73,177     |       | 9.74                  | %          | 30,048                |       | 4.00                  | %          | $                     | 37,559     |   | 5.00 | % |
|                                     |       |       |       |                  |       |                  |       |                  |       |                  |       |   |   |
| Total Capital to Risk-Weighted Assets    |       | 74,704     |       | 13.75                 | %          | 43,450                |       | 8.00                  | %          | 54,313                |       | 10.00 | % |
|                                     |       |       |       |                  |       |                  |       |                  |       |                  |       |   |   |
| Tier I Capital to Risk-Weighted Assets   |       | 73,177     |       | 13.47                 | %          | N/A                   |       | N/A                   |       | 32,588                |       | 6.00 | % |
|                                     |       |       |       |                  |       |                  |       |                  |       |                  |       |   |   |
| 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 | % |
|                                          |            |            |            |                       |            |                       |            |                       |            |                       |            |  |  |  |  |  |

 

**18.          RELATED PARTY TRANSACTIONS**

 

In the normal course ofbusiness, the Bank has made loans to its directors, officers, and their relatedbusiness interests. In the opinion of management, related party loans are madeon substantially the same terms, including interest rates and collateral, asthose prevailing at the time for comparable transactions with unrelated personsand do not involve more than the normal risk of collectibility. The aggregatedollar amount of loans outstanding to directors, officers, and their relatedbusiness interests was approximately $2.6 and $2.5 million at December 31,2004 and 2003, respectively.

 

Deposits from relatedparties held by the Bank at December 31, 2004 and 2003 amounted to $2.8million and $3.9 million, respectively.

 

71

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

 

The following condensedstatements of financial condition, as of December 31, 2004 and 2003, andcondensed statements of income and of cash flows for each of the three years inthe period ended December 31, 2004, for First Federal Bancshares ofArkansas, Inc. should be read in conjunction with the consolidated financialstatements and the notes herein.

 

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

**(Parent Company Only)**

 

**CONDENSED STATEMENTS OF FINANCIAL CONDITION**

**DECEMBER 31, 2004 AND 2003**

**(In thousands)**

 
| ** **                                    | ** ** | **2004**   | ** ** | **2003**   | ** ** |
|-----------------------------------------------|------------|------------|------------|------------|------------|
| **ASSETS**                                    | ** ** | ** ** | ** ** | ** ** | ** ** |
| Cash and cash equivalents (deposits in  Bank) |       | $          | 206        |       | $          | 236 |   |
| Loan to Bank subsidiary                       |       | 1,001      |       | 3,195      |       |
| Accrued interest receivable                   |       | 3          |       | 2          |       |
| Investment in Bank                            |       | 73,426     |       | 71,122     |       |
| Other assets                                  |       | 702        |       | 938        |       |
|                                          |       |       |       |       |       |
| TOTAL                                         |       | $          | 75,338     |       | $          | 75,493 |   |
|                                          |       |       |       |       |       |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY** |       |       |       |       |       |
|                                          |       |       |       |       |       |
| Accrued expenses and other liabilities        |       | $          | 37         |       | $          | 415 |   |
| Stockholders’ equity                     |       | 75,301     |       | 75,078     |       |
|                                          |       |       |       |       |       |
| TOTAL                                         |       | $          | 75,338     |       | $          | 75,493 |   |

 

72

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**FIRSTFEDERAL BANCSHARES OF ARKANSAS, INC.**

**(ParentCompany Only)**

 

**CONDENSEDSTATEMENTS OF INCOME**

**YEARS ENDEDDECEMBER 31, 2004, 2003, AND 2002**

**(Inthousands)**

 
| ** **                                                                                       | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
|--------------------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
|                                                                                             |       |     |       |     |       |     |       |
| INCOME:                                                                                          |       |     |       |     |       |     |       |
| Dividends from the Bank                                                                          |       | $        | 6,000      |     | $          | 3,000    |       | $ | 8,000 |   |
| Interest income—loan to the Bank                                                            |       | 22       |       | 24       |       | 34       |       |
|                                                                                             |       |     |       |     |       |     |       |
| Total income                                                                                     |       | 6,022    |       | 3,024    |       | 8,034    |       |
|                                                                                             |       |     |       |     |       |     |       |
| EXPENSES:                                                                                        |       |     |       |     |       |     |       |
| Management fees                                                                                  |       | 66       |       | 66       |       | 66       |       |
| Other operating expenses                                                                         |       | 234      |       | 228      |       | 184      |       |
|                                                                                             |       |     |       |     |       |     |       |
| Total expenses                                                                                   |       | 300      |       | 294      |       | 250      |       |
|                                                                                             |       |     |       |     |       |     |       |
| INCOME BEFORE INCOME TAX BENEFIT AND EQUITY  IN UNDISTRIBUTED EARNINGS (LOSS) OF BANK SUBSIDIARY |       | 5,722    |       | 2,730    |       | 7,784    |       |
|                                                                                             |       |     |       |     |       |     |       |
| INCOME TAX BENEFIT                                                                               |       | 107      |       | 103      |       | 82       |       |
|                                                                                             |       |     |       |     |       |     |       |
| INCOME BEFORE EQUITY IN UNDISTRIBUTED EARNINGS  (LOSS) OF BANK SUBSIDIARY                        |       | 5,829    |       | 2,833    |       | 7,866    |       |
|                                                                                             |       |     |       |     |       |     |       |
| EQUITY IN UNDISTRIBUTED EARNINGS (LOSS) OF BANK  SUBSIDIARY                                      |       | 1,976    |       | 4,623    |       | (88      | )          |
|                                                                                             |       |     |       |     |       |     |       |
| NET INCOME                                                                                       |       | $        | 7,805      |     | $          | 7,456    |       | $ | 7,778 |   |

 

73

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

**(Parent Company Only)**

 

**CONDENSED STATEMENTS OF CASH FLOWS**

**YEARS ENDED DECEMBER 31, 2004, 2003, AND 2002**

**(In thousands)**

 
| ** **                                                                         | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
|------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
|                                                                               |       |     |       |     |       |     |       |
| OPERATING ACTIVITIES:                                                              |       |     |       |     |       |     |       |
| Net income                                                                         |       | $        | 7,805      |     | $          | 7,456    |       | $ | 7,778 |   |
| Adjustments to reconcile net income to net  cash provided by operating activities: |       |     |       |     |       |     |       |
| Equity in undistributed net (earnings) loss  of Bank                               |       | (1,976   | )          | (4,623   | )          | 88       |       |
| Release of ESOP shares                                                             |       | 1,712    |       | 1,322    |       | 1,016    |       |
| Stock compensation expense                                                         |       | 56       |       | 45       |       |     |       |
| Changes in operating assets and  liabilities:                                      |       |     |       |     |       |     |       |
| Accrued interest receivable                                                        |       | (1       | )          |     |       | 4        |       |
| Other assets                                                                       |       | 235      |       | (190     | )          | (236     | )          |
| Accrued expenses and other liabilities                                             |       | (378     | )          | 264      |       | 30       |       |
|                                                                               |       |     |       |     |       |     |       |
| Net cash provided by operating activities                                          |       | 7,453    |       | 4,274    |       | 8,680    |       |
|                                                                               |       |     |       |     |       |     |       |
| INVESTING ACTIVITIES—Loan to bank—net of  repayments                     |       | 2,194    |       | (1,228   | )          | 2,129    |       |
|                                                                               |       |     |       |     |       |     |       |
| Net cash provided by (used in) investing  activities                               |       | 2,194    |       | (1,228   | )          | 2,129    |       |
|                                                                               |       |     |       |     |       |     |       |
| FINANCING ACTIVITIES:                                                              |       |     |       |     |       |     |       |
| Purchase of treasury stock                                                         |       | (9,534   | )          | (2,805   | )          | (9,547   | )          |
| Dividends paid                                                                     |       | (2,178   | )          | (1,814   | )          | (1,471   | )          |
| Stock options exercised                                                            |       | 2,035    |       | 1,418    |       | 422      |       |
|                                                                               |       |     |       |     |       |     |       |
| Net cash used in financing activities                                              |       | (9,677   | )          | (3,201   | )          | (10,596  | )          |
|                                                                               |       |     |       |     |       |     |       |
| NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS                               |       | (30      | )          | (155     | )          | 213      |       |
|                                                                               |       |     |       |     |       |     |       |
| CASH AND CASH EQUIVALENTS:                                                         |       |     |       |     |       |     |       |
| Beginning of period                                                                |       | 236      |       | 391      |       | 178      |       |
|                                                                               |       |     |       |     |       |     |       |
| End of period                                                                      |       | $        | 206        |     | $          | 236      |       | $ | 391 |   |

 

******

 

74

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**SELECTED QUARTERLY OPERATING RESULTS**

(INTHOUSANDS, EXCEPT SHARE AND PER SHARE DATA)

 
| **YEAR ENDED DECEMBER 31, 2004**                     | ** ** | **FOURTH  QUARTER** | ** **   | **THIRD  QUARTER** | ** ** | **SECOND  QUARTER** | ** ** | **FIRST  QUARTER** | ** **  |
|------------------------------------------------------|------------|---------------------|--------------|--------------------|------------|---------------------|------------|--------------------|-------------|
| Interest income                                      |       | $                   |  10,194 |               | $          |  10,083        |       | $                  |  9,713 |   | $ |  9,380 | ** ** |
| Interest expense                                     |       | 3,779               |         | 3,620              |       | 3,433               |       | 3,506              |        |
| Net interest income                                  |       | 6,415               |         | 6,463              |       | 6,280               |       | 5,874              |        |
| Provision for loan losses                            |       | 357                 |         | 202                |       | 202                 |       | 259                |        |
| Net interest income after  provision for loan losses |       | 6,058               |         | 6,261              |       | 6,078               |       | 5,615              |        |
| Noninterest income                                   |       | 1,684               |         | 1,573              |       | 1,585               |       | 1,432              |        |
| Noninterest expense                                  |       | 4,751               |         | 4,734              |       | 4,824               |       | 4,474              |        |
| Income before income taxes                           |       | 2,991               |         | 3,100              |       | 2,839               |       | 2,573              |        |
| Provision for income taxes                           |       | 975                 |         | 1,002              |       | 908                 |       | 813                |        |
| Net income                                           |       | $                   | 2,016        |               | $          | 2,098               |       | $                  | 1,931       |   | $ | 1,760 |   |
| Earnings per share(1):                               |       |                |         |               |       |                |       |               |        |
| Basic                                                |       | $                   | 0.40         |               | $          | 0.42                |       | $                  | 0.38        |   | $ | 0.34 |   |
| Diluted                                              |       | $                   | 0.38         |               | $          | 0.39                |       | $                  | 0.36        |   | $ | 0.32 |   |
|                                                 |       |                |         |               |       |                |       |               |        |
| Selected Ratios  (Annualized):                       |       |                |         |               |       |                |       |               |        |
| Net interest margin                                  |       | 3.73                | %            | 3.83               | %          | 3.84                | %          | 3.61               | %           |
| Return on average assets                             |       | 1.10                |         | 1.16               |       | 1.10                |       | 1.01               |        |
| Return on average equity                             |       | 10.76               |         | 11.20              |       | 10.21               |       | 9.33               |        |

 
| **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              |   |

 

----

(1)                                  Basic anddiluted earnings per share, as well as basic and diluted shares outstanding,have been restated for the effect of the two-for-one stock split paid onDecember 31, 2003.  Basic and diluted sharesoutstanding are summarized below.

 
| ** **                         | ** ** | **FOURTH  QUARTER** | ** ** | **THIRD  QUARTER** | ** ** | **SECOND  QUARTER** | ** ** | **FIRST  QUARTER** | ** ** |
|------------------------------------|------------|---------------------|------------|--------------------|------------|---------------------|------------|--------------------|------------|
| YEAR ENDED DECEMBER 31, 2004       |       |                |       |               |       |                |       |               |       |
| Basic weighted - average  shares   |       | 4,986,156           |       | 5,022,009          |       | 5,113,191           |       | 5,146,747          |       |
| Effect of dilutive  securities     |       | 296,534             |       | 299,808            |       | 313,711             |       | 345,290            |       |
| Diluted weighted - average  shares |       | 5,282,690           |       | 5,321,817          |       | 5,426,902           |       | 5,492,037          |       |
|                               |       |                |       |               |       |                |       |               |       |
| 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          |       |

 

75

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**Item9.  Changes in and Disagreements withAccountants on Accounting and Financial Disclosure.**

 

Not Applicable.

 

**Item9A.  Controls and Procedures.**

 

Our management evaluated, withthe participation of our Chief Executive Officer and Chief Financial Officer,the effectiveness of the design and operation of our disclosure controls andprocedures (as defined in Rules 13a-15(e) and 15d-15(e) under the SecuritiesExchange Act of 1934) as of the end of the period covered by this report.  Based on such evaluation, our Chief ExecutiveOfficer and Chief Financial Officer have concluded that our disclosure controlsand procedures are designed to ensure that information required to be disclosedby us in the reports that we file or submit under the Securities Exchange Actof 1934 is recorded, processed, summarized and reported within the time periodsspecified in the SEC’s rules and regulations and are operating in an effectivemanner.

 

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

 

No change in the Company’s internal controlover financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under theExchange Act) occurred during the fiscal quarter ended December 31, 2004 thathas materially affected, or is reasonably likely to materially affect, theCompany’s internal control over financial reporting.

 

**Item9B.  Other Information.**

 

Not Applicable.

 

**PART III.**

 

**Item10.  Directors and Executive Officers ofthe Registrant.**

 

Theinformation regarding directors and executive officers is incorporated hereinby reference from the section entitled “Information with Respect to Nominee forDirector, Continuing Directors and Executive Officers” in our definitive ProxyStatement (“2005 Proxy Statement”) to be filed pursuant to Regulation 14A ofthe Securities Exchange Act of 1934, as amended, for our Annual Meeting ofStockholders to be held on April 27, 2005. The 2005 Proxy Statement will befiled within 120 days after the end of our fiscal year ended December 31, 2004.

 

Theinformation regarding compliance with Section 16(a) of the Securities andExchange Act of 1934 is incorporated herein by reference from the sectionentitled “Section 16(a) Beneficial Ownership Reporting Compliance” of our 2005Proxy Statement.

 

Theinformation regarding audit committee financial experts is incorporated by referenceherein from the subsection entitled “Committees and Meetings of the Board ofthe Company and the Bank” in the section entitled “Information with Respect toNominee for Director, Continuing Directors and Executive Officers” in our 2005Proxy Statement.

 

Theinformation regarding the code of ethics applicable to our principal executiveofficer, principal financial officer and principal accounting officer isincorporated herein by reference from the subsection entitled—”Code of Ethicsfor Executive Officers and Financial Professionals” in the section entitled“Information with Respect to Nominee for Director, Continuing Directors andExecutive Officers” in our 2005 Proxy Statement.

 

**Item11.  Executive Compensation.**

 

Informationregarding executive compensation is incorporated herein by reference from thesections entitled “Executive Compensation” and “Performance Graph” in our 2005Proxy Statement.

 

76

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**Item12.  Security Ownership of CertainBeneficial Owners and Management and Related Stockholder Matters.**

 

Informationregarding security ownership of certain beneficial owners and management isincorporated herein by reference from the section entitled “BeneficialOwnership of Common Stock By Certain Beneficial Owners and Management andRelated Stockholder Matters” and information regarding securities authorizedfor issuance under equity compensation plans is incorporated herein byreference from the subsection entitled “Equity-Based Compensation Plans” in our2005 Proxy Statement.

 

**Item13.  Certain Relationships and RelatedTransactions.**

 

Informationregarding certain relationships and related transactions is incorporated hereinby reference from the section entitled “Transactions with Certain Related Persons”in our 2005 Proxy Statement.

 

**Item14.  Principal Accountant Fees andServices.**

 

Theinformation regarding principal auditor fees and services is incorporatedherein by reference from the section entitled “Relationship with IndependentAuditors” in our 2005 Proxy Statement.

 

**PART IV.**

 

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

 

**(a)****   ****Documents****Filed as Part of this Report**

 

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

 

(2)    All schedules for which provision is made in the applicable accountingregulation of the SEC are omitted because of the absence of conditions underwhich they are required or because the required information is included in thefinancial statements and related notes thereto.

 

**(b) Exhibit Index.**

 
| 2.1*    |   | Plan of  Conversion                                                                                                                                         |   |
|---------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|
| 3.1*    |   | Articles of  Incorporation of First Federal Bancshares of Arkansas, Inc.                                                                                    |   |
| 3.2*    |   | 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 theCompany’s Registration Statement on Form S-1 (File No. 333-612) filed with theSEC.

 

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

 

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

 

77

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**SIGNATURES**

 

Pursuant to the requirements of Section 13 or15(d) of the Securities Exchange Act of 1934, the Registrant has duly causedthis report to be signed on its behalf by the undersigned, thereunto dulyauthorized.

 

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

 

 

Pursuant to the requirements of theSecurities Exchange Act of 1934, this report has been signed below by thefollowing persons on behalf of the Registrant and in the capacities and on thedates indicated.

 

 
| /s/ Larry J. Brandt                 |   |   | February 28, 2005 |
|-------------------------------------|--------|--------|-------------------|
| Larry J. Brandt                |   |   |
| President and Chief                 |   |   |
| Executive Officer                   |   |   |
|                                |   |   |
| /s/ John P. Hammerschmidt           |   |   | February 28, 2005 |
| John P. Hammerschmidt               |   |   |
| Chairman                            |   |   |
|                                |   |   |
| /s/ Jeff Brandt                     |   |   | February 28, 2005 |
| Jeff Brandt                    |   |   |
| Director                            |   |   |
|                                |   |   |
| /s/ Kenneth C. Savells              |   |   | February 28, 2005 |
| Kenneth C. Savells             |   |   |
| Director                            |   |   |
|                                |   |   |
| /s/ Frank Conner                    |   |   | February 28, 2005 |
| Frank Conner                   |   |   |
| Director                            |   |   |
|                                |   |   |
| /s/ Sherri R. Billings              |   |   | February 28, 2005 |
| Sherri R. Billings             |   |   |
| Executive Vice President  and Chief |   |   |
| Financial Officer                   |   |   |
|                                     |        |        |                   |  |  |  |

 

78

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