# **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, 2005**                                                                                                            |
|                                                                                                                                                       |                                                                                          |       |
| **OR**                                                                                                                                                     |
|                                                                                                                                                       |                                                                                          |       |
| **o**                                                                                                                                                      | **TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE  SECURITIES EXCHANGE ACT OF 1934** | ** ** |
|                                                                                                                                                       |
| **For the transition period from             to          ** |
|                                                                                                                                                       |                                                                                          |       |
| **Commission File No.:****0-28312**                                                                                                                        |
|                                                                                                                                                            |                                                                                               |            |  |

 

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

(Exact name of registrant as specified in its charter)

 

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

 

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

 

Indicate by check mark if the registrant is not required to filereports pursuant to Section 13 or Section 15(d) of the Act. Yes  oNo  ý

 

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

 

Indicateby check mark whether the registrant is a large accelerated filer, anaccelerated filer or a non-accelerated filer.

 
| Large Accelerated Filer o |   | Accelerated  Filer ý |   | Non-accelerated  Filer o |
|---------------------------|--------|---------------------------|--------|--------------------------|

 

Indicate by check mark whether the registrant is a shell company (asdefined in Rule 12B-2 of the Act). Yes  o  No ý

 

As of June 30, 2005, the aggregate value of the 4,442,356 shares ofCommon Stock of the Registrant issued and outstanding on such date, whichexcludes 610,852 shares held by directors and officers of the Registrant as agroup, was approximately $99.7 million. This figure is based on the last salesprice of $22.45 per share of the Registrant’s Common Stock on June 30, 2005.

 

Number of shares of Common Stock outstanding as of February 27,2006:  5,072,610

 

# **DOCUMENTSINCORPORATED BY REFERENCE**

# ** **

List hereunderthe following documents incorporated by reference and the Part of the Form 10-Kinto which the document is incorporated.

 

Portions of thedefinitive proxy statement for the 2006 Annual Meeting of Stockholders areincorporated into Part III, Items 10 through 14 of this Form 10-K.

 

 

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** **

**FirstFederal Bancshares of Arkansas, Inc.**

**Form 10-K**

**For the Year Ended December 31, 2005**

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

 

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** **

**PARTI.**

 

**Item 1. Business**

 

**First Federal Bancshares of Arkansas, Inc.**First Federal Bancshares of Arkansas, Inc.(the “Company”) is a Texas corporation organized in January 1996 by First FederalBank of Arkansas, FA (“First Federal” or the “Bank”) for the purpose ofbecoming a unitary holding company of the Bank. The only significant assets ofthe Company are the capital stock of the Bank, the Company’s loan to theEmployee Stock Ownership Plan (“ESOP”), and cash. The business and managementof the Company consists of the business and management of the Bank. The Companydoes not presently own or lease any property, but instead uses the premises,equipment and furniture of the Bank. At the present time, the Company does notemploy any persons other than officers of the Bank, and the Company utilizesthe support staff of the Bank from time to time. Additional employees will behired as appropriate to the extent the Company expands or changes its businessin the future. At December 31, 2005, the Company had $852.4 million in totalassets, $611.7 million in total deposits and $77.8 million in stockholders’equity.

 

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

 

**First Federal Bank of Arkansas, FA.**The Bank is a federally chartered stocksavings and loan association formed in 1934. First Federal conducts businessfrom its main office and fifteen full service branch offices, all of which arelocated in a six county area in Northcentral and Northwest Arkansas comprisedof Benton, Marion, Washington, Carroll, Baxter and Boone counties. FirstFederal’s deposits are insured by the Savings Association Insurance Fund (“SAIF”),which is administered by the Federal Deposit Insurance Corporation (“FDIC”), tothe maximum extent permitted by law.

 

The Bank is a community-orientedfinancial institution offering a wide range of retail and business depositaccounts, including noninterest bearing and interest bearing checking, savingsand money market accounts, certificates of deposit, and individual retirementaccounts. Loan products offered by the Bank include residential real estate,consumer, construction, lines of credit, commercial real estate and commercialnon-real estate. Other financial services include investment products offeredthrough First Federal Investment Services, Inc.; automated teller machines;24-hour telephone banking; internet banking, including account access, billpayment, e-statements 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 also regulated by the FDIC, the administrator ofthe SAIF. The Bank is also subject to certain reserve requirements establishedby the Board of Governors of the Federal Reserve System (“FRB”) and is a memberof the Federal Home Loan Bank (“FHLB”) of Dallas, which is one of the 12regional banks comprising the FHLB System.

 

This Form 10-K contains certain forward-lookingstatements and information relating to the Company that are based on thebeliefs of management as well as assumptions made by and information currentlyavailable to management. In addition, in those and other portions of thisdocument, the words “anticipate,” “believe,” “estimate,” “expect,” “intend,” “should”and similar expressions, or the negative thereof, as they relate to the Companyor the Company’s management, are intended to identify forward-lookingstatements. Such statements reflect the current views of the Company withrespect to future looking events and are subject to certain risks,uncertainties and assumptions. Should one or more of these risks oruncertainties materialize or should underlying assumptions prove incorrect,actual results may vary materially from those described herein as anticipated,believed, estimated, expected or intended. The Company does not intend toupdate these forward-looking statements.

 

## **Employees**

## ** **

TheBank had 283 full-time employees and 50 part-time employees at December 31,2005, compared to 229 full-time employees and 38 part-time employees atDecember 31, 2004. None of these employees is represented by a collectivebargaining agent, and the Bank believes that it enjoys good relations with itspersonnel.

 

## **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.

 

1

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## **Competition**

 

TheBank faces strong competition both in attracting deposits and making loans. Itsmost direct competition for deposits has historically come from other savingsassociations, community banks, credit unions and commercial banks, includingmany large financial institutions that have greater financial and marketingresources available to them. In addition, the Bank has faced additionalsignificant competition for investors’ funds from short-term money marketsecurities, mutual funds and other corporate and government securities. Theability of the Bank to attract and retain savings and certificates of depositdepends on its ability to generally provide a rate of return, liquidity andrisk comparable to that offered by competing investment opportunities. The Bank’sability to increase checking deposits depends on offering competitive checkingaccounts and promoting these products through effective channels. Additionally,the Bank must offer convenient hours, locations and online services to attractcustomers.

 

TheBank experiences strong competition for loans principally from savingsassociations, community banks, commercial banks and mortgage companies. Newcommunity banks as well as well-established financial institutions arecontinuing  to establish branches in theWashington-Benton county area, providing for increased competition. The Bankcompetes for loans principally through the interest rates and loan fees itcharges and the efficiency and quality of services it provides borrowers.

 

**Lending Activities**

 

**General.**At December 31, 2005, the Bank’s portfolio of net loans receivableamounted to $719.2 million or 84.4% of the Company’s total assets. The Bank hastraditionally concentrated its lending activities on loans collateralized byreal estate. Consistent with such approach, $679.3 million or 85.9% of the Bank’stotal portfolio of loans receivable (“total loan portfolio”) consisted of loanscollateralized by first mortgage loans at December 31, 2005.

 

Inrecent years, the Bank has placed an increased emphasis on commercial realestate lending, construction lending, and commercial lending in order todiversify its loan portfolio, take advantage of market opportunities for thesetypes of loans, and transition to more of a full-service community bank. The table below summarizes the changes in thecomposition of the loan portfolio between December 31, 2001, which is theearliest year presented in the loan composition table on page 3, and December31, 2005 (dollars in thousands):

 
| ** **               | ** ** | **2005 vs 2001**   | ** ** | **Year Ended December 31,** | ** ** |
|--------------------------|------------|------------------------------|------------|--------------------------------------------|------------|
| ** **               | ** ** | **Increase (Decrease)** | ** ** | **2005**                                   | ** ** | **2001** | ** ** |
| ** **               | ** ** | **Amount**                   | ** ** | **Percentage  of Loans**              | ** ** | **Amount** | ** ** | **Percentage  of Loans** | ** ** | **Amount** | ** ** | **Percentage  of Loans** | ** ** |
| ** **               | ** ** | ** **                   | ** ** | ** **                                 | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Real estate loans:       |       |                         |       |                                       |       |   |   |   |   |   |   |   |   |
| 1-4 family residential   |       | $                            | (61,184    | )                                          | (33.74     | )% | $ | 269,660 |   | 34.11 | % | $ | 330,844 |   | 67.85 | % |
| Multi-family residential |       | 8,514                        |       | 0.73                                       |       | 12,900 |   | 1.63 |   | 4,386 |   | 0.90 |   |
| Commercial real estate   |       | 106,086                      |       | 9.37                                       |       | 157,678 |   | 19.95 |   | 51,592 |   | 10.58 |   |
| Construction             |       | 214,220                      |       | 25.15                                      |       | 239,062 |   | 30.24 |   | 24,842 |   | 5.09 |   |
| Total real estate loans  |       | 267,636                      |       | 1.51                                       |       | 679,300 |   | 85.93 |   | 411,664 |   | 84.42 |   |
|                     |       |                         |       |                                       |       |   |   |   |   |   |   |   |   |
| Commercial loans         |       | 13,938                       |       | 0.29                                       |       | 32,693 |   | 4.14 |   | 18,755 |   | 3.85 |   |
|                     |       |                         |       |                                       |       |   |   |   |   |   |   |   |   |
| Consumer loans           |       | 21,357                       |       | (1.80                                      | )          | 78,577 |   | 9.93 |   | 57,220 |   | 11.73 |   |
|                     |       |                         |       |                                       |       |   |   |   |   |   |   |   |   |
| Total (1)                |       | $                            | 302,931    |                                       | 0.00       | % | $ | 790,570 |   | 100.00 | % | $ | 487,639 |   | 100.00 | % |

 

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

 

Commercial real estate, construction and commercial lending aregenerally considered to involve a higher degree of risk than residential realestate lending due to the relatively larger loan amounts and the effect ofgeneral economic conditions on the successful operation of the related businessand/or income-producing properties. The Bank has attempted to reduce such riskby evaluating the credit history and past performance of the borrower, thequality of the borrower’s 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 “AssetQuality.”

 

2

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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,** | ** ** |
|-----------------------------------------------|------------|-----------------------|------------|
| ** **                                    | ** ** | **2005**              | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** |
| ** **                                    | ** ** | **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                        |       | $                     | 269,660    |   | 34.11 | % | $ | 282,144 |   | 40.35 | % | $ | 259,121 |   | 47.09 | % | $ | 289,106 |   | 57.03 | % | $ | 330,844 |   | 67.85 | % |
| Multi-family residential                      |       | 12,900                |       | 1.63 |   | 9,454 |   | 1.35 |   | 7,673 |   | 1.39 |   | 5,821 |   | 1.15 |   | 4,386 |   | 0.90 |   |
| Commercial real estate                        |       | 157,678               |       | 19.95 |   | 145,909 |   | 20.87 |   | 97,310 |   | 17.69 |   | 75,234 |   | 14.84 |   | 51,592 |   | 10.58 |   |
| Construction                                  |       | 239,062               |       | 30.24 |   | 159,111 |   | 22.76 |   | 89,332 |   | 16.24 |   | 49,144 |   | 9.69 |   | 24,842 |   | 5.09 |   |
| Total first mortgage loans                    |       | 679,300               |       | 85.93 |   | 596,618 |   | 85.33 |   | 453,436 |   | 82.41 |   | 419,305 |   | 82.71 |   | 411,664 |   | 84.42 |   |
|                                          |       |                  |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Commercial loans                              |       | 32,693                |       | 4.14 |   | 27,545 |   | 3.94 |   | 21,491 |   | 3.91 |   | 19,601 |   | 3.87 |   | 18,755 |   | 3.85 |   |
|                                          |       |                  |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Consumer loans:                               |       |                  |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Home equity and second mortgage loans         |       | 49,680                |       | 6.28 |   | 45,256 |   | 6.47 |   | 42,421 |   | 7.71 |   | 35,856 |   | 7.07 |   | 28,798 |   | 5.91 |   |
| Automobile                                    |       | 15,748                |       | 1.99 |   | 19,101 |   | 2.73 |   | 22,087 |   | 4.01 |   | 22,570 |   | 4.45 |   | 20,506 |   | 4.20 |   |
| Other                                         |       | 13,149                |       | 1.66 |   | 10,685 |   | 1.53 |   | 10,780 |   | 1.96 |   | 9,621 |   | 1.90 |   | 7,916 |   | 1.62 |   |
| Total consumer loans                          |       | 78,577                |       | 9.93 |   | 75,042 |   | 10.73 |   | 75,288 |   | 13.68 |   | 68,047 |   | 13.42 |   | 57,220 |   | 11.73 |   |
|                                          |       |                  |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Total loans receivable                        |       | 790,570               |       | 100.00 | % | 699,205 |   | 100.00 | % | 550,215 |   | 100.00 | % | 506,953 |   | 100.00 | % | 487,639 |   | 100.00 | % |
|                                          |       |                  |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Less:                                         |       |                  |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Undisbursed loan funds                        |       | (69,086               | )          |   |   | (62,661 | ) |   |   | (35,181 | ) |   |   | (20,618 | )  |   |   | (10,144 | )  |   |   |
| Unearned discounts and net deferred loan fees |       | (156                  | )          |   |   | (481 | ) |   |   | (657 | ) |   |   | (1,338 | )  |   |   | (2,078 | )  |   |   |
| Allowance for loan losses                     |       | (2,114                | )          |   |   | (1,846 | ) |   |   | (1,621 | ) |   |   | (1,529 | )  |   |   | (923 | )  |   |   |
| Total loans receivable, net                   |       | $                     | 719,214    |   |   |   | $ | 634,217 |   |   |   | $ | 512,756 |   |   |   | $ | 483,468 |   |   |   | $ | 474,494 |   |   |   |

 

3

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** **

**Loan Maturity and Interest Rates.**The following table sets forth certaininformation at December 31, 2005, regarding the dollar amount of loans maturingin the Bank’s loan portfolio based on their contractual terms to maturity. Demandloans and loans having no stated schedule of repayments and no stated maturityare reported as due in one year or less. All other loans are included in theperiod in which 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   |       | $                         | 2,983      |                                        | $          | 18,354                     |       | $         | 248,323    |   | $ | 269,660 |   |
| Multi-family residential |       | 316                       |       | 6,259                                       |       | 6,325                      |       | 12,900    |       |
| Commercial real estate   |       | 46,005                    |       | 87,965                                      |       | 23,708                     |       | 157,678   |       |
| Construction             |       | 230,773                   |       | 8,289                                       |       | —                     |       | 239,062   |       |
| Commercial loans         |       | 21,724                    |       | 9,829                                       |       | 1,140                      |       | 32,693    |       |
| Consumer loans           |       | 34,742                    |       | 38,738                                      |       | 5,097                      |       | 78,577    |       |
| Total(1)                 |       | $                         | 336,543    |                                        | $          | 169,434                    |       | $         | 284,593    |   | $ | 790,570 |   |

 

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(1)     Gross ofundisbursed loan funds, unearned discounts and net deferred loan fees and theallowance for loan losses.

 

Thefollowing table sets forth the dollar amount of the Bank’s loans at December31, 2005, due after one year from such date which have fixed interest rates orwhich have floating or adjustable interest rates.

 
| ** **               | ** ** | **Fixed Rates** | ** ** | **Floating or  Adjustable Rates** | ** ** | **Total**  | ** ** |
|--------------------------|------------|----------------------|------------|---------------------------------------------|------------|------------|------------|
| ** **               | ** ** | ** **           | ** ** | **(In Thousands)**                     | ** ** | ** ** | ** ** |
| ** **               | ** ** | ** **           | ** ** | ** **                                  | ** ** | ** ** | ** ** |
| Real estate loans:       |       |                 |       |                                        |       |       |       |
| 1-4 family residential   |       | $                    | 60,614     |                                        | $          | 206,063    |       | $ | 266,677 |   |
| Multi-family residential |       | 11,840               |       | 744                                         |       | 12,584     |       |
| Commercial real estate   |       | 105,996              |       | 5,677                                       |       | 111,673    |       |
| Construction             |       | 8,289                |       | —                                      |       | 8,289      |       |
| Commercial loans         |       | 8,926                |       | 2,043                                       |       | 10,969     |       |
| Consumer loans           |       | 35,916               |       | 7,919                                       |       | 43,835     |       |
| Total                    |       | $                    | 231,581    |                                        | $          | 222,446    |       | $ | 454,027 |   |

 

Scheduled contractual maturities of loans do notnecessarily reflect the actual term of the Bank’s loan portfolio. The averagelife of mortgage loans is substantially less than their average contractualterms because of loan prepayments and refinancing. The average life of mortgageloans tends to increase, however, when current mortgage loan ratessubstantially exceed rates on existing mortgage loans and, conversely, decreasewhen rates on existing mortgage loans substantially exceed current mortgageloan rates.

 

**Origination, Purchase and Sale of Loans.**Thelending activities of the Bank are subject to the written, non-discriminatoryunderwriting standards and policies established by the Bank’s board ofdirectors and management. Loan originations are obtained from a variety ofsources, 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. TheBank continually emphasizes its community ties and its practice of quick andefficient underwriting and loan approval processes, made possible in partthrough the use of automated underwriting software. The Bank believes itprovides exceptional personalized service to its customers. The Bank requireshazard insurance, title insurance, and to the extent applicable, floodinsurance on all secured real property.

 

Applicationsare initially received by loan officers or from the Bank’s secure website. Applicationsreceived over the Bank’s website are forwarded to loan officers. All loansexceeding individual officer’s approval authority are subject to review bymembers of the appropriate loan committee. The bank has three loan committees(Senior Loan Committee, Executive Loan Committee, and Director Loan Committee)which review and make a decision based upon type, size, and classification.

 

4

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During2005, the Bank purchased a $397,000 participation in a commercial real estateloan. 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, theBank purchased two commercial loan participations totaling $3.1 million. Allparticipations purchased were current as of December 31, 2005.

 

To minimize interest rate risk, fixed rate loans with terms of fifteenyears or greater are typically sold to specific investors in the secondarymortgage market. The rights to service such loans are typically sold with theloans. This allows the Bank to provide its customers competitive long-term fixedrate 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 subject to Fannie Mae and/or Freddie Macunderwriting guidelines and are typically underwritten and validated by a thirdparty 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 loans being underwritten by a third party, therepurchase risk associated with these loans is substantially assumed by the underwriter.The Bank believes it has minimal risk of repurchase of these loans based uponthe contracts with the specific investors. This risk typically involvespotential early prepayments of the mortgage or an early default of a loan. In2005, 2004, and 2003, the Bank was not required to repurchase any loans. In2005, 2004, and 2003, the Bank’s secondary market loan sales amounted to $55.4million, $45.8 million, and  $123.5million, respectively. The significant amount of loan sales in 2003 wasprimarily 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.

 

Inaddition to sales of loans on the secondary market, the Bank periodically sellslarger commercial loans or participations in such loans in order to comply withthe Bank’s loans to one borrower limit. In such situations the loans aretypically sold with servicing retained. During the years ended December 31,2005, 2004, and 2003, such loans sold amounted to approximately $1.8 million,$21.5 million, and $6.6 million, respectively. At December 31, 2005, 2004, and2003, the balances of loans sold with servicing retained were approximately$19.6 million, $18.9 million, and $8.4 million, respectively. Loan servicingfee income for the years ended December 31, 2005, 2004, and 2003, wasapproximately $100,000, $159,000, and $36,000, respectively.

 

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

 
| ** **                              | ** ** | **Year Ended December 31,** | ** ** |
|-----------------------------------------|------------|--------------------------------------------|------------|
| ** **                              | ** ** | **2005**                                   | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                              | ** ** | ** **                                 | ** ** | **(In Thousands)** | ** ** | ** ** | ** ** |
|                                    |       |                                       |       |   |   |   |   |
| Loans receivable at beginning of period |       | $                                          | 699,205    |   | $ | 550,215 |   | $ | 506,953 |   |
| Loan originations:                      |       |                                       |       |   |   |   |   |
| Real estate:                            |       |                                       |       |   |   |   |   |
| 1-4 family residential                  |       | 121,270                                    |       | 135,584 |   | 199,984 |   |
| Multi-family residential                |       | 6,341                                      |       | 11,303 |   | 6,103 |   |
| Commercial real estate                  |       | 69,115                                     |       | 94,508 |   | 44,958 |   |
| Construction                            |       | 195,784                                    |       | 158,929 |   | 94,105 |   |
| Commercial loans                        |       | 29,862                                     |       | 28,008 |   | 24,646 |   |
| Consumer:                               |       |                                       |       |   |   |   |   |
| Home equity and second mortgage loans   |       | 41,661                                     |       | 36,135 |   | 27,507 |   |
| Automobile                              |       | 9,537                                      |       | 12,467 |   | 15,245 |   |
| Other                                   |       | 11,710                                     |       | 9,851 |   | 15,029 |   |
| Total loan originations                 |       | 485,280                                    |       | 486,785 |   | 427,577 |   |
| Loan purchases                          |       | 397                                        |       | 15,000 |   | 3,140 |   |
| Repayments                              |       | (336,427                                   | )          | (284,830 | ) | (254,015 | ) |
| Loan sales                              |       | (57,150                                    | )          | (67,301 | ) | (130,169 | ) |
| Transfers to real estate owned          |       | (1,002                                     | )          | (894 | ) | (1,771 | ) |
| Other                                   |       | 267                                        |       | 230 |   | (1,500 | ) |
| Net loan activity                       |       | 91,365                                     |       | 148,990 |   | 43,262 |   |
| Loans receivable at end of period(1)    |       | $                                          | 790,570    |   | $ | 699,205 |   | $ | 550,215 |   |

 

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(1)          Grossof undisbursed loan funds, unearned discounts and net loan fees and theallowance for loan losses.

 

5

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**Loans to One Borrower.**A savings institution generally may not makeloans to one borrower and related entities in an amount which exceeds 15% ofits unimpaired capital and surplus, although loans in an amount equal to anadditional 10% of unimpaired capital and surplus may be made to a borrower ifthe loans are fully secured by readily marketable securities. At December 31,2005, the Bank’s limit on loans to one borrower was approximately $11.5 million.At December 31, 2005, the Bank’s largest loan or group of loans to oneborrower, including persons or entities related to the borrower, amounted to$11.2 million. The Bank’s ten largest loans or groups of loans to one borrower,including persons or entities related to the borrower, including unfundedcommitments, totaled $87.3 million at December 31, 2005. None of theseloans were 90 days or more past due at December 31, 2005.

 

**One- to Four-Family Residential Real 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, 2005,$269.7 million or 34.1% of the Bank’s total loan portfolio consisted of one- tofour-family residential real estate loans. Of the $269.7 million of such loansat December 31, 2005, $206.4 million or 76.5% had adjustable rates ofinterest (including $52.5 million of seven-year adjustable rate loans) and$63.3 million or 23.5% had fixed rates of interest.

 

TheBank currently originates both fixed rate and adjustable rate one- tofour-family residential mortgage loans. The Bank’s fixed rate loans to be heldin portfolio are typically originated with maximum terms of fifteen years andare typically fully amortizing with monthly payments sufficient to repay thetotal amount of the loan with interest by the end of the loan term. The Bankdoes offer fixed rate loans with terms exceeding fifteen years and such loansare typically sold in the secondary market. The Bank’s one- to four-familyloans are typically originated under terms, conditions and documentation whichpermit them to be sold to U.S. Government-sponsored agencies such as Fannie Maeor Freddie Mac. However, as stated above, such loans with terms of less thanfifteen years are generally originated for portfolio while substantially all ofsuch loans with terms of fifteen years or longer are sold in the secondarymarket. The Bank’s fixed rate loans typically include “due on sale” clauses.

 

TheBank’s adjustable rate mortgage loans that are held in the portfolio typicallyprovide for an interest rate which adjusts every one, three, five or sevenyears in accordance with a designated index plus a margin. Such loans aretypically based on a 15-, 20-, 25- or 30-year amortization schedule. The Bankgenerally does not offer below market rates, and the amount of any increase ordecrease in the interest rate per one- or three-year period is generallylimited to 2%, with a limit of 6% over the life of the loan. The Bank’sfive-year adjustable rate loans provide that any increase or decrease in theinterest rate per period is limited to 3%, with a limit of 6% over the life ofthe loan. The Bank’s seven-year adjustable rate loans provide that any increaseor decrease in the interest rate per period is limited to 5%, with a limit of5% over the life of the loan. The Bank’s adjustable rate loans are assumable(generally without release of the initial borrower), do not contain prepaymentpenalties and do not provide for negative amortization. The Bank’s adjustablerate mortgage loans typically include “due on sale” clauses. The Bank generallyunderwrites its one- and three-year adjustable rate loans on the basis of theborrowers’ ability to pay at the rate after the first interest rate adjustment.Adjustable rate loans decrease the risks associated with changes in interest ratesbut involve other risks, primarily because as interest rates rise, the paymentby the borrower rises to the extent permitted by the terms of the loan, therebyincreasing the potential for default. At the same time, the marketability ofthe underlying property may be adversely affected by higher interest rates.

 

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, extenda loan up to 90% of the appraised value of the secured property without privatemortgage insurance coverage. However, these exceptions are minimal and are onlyapproved on loans with exceptional credit scores, sizeable asset reserves, orother compensating factors. At December 31, 2005, the Bank had $2.6million of nonaccrual one- to four-family residential loans. See “AssetQuality.”

 

**Multi-Family Residential Real Estate Loans.**The Bank offers mortgage loans for theacquisition and refinancing of multi-family residential properties. At December31, 2005, $12.9 million or 1.6% of the Bank’s total loan portfolio consisted ofloans collateralized by existing multi-family residential real estateproperties.

 

6

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TheBank currently originates both fixed rate and adjustable rate multi-familyloans. Fixed rate loans are generally originated with amortization periods notto exceed 30 years, and typically have balloon periods of three, five or sevenyears. Adjustable rate loans are typically amortized over terms up to 30 years,with interest rate adjustments every five to seven years. Loan-to-value ratioson the Bank’s multi-family real estate loans are currently limited to 80%. Itis also the Bank’s general policy to obtain corporate or personal guarantees,as applicable, on its multi-family residential real estate loans from theprincipals 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 largeloan balances to single borrowers or groups 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 multi-family real estate aswell as regional and economic conditions generally. At December 31, 2005, theBank did not have any nonaccrual multi-family real estate loans. See “AssetQuality.”

 

**Commercial Real Estate Loans.**The Bank originates mortgage loans for theacquisition and refinancing of commercial real estate properties. At December31, 2005, $157.7 million or 20.0% of the Bank’s total loan portfolio consistedof loans collateralized by existing commercial real estate properties anddeveloped 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.

 

Manyof the Bank’s commercial real estate loans are collateralized by propertiessuch as office buildings, convenience stores, service stations, mini-storagefacilities, motels, churches, small shopping malls, and strip centers. The Bankhas experienced an increase in this type of lending over the last few years andunderwrites commercial real estate loans specifically in relation to the typeof property being collateralized. Cash flows and vacancy rates are primaryconsiderations when underwriting loans collateralized by office buildings,mini-storage facilities and motels. Loans with borrowers that are corporations,limited liability companies, trusts, or other such legal entities are alsotypically personally guaranteed by the principals of the respective entity. Thefinancial strength of the individuals who are personally guaranteeing the loanis also a primary underwriting factor.

 

Commercial real estate loans include loans for the acquisition anddevelopment of land. This segment of the portfolio totaled $38.4 million, $30.9million, $7.0 million, $5.5 million, and $2.7 million as of December 31, 2005,2004, 2003, 2002, and 2001, respectively. The Bank has experienced asignificant increase in this type of lending during 2005 and 2004, primarilydue to opportunities resulting from the growth and development of the Bentonand Washington county areas discussed below. These loans are often made toborrowers with whom the Bank has had previous favorable experience and whosepersonal financial position is strong. These loans include land purchased fordevelopment into single-family subdivision lots, condominium lots, andcommercial lots. Generally, these loans are collateralized by properties in theBank’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 andlocation of the real estate, the creditworthiness of the borrower, the cashflow of the project, and the quality of management involved with the property. TheBank’s commercial real estate loans are generally originated with amortizationperiods not to exceed 25 years and typically have three-, five-, or seven-yearballoon terms. The Bank has originated some loans with variable rate termsbased upon Wall Street Journal Prime. To a lesser degree, the Bank has in thepast offered a limited number of fixed rate commercial real estate loans withterms not to exceed fifteen years subject to then-current interest ratescenarios. As part of the criteria for underwriting multi-family and commercialreal estate loans, the Bank generally estimates a cash flow analysis thatincludes a vacancy rate projection, expenses for taxes, insurance, maintenanceand repair reserves as well as debt coverage ratios. This information is alsoestimated and included in commercial real estate appraisals.

 

Commercialreal estate lending entails additional risks as compared to the Bank’s one- tofour-family residential property loans. Commercial real estate loans generallyinvolve larger loan balances to single borrowers or groups of related borrowers.The payment experience on such loans is typically dependent on the successfuloperation of the real estate project. The success of such projects is sensitiveto changes in supply and demand conditions in the market for commercial realestate, as well as regional and economic conditions generally. The Bankbelieves it has mitigated some of these additional risks by focusing itscommercial real estate lending activities in the economically strongWashington/Benton County, Arkansas market. This region is the home of the world’slargest retailer, Wal-Mart; as well as the nation’s largest meat company, TysonFoods; the trucking firm J. B. Hunt; and the University of Arkansas.

 

7

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Reportshave ranked the region as one of the top performing economic areas in thecountry in the last few years. Population growth, job growth and lowunemployment rates in this region add additional support to the Bank’s growthin the area of commercial real estate loans. At December 31, 2005, the Bank hadone impaired commercial real estate loan relationship of $3.8 million, forwhich no allowance for loan losses had been recorded. At December 31, 2005,none of the loans in this relationship were over 90 days past due. At December31, 2005, the Bank also had $707,000 of nonaccrual commercial real estateloans. See “Asset Quality.”

 

**Construction Loans.**The Bank originatesone- to four-family residential, multi-family, and commercial real estateconstruction loans. However, the Bank’s primary emphasis has been residentialconstruction lending. The Bank’s construction lending activities are typicallylimited to the Bank’s primary market areas. At December 31, 2005, constructionloans amounted to $239.1 million or 30.2% of the Bank’s total loan portfolio,of which, $51.6 million consisted of one-to four-family residentialconstruction loans, $104.0 million consisted of speculative one-to four-familyresidential construction loans, $40.3 million consisted of land developmentconstruction loans, $22.3 million consisted of commercial real estateconstruction loans, and $20.9 million consisted of multi-family residentialconstruction loans. As discussed above in the commercial real estate section,our market areas of Benton and Washington counties have experienced tremendousprosperity and growth and provided the Bank with increased lendingopportunities, which can be demonstrated by the significant growth inconstruction lending. However, as stated previously, our primary focus inconstruction lending has been and remains residential construction lending. TheBank has been successful in marketing its lending products to the residentialconstruction market, including involvement in homebuilders’ associations andmaintaining established relationships with builders.

 

The Bank’s construction loans generally have fixed interest rates orvariable rates that float with Wall Street Journal Prime and are typicallyissued for terms of six to eighteen months. However, the Bank is permitted tooriginate construction loans with terms up to two years under its loan policy. Thispractice is generally limited to larger projects that cannot be completed inthe typical six- to eighteen-month period. Construction loans are typicallymade with a maximum loan-to-value ratio of 80% on an as-completed basis.

 

Themajority of the Bank’s construction loans are made to individual homeowners andlocal builders and developers for the purpose of constructing one- tofour-family residences. To a lesser but growing extent, construction loans arealso originated for multi-family and commercial properties. The Bank typicallyrequires that permanent financing with the Bank or some other lender be inplace prior to closing any non-speculative construction loan. Interest onconstruction/permanent loans is due upon completion of the construction phaseof the loan. At such time, the loan will convert to a permanent loan at theinterest rate established at the initial closing of the construction/permanentloan.

 

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 tocredit review, analysis of personal and, if applicable, corporate financialstatements, and an appraisal of the property to be constructed. The Bank alsoreviews and inspects the project prior to the disbursement of funds (draws)during the construction term. Loan proceeds are disbursed after a satisfactoryinspection of the project has been made based upon percentage of completion. Intereston these construction loans is due upon maturity. The Bank may extend the termof a construction loan upon payment of interest accrued if the property has notbeen sold by the maturity date. The Bank has not experienced any materialcredit or delinquency problems in this regard.

 

Construction lending is generally considered to involve a higher levelof risk as compared to one- to four-family residential loans. This is due, in part,to the concentration of principal in a limited number of loans and borrowers,and the effects of general economic conditions on developers and builders. Inaddition, construction loans to a builder for construction of homes that arenot pre-sold possess a greater potential risk to the Bank than constructionloans to individuals on their personal residences or on houses that arepre-sold prior to the inception of the loan. The Bank analyzeseach borrower involved in speculative building and limits the principal amountand number of unsold speculative homes at any one time with such borrower. AtDecember 31, 2005, the Bank had nonaccrual construction loans totaling$1.2 million. 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, 2005, such loans amounted to $32.7million or 4.1% of the total loan portfolio. At December 31, 2005, the Bank hadnonaccrual commercial loans totaling $236,000. See “Asset Quality.”

 

8

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TheBank’s commercial loans are typically originated with fixed interest rates andcall provisions between one and five years. These loans are typically based ona maximum fifteen-year amortization schedule. The Bank also originatesinterest-only commercial loans and variable rate commercial 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$78.6 million or 9.9% of the total loan portfolio at December 31, 2005, ofwhich $49.7 million, $15.7 million and $13.2 million consisted of home equityand second mortgage loans, automobile loans, and other consumer loans,respectively. The Bank intends to continue its emphasis on consumer loans infurtherance of its role as a community-oriented financial institution.

 

TheBank’s home equity and second mortgage loans are fixed rate loans with fullyamortized terms of up to fifteen years, or variable rate interest-only loanswith terms up to three years. The variable rate loans are typically tied toWall Street Journal Prime, plus a margin commensurate with the risk asdetermined by the borrower’s credit score. Longer-term amortizing loanstypically have a balloon feature in five, seven, or ten years. Although theBank does not require that it hold the first mortgage on the secured property,the Bank does hold the first mortgage on a significant number of its homeequity loans. The Bank generally limits the total loan-to-value on thesemortgages 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 are generally originated with a maximum termof five years. The Bank does offer extended terms on automobile loans to somecustomers based upon their creditworthiness.

 

Otherconsumer loans consist primarily of deposit account loans and unsecured loans. Loanssecured by deposit accounts are originated for up to 95% of the accountbalance, with a hold placed on the account restricting the withdrawal of theaccount 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 repossessedcollateral for a defaulted consumer loan may not provide an adequate source ofrepayment of the outstanding loan balance as a result of the greater likelihoodof damage, loss or depreciation. In addition, consumer loan collections aredependent on the borrower’s continuing financial stability, and thus are morelikely to be adversely affected by job loss, divorce, illness or personalbankruptcy. Furthermore, the application of various federal and state laws,including federal and state bankruptcy and insolvency laws, may limit theamount which can be recovered on such loans. At December 31, 2005, the Bank had$556,000 of nonaccrual consumer loans. 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. Dependingupon the type of loan, late notices are sent and/or personal contacts are made.In most cases, deficiencies are cured 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 placed on nonaccrual status, previously accruedbut unpaid interest is deducted from interest income. The Bank generally doesnot accrue interest on loans past due 90 days or more. Loans may be reinstatedto accrual status when payments are made to bring the loan under 90 days pastdue and, in the opinion of management, collection of the remaining balance canbe reasonably expected. The Bank may continue to accrue interest on certainloans that are 90 days past due or more if such loans are in the process ofcollection and collection is reasonably assured.

 

Realestate properties acquired through foreclosure are initially recorded at fairvalue less estimated selling costs. Valuations are periodically performed bymanagement and the real estate is carried at the lower of carrying amount orfair value less cost to sell.

 

9

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** **

**Delinquent Loans.**The following table sets forth information concerning delinquent loansat December 31, 2005, in dollar amounts and as a percentage of the Bank’stotal loan portfolio. The amounts presented represent the total outstandingprincipal balances of the related loans, rather than the actual payment amountswhich 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        |       | $                                              | 3,449      |                                 | 0.44       | %                                | $          | 2,962                                |       | 0.37         | %          | $ | 57 |   | 0.01 | % | $ | 317 |   | 0.04 | % | $ | 703 |   | 0.09 | % |
|              |       |                                           |       |                                 |       |                             |       |                                 |       |         |       |   |   |   |   |   |   |   |   |   |   |
| 60-89 days        |       | 2,255                                          |       | 0.29                                 |       | 774                              |       | 0.10                                 |       | 127          |       | 0.02 |   | 327 |   | 0.04 |   | 484 |   | 0.06 |   |
|              |       |                                           |       |                                 |       |                             |       |                                 |       |         |       |   |   |   |   |   |   |   |   |   |   |
| 90 days and over  |       | 3,283                                          |       | 0.42                                 |       | 1,177                            |       | 0.15                                 |       | 1,521        |       | 0.19 |   | 368 |   | 0.05 |   | 522 |   | 0.07 |   |
|              |       |                                           |       |                                 |       |                             |       |                                 |       |         |       |   |   |   |   |   |   |   |   |   |   |
| Total             |       | $                                              | 8,987      |                                 |       |                             | $          | 4,913                                |       |         |       | $ | 1,705 |   |   |   | $ | 1,012 |   |   |   | $ | 1,709 |   |   |   |

 

Interest income that would have been recorded under the original termsof the Bank’s nonaccruing loans for the year ended December 31, 2005, amountedto $169,000, and the interest recognized during this period amounted to$35,000.

 

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

 
| ** **                                                                                                                   | ** ** | **December 31,** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                                                                                   | ** ** | **2005**              | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** |
| ** **                                                                                                                   | ** ** | ** **            | ** ** | **(Dollars in Thousands)** | ** ** | ** ** | ** ** |
| ** **                                                                                                                   | ** ** | ** **            | ** ** | ** ** | ** ** | ** ** | ** ** |
| Nonaccrual loans:                                                                                                            |       |                  |       |   |   |   |   |   |   |   |   |
| One- to four-family residential                                                                                              |       | $                     | 2,630      |   | $ | 2,619 |   | $ | 1,537 |   | $ | 2,184 |   | $ | 2,024 |   |
| Multi-family residential                                                                                                     |       | —                |       | — |   | — |   | — |   | — |   |
| Construction loans                                                                                                           |       | 1,177                 |       | 634 |   | — |   | — |   | 350 |   |
| Commercial real estate                                                                                                       |       | 707                   |       | — |   | 99 |   | 124 |   | 269 |   |
| Commercial loans                                                                                                             |       | 236                   |       | 186 |   | 131 |   | 245 |   | 54 |   |
| Consumer loans                                                                                                               |       | 556                   |       | 723 |   | 564 |   | 175 |   | 409 |   |
| Total nonaccrual loans                                                                                                       |       | 5,306                 |       | 4,162 |   | 2,331 |   | 2,728 |   | 3,106 |   |
|                                                                                                                         |       |                  |       |   |   |   |   |   |   |   |   |
| Accruing loans 90 days or more past due                                                                                      |       | 1,600                 |       | — |   | — |   | — |   | — |   |
| Restructured loans                                                                                                           |       | 6,264                 |       | 3,790 |   | 1,352 |   | 4,219 |   | — |   |
| Real estate owned                                                                                                            |       | 892                   |       | 563 |   | 822 |   | 320 |   | 455 |   |
|                                                                                                                         |       |                  |       |   |   |   |   |   |   |   |   |
| Total nonperforming assets                                                                                                   |       | $                     | 14,062     |   | $ | 8,515 |   | $ | 4,505 |   | $ | 7,267 |   | $ | 3,561 |   |
|                                                                                                                         |       |                  |       |   |   |   |   |   |   |   |   |
| Total nonaccrual, accruing loans 90 days or  more past due and restructured loans as a percentage of total loans  receivable |       | 1.67                  | %          | 1.14 | % | 0.67 | % | 1.37 | % | 0.64 | % |
|                                                                                                                         |       |                  |       |   |   |   |   |   |   |   |   |
| Total nonperforming assets as a percentage  of total assets                                                                  |       | 1.65                  | %          | 1.13 | % | 0.65 | % | 1.07 | % | 0.53 | % |

 

 

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The increase in nonaccrual commercial realestate loans between December 31, 2004 and December 31, 2005 was primarily dueto a single commercial real estate loan of approximately $700,000. This loan isincluded in a lending relationship of five nonaccrual loans totaling $1.5 million, consisting of$700,000 of one- to four- family residential first mortgage loans secured bytwo residential properties and $138,000 of commercial loans secured by juniorliens on an office building and residential property. The Bank has initiatedforeclosure proceedings on all properties. At December 31, 2005, each of theloans in this relationship was reviewed and the value of underlying collateralwas estimated, primarily based on appraisals. The Bank estimates, based oncurrent information, that it will incur no loss.

 

The increase in accruing loans 90 days or more past due andrestructured loans was due to a relationship including 24 loans totaling $4.0million, all classified as substandard. These loans consisted of $786,000 ofone- to four-family residential loans, $890,000 of commercial real estateloans, $2.3 million of commercial loans, and $40,000 of consumer loans. TheBank has received correspondence from the borrower’s attorney that the borrowerintends to refinance $1.8 million with other institutions and pay interestcurrent for the remaining $2.2 million of loans held at the Bank. The Bankreceived the interest payments on the $2.2 million as promised and extended theloans. These loans have been classified as troubled debt restructurings and are included in the restructuredloans total above. Based on the payment history of the borrower, the underlyingvalue of the collateral, and correspondence with the borrower, the interest onall of this borrower’s loans remains on accrual status and no loss is currentlyestimated on this relationship.

 

AtDecember 31, 2005 and December 31, 2004, restructured loans also include agroup of commercial loans and commercial real estate loans to a single borrowertotaling $3.8 million. Although the loans were not past due more than 90 daysat either date, the borrower has used overdraft privileges with the Bank tomaintain payments on the loans. At December 31, 2004, the borrower was overdrawn$151,000. During the third quarter of 2005, the Bank suspended the borrower’sunsecured overdraft privileges and transferred the outstanding balance of theoverdraft to a line of credit secured by real estate. The line of credit has amaximum amount of $250,000. At December 31, 2005, the outstanding balance ofthe line of credit was $240,000. The Bank estimates that it will incur no losson this relationship based on the value of the underlying collateral.

 

**Classified Assets.**Federal regulations require that each insured savings associationclassify its assets on a regular basis. In addition, in connection withexaminations of insured institutions, federal examiners have authority toidentify problem assets and, if appropriate, classify them. There are threeclassifications 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. Doubtfulassets have the weaknesses of substandard assets with the additionalcharacteristic that the weaknesses make collection or liquidation in full onthe basis of currently existing facts, conditions and values questionable, andthere is a high possibility of loss. An asset classified loss is considereduncollectible and of such little value that continuance as an asset of theinstitution is not warranted. At December 31, 2005, the Bank had $14.1million of classified assets, $13.9 million of which were classified assubstandard and $200,000 of which were classified as loss. In addition, at suchdate, the Bank had $2.3 million of assets designated as special mention. Specialmention assets have potential weaknesses that deserve management’s closeattention. If left uncorrected, these potential weaknesses may result indeterioration of the repayment prospects for the asset or the institution’scredit position at some future date.

 

**Allowance for Loan Losses.**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. Subsequentrecoveries, if any, are credited to the allowance.

 

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

 

11

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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 quarterly basis. TheBank considers commercial real estate, construction, multi-family, andcommercial loans to be non-homogeneous loans. A loan is considered impairedwhen, based on current information and events, it is probable that the Bankwill be unable to collect the scheduled payments of principal or interest whendue according to the contractual terms of the loan agreement. Factorsconsidered by management in determining impairment include payment status,collateral value, and the probability of collecting scheduled principal andinterest payments when due. Loans that experience insignificant payment delaysand payment shortfalls generally are not classified as impaired. Managementdetermines the significance of payment delays and payment shortfalls on acase-by-case basis, taking into consideration all of the circumstancessurrounding the loan and the borrower, including the length of the delay, thereasons for the delay, the borrower’s prior payment record, and the amount ofthe shortfall in relation to the principal and interest owed. Impairment 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 loansare those that are considered to have common characteristics that provide forevaluation on an aggregate or pool basis. The Bank considers thecharacteristics of (1) one- to four-family residential first mortgage loans;(2) unsecured consumer loans; and (3) collateralized consumer loans to permitconsideration of the appropriateness of the allowance for losses of each groupof 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 aloss factor to the remaining pool balance based on several factors includingpast loss experience, inherent risks, and economic conditions in the primarymarket areas.

 

In estimating theamount of credit losses inherent in our loan portfolio, various judgments andassumptions are made. For example, when assessing the condition of the overalleconomic environment, assumptions are made regarding future market conditionsand their impact on the loan portfolio. In the event the national or localeconomy 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 arecollateral dependent, the estimated fair value of the collateral may deviatesignificantly from the proceeds received when the collateral is sold in theevent that the Bank has to foreclose or repossess the collateral.

 

Although we considerthe allowance for loan losses of approximately $2.1 million adequate to coverlosses inherent in our loan portfolio at December 31, 2005, no assurance can begiven that we will not sustain loan losses that are significantly differentfrom the amount recorded, or that subsequent evaluations of the loan portfolio,in light of factors then prevailing, would not result in a significant changein the allowance for loan losses.

 

12

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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,** | ** ** |
|----------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                             | ** ** | **2005**                                   | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** |
| ** **                                                                             | ** ** | ** **                                 | ** ** | **(Dollars in Thousands)** | ** ** | ** ** | ** ** |
| ** **                                                                             | ** ** | ** **                                 | ** ** | ** ** | ** ** | ** ** | ** ** |
| Total loans outstanding at end of period                                               |       | $                                          | 790,570    |   | $ | 699,205 |   | $ | 550,215 |   | $ | 506,953 |   | $ | 487,639 |   |
| Average loans outstanding                                                              |       | $                                          | 687,373    |   | $ | 573,520 |   | $ | 492,492 |   | $ | 481,330 |   | $ | 488,942 |   |
| Allowance at beginning of period                                                       |       | $                                          | 1,846      |   | $ | 1,621 |   | $ | 1,529 |   | $ | 923 |   | $ | 691 |   |
| Charge-offs:                                                                           |       |                                       |       |   |   |   |   |   |   |   |   |
| One- to four-family residential                                                        |       | (151                                       | )          | (152 | ) | (73 | ) | (54 | ) | (75 | ) |
| Commercial real estate                                                                 |       | —                                     |       | (71 | ) | — |   | (56 | ) | — |   |
| Commercial loans                                                                       |       | (41                                        | )          | (184 | ) | (109 | ) | (415 | ) | (41 | ) |
| Consumer loans (1)                                                                     |       | (764                                       | )          | (491 | ) | (496 | ) | (461 | ) | (121 | ) |
| Total charge-offs                                                                      |       | (956                                       | )          | (898 | ) | (678 | ) | (986 | ) | (237 | ) |
| Recoveries:                                                                            |       |                                       |       |   |   |   |   |   |   |   |   |
| One- to four-family residential                                                        |       | —                                     |       | 2 |   | 1 |   | 6 |   | — |   |
| Commercial real estate                                                                 |       | —                                     |       | — |   | — |   | 2 |   | — |   |
| Commercial loans                                                                       |       | 1                                          |       | 2 |   | — |   | — |   | — |   |
| Consumer loans (1)                                                                     |       | 122                                        |       | 99 |   | 79 |   | 84 |   | 17 |   |
| Total recoveries                                                                       |       | 123                                        |       | 103 |   | 80 |   | 92 |   | 17 |   |
| Net charge-offs                                                                        |       | (833                                       | )          | (795 | ) | (598 | ) | (894 | ) | (220 | ) |
| Total provisions for losses                                                            |       | 1,101                                      |       | 1,020 |   | 690 |   | 1,500 |   | 452 |   |
| Allowance at end of period                                                             |       | $                                          | 2,114      |   | $ | 1,846 |   | $ | 1,621 |   | $ | 1,529 |   | $ | 923 |   |
|                                                                                   |       |                                       |       |   |   |   |   |   |   |   |   |
| Allowance for loan losses as a percentage  of total loans outstanding at end of period |       | 0.27                                       | %          | 0.26 | % | 0.29 | % | 0.30 | % | 0.19 | % |
| Net loans charged-off as a percentage of  average loans outstanding                    |       | 0.12                                       | %          | 0.14 | % | 0.12 | % | 0.19 | % | 0.05 | % |

 

----

(1)Consumer loan charge-offs include overdraft charge-offs of  $522,000, $323,000, $182,000 and $214,000 forthe years ended December 31, 2005, 2004, 2003, and 2002, respectively. Consumerloan recoveries include recoveries of overdraft charge-offs of $114,000,$85,000, $50,000, and $53,000 for the years ended December 21, 2005, 2004,2003, and 2002, respectively. Overdraft charge-offs and recoveries for the yearended December 31, 2001 were not significant.

 

13

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

** **
| ** **                  | ** ** | **December 31,** | ** ** |
|-----------------------------|------------|-----------------------|------------|
| ** **                  | ** ** | **2005**              | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** |
| ** **                  | ** ** | **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     |       | $                     | 204        |   | 34.11 | % | $ | 318 |   | 40.35 | % | $ | 239 |   | 47.09 | % | $ | 128 |   | 57.03 | % | $ | 66 |   | 67.85 | % |
| Multi-family  residential   |       | 42                    |       | 1.63 |   | 39 |   | 1.35 |   | 31 |   | 1.39 |   | 1 |   | 1.15 |   | 1 |   | 0.90 |   |
| Commercial real  estate (1) |       | 529                   |       | 19.95 |   | 420 |   | 20.87 |   | 256 |   | 17.69 |   | 719 |   | 14.84 |   | 240 |   | 10.58 |   |
| Construction  loans (2)     |       | 295                   |       | 30.24 |   | — |   | 22.76 |   | — |   | 16.24 |   | — |   | 9.69 |   | 25 |   | 5.09 |   |
| Commercial loans            |       | 371                   |       | 4.14 |   | 509 |   | 3.94 |   | 404 |   | 3.91 |   | 209 |   | 3.87 |   | 133 |   | 3.85 |   |
| Consumer loans              |       | 573                   |       | 9.93 |   | 508 |   | 10.73 |   | 628 |   | 13.68 |   | 463 |   | 13.42 |   | 327 |   | 11.73 |   |
| Unallocated                 |       | 100                   |       | — |   | 52 |   | — |   | 63 |   | — |   | 9 |   | — |   | 131 |   | — |   |
| Total                       |       | $                     | 2,114      |   | 100.00 | % | $ | 1,846 |   | 100.00 | % | $ | 1,621 |   | 100.00 | % | $ | 1,529 |   | 100.00 | % | $ | 923 |   | 100.00 | % |

 

----

(1)** **Theallowance allocated to commercial real estate loans decreased between 2003 and2002 primarily due to two factors. At December 31, 2002, there was a valuationallowance on an impaired loan that was not recorded in 2003 and the lossexperience factor was revised downward in 2003 due to a more establishedhistory of low levels of charge-offs. The allowance increased in this category between 2003 and 2004 due  primarily to****loan growth.

 

(2)  The allowance allocated toconstruction loans was increased due to an increase in speculative 1-4 familyresidential construction loans. In previous years the allowance on this segmentof the portfolio was included with other 1-4 family residential loans.

 

14

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** **

**Investment Activities**

 

**Investment Securities.**The investment policy of the Bank, asestablished by the board of directors, is designed primarily to provide andmaintain liquidity, to provide collateral for pledging requirements, tocomplement the Bank’s interest rate risk strategy and to generate a favorablereturn on investments. The Bank’s investment policy is currently implemented bythe Bank’s Chief Executive Officer within the parameters set by the investmentcommittee 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 amortized cost.Investment securities classified as available for sale are reported at fairvalue, with unrealized gains and losses excluded from earnings and reported netof tax in other comprehensive income. At December 31, 2005, all of the Bank’sinvestment securities were classified as held to maturity. AtDecember 31, 2005, approximately $48.4 million of the Bank’sinvestment securities were pledged as collateral for certain deposits in excessof $100,000. In addition, certain U.S. Government and agency securities werepledged as collateral for FHLB advances under the FHLB’s blanket lien. AtDecember 31, 2005, investments in the debt and/or equity securities of any oneissuer, other than those issued by U.S. Government agencies, did not exceedmore than 10% of the 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, 2005.Weighted average yields for municipal obligations have not been adjusted to atax-equivalent basis. Expected maturities may differ from contractualmaturities because issuers may have the right to call or prepay the obligationwithout 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)** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                             | ** ** | ** **                        | ** ** | ** **                       | ** ** | ** **                       | ** ** | ** **                | ** ** | ** **              | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Municipal securities                   |       | $                                 | —     |                             | —     | %                                | $          | 425                       |       | 3.50                    | %          | $ | 4,825 |   | 4.48 | % | $ | 11,411 |   | 4.51 | % | $ | 16,661 |   | 4.47 | % |
| U.S. Government and agency obligations |       | —                            |       | —                           |       | 200                              |       | 3.63                      |       | 14,878                  |       | 4.59 |   | 24,956 |   | 5.02 |   | 40,034 |   | 4.86 |   |
| Total                                  |       | $                                 | —     |                             | —     | %                                | $          | 625                       |       | 3.54                    | %          | $ | 19,703 |   | 4.57 | % | $ | 36,367 |   | 4.86 | % | $ | 56,695 |   | 4.74 | % |

 

Asof December 31, 2005, there were approximately $55.5 million of investmentsecurities at an average interest rate of 4.75% with issuer call options, ofwhich approximately $41.0 million at an average interest rate of 4.89% arecallable within one year. In a rising interest rate environment, the Companybelieves that the issuers would not call these investment securities.

 

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

 
| ** **                              | ** ** | **December 31,**   | ** ** |
|-----------------------------------------|------------|-------------------------|------------|
| ** **                              | ** ** | **2005**                | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                              | ** ** | **(In Thousands)** | ** ** |
| ** **                              | ** ** | ** **              | ** ** |
| Investment securities held to maturity: |       |                    |       |   |   |   |   |
| Certificates of deposit                 |       | $                       | —     |   | $ | 3,000 |   | $ | 9,000 |   |
| Municipal securities                    |       | 16,661                  |       | 15,839 |   | 14,303 |   |
| U.S. Government and agency obligations  |       | 40,034                  |       | 37,821 |   | 57,076 |   |
| Total                                   |       | $                       | 56,695     |   | $ | 56,660 |   | $ | 80,379 |   |

 

As a member of the FHLB of Dallas, the Bank is required to maintain aninvestment in FHLB stock. At December 31, 2005, the Bank’s investment inFHLB stock amounted to $8.4 million. No ready market exists for such stock andit has no quoted market value.

 

15

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** **

**Sources of Funds**

 

**General.**Deposits are the primary source of the Bank’s funds for lending andother investment purposes. In addition to deposits, the Bank derives funds fromloan principal repayments and prepayments and interest payments, maturities andcalls of investment securities and advances from the FHLB of Dallas. Loanrepayments are a relatively stable source of funds, while deposit inflows andoutflows are significantly influenced by general interest rates and moneymarket conditions. Borrowings are used when funds from deposit sources areinsufficient to meet funding needs. They may also be used on a longer-termbasis for general business purposes. FHLB advances are the primary source ofborrowings.

 

**Deposits.**The Bank’s deposit products include a broad selection of depositinstruments, including negotiable order of withdrawal (“NOW”) accounts, demanddeposit accounts (“DDA”), money market accounts, regular savings accounts andterm certificate accounts. Deposit account terms vary, with the principaldifferences being the minimum balance required, the time period the funds mustremain on deposit, early withdrawal penalties and the interest rate.

 

TheBank considers its primary market area to be Northcentral and NorthwestArkansas. The Bank utilizes traditional marketing methods to attract newcustomers and savings deposits. In the second quarter of 2004, the Bankbegan a direct mail campaign to solicit checking accounts.  This programwas instrumental in attaining 14.2% growth in checking account balances in2005.  The Bank will continue to focus much of its marketing resources oncross-selling checking accounts and developing new checking accountrelationships with the Bank. TheBank does not advertise for deposits outside of its primary market area andmanagement believes that an insignificant number of deposit accounts were heldby non-residents of Arkansas at December 31, 2005. Services of deposit brokershave been used on a limited basis with less than 2% of certificates of depositat December 31, 2005, 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 generallydictates which deposit maturities and rates will be accepted by the public, theBank intends to continue to offer longer-term deposits to the extent possibleand consistent with its asset and liability 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,**                | ** ** |
|----------------------------|------------|--------------------------------------|------------|
| ** **                 | ** ** | **2005**                             | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                 | ** ** | **Amount**                           | ** ** | **%** | ** ** | **Amount** | ** ** | **%** | ** ** | **Amount** | ** ** | **%** | ** ** |
| ** **                 | ** ** | **(Dollars in Thousands)** | ** ** |
| ** **                 | ** ** | ** **                           | ** ** |
| Certificate accounts:      |       |                                 |       |   |   |   |   |   |   |   |   |   |   |
| Less than 3.00%            |       | $                                    | 62,689     |   | 10.2 | % | $ | 168,779 |   | 29.0 | % | $ | 180,301 |   | 31.4 | % |
| 3.00% - 3.99%              |       | 164,600                              |       | 26.9 |   | 68,140 |   | 11.7 |   | 38,057 |   | 6.6 |   |
| 4.00% - 5.99%              |       | 156,224                              |       | 25.5 |   | 81,725 |   | 14.0 |   | 99,801 |   | 17.4 |   |
| 6.00% - 7.99%              |       | 7,757                                |       | 1.3 |   | 15,911 |   | 2.7 |   | 21,271 |   | 3.7 |   |
| 8.00% and over             |       | 458                                  |       | 0.1 |   | 423 |   | 0.1 |   | 391 |   | 0.1 |   |
| Total certificate accounts |       | 391,728                              |       | 64.0 |   | 334,978 |   | 57.5 |   | 339,821 |   | 59.2 |   |
|                       |       |                                 |       |   |   |   |   |   |   |   |   |   |   |
| Transaction accounts:      |       |                                 |       |   |   |   |   |   |   |   |   |   |   |
| Savings                    |       | 30,521                               |       | 5.0 |   | 31,611 |   | 5.4 |   | 29,269 |   | 5.1 |   |
| Money market accounts      |       | 64,021                               |       | 10.5 |   | 106,063 |   | 18.2 |   | 108,400 |   | 18.9 |   |
| NOW accounts/DDA           |       | 125,397                              |       | 20.5 |   | 109,772 |   | 18.9 |   | 96,090 |   | 16.8 |   |
| Total transaction accounts |       | 219,939                              |       | 36.0 |   | 247,446 |   | 42.5 |   | 233,759 |   | 40.8 |   |
| Total deposits             |       | $                                    | 611,667    |   | 100.0 | % | $ | 582,424 |   | 100.0 | % | $ | 573,580 |   | 100.0 | % |

 

During2005, due in large part to the recent increases in short-term market interestrates, the Bank experienced a shift in deposits from money market accounts andsavings accounts to higher rate certificates of deposit. The increase in ratesis also reflected in the shift between lower rate certificates of deposit tohigher rate certificates of deposit.

 

16

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The following table presents the average balance of each type ofdeposit and the average rate paid on each type of deposit and/or total depositsfor the periods indicated.

 
| ** **              | ** ** | **Year Ended ****December 31,** | ** ** |
|-------------------------|------------|------------------------------------------------|------------|
| ** **              | ** ** | **2005**                                       | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **              | ** ** | **Average  Balance**                           | ** ** | **Average  Rate  Paid** | ** ** | **Average  Balance** | ** ** | **Average  Rate  Paid** | ** ** | **Average  Balance** | ** ** | **Average  Rate  Paid** | ** ** |
| ** **              | ** ** | ** **                                     | ** ** | ** ** | ** ** | **(Dollars in Thousands)** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **              | ** ** | ** **                                     | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Savings accounts        |       | $                                              | 31,276     |   | 0.50 | % | $ | 31,096 |   | 0.41 | % | $ | 28,664 |   | 0.66 | % |
| Money market accounts   |       | 82,492                                         |       | 1.76 |   | 113,842 |   | 1.46 |   | 99,426 |   | 1.71 |   |
| NOW accounts            |       | 82,522                                         |       | 0.50 |   | 75,416 |   | 0.37 |   | 69,168 |   | 0.73 |   |
| Demand deposit accounts |       | 35,387                                         |       | — |   | 29,263 |   | — |   | 23,969 |   | — |   |
| Certificates of deposit |       | 359,076                                        |       | 3.54 |   | 331,662 |   | 3.20 |   | 350,180 |   | 3.49 |   |
| Total deposits          |       | $                                              | 590,753    |   | 2.47 | % | $ | 581,279 |   | 2.18 | % | $ | 571,407 |   | 2.56 | % |

 

The following table presents, by various interest rate categories, theamount of certificates of deposit at December 31, 2005 and 2004, andthe amounts at December 31, 2005, which mature during the periods indicated.

 
| ** **                 | ** ** | **December 31,** | ** ** | **Balance at December 31, 2005  Maturing in the 12 Months Ending December 31,** | ** ** |
|----------------------------|------------|-----------------------|------------|----------------------------------------------------------------------------------------------------------------------------------------|------------|
| ** **                 | ** ** | **2005**              | ** ** | **2004**                                                                                                                               | ** ** | **2006** | ** ** | **2007** | ** ** | **2008** | ** ** | **Thereafter** | ** ** |
| ** **                 | ** ** | ** **            | ** ** | ** **                                                                                                                             | ** ** | **(In Thousands)** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                 | ** ** | ** **            | ** ** | ** **                                                                                                                             | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Certificate accounts: |       |                  |       |                                                                                                                                   |       |   |   |   |   |   |   |   |   |
| Less than 3.00%            |       | $                     | 62,689     |                                                                                                                                   | $          | 168,779 |   | $ | 58,217 |   | $ | 3,969 |   | $ | 490 |   | $ | 13 |   |
| 3.00% - 3.99%              |       | 164,600               |       | 68,140                                                                                                                                 |       | 92,508 |   | 37,688 |   | 31,312 |   | 3,092 |   |
| 4.00% - 5.99%              |       | 156,224               |       | 81,725                                                                                                                                 |       | 58,601 |   | 59,678 |   | 4,860 |   | 33,085 |   |
| 6.00% - 7.99%              |       | 7,757                 |       | 15,911                                                                                                                                 |       | 3,944 |   | 22 |   | 922 |   | 2,869 |   |
| 8.00% and over             |       | 458                   |       | 423                                                                                                                                    |       | 458 |   | — |   | — |   | — |   |
| Total certificate accounts |       | $                     | 391,728    |                                                                                                                                   | $          | 334,978 |   | $ | 213,728 |   | $ | 101,357 |   | $ | 37,584 |   | $ | 39,059 |   |

 

Thefollowing table sets forth maturities of the Bank’s certificates of deposit of$100,000 or more at December 31, 2005 by time remaining to maturity.

 

| ** **                                                       | ** ** | **Amount**              | ** ** |
|------------------------------------------------------------------|------------|-------------------------|------------|
|                                                             | ** ** | **(In Thousands)** | ** ** |
| Period Ending:                                              | ** ** | ** **              | ** ** |
| March 31, 2006                                                   |       | $                       | 16,175     |   |
| June 30, 2006                                                    |       | 24,869                  |       |
| September 30, 2006                                               |       | 9,929                   |       |
| December 31, 2006                                                |       | 16,836                  |       |
| After December 31, 2006                                          |       | 50,124                  |       |
| Total certificates of deposit with balances  of $100,000 or more |       | $                       | 117,933    |   |

 

**Borrowed funds.**TheBank utilizes FHLB advances in its normal operating 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 the blanket lien includes First MortgageCollateral (as defined by FHLB), multi-family residential mortgages meeting therequirements for eligibility as First Mortgage Collateral, U.S. Government andAgency Securities (as defined by FHLB), privately issued mortgage-backedsecurities that qualify as eligible collateral under applicable regulations,FHLB Term Deposit Accounts, and other non-securitized real estate relatedcollateral.

 

17

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Advancesat December 31, 2005, have maturity dates and weighted average rates asfollows:

 

| **Year Ending  December 31,** | ** ** | **Weighted  Average  Rate** | ** ** | **Amount**                           | ** ** |
|-----------------------------------------|------------|-----------------------------|------------|--------------------------------------|------------|
| ** **                              | ** ** | ** **                  | ** ** | **(Dollars in Thousands)** | ** ** |
| 2006                                    |       | 4.03                        | %          | $                                    | 60,766     |   |
| 2007                                    |       | 4.07                        |       | 51,585                               |       |
| 2008                                    |       | 4.09                        |       | 22,349                               |       |
| 2009                                    |       | 4.09                        |       | 11,051                               |       |
| 2010                                    |       | 4.33                        |       | 4,738                                |       |
| Thereafter                              |       | 4.32                        |       | 7,751                                |       |
| Total                                   |       | 4.08                        | %          | $                                    | 158,240    |   |

 

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,** | ** ** |
|---------------------------------|------------|------------------------------------------------------------------------------|------------|
| ** **                      | ** ** | **2005**                                                                     | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                      | ** ** | **(Dollars in Thousands)**                                         | ** ** |
| Maximum balance                 |       | $                                                                            | 171,203    |   | $ | 89,756 |   | $ | 49,458 |   |
|                            |       |                                                                         |       |   |   |   |   |
| Average balance                 |       | 135,636                                                                      |       | 53,299 |   | 43,321 |   |
|                            |       |                                                                         |       |   |   |   |   |
| Year end balance                |       | 158,240                                                                      |       | 89,756 |   | 39,562 |   |
|                            |       |                                                                         |       |   |   |   |   |
| Weighted average interest rate: |       |                                                                         |       |   |   |   |   |
|                            |       |                                                                         |       |   |   |   |   |
| At end of year                  |       | 4.08                                                                         | %          | 3.23 | % | 3.26 | % |
|                            |       |                                                                         |       |   |   |   |   |
| During the year                 |       | 3.68                                                                         | %          | 3.09 | % | 3.18 | % |
|                                 |            |                                                                              |            |  |  |  |  |  |  |  |  |  |

 

## **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 additional investmentof 1% of assets when such additional investment is utilized primarily forcommunity development purposes. The Bank’s only subsidiary, First HarrisonService Corporation (the “Service Corporation”), was formed in 1971. AtDecember 31, 2005, 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 understanding ofthe extent to which the Company and the Bank are regulated. The description ofthe laws and regulations hereunder, as well as descriptions of laws andregulations contained elsewhere herein, does not purport to be complete and isqualified in its entirety by reference to applicable laws and regulations.*

 

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** **

**The Company**

** **

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

 

**Holding Company Acquisitions.**Federal law generally prohibits a savings andloan holding company, without prior OTS approval, from acquiring the ownershipor control of any other savings institution or savings and loan holdingcompany, or all, or substantially all, of the assets or more than 5% of thevoting shares thereof which is not a subsidiary. These provisions alsoprohibit, among other things, any director or officer of a savings and loanholding company, or any individual who owns or controls more than 25% of thevoting shares 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 are generally no restrictions on theactivities of a savings and loan holding company, such as the Company, whichcontrolled only one subsidiary savings association on or before May 4, 1999 (a “grandfatheredholding company”). However, if the Director of the OTS determines that there isreasonable cause to believe that the continuation by a savings and loan holdingcompany of an activity constitutes a serious risk to the financial safety,soundness or stability of its subsidiary savings association, the Director mayimpose such restrictions as it deems necessary to address such risk, includinglimiting (i) payment of dividends by the savings association; (ii) transactionsbetween the savings association and its affiliates; and (iii) any activities ofthe savings association that might create a serious risk that the liabilitiesof the holding company and its affiliates may be imposed on the savingsassociation. Notwithstanding the above rules as to permissible businessactivities of unitary savings and loan holding companies, if the savingsassociation subsidiary of such a holding company fails to meet the qualifiedthrift lender (“QTL”) test, then such unitary holding company also shall becomesubject to the activities restrictions applicable to multiple savings and loanholding companies and, unless the savings association requalifies as a QTLwithin one year thereafter, shall register as, and become subject to therestrictions 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, multiplesavings and loan holding companies are subject to restrictions on theiractivities that are not imposed on a grandfathered 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. Multiple savings and loan holding companies may:

 

•                        furnish or perform management services for a savings associationsubsidiary of a savings and loan holding company;

•                        hold, manage or liquidate assets owned or acquired from a savingsassociation subsidiary of a savings and loan holding company;

•                        hold or manage properties used or occupied by a savings associationsubsidiary of a savings and loan holding company;

•                        engage in activities determined by the Federal Reserve to be closelyrelated to banking and a proper incident thereto; and

•                        engage in services and activities previously determined by the FederalHome Loan Bank Board by regulation to be permissible for a multiple savings andloan holding company as of March 5, 1987.

 

Theactivities financial holding companies may engage in include:

 

•                        lending, exchanging, transferring or investing for others, orsafeguarding money or securities;

•                        insuring, guaranteeing or indemnifying others, issuing annuities, andacting as principal, agent or broker for purposes of the foregoing;

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

•                        issuingor selling interests in pooled assets that a bank could hold directly;

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

•                        merchant banking activities.

 

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

 

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** **

**Restrictions on Transactions with Affiliates**. Transactions between a savings institutionand its “affiliates” are subject to quantitative and qualitative restrictionsunder Sections 23A and 23B of the Federal Reserve Act and OTS regulations. Affiliatesof a savings institution generally include, among other entities, the savingsinstitution’s holding company and companies that are controlled by or undercommon control with the savings institution. Generally, Section 23A (i) limitsthe extent to which the savings association or its subsidiaries may engage in “coveredtransactions” with any one affiliate to an amount equal to 10% of suchassociation’s capital stock and surplus, and contain an aggregate limit on allsuch transactions with all affiliates to an amount equal to 20% of such capitalstock and surplus. Section 23B applies to “covered transactions” as well ascertain other transactions and requires that all transactions be on termssubstantially the same, or at least favorable, to the association or subsidiaryas those provided to a non-affiliate. The term “covered transaction” includesthe making of loans to, purchase of assets from, issuance of a guarantee to anaffiliate and similar transactions. Section 23B transactions also apply to theprovision of services and the sale of assets by a savings association to anaffiliate. In addition to the restrictions imposed by Sections 23A and 23B,Section 11 of the HOLA prohibits a savings association from (i) making a loanor other extension of credit to an affiliate, except for any affiliate whichengages only in certain activities which are permissible for bank holdingcompanies, or (ii) purchasing or investing in any stocks, bonds, debentures,notes or similar obligations of any affiliate, except for affiliates which aresubsidiaries of the savings association.

 

Inaddition, Sections 22(g) and (h) of the Federal Reserve Act place restrictionson loans to executive officers, directors and principal stockholders. UnderSection 22(h), loans to a director, an executive officer and to a greater than10% stockholder of a savings institution (“a principal stockholder”), andcertain affiliated interests of either, may not exceed, together with all otheroutstanding loans to such person and affiliated interests, the savingsinstitution’s loans to one borrower limit (generally equal to 15% of theinstitution’s unimpaired capital and surplus). Section 22(h) also requires thatloans to directors, executive officers and principal stockholders be made onterms substantially the same as offered in comparable transactions to otherpersons unless the loans are made pursuant to a benefit or compensation programthat (i) is widely available to employees of the institution and (ii) does notgive preference to any director, executive officer or principal stockholder, orcertain affiliated interests of either, over other employees of the savingsinstitution. Section 22(h) also requires prior board approval for certain loans.In addition, the aggregate amount of extensions of credit by a savingsinstitution to all insiders cannot exceed the institution’s unimpaired capitaland surplus. Furthermore, Section 22(g) places additional restrictions on loansto executive officers. At December 31, 2005, the Bank was in compliance withthe above restrictions.

 

**Sarbanes-Oxley Act of 2002*.***On July 30,2002, President George W. Bush signed into law the Sarbanes-Oxley Act of 2002,which generally establishes a comprehensive framework to modernize and reformthe oversight of public company auditing, improve the quality and transparencyof financial reporting by those companies and strengthen the independence ofauditors. Certain of the legislation’s more significant reforms are notedbelow.

 

The legislation creates a public company accounting oversight boardwhich is empowered to set auditing, quality control and ethics standards, toinspect registered public accounting firms, to conduct investigations and totake disciplinary actions, subject to SEC oversight and review. The board willbe funded by mandatory fees paid by all public companies. The legislation alsoimproves the Financial Accounting Standards Board, giving it full financialindependence from the accounting industry.

 

The legislation strengthens auditor independence from corporatemanagement by, among other things, limiting the scope of consulting servicesthat auditors can offer their public company audit clients.

 

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, the legislation provides for a strongpublic company audit committee that will be directly responsible for theappointment, compensation and oversight of the work of the public companyauditors.

 

The legislation contains a number of provisions to deter wrongdoing. CEOsand CFOs have to certify that company financial statements fairly present thecompany’s financial condition. If a misleading financial statement laterresulted in a restatement, the CEO and CFO must forfeit and return to thecompany any bonus, stock or stock option compensation received in the twelvemonths following the misleading financial report. The legislation alsoprohibits any company officer or director from attempting to mislead or coercean auditor. Among other reforms, the legislation empowers the SEC to barcertain persons from serving as officers or directors of a public company;prohibits insider trades during pension fund “blackout periods;” directs theSEC to adopt rules requiring attorneys to report securities law violations; andrequires that civil penalties imposed by the SEC go into a disgorgement fund tobenefit harmed investors.

 

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The legislation imposes a range of corporate disclosure requirements. Amongother things, the legislation requires public companies to report alloff-balance-sheet transactions and conflicts, as well as to present any proforma disclosures in a way that is not misleading and in accordance withrequirements to be established by the SEC. The legislation also accelerated therequired reporting of insider transactions, which now generally must bereported by the end of the second business day following a covered transaction;requires that annual reports filed with the SEC include a statement bymanagement asserting that it is responsible for creating and maintainingadequate internal controls and assessing the effectiveness of those controls;and requires companies to disclose whether or not they have adopted an ethicscode for senior financial officers, and, if not, why not, and whether the auditcommittee includes at least one “financial expert,” as defined by the SEC. Thelegislation also requires the SEC, based on certain enumerated factors, toregularly and systematically review corporate filings.

 

The legislation contains provisions which generally seek to limit andexpose to public view possible conflicts of interest affecting securitiesanalysts.

 

Finally, the legislation imposes a range of criminal penalties forfraud and other wrongful acts, as well as extends the period during whichcertain types of lawsuits can be brought against a company or its insiders.

 

**The Bank**

 

**General.**The OTS has extensive authority over the operations of federallychartered savings institutions. As part of this authority, savings institutionsare required to file periodic reports with the OTS and are subject to periodicexaminations by the OTS and the FDIC. The last regulatory examination of theBank by the OTS was completed in March 2005. The Bank was not required to makeany material changes to its operations as 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, these enforcement actions may be initiated forviolations of laws and regulations and unsafe 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 deposits of the Bank are insured to themaximum extent permitted by the SAIF, which is administered by the FDIC, andare backed by the full faith and credit of the U.S. Government. As insurer, theFDIC is authorized to conduct examinations of, and to require reporting by,FDIC-insured institutions. It also may prohibit any FDIC-insured institutionfrom engaging in any activity the FDIC determines by regulation or order topose 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 the depositoryinstitution. The FDIC also assesses depository institutions the FinancingCorporation (“FICO”) debt service assessment which became applicable to allinsured institutions as of January 1, 1997, in accordance with the DepositInsurance Funds Act of 1996. SAIF and Bank Insurance Fund (“BIF”) members bothpaid quarterly FICO debt service assessments ranging from 1.34 basis points to1.44 basis points in 2005. The current assessment rate is 1.34 basis points andis 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. Italso may suspend deposit insurance temporarily during the hearing process forthe permanent termination of insurance, if the institution has no tangiblecapital. If insurance of accounts is terminated, the accounts at theinstitution at the time of the termination, less subsequent withdrawals, shallcontinue to be insured for a period of six months to two years, as determinedby the FDIC. Management is aware of no existing circumstances which wouldresult in termination of the Bank’s deposit insurance.

 

**Deposit Insurance Reform*****.***On February 8, 2006, PresidentBush signed into law legislation that merges the BIF and the SAIF, eliminatesany disparities in bank and thrift risk-based premium assessments, reduces theadministrative burden of maintaining and operating two separate funds andestablishes certain new insurance coverage limits and a mechanism for possibleperiodic increases. The legislation also gives the FDIC greater discretion toidentify the relative risks all institutions present to the deposit insurancefund and set risk-based premiums.

 

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Major provisions in the legislation include:  maintaining basic deposit and municipalaccount insurance coverage at $100,000 but providing for a new basic insurancecoverage for retirement accounts of $250,000; allowing insurance coverage forbasic deposit and retirement accounts to be increased for inflation every fiveyears in $10,000 increments beginning in 2011; providing the FDIC with theability to set the designated reserve ratio within a range of between 1.15% and1.50%, rather than maintaining 1.25% at all times regardless of prevailingeconomic conditions; providing a one-time assessment credit of $4.7 billion tobanks and savings associations in existence on December 31, 1996, which may beused to offset future premiums with certain limitations; requiring the paymentof dividends of 100% of the amount that the insurance fund exceeds 1.5% of theestimated insured deposits; requiring the payment of dividends of 50% of theamount that the insurance fund exceeds****1.35% of theestimated insured deposits (when the reserve is greater than 1.35% but no morethan 1.5%); and requiring that the merger of the SAIF and BIF occur no laterthan July 1, 2006. Other provisions will become effective within 90 days of thepublication date of the final FDIC regulations implementing the legislation.

 

**Regulatory Capital Requirements.**Federally insured savings institutions arerequired to maintain minimum levels of regulatory capital. The OTS hasestablished capital standards applicable to all savings institutions. Thesestandards generally must be as stringent as the comparable capital requirementsimposed on national banks. The OTS also is authorized to impose capitalrequirements in excess of these standards on individual institutions on acase-by-case basis.

 

CurrentOTS capital standards require savings institutions to satisfy three differentcapital requirements. Under these standards, savings institutions must maintain“tangible” capital equal to at least 1.5% of adjusted total assets, “core”capital equal to at least 4.0% of adjusted total assets and “total” capital (acombination of core and “supplementary” capital) equal to at least 8.0% of “risk-weighted”assets. For purposes of the regulation, core capital generally consists ofcommon stockholders’ equity (including retained earnings), noncumulativeperpetual preferred stock and related surplus, minority interests in the equityaccounts of fully consolidated subsidiaries, certain nonwithdrawable accountsand pledged deposits and “qualifying supervisory goodwill.”  Tangible capital is given the same definitionas core capital but does not include qualifying supervisory goodwill and isreduced by the amount of all the savings institution’s intangible assets, withonly a limited exception for purchased mortgage servicing rights. Both core andtangible capital are further reduced by an amount equal to a savingsinstitution’s debt and equity investments in subsidiaries engaged in activitiesnot permissible to national banks (other than subsidiaries engaged inactivities undertaken as agent for customers or in mortgage banking activitiesand subsidiary depository institutions or their holding companies). Theseadjustments do not materially affect the Bank’s regulatory capital. At December31, 2005, the Bank exceeded its tangible, core and risk-based capitalrequirements.

 

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. Supplementarycapital generally consists of hybrid capital instruments; perpetual preferredstock which is not eligible to be included as core capital; subordinated debtand intermediate-term preferred stock; and general allowances for loan lossesup to a maximum of 1.25% of risk-weighted assets. In determining the requiredamount of risk-based capital, total assets, including certain off-balance sheetitems, are multiplied by a risk weight based on the risks inherent in the typeof assets. The risk weights assigned by the OTS for principal categories ofassets are (i) 0% for cash and securities issued by the U.S. Government orunconditionally backed by the full faith and credit of the U.S. Government;(ii) 20% for securities (other than equity securities) issued by U.S.Government-sponsored agencies and mortgage-backed securities issued by, orfully guaranteed as to principal and interest by, the FNMA or the FHLMC, exceptfor those classes with residual characteristics or stripped mortgage-relatedsecurities; (iii) 50% for prudently underwritten permanent one- to four-familyfirst lien mortgage loans not more than 90 days delinquent and having aloan-to-value ratio of not more than 90% at origination unless insured to suchratio by an insurer approved by the FNMA or the FHLMC, qualifying residentialbridge loans made directly for the construction of one- to four-familyresidences and qualifying multi-family residential loans; and (iv) 100% for allother loans and investments, including consumer loans, commercial loans, andone- to four-family residential real estate loans more than 90 days delinquent,and for repossessed assets.

 

**Qualified Thrift Lender Test.**All savingsinstitutions are required to meet a QTL test to avoid certain restrictions ontheir operations.  A savings institution that does not meet the QTL testmust either convert to a bank charter or comply with the following restrictionson its operations: (i) the institution may not engage in any new activity or makeany new investment, directly or indirectly, unless such activity or investmentis permissible for a national bank; (ii) the branching powers of theinstitution shall be restricted to those of a national bank; and (iii) paymentof dividends by the institution shall be subject to the rules regarding paymentof dividends by a national bank.  Upon the expiration of three years fromthe date the savings institution ceases to be a QTL, it must cease any activityand not retain any investment not permissible for a national bank.

 

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Currently,the QTL test requires either (i) that a savings association qualifies as adomestic building and loan association as defined in Section 7701 (a)(19) ofthe Internal Revenue Code of 1986, as amended, (“Code”) or (ii) that 65% of aninstitution’s “portfolio assets” (as defined) consist of certain housing andconsumer-related assets on a monthly average basis in nine out of every 12months. Assets that qualify without limit for inclusion as part of the 65%requirement are loans made to purchase, refinance, construct, improve or repairdomestic residential housing and manufactured housing; home equity loans;educational loans; small business loans; loans made through credit cards orcredit card accounts; mortgage-backed securities (where the mortgages aresecured by domestic residential housing or manufactured housing); stock issuedby the FHLB of Dallas; and direct or indirect obligations of the FDIC. Inaddition, the following assets, among others, may be included in meeting thetest subject to an overall limit of 20% of the savings institution’s portfolioassets: 50% of residential mortgage loans originated and sold within 90 days oforigination; investments in a service corporation that derives at least 80% ofits gross revenues from activities related to domestic or manufacturedresidential housing; 200% of the amount of loans and investments in “starterhomes”; 200% of the amount of certain loans in “credit-needy” areas; loans forthe purchase, construction, development, or improvements of “community 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 assetsminus the sum of (i) goodwill and other intangible assets, (ii) propertyused by the savings institution to conduct its business, and (iii) liquidassets up to 20% of the institution’s total assets. At December 31, 2005,the qualified thrift investments of the Bank were approximately 76.8% of itsportfolio assets.

 

**Federal Home Loan Bank System.**The Bank is a member of the FHLB of Dallas,which is one of 12 regional FHLBs that administers the home financing creditfunction of savings institutions. Each FHLB serves as a reserve or central bankfor its members within its assigned region. It is funded primarily fromproceeds derived from the sale of consolidated obligations of the FHLB System. Itmakes loans to members (i.e., advances) in accordance with policies andprocedures established by the board of directors of the FHLB. At December 31,2005, the Bank had $158.2 million of outstanding FHLB advances.

 

Asa member, the Bank is required to purchase and maintain stock in the FHLB ofDallas in an amount equal to the sum of 0.09% of total assets as of theprevious December 31 and 4.10% of outstanding advances. At December 31, 2005,the Bank had $8.4 million in FHLB stock, which was in compliance with thisrequirement. No ready market exists for such stock and it has no quoted marketvalue.

 

TheFHLBs are required to provide funds for the resolution of troubled savingsinstitutions and to contribute to affordable housing programs through directloans or interest subsidies on advances targeted for community investment andlow- and moderate-income housing projects. These contributions have adverselyaffected the level of FHLB dividends paid in the past and could continue to doso in the future. These contributions also could have an adverse effect on thevalue of FHLB stock in the future.

 

**Federal Reserve System.**The FRB requires all depository institutionsto maintain reserves against their transaction accounts and non-personal timedeposits. As of December 31, 2005, no reserves were required to be maintainedon the first $7.8 million of transaction accounts, reserves of 3% were requiredto be maintained against the next $40.5 million of net transaction accounts(with such dollar amounts subject to adjustment by the FRB), and a reserve of10% against all remaining net transaction accounts. Because required reservesmust be maintained in the form of vault cash or a noninterest bearing accountat a Federal Reserve Bank, the effect of this reserve requirement is to reducean institution’s earning assets.

 

## **TAXATION**

## ** **

**Federal Taxation**

 

**General.**The Company and Bank are subject to the generally applicable corporatetax provisions of the Code, and the Bank is subject to certain additionalprovisions of the Code which apply to thrift and other types of financialinstitutions. 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.**TheBank files a federal income tax return on the basis of a fiscal year ending onDecember 31. The Company filed a consolidated federal income tax return withboth the Bank and the Service Corporation.

 

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**Bad Debt Reserves. **Prior to theenactment of the Small Business Jobs Protection Act (the “Act”), which wassigned into law on August 21, 1996, certain thrift institutions, such asthe Bank, were allowed deductions for bad debts under methods more favorablethan those granted to other taxpayers. Qualified thrift institutions could compute deductions for bad debtsusing either the specific charge-off method of Section 166 of the Code orthe reserve method of Section 593 of the Code.

 

UnderSection 593, a thrift institution annually could elect to deduct bad debtsunder either (i) the “percentage of taxable income” method applicable onlyto thrift institutions, or (ii) the “experience” method that also wasavailable to small banks.  Under thepercentage of taxable income method, a thrift institution generally was alloweda deduction for an addition to its bad debt reserve equal to 8% of its taxableincome (determined without regard to this deduction and with additionaladjustments).  Under the experience method,a thrift institution was generally allowed a deduction for an addition to itsbad debt reserve equal to the greater of (i) an amount based on its actualaverage experience for losses in the current and five preceding taxable years,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) ofthe 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) ofthe Code 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 forlosses on qualifying real property loans (generally loans secured by improvedreal estate) and its reserve for losses on nonqualifying loans (all other typesof loans) 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 ofits reserve for losses on qualifying real property loans and its reserve forlosses on nonqualifying loans as of the close of its last taxable yearbeginning before January 1, 1996, over (ii) the greater of thebalance of (a) its pre-1988 reserves or, (b) what the thrift’sreserves would have been at the close of its last year beginning before January 1,1996, had the thrift always 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) (C) (v) (generally a loansecured by residential or church property and certain mobile homes), but onlyto the extent that the loan is made to the owner of the property.  The Bank’s applicable excess reserves werefully recaptured ratably over a period of six taxable years, beginning withtaxable year 1998 and concluding with taxable 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, the pre-1988reserves would be reduced and the Bank’s gross income for tax purposes would beincreased 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, 2005, the Bank’spre-1988 reserves for tax purposes totaled approximately $4.2 million.

 

24

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**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 orafter August 8, 1986) private activity bonds other than certainqualified bonds and (b) 75% of the excess (if any) of (i) adjustedcurrent earnings as defined in the Code, over (ii) AMTI (determinedwithout regard to this preference and prior to reduction by net operatinglosses).

 

**Net Operating Loss Carryovers. **A financial institution may, for federal income tax purposes, 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, 2005, 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 31,2002 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 6.5% 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.

 

25

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**Item 1A.  Risk Factors**

 

*In analyzing whether to make or to continuean investment in our securities, investors should consider, among otherfactors, the following risk factors.*

 

**Our results of operations are significantlydependent on economic conditions and related uncertainties.**

 

Commercial banking is affected, directly and indirectly, by domesticand international economic and political conditions and by governmental monetaryand fiscal policies.  Conditions such asinflation, recession, unemployment, volatile interest rates, real estatevalues, government monetary policy, international conflicts, the actions ofterrorists and other factors beyond our control may adversely affect ourresults of operations.  Changes ininterest rates, in particular, could adversely affect our net interest incomeand have a number of other adverse effects on our operations, as discussed inthe immediately succeeding risk factor. Adverse economic conditions also could result in an increase in loandelinquencies, foreclosures and nonperforming assets and a decrease in thevalue of the property or other collateral which secures our loans, all of whichcould adversely affect our results of operations.  We are particularly sensitive to changes ineconomic conditions and related uncertainties in Northcentral and NorthwestArkansas because we derive substantially all of our loans, deposits and otherbusiness from this area.  Accordingly, weremain subject to the risks associated with prolonged declines in national orlocal economies.

 

**Changes in interest rates could have amaterial adverse effect on our operations.**

 

The operations of financial institutions such as the Bank are dependentto a large extent on net interest income, which is the difference between theinterest income earned on interest earning assets such as loans and investmentsecurities and the interest expense paid on interest bearing liabilities suchas deposits and borrowings.  Changes inthe general level of interest rates can affect our net interest income byaffecting the difference between the weighted average yield earned on ourinterest earning assets and the weighted average rate paid on our interestbearing liabilities, or interest rate spread, and the average life of ourinterest earning assets and interest bearing liabilities.  Changes in interest rates also can affect ourability to originate loans; the value of our interest earning assets; ourability to obtain and retain deposits in competition with other availableinvestment alternatives; and the ability of our borrowers to repay adjustableor variable rate loans.  Interest ratesare highly sensitive to many factors, including governmental monetary policies,domestic and international economic and political conditions and other factorsbeyond our control.  Although we believethat the estimated maturities of our interest earning assets currently are wellbalanced in relation to the estimated maturities of our interest bearing liabilities(which involves various estimates as to how changes in the general level ofinterest rates will impact these assets and liabilities), there can be noassurance that our profitability would not be adversely affected during anyperiod of changes in interest rates.

 

**There are increased risks involved withcommercial real estate, construction, commercial business and consumer lendingactivities.**

 

Our lending activities include loans secured by existing commercialreal estate.  In addition, we originateloans for the construction of single-family residential real estate and landacquisition and development loans. Commercial real estate and construction lending generally is consideredto involve a higher degree of risk than single-family residential lending dueto a variety of factors, including generally larger loan balances, thedependency on successful completion or operation of the project for repayment,the difficulties in estimating construction costs and loan terms which often donot require full amortization of the loan over its term and, instead, providefor a balloon payment at stated maturity. Our lending activities also include commercial business loans to small-to medium-sized businesses, which generally are secured by various equipment, machineryand other corporate assets, and a wide variety of consumer loans, includinghome equity and second mortgage loans, automobile loans, deposit accountsecured loans and unsecured loans. Although commercial business loans and consumer loans generally haveshorter terms and higher interest rates than mortgage loans, they generallyinvolve more risk than mortgage loans because of the nature of, or in certaincases the absence of, the collateral which secures such loans.

 

**Our allowance for losses on loans may not beadequate to cover probable losses.**

 

We have established an allowance for loan losses which we believe isadequate to offset probable losses on our existing loans.  There can be no assurance that any futuredeclines in real estate market conditions, general economic conditions orchanges in regulatory policies will not require us to increase our allowancefor loan losses, which would adversely affect our results of operations.

 

26

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**We are subject to extensive regulation whichcould adversely affect our business and operations.**

 

We are subject to extensive federal and state governmental supervisionand regulation, which are intended primarily for the protection ofdepositors.  In addition, we are subjectto changes in federal and state laws, as well as changes in regulations,governmental policies and accounting principles.  The effects of any such potential changescannot be predicted but could adversely affect our business and operations andthat of our subsidiaries in the future.

 

**We face strong competition which mayadversely affect our profitability.**

 

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

 

**Our ability to successfully compete may bereduced if we are unable to make technological advances.**

 

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

 

**We and our banking subsidiary are subject tocapital and other requirements which restrict our ability to pay dividends.**

 

Our ability to pay dividends to our shareholders depends to a largeextent upon the dividends we receive from the Bank.  Dividends paid by the Bank are subject torestrictions under the federal laws and regulations.  In addition, the Bank must maintain certaincapital levels, which may restrict the ability of the Bank to pay dividends tous and our ability to pay dividends to our shareholders.

 

**Holders of our common stock have nopreemptive rights and are subject to potential dilution.**

 

Our certificate of incorporation does not provide any shareholder witha preemptive right to subscribe for additional shares of common stock upon anyincrease thereof.  Thus, upon theissuance of any additional shares of common stock or other voting securities ofthe Company or securities convertible into common stock or other votingsecurities, shareholders may be unable to maintain their pro rata voting orownership interest in us.

 

**Item 1B.  UnresolvedStaff Comments**

 

None

 

27

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

 

At December 31, 2005, the Bank conducted itsbusiness from its executive office in Harrison, Arkansas, and fifteen fullservice offices, all of which are located in Northcentral and NorthwestArkansas.

 

The following table sets forth information withrespect to the offices and other properties of the Bank at December 31,2005.

 
| **Description/Address**                                       | ** ** | **Leased/  Owned** | ** ** |
|---------------------------------------------------------------|------------|--------------------|------------|
|                                                          |       |               |       |
| 1401 Highway 62-65 NorthHarrison, AR  72601              |       | Owned              |       |
|                                                          |       |               |       |
| 200 West StephensonHarrison, AR 72601                         |       | Owned              |       |
|                                                          |       |               |       |
| Corner Central & WillowHarrison, AR  72601      |       | Owned              |       |
|                                                          |       |               |       |
| 324 Hwy. 62-65 BypassHarrison, AR  72601                 |       | Owned              |       |
|                                                          |       |               |       |
| 210 South MainBerryville, AR  72616                      |       | Owned              |       |
|                                                          |       |               |       |
| 668 Highway 62 EastMountain Home, AR  72653              |       | Owned              |       |
|                                                          |       |               |       |
| 1337 Highway 62 SWMountain Home, AR 72653                     |       | Owned              |       |
|                                                          |       |               |       |
| 301 Highway 62 WestYellville, AR  72687                  |       | Owned              |       |
|                                                          |       |               |       |
| 307 North Walton Blvd.Bentonville, AR  72712             |       | Owned              |       |
|                                                          |       |               |       |
| 2501 E. Central Ave., Suite 2Bentonville, AR  72712 |       | Leased(1)          |       |
|                                                          |       |               |       |
| 3460 North CollegeFayetteville, AR  72703                |       | Owned              |       |
|                                                          |       |               |       |
| 1303 West HudsonRogers, AR  72756                        |       | Owned              |       |
|                                                          |       |               |       |
| 201 East Henri De Tonti Blvd.Tontitown, AR  72764        |       | Owned              |       |
|                                                          |       |               |       |
| 2025 North Crossover RoadFayetteville, AR 72703               |       | Owned              |       |
|                                                          |       |               |       |
| 249 West Main StreetFarmington, AR 72730                      |       | Leased(2)          |       |
|                                                          |       |               |       |
| 2030 West ElmRogers, AR 72756                                 |       | Owned              |       |
|                                                          |       |               |       |
| 1023 East Millsap RoadFayetteville, AR  72703            |       | Owned              |       |
|                                                          |       |               |       |
| 3027 Highway 62 EastMountain Home, AR 72653                   |       | Owned              |       |

 

----

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

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

 

**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 of Matters to Vote of Security Holders.**

 

Nomatters were submitted to a vote of security holders during the fourth quarterof 2005.

 

**PART II.**

 

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

 

Shares of the Company’s common stock aretraded under the symbol “FFBH” on the Nasdaq National Market System.  At February 27, 2006, the Company had5,072,610 shares of common stock outstanding and had approximately 1,169 beneficialholders of common stock.

 

28

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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.

** **
| **Quarter    Ended**  | ** ** | **Year Ended  December 31, 2005** | ** ** | **Year Ended  December 31, 2004** | ** ** |
|-----------------------|------------|----------------------------------------|------------|----------------------------------------|------------|
| ** **            | ** ** | **High**                               | ** ** | **Low**                                | ** ** | **Dividend** | ** ** | **High** | ** ** | **Low** | ** ** | **Dividend** | ** ** |
| **March 31**     |       | $                                      | 25.55      |                                   | $          | 22.00 |   | $ | 0.12 |   | $ | 21.03 |   | $ | 19.89 |   | $ | 0.10 |   |
|                  |       |                                   |       |                                   |       |   |   |   |   |   |   |   |   |
| **June 30**      |       | $                                      | 25.95      |                                   | $          | 22.45 |   | $ | 0.12 |   | $ | 20.85 |   | $ | 18.34 |   | $ | 0.10 |   |
|                  |       |                                   |       |                                   |       |   |   |   |   |   |   |   |   |
| **September 30** |       | $                                      | 25.59      |                                   | $          | 22.00 |   | $ | 0.13 |   | $ | 21.28 |   | $ | 18.89 |   | $ | 0.11 |   |
|                  |       |                                   |       |                                   |       |   |   |   |   |   |   |   |   |
| **December 31**  |       | $                                      | 25.50      |                                   | $          | 22.50 |   | $ | 0.13 |   | $ | 23.50 |   | $ | 20.21 |   | $ | 0.11 |   |

 

**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, 2005   |       | —                                              |       | —                                    |       | —                                                                                            |       | —                                                                                          |       |
| November 1 to November 30, 2005 |       | 62,322                                              |       | $                                         | 25.55      |                                                                                              | 62,322     |                                                                                            | 5,470      |   |
| December 1 to December 31, 2005 |       | 12,565                                              |       | $                                         | 25.15      |                                                                                              | 12,565     |                                                                                            | 241,221    |   |

 

During the quarter ended December 31, 2005, the Company completedits 17th announced repurchase program and began its 18thprogram.  The 18th announced repurchaseprogram was approved by the board of directors on July 28, 2005, andpublicly announced on December 2, 2005. Total shares approved to bepurchased in this program are 248,316, of which 7,095 had been purchased as of December 31,2005.  All treasury stock purchases aremade under publicly announced repurchase programs.

 

29

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

 

The selected consolidated financial and otherdata of the Company set forth below and on the following page is notcomplete and should be read in conjunction with, and is qualified in itsentirety by, the more detailed information, including the ConsolidatedFinancial Statements and related Notes, appearing elsewhere herein.

 
| ** **                                           | ** ** | **At or For the  Year Ended December 31,** | ** ** |
|------------------------------------------------------|------------|-------------------------------------------------|------------|
| ** **                                           | ** ** | **2005**                                        | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** |
| ** **                                           | ** ** | **(In Thousands, Except  Per Share Data)**      | ** ** |
|                                                 |       |                                            |       |   |   |   |   |   |   |   |   |
| **Selected Financial Condition Data:**               |       |                                            |       |   |   |   |   |   |   |   |   |
| Total assets                                         |       | $                                               | 852,411    |   | $ | 751,665 |   | $ | 690,653 |   | $ | 679,896 |   | $ | 680,255 |   |
| Cash and cash equivalents                            |       | 21,109                                          |       | 16,003 |   | 56,201 |   | 44,493 |   | 72,326 |   |
| Investment securities                                |       | 56,695                                          |       | 56,660 |   | 80,379 |   | 114,471 |   | 100,878 |   |
| Loans receivable, net                                |       | 719,214                                         |       | 634,217 |   | 512,756 |   | 483,468 |   | 474,494 |   |
| Allowance for loan losses                            |       | 2,114                                           |       | 1,846 |   | 1,621 |   | 1,529 |   | 923 |   |
| Deposits                                             |       | 611,667                                         |       | 582,424 |   | 573,580 |   | 568,762 |   | 555,933 |   |
| Federal Home Loan Bank  advances                     |       | 158,240                                         |       | 89,756 |   | 39,562 |   | 38,610 |   | 47,844 |   |
| Stockholders’ equity                            |       | 77,842                                          |       | 75,301 |   | 75,078 |   | 69,266 |   | 71,065 |   |
|                                                 |       |                                            |       |   |   |   |   |   |   |   |   |
| **Selected Operating Data:**                         |       |                                            |       |   |   |   |   |   |   |   |   |
| Interest income                                      |       | $                                               | 46,085     |   | $ | 39,370 |   | $ | 38,745 |   | $ | 44,094 |   | $ | 50,152 |   |
| Interest expense                                     |       | 19,604                                          |       | 14,338 |   | 15,986 |   | 21,633 |   | 31,862 |   |
| Net interest income                                  |       | 26,481                                          |       | 25,032 |   | 22,759 |   | 22,461 |   | 18,290 |   |
| Provision for loan losses                            |       | 1,101                                           |       | 1,020 |   | 690 |   | 1,500 |   | 452 |   |
| Net interest income after  provision for loan losses |       | 25,380                                          |       | 24,012 |   | 22,069 |   | 20,961 |   | 17,838 |   |
| Noninterest income                                   |       | 6,961                                           |       | 6,274 |   | 6,989 |   | 5,346 |   | 3,745 |   |
| Noninterest expense                                  |       | 20,768                                          |       | 18,783 |   | 18,263 |   | 14,524 |   | 13,596 |   |
| Income before income taxes                           |       | 11,573                                          |       | 11,503 |   | 10,795 |   | 11,783 |   | 7,987 |   |
| Provision for income taxes                           |       | 3,723                                           |       | 3,698 |   | 3,339 |   | 4,005 |   | 2,527 |   |
| Net income                                           |       | $                                               | 7,850      |   | $ | 7,805 |   | $ | 7,456 |   | $ | 7,778 |   | $ | 5,460 |   |
|                                                 |       |                                            |       |   |   |   |   |   |   |   |   |
| **Earnings per Share (1):**                          |       |                                            |       |   |   |   |   |   |   |   |   |
| Basic                                                |       | $                                               | 1.57       |   | $ | 1.54 |   | $ | 1.46 |   | $ | 1.44 |   | $ | 0.88 |   |
| Diluted                                              |       | $                                               | 1.50       |   | $ | 1.45 |   | $ | 1.38 |   | $ | 1.38 |   | $ | 0.87 |   |
|                                                 |       |                                            |       |   |   |   |   |   |   |   |   |
| **Cash  Dividends Declared per Share (1)**           |       | $                                               | 0.50       |   | $ | 0.42 |   | $ | 0.34 |   | $ | 0.26 |   | $ | 0.22 |   |

 

----

(1)  Per share amounts have beenrestated for the two-for-one stock split that was paid on December 31,2003.

 

30

----

 
| ** **                                                                  | ** ** | **At or For the Year  Ended December 31,** | ** ** |
|-----------------------------------------------------------------------------|------------|-------------------------------------------------|------------|
| ** **                                                                  | ** ** | **2005**                                        | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** |
| **Selected Operating Ratios(1):**                                           |       |                                            |       |   |   |   |   |   |   |   |   |
| Return on average assets                                                    |       | .97                                             | %          | 1.09 | % | 1.08 | % | 1.14 | % | 0.79 | % |
| Return on average equity                                                    |       | 10.27                                           |       | 10.37 |   | 10.25 |   | 11.01 |   | 7.36 |   |
| Average equity to average assets                                            |       | 9.46                                            |       | 10.53 |   | 10.52 |   | 10.39 |   | 10.74 |   |
| Interest rate spread(2)                                                     |       | 3.41                                            |       | 3.64 |   | 3.40 |   | 3.30 |   | 2.35 |   |
| Net interest margin(2)                                                      |       | 3.51                                            |       | 3.75 |   | 3.52 |   | 3.50 |   | 2.76 |   |
| Net interest income after  provision for loan losses to noninterest expense |       | 122.21                                          |       | 127.84 |   | 120.84 |   | 144.32 |   | 131.20 |   |
| Noninterest expense to average assets                                       |       | 2.57                                            |       | 2.63 |   | 2.64 |   | 2.14 |   | 1.97 |   |
| Average interest earning  assets to average interest bearing liabilities    |       | 103.80                                          |       | 105.12 |   | 105.08 |   | 106.10 |   | 108.61 |   |
| Operating efficiency(3)                                                     |       | 62.10                                           |       | 60.00 |   | 61.39 |   | 52.23 |   | 61.70 |   |
|                                                                        |       |                                            |       |   |   |   |   |   |   |   |   |
| **Asset Quality Ratios(4):**                                                |       |                                            |       |   |   |   |   |   |   |   |   |
| Nonaccrual and restructured loans to total  loans(5)                        |       | 1.67                                            |       | 1.14 |   | 0.67 |   | 1.37 |   | 0.64 |   |
| Nonperforming assets to total assets(5)                                     |       | 1.65                                            |       | 1.13 |   | 0.66 |   | 1.07 |   | 0.53 |   |
| Allowance for loan losses to non -  performing loans(5)                     |       | 16.06                                           |       | 23.21 |   | 44.01 |   | 22.01 |   | 29.71 |   |
| Allowance for loan losses to total loans                                    |       | 0.27                                            |       | 0.26 |   | 0.29 |   | 0.30 |   | 0.19 |   |
|                                                                        |       |                                            |       |   |   |   |   |   |   |   |   |
| **Capital Ratios(6):**                                                      |       |                                            |       |   |   |   |   |   |   |   |   |
| Tangible capital to adjusted total assets                                   |       | 8.78                                            |       | 9.74 |   | 10.27 |   | 9.78 |   | 9.79 |   |
| Core capital to adjusted total assets                                       |       | 8.78                                            |       | 9.74 |   | 10.27 |   | 9.78 |   | 9.79 |   |
| Risk-based capital to risk-weighted assets                                  |       | 12.06                                           |       | 13.75 |   | 16.25 |   | 17.03 |   | 17.29 |   |
|                                                                        |       |                                            |       |   |   |   |   |   |   |   |   |
| **Other Data:**                                                             |       |                                            |       |   |   |   |   |   |   |   |   |
| Dividend payout ratio(7)                                                    |       | 32.19                                           | %          | 27.91 | % | 24.32 | % | 18.91 | % | 26.33 | % |
| Full service offices at end of period                                       |       | 16                                              |       | 15 |   | 15 |   | 14 |   | 14 |   |

 

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(1)          Ratios are based on average daily balances.

 

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

 

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

 

(4)          Asset quality ratios are end of periodratios.

 

(5)          Nonperformingassets consist of nonperforming loans and real estate owned (“REO”).  Nonperforming loans consist of nonaccrualloans, accruing loans 90 days or more, past due and restructured loans, whileREO consists of real estate acquired in settlement of loans.

 

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

 

(7)          Dividend payout ratio is the total dividendsdeclared divided by net income.

 

31

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

 

**GENERAL**

 

Management’s discussion and analysisof financial condition and results of operations is intended to assist a readerinunderstandingthe 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 which was formed in 1934.  First Federal conducts business from its mainoffice and fifteen 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-orientedfinancial institution offering a wide range of retail and commercial depositaccounts, including noninterest bearing and interest bearing checking, savingsand money market accounts, certificates of deposit, and individual retirementaccounts.  Loan products offered by theBank include residential real estate, consumer, construction, lines of credit,commercial real estate and commercial business loans. Other financial servicesinclude investment products offered through First Federal Investment Services, Inc.;automated teller machines; 24-hour telephone banking; internet banking,including account access, e-statements, bill payment and online loanapplications; Bounce ProtectionTM overdraft service; debit cards; andsafe deposit boxes.

 

First Federal’s lending focushas traditionally been on permanent residential real estate.  However, in recent years, an increasedemphasis has been placed on commercial real estate lending and constructionlending. While our first mortgage real estate portfolio comprises a relativelysteady 86% of our gross loan portfolio, commercial real estate loans andconstruction loans now comprise more than half of first mortgage loans.  Most of our lending growth has occurred inthe Washington and Benton county areas, which are the headquarters of the state’stwo 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 September 2005,unemployment in the Fayetteville/Springdale/Rogers metro area was 3.6%,compared to the Arkansas rate of 5.8% and the U.S. rate of 5.1%.  We expect loan growth to continue inNorthwest Arkansas, although not necessarily at the level experienced in thepast.

 

Certificates of deposit andsavings accounts continue to comprise the majority of our depositaccounts.  However, in recent years,increased emphasis has been placed on growth in checking accounts   This emphasis will continue with plans toattract checking accounts through the utilization of targeted direct mailthroughout our market area and “thank you” gifts.   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, FirstFederal Bank’s two greatest challenges are managing interest rate risk andasset quality.  The Bank’s currentinterest rate risk position as measured by our regulator, the OTS, is at aminimal 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 efficientliquidation of 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.

 

32

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### **CRITICALACCOUNTING POLICIES**

### ** **

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 describedin greater detail in subsequent sections of Management’s Discussion andAnalysis and in the Notes to the Consolidated Financial Statements includedherein.  In particular, Note 1 to theConsolidated Financial Statements – “Summary of Significant Accounting Policies”describes generally our accounting policies. We believe that the judgments, estimates and assumptions used in thepreparation of our Consolidated Financial Statements are appropriate given thefactual circumstances at the time. However, given the sensitivity of our Consolidated Financial Statementsto this critical accounting policy, the use of other judgments, estimates andassumptions could result in material differences in our results of operationsor financial condition.

 

Inestimating the amount of credit losses inherent in our loan portfolio, variousjudgments and assumptions are made.  Forexample, when assessing the condition of the overall economic environment,assumptions are made regarding future market conditions and their impact on theloan portfolio.  In the event thenational economy were to sustain a prolonged downturn, the loss factors appliedto our portfolios 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 betweenDecember 31, 2005 and 2004 are presented in the following table (dollarsin thousands).  Material changes betweenperiods are discussed in the sections which follow the table.

 
| ** **                                     | ** ** | **December 31,** | ** ** | **Increase** | ** ** | ** **     | ** ** |
|------------------------------------------------|------------|-----------------------|------------|--------------|------------|----------------|------------|
| ** **                                     | ** ** | **2005**              | ** ** | **2004**     | ** ** | **(Decrease)** | ** ** | **%****Change** | ** ** |
|                                           |       |                  |       |         |       |           |       |   |   |
| **ASSETS**                                     |       |                  |       |         |       |           |       |   |   |
| Cash and cash equivalents                      |       | $                     | 21,109     |         | $          | 16,003         |       | $ | 5,106 |   | 31.9 | % |
| Investment securities held to maturity         |       | 56,695                |       | 56,660       |       | 35             |       | 0.1 |   |
| FHLB Stock                                     |       | 8,412                 |       | 4,876        |       | 3,536          |       | 72.5 |   |
| Loans receivable, net                          |       | 719,214               |       | 634,217      |       | 84,997         |       | 13.4 |   |
| Accrued interest receivable                    |       | 7,490                 |       | 4,427        |       | 3,063          |       | 69.2 |   |
| Office properties and equipment, net           |       | 18,522                |       | 15,295       |       | 3,227          |       | 21.1 |   |
| Prepaid expenses and other assets              |       | 20,969                |       | 20,187       |       | 782            |       | 3.9 |   |
|                                           |       |                  |       |         |       |           |       |   |   |
| TOTAL                                          |       | $                     | 852,411    |         | $          | 751,665        |       | $ | 100,746 |   | 13.4 | % |
|                                           |       |                  |       |         |       |           |       |   |   |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY** | ** ** | ** **            | ** ** | ** **   | ** ** | ** **     | ** ** | ** ** | ** ** |
| LIABILITIES:                                   |       |                  |       |         |       |           |       |   |   |
| Deposits                                       |       | $                     | 611,667    |         | $          | 582,424        |       | $ | 29,243 |   | 5.0 | % |
| FHLB advances                                  |       | 158,240               |       | 89,756       |       | 68,484         |       | 76.3 |   |
| Other liabilities                              |       | 4,662                 |       | 4,184        |       | 478            |       | 11.4 |   |
| Total liabilities                              |       | 774,569               |       | 676,364      |       | 98,205         |       | 14.5 |   |
|                                           |       |                  |       |         |       |           |       |   |   |
| STOCKHOLDERS’  EQUITY                     |       | 77,842                |       | 75,301       |       | 2,541          |       | 3.4 |   |
| TOTAL                                          |       | $                     | 852,411    |         | $          | 751,665        |       | $ | 100,746 |   | 13.4 | % |
|                                           |       |                  |       |         |       |           |       |   |   |
| BOOK VALUE  PER SHARE                          |       | $                     | 15.42      |         | $          | 14.78          |       |   |   |   |   |
|                                           |       |                  |       |         |       |           |       |   |   |
| EQUITY TO  ASSETS                              |       | 9.1                   | %          | 10.0         | %          |           |       |   |   |
|                                                |            |                       |            |              |            |                |            |  |  |  |  |  |  |  |

 

33

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**Loans Receivable. **Changes in loan composition between December 31,2005 and 2004 are presented in the following table (dollars in thousands).

 
| ** **                                     | ** ** | **December 31,** | ** ** | **Increase** | ** ** | ** **     | ** ** |
|------------------------------------------------|------------|-----------------------|------------|--------------|------------|----------------|------------|
| ** **                                     | ** ** | **2005**              | ** ** | **2004**     | ** ** | **(Decrease)** | ** ** | **%****Change** | ** ** |
|                                           |       |                  |       |         |       |           |       |   |   |
| One- to  four-family residences                |       | $                     | 269,660    |         | $          | 282,144        |       | $ | (12,484 | ) |   |   |
| Multi-family                                   |       | 12,900                |       | 9,454        |       | 3,446          |       |   |   |
| Commercial  real estate                        |       | 119,323               |       | 114,986      |       | 4,337          |       |   |   |
| Land                                           |       | 38,355                |       | 30,923       |       | 7,432          |       |   |   |
| Construction:                                  |       |                  |       |         |       |           |       |   |   |
| One-to four-family residences                  |       | 51,579                |       | 29,006       |       | 22,573         |       |   |   |
| Speculative one-to four-family residences      |       | 104,001               |       | 82,709       |       | 21,292         |       |   |   |
| Multi-family                                   |       | 20,919                |       | 21,938       |       | (1,019         | )          |   |   |
| Commercial real estate                         |       | 22,331                |       | 11,436       |       | 10,895         |       |   |   |
| Land development                               |       | 40,232                |       | 14,022       |       | 26,210         |       |   |   |
| Total first mortgage loans                     |       | 679,300               |       | 596,618      |       | 82,682         |       | 13.9 | % |
|                                           |       |                  |       |         |       |           |       |   |   |
| Commercial                                     |       | 32,693                |       | 27,545       |       | 5,148          |       | 18.7 | % |
|                                           |       |                  |       |         |       |           |       |   |   |
| Home equity  and second mortgage               |       | 49,680                |       | 45,256       |       | 4,424          |       |   |   |
| Automobile                                     |       | 15,748                |       | 19,101       |       | (3,353         | )          |   |   |
| Other                                          |       | 13,149                |       | 10,685       |       | 2,464          |       |   |   |
| Total consumer                                 |       | 78,577                |       | 75,042       |       | 3,535          |       | 4.7 | % |
|                                           |       |                  |       |         |       |           |       |   |   |
| Total loans  receivable                        |       | 790,570               |       | 699,205      |       | 91,365         |       | 13.1 | % |
| Less:                                          |       |                  |       |         |       |           |       |   |   |
| Undisbursed  loan funds                        |       | (69,086               | )          | (62,661      | )          | 6,425          |       |   |   |
| Unearned  discounts and net deferred loan fees |       | (156                  | )          | (481         | )          | (325           | )          |   |   |
| Allowance  for loan losses                     |       | (2,114                | )          | (1,846       | )          | 268            |       |   |   |
| Loans  receivable, net                         |       | $                     | 719,214    |         | $          | 634,217        |       | $ | 84,997 |   | 13.4 | % |
|                                                |            |                       |            |              |            |                |            |  |  |  |  |  |  |  |

 

The growth in the Bank’s loan portfolio was primarily due to anincrease in construction loans, which increased approximately $80 million dueto opportunities afforded by the economic growth in the Northwest Arkansasarea. The robust economy of our entire market area provided increased demandand opportunity for our other loan products as well. Several years ago, theBank began to emphasize commercial real estate lending, construction lending,and commercial lending to diversify its loan portfolio, take advantage ofmarket opportunities in these types of loans, and help the Bank transition to amore full-service community bank, as well as to provide opportunities tocross-sell its other banking products.  The Bank plans to continue this emphasis as long as prudent lendingopportunities are available.

 

**Allowance for LoanLosses**.  Changes in the compositionof the allowance for loan losses between December 31, 2005 and 2004 arepresented in the following table (in thousands).

 
| ** **  | ** ** | **December 31,** | ** ** | **Increase** | ** ** |
|-------------|------------|-----------------------|------------|--------------|------------|
| ** **  | ** ** | **2005**              | ** ** | **2004**     | ** ** | **(Decrease)** | ** ** |
| General     |       | $                     | 1,831      |         | $          | 1,476 |   | $ | 355 |   |
| Specific    |       | 183                   |       | 318          |       | (135 | ) |
| Unallocated |       | 100                   |       | 52           |       | 48 |   |
|        |       | $                     | 2,114      |         | $          | 1,846 |   | $ | 268 |   |

 

34

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The general component of the allowance for loan losses increased bothdue to loan growth and an increase in the estimated loss rate applied tospeculative one- to four- family residential construction loans.  The loss rate was increased due to theincrease in these loan balances and the inherently riskier nature of thiscategory of loans.    The decrease 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, 2005.

 

**Investment Securities. **Changes in the composition ofinvestment securities held to maturity between December 31, 2005 and 2004are presented in the following table (in thousands).

 
| ** **                              | ** ** | **December 31,** | ** ** | **Increase** | ** ** |
|-----------------------------------------|------------|-----------------------|------------|--------------|------------|
| ** **                              | ** ** | **2005**              | ** ** | **2004**     | ** ** | **(Decrease)** | ** ** |
| Certificates  of deposit                |       | $                     | —     |         | $          | 3,000 |   | $ | (3,000 | ) |
| U.S.  Government and agency obligations |       | 40,034                |       | 37,821       |       | 2,213 |   |
| Municipal  securities                   |       | 16,661                |       | 15,839       |       | 822 |   |
| Total                                   |       | $                     | 56,695     |         | $          | 56,660 |   | $ | 35 |   |

 

During 2005, investment securities totaling approximately$4.7 million were purchased and $4.6 million matured or were called.   The majority of these purchases andmaturities were U.S. Government and agency obligations.  The decrease in certificates of deposit wasdue to maturities.

 

**Federal Home LoanBank Stock. **FHLB stockincreased by approximately $3.5 million due to required purchases related tothe increase in FHLB advances.

 

**Accrued InterestReceivable. **The increasein accrued interest receivable was due to an increase in the number of daysaccrued, primarily related to the increase in construction loans, as well as anincrease in the loan yield at December 31, 2005 compared to December 31,2004.

 

**Office Properties and Equipment.  **The increasein office properties and equipment of $3.2 million was due primarily to thepurchase of land for future branch expansion, construction costs for the newbranch in Mountain Home and future branches in Centerton and Springdale, aswell as renovation of certain existing branch locations.

 

**Deposits. **Changes in the composition of depositsbetween December 31, 2005 and 2004 are presented in the following table(dollars in thousands).

 
| ** **               | ** ** | **December 31,** | ** ** | **Increase** | ** ** | ** **     | ** ** |
|--------------------------|------------|-----------------------|------------|--------------|------------|----------------|------------|
| ** **               | ** ** | **2005**              | ** ** | **2004**     | ** ** | **(Decrease)** | ** ** | **%****Change** | ** ** |
|                     |       |                  |       |         |       |           |       |   |   |
| DDA and NOW  accounts    |       | $                     | 125,397    |         | $          | 109,772        |       | $ | 15,625 |   | 14.2 | % |
| Money market  accounts   |       | 64,021                |       | 106,063      |       | (42,042        | )          | (39.6 | )% |
| Savings  accounts        |       | 30,521                |       | 31,611       |       | (1,090         | )          | (3.5 | )% |
| Certificates  of deposit |       | 391,728               |       | 334,978      |       | 56,750         |       | 16.9 | % |
|                     |       |                  |       |         |       |           |       |   |   |
| Total  deposits          |       | $                     | 611,667    |         | $          | 582,424        |       | $ | 29,243 |   | 5.0 | % |

 

Deposits increased during the year primarilydue to focused marketing efforts to increase checking accounts.  During the year ended December 31, 2005,DDA and NOW account balances increased by $15.6 million, or 14.2%, and thenumber of such accounts increased by 5.9%. The Bank expanded its checking account marketing efforts in the secondquarter of 2005 by targeting small- and medium-sized business accounts.  The Bank will continue to aggressivelypromote checking accounts with its direct mail campaign and “thank you”gifts.  Checking accounts are anattractive source of funds for the Bank as they offer low interest deposits,fee income potential, and the opportunity to cross-sell other financialservices.

 

35

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The Bank also experienced a shift inthe mix of deposits from money market and savings accounts to certificates ofdeposit during the year.  Certificates ofdeposit increased as interest rates began to rise.  Further, the Bank has advertised several CDproducts with special rates and terms ranging from 7 to 40 months.  The cost of deposit funds increased from2.18% at December 31, 2004 to 2.47% at December 31, 2005.

 

**FHLB Advances.**  The Bank experienced $68.5 million or 76.3%growth in FHLB of Dallas advances during the year.  The advances were used to fund loan growth in2005.  The balance of advances at December 31,2005 of $158.2 million consisted of $100.9 million of fixed rate advances withan average cost of 3.9% and $57.3 million of floating rate advances with anaverage cost of 4.4%.

 

**Stockholders’ Equity. **Stockholders’ equity increasedapproximately $2.5 million from December 31, 2004 to December 31,2005.  The increase in stockholders’equity was primarily due to net income of $7.9 million, the reissuance of262,529 shares of treasury stock totaling $2.2 million resulting from theexercise of stock options, and the release of ESOP shares totaling $2.0million, offset by the purchase of treasury stock totaling $7.6 million andpayment of dividends totaling $2.5 million during 2005.  See the Consolidated Statements ofStockholders’ Equity for the years ended December 31, 2005, 2004 and 2003for more detail.

 

36

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**Average Balance Sheets**

 

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, 2005.  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 31,2005.  Average balances are based ondaily balances during the periods.

 
| ** **                                                       | ** ** | **December 31,**      | ** ** | **Year Ended December 31,** | ** ** |
|------------------------------------------------------------------|------------|----------------------------|------------|----------------------------------|------------|
| ** **                                                       | ** ** | **2005**                   | ** ** | **2005**                         | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                                       | ** ** | **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)                                              |       | 6.63                       | %          | $                                | 687,373    |   | $ | 43,057 |   | 6.26 | % | $ | 573,520 |   | $ | 35,685 |   | 6.22 | % | $ | 492,492 |   | $ | 34,188 |   | 6.94 | % |
| Investment securities(2)                                         |       | 4.66                       |       | 62,761                           |       | 2,902 |   | 4.62 |   | 78,468 |   | 3,533 |   | 4.50 |   | 92,564 |   | 3,938 |   | 4.25 |   |
| Other interest earning assets                                    |       | 3.91                       |       | 3,875                            |       | 126 |   | 3.25 |   | 15,053 |   | 152 |   | 1.01 |   | 60,881 |   | 619 |   | 1.02 |   |
| Total interest earning assets                                    |       | 6.46                       |       | 754,009                          |       | 46,085 |   | 6.11 |   | 667,041 |   | 39,370 |   | 5.90 |   | 645,937 |   | 38,745 |   | 6.00 |   |
| Noninterest earning  assets                                      |       |                       |       | 54,388                           |       |   |   |   |   | 47,793 |   |   |   |   |   | 45,383 |   |   |   |   |   |
| Total assets                                                     |       |                       |       | $                                | 808,397    |   |   |   |   |   | $ | 714,834 |   |   |   |   |   | $ | 691,320 |   |   |   |   |   |
| Interest bearing  liabilities:                                   |       |                       |       |                             |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Deposits                                                         |       | 2.85                       |       | $                                | 590,753    |   | 14,617 |   | 2.47 |   | $ | 581,279 |   | 12,690 |   | 2.18 |   | $ | 571,407 |   | 14,607 |   | 2.56 |   |
| FHLB advances                                                    |       | 4.08                       |       | 135,636                          |       | 4,987 |   | 3.68 |   | 53,299 |   | 1,648 |   | 3.09 |   | 43,321 |   | 1,379 |   | 3.18 |   |
| Total interest bearing liabilities                               |       | 3.11                       |       | 726,389                          |       | 19,604 |   | 2.70 |   | 634,578 |   | 14,338 |   | 2.26 |   | 614,728 |   | 15,986 |   | 2.60 |   |
| Noninterest bearing liabilities                                  |       |                       |       | 5,543                            |       |   |   |   |   | 5,002 |   |   |   |   |   | 3,886 |   |   |   |   |   |
| Total liabilities                                                |       |                       |       | 731,932                          |       |   |   |   |   | 639,580 |   |   |   |   |   | 618,614 |   |   |   |   |   |
| Stockholders’ equity                                        |       |                       |       | 76,465                           |       |   |   |   |   | 75,254 |   |   |   |   |   | 72,706 |   |   |   |   |   |
| Total liabilities and stockholders’ equity                  |       |                       |       | $                                | 808,397    |   |   |   |   |   | $ | 714,834 |   |   |   |   |   | $ | 691,320 |   |   |   |   |   |
|                                                             |       |                       |       |                             |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Net interest income                                              |       |                       |       |                             |       | $ | 26,481 |   |   |   |   |   | $ | 25,032 |   |   |   |   |   | $ | 22,759 |   |   |   |
| Net earning assets                                               |       |                       |       | $                                | 27,620     |   |   |   |   |   | $ | 32,463 |   |   |   |   |   | $ | 31,209 |   |   |   |   |   |
| Interest rate spread                                             |       | 3.35                       | %          |                             |       |   |   | 3.41 | % |   |   |   |   | 3.64 | % |   |   |   |   | 3.40 | % |
| Net interest margin                                              |       |                       |       |                             |       |   |   | 3.51 | % |   |   |   |   | 3.75 | % |   |   |   |   | 3.52 | % |
| Ratio of interest earning assets to interest bearing liabilities |       |                       |       |                             |       |   |   | 103.80 | % |   |   |   |   | 105.12 | % |   |   |   |   | 105.08 | % |

 

----

(1)  Includes nonaccrual loans.

(2)  Includes FHLB of Dallas stock.

 

37

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## **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 changesattributable to (i) changes in volume (changes in average volumemultiplied by prior rate); (ii) changes in rate (change in rate multipliedby prior average volume); (iii) changes in rate-volume (changes in ratemultiplied by the change in average volume); and (iv) the net change.

 
| ** **                          | ** ** | **Year Ended December 31,** | ** ** |
|-------------------------------------|------------|----------------------------------|------------|
| ** **                          | ** ** | **2005 vs. 2004**                | ** ** | **2004 vs. 2003** | ** ** |
| ** **                          | ** ** | **Increase (Decrease)  Due to**  | ** ** | **Total  Increase  (Decrease)** | ** ** | **Increase (Decrease)  Due to** | ** ** | **Total  Increase  (Decrease)** | ** ** |
| ** **                          | ** ** | **Volume**                       | ** ** | **Rate** | ** ** | **Rate/  Volume** | ** ** | ** ** | **Volume** | ** ** | **Rate** | ** ** | **Rate/  Volume** | ** ** | ** ** |
| ** **                          | ** ** | **(In Thousands)**               | ** ** |
| Interest income:                    |       |                             |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Loans receivable                    |       | $                                | 7,084      |   | $ | 240 |   | $ | 48 |   | $ | 7,372 |   | $ | 5,624 |   | $ | (3,544 | ) | $ | (583 | ) | $ | 1,497 |   |
| Investment securities               |       | (707                             | )          | 95 |   | (19 | ) | (631 | ) | (600 | ) | 230 |   | (35 | ) | (405 | ) |
| Other interest earning  assets      |       | (113                             | )          | 337 |   | (250 | ) | (26 | ) | (466 | ) | (5 | ) | 4 |   | (467 | ) |
| Total interest earning  assets      |       | 6,264                            |       | 672 |   | (221 | ) | 6,715 |   | 4,558 |   | (3,319 | ) | (614 | ) | 625 |   |
|                                |       |                             |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Interest expense:                   |       |                             |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Deposits                            |       | 207                              |       | 1,692 |   | 28 |   | 1,927 |   | 252 |   | (2,132 | ) | (37 | ) | (1,917 | ) |
| FHLB advances                       |       | 2,546                            |       | 312 |   | 481 |   | 3,339 |   | 317 |   | (39 | ) | (9 | ) | 269 |   |
| Total interest bearing  liabilities |       | 2,753                            |       | 2,004 |   | 509 |   | 5,266 |   | 569 |   | (2,171 | ) | (46 | ) | (1,648 | ) |
| Net change in net interest  income  |       | $                                | 3,511      |   | $ | (1,332 | ) | $ | (730 | ) | $ | 1,449 |   | $ | 3,989 |   | $ | (1,148 | ) | $ | (568 | ) | $ | 2,273 |   |

 

38

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** **

**CHANGES IN RESULTS OFOPERATIONS**

 

The table below presents a comparisonof results of operations for the years ended December 31, 2005, 2004, and2003 (dollars in thousands).  Specificchanges in captions will be discussed below the table.

 
| ** **                                            | ** ** | **Year  Ended December 31,** | ** ** | **Dollar Change** | ** ** | **Percentage Change** | ** ** |
|-------------------------------------------------------|------------|-----------------------------------|------------|-------------------|------------|-----------------------|------------|
| ** **                                            | ** ** | **2005**                          | ** ** | **2004**          | ** ** | **2003**              | ** ** | **2005 vs 2004** | ** ** | **2004 vs  2003** | ** ** | **2005 vs 2004** | ** ** | **2004 vs  2003** | ** ** |
| Interest income:                                      |       |                              |       |              |       |                  |       |   |   |   |   |   |   |   |   |
| Loans receivable                                      |       | $                                 | 43,057     |              | $          | 35,685                |       | $ | 34,188 |   | $ | 7,372 |   | $ | 1,497 |   | 20.7 | % | 4.4 | % |
| Investment  securities                                |       | 2,902                             |       | 3,533             |       | 3,938                 |       | (631 | ) | (405 | ) | (17.9 | ) | (10.3 | ) |
| Other                                                 |       | 126                               |       | 152               |       | 619                   |       | (26 | ) | (467 | ) | (17.1 | ) | (75.4 | ) |
| Total interest  income                                |       | 46,085                            |       | 39,370            |       | 38,745                |       | 6,715 |   | 625 |   | 17.1 |   | 1.6 |   |
| Interest expense:                                     |       |                              |       |              |       |                  |       |   |   |   |   |   |   |   |   |
| Deposits                                              |       | 14,617                            |       | 12,690            |       | 14,607                |       | 1,927 |   | (1,917 | ) | 15.2 |   | (13.1 | ) |
| FHLB advances                                         |       | 4,987                             |       | 1,648             |       | 1,379                 |       | 3,339 |   | 269 |   | 202.6 |   | 19.5 |   |
| Total interest  expense                               |       | 19,604                            |       | 14,338            |       | 15,986                |       | 5,266 |   | (1,648 | ) | 36.7 |   | (10.3 | ) |
| Net interest  income before provision for loan losses |       | 26,481                            |       | 25,032            |       | 22,759                |       | 1,449 |   | 2,273 |   | 5.8 |   | 10.0 |   |
| Provision for loan losses                             |       | 1,101                             |       | 1,020             |       | 690                   |       | 81 |   | 330 |   | 7.9 |   | 47.8 |   |
| Net interest  income after provision for loan losses  |       | 25,380                            |       | 24,012            |       | 22,069                |       | 1,368 |   | 1,943 |   | 5.7 |   | 8.8 |   |
| Noninterest  income:                                  |       |                              |       |              |       |                  |       |   |   |   |   |   |   |   |   |
| Deposit fee  income                                   |       | 4,486                             |       | 3,674             |       | 2,893                 |       | 812 |   | 781 |   | 22.1 |   | 27.0 |   |
| Gain on sale of  loans                                |       | 764                               |       | 607               |       | 1,696                 |       | 157 |   | (1,089 | ) | 25.9 |   | (64.2 | ) |
| Other                                                 |       | 1,711                             |       | 1,993             |       | 2,400                 |       | (282 | ) | (407 | ) | (14.1 | ) | (17.0 | ) |
| Total noninterest  income                             |       | 6,961                             |       | 6,274             |       | 6,989                 |       | 687 |   | (715 | ) | 11.0 |   | (10.2 | ) |
| Noninterest  expenses:                                |       |                              |       |              |       |                  |       |   |   |   |   |   |   |   |   |
| Salaries and  employee benefits                       |       | 12,722                            |       | 11,094            |       | 10,417                |       | 1,628 |   | 677 |   | 14.7 |   | 6.5 |   |
| Net occupancy  expense                                |       | 2,079                             |       | 2,009             |       | 1,926                 |       | 70 |   | 83 |   | 3.5 |   | 4.3 |   |
| Data processing                                       |       | 1,562                             |       | 1,546             |       | 1,507                 |       | 16 |   | 39 |   | 1.0 |   | 2.6 |   |
| Advertising and  public relations                     |       | 1,137                             |       | 972               |       | 613                   |       | 165 |   | 359 |   | 17.0 |   | 58.6 |   |
| Other                                                 |       | 3,268                             |       | 3,162             |       | 3,800                 |       | 106 |   | (638 | ) | 3.4 |   | (16.8 | ) |
| Total noninterest  expenses                           |       | 20,768                            |       | 18,783            |       | 18,263                |       | 1,985 |   | 520 |   | 10.6 |   | 2.9 |   |
| Income before provision for income taxes              |       | 11,573                            |       | 11,503            |       | 10,795                |       | 70 |   | 708 |   | 0.6 |   | 6.6 |   |
| Income tax provision                                  |       | 3,723                             |       | 3,698             |       | 3,339                 |       | 25 |   | 359 |   | 0.7 |   | 10.8 |   |
| Net income                                            |       | $                                 | 7,850      |              | $          | 7,805                 |       | $ | 7,456 |   | $ | 45 |   | $ | 349 |   | 0.6 | % | 4.7 | % |
|                                                  |       |                              |       |              |       |                  |       |   |   |   |   |   |   |   |   |
| Basic earnings per share                              |       | $                                 | 1.57       |              | $          | 1.54                  |       | $ | 1.46 |   | $ | 0.03 |   | $ | 0.08 |   | 1.9 | % | 5.5 | % |
| Diluted earnings per share                            |       | $                                 | 1.50       |              | $          | 1.45                  |       | $ | 1.38 |   | $ | 0.05 |   | $ | 0.07 |   | 3.5 | % | 5.1 | % |
|                                                  |       |                              |       |              |       |                  |       |   |   |   |   |   |   |   |   |
| Interest rate spread                                  |       | 3.41                              | %          | 3.64              | %          | 3.40                  | %          |   |   |   |   |   |   |   |   |
| Net interest margin                                   |       | 3.51                              | %          | 3.75              | %          | 3.52                  | %          |   |   |   |   |   |   |   |   |
|                                                  |       |                              |       |              |       |                  |       |   |   |   |   |   |   |   |   |
| Full-time equivalents                                 |       | 303                               |       | 243               |       | 252                   |       |   |   |   |   |   |   |   |   |
| Full service offices                                  |       | 16                                |       | 15                |       | 15                    |       |   |   |   |   |   |   |   |   |

 

39

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**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.

 

**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 a previous page.

 

**Interest Income. **The increasein the 2005 vs. 2004 period was primarily due to an increase in theaverage balance of loans, an increase in the average yield earned on loans andan increase in the average yield earned on other interest earning assets,partially offset by a decrease in the average balance of investment securitiesand a decrease in the average balance of other interest earning assets.  The increase in the average yield earned onloans was due to increased rates on new loans, particularly construction loans,in conjunction with recent increases in market interest rates.   The average balance of loans increasedprimarily due to increased construction loan origination activity.  The average balance of investment securitiesdecreased due to calls and maturities.

 

The increase in the 2004 vs. 2003 period was primarily due to anincrease in the average balance of loans and an increase in the average yieldearned on investment securities, offset by decreases in the average balances ofinvestment securities and other interest earning assets and decreases in theaverage yields earned on loans and other interest earning assets.  The decrease in the average yield earned onloans was primarily due to an overall decline in rates during the periods andcustomers’ refinancing to lower rates. The decrease in the average balances of investment securities held tomaturity and other interest earning assets was due to proceeds from called ormatured investments and interest earning cash balances being used to fund loangrowth.  The average balance of loansincreased primarily due to construction and commercial real estate loan growthin 2004.

 

**Interest Expense.  **The increasein interest expense in the 2005 vs. 2004 period was primarily due to increasesin the average rates paid on deposit accounts and FHLB advances, as well as theincrease in the average balance of deposit accounts and FHLB advances.  The increase in FHLB advances was due to theuse of FHLB advances to fund the loan growth during the year.  The increase in the average rates paid ondeposit accounts reflects both the shift in deposits from money market accountsand savings accounts to higher rate certificates of deposit as well as therecent increases in market interest rates.

 

The decrease in interest expense in the 2004 vs. 2003 period wasprimarily due to decreases in the average rates paid on deposit accountsand FHLB advances, offset by increases in the average balances of deposits andFHLB advances.  The decrease in theaverage interest rate paid on deposits was primarily the result of maturingcertificates and variable interest bearing deposits being repriced to lowerinterest rates.  The increase in FHLBadvances was due to the use of FHLB advances to fund loan growth.

 

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

 

The increase in the provision for loan losses for the 2005 vs. 2004period was due primarily to an increase in charge-offs on overdrafts.

 

Factors influencing management’s decision to increase the provision inthe 2004 vs. 2003 period include an increase in the loan portfolio,particularly commercial real estate and construction loans, as well as anincrease in nonaccrual and restructured loans.

 

40

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**Noninterest Income. **Deposit feeincome increased as a result of the increase in the number of checkingaccounts.  The number of checkingaccounts increased approximately 5.9% from December 31, 2004 to December 31,2005 and increased  8.0% from December 31,2003 to December 31, 2004.  The Bankplans to continue to aggressively promote checking accounts in 2006 throughdirect mail campaigns and offering “thank you” gifts to further expand itschecking accounts 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,** | ** ** |
|-------------------------------------------|------------|----------------------------------|------------|
| ** **                                | ** ** | **2005**                         | ** ** | **2004** | ** ** | **2003** | ** ** |
| Loans held  for sale, beginning of period |       | $                                | 1,623      |   | $ | 1,687 |   | $ | 8,264 |   |
| Originations  of loans held for sale      |       | 56,153                           |       | 45,763 |   | 119,833 |   |
| Sales                                     |       | (55,135                          | )          | (45,827 | ) | (126,410 | ) |
| Loans held  for sale, end of period       |       | $                                | 2,641      |   | $ | 1,623 |   | $ | 1,687 |   |
|                                      |       |                             |       |   |   |   |   |
| Gain on sale  of loans                    |       | $                                | 764        |   | $ | 607 |   | $ | 1,696 |   |

 

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

 

Other noninterest income decreased during the 2005 vs. 2004 periodprimarily due to a decrease in loan-related fees and a decrease in gains onsales of office properties and equipment and real estate owned.  The decrease in loan-related fees was due toa reduction in the amount of fees collected due to competitive factors in theBank’s market area.

 

Other noninterest income decreased during the 2004 vs. 2003 periodprimarily due to an adjustment of the carrying value of donated real estatefrom its cost to its estimated fair value. The gain on contribution of $414,000 was recognized during the yearended December 31, 2003.  Acorresponding expense in the amount of $500,000, the fair value of the donatedreal estate, was also recorded during the year ended December 31, 2003,and is included in the balance of contributions expense within othernoninterest 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** | ** ** |
|-----------------------------------|------------|----------------------------------|------------|------------|------------|
| ** **                        | ** ** | **2005**                         | ** ** | **2004**   | ** ** | **2003** | ** ** | **2005 vs 2004** | ** ** | **2004 vs 2003** | ** ** |
| Salaries                          |       | $                                | 8,516      |       | $          | 7,635 |   | $ | 7,315 |   | $ | 881 |   | $ | 320 |   |
| Payroll  taxes                    |       | 773                              |       | 701        |       | 638 |   | 72 |   | 63 |   |
| Insurance                         |       | 630                              |       | 572        |       | 579 |   | 58 |   | (7 | ) |
| ESOP expense  (1)                 |       | 1,965                            |       | 1,661      |       | 1,230 |   | 304 |   | 431 |   |
| MRP expense  (2)                  |       | 27                               |       | 27         |       | 45 |   | — |   | (18 | ) |
| Defined benefit plan contribution |       | 660                              |       | 358        |       | 480 |   | 302 |   | (122 | ) |
| Other                             |       | 151                              |       | 140        |       | 130 |   | 11 |   | 10 |   |
| Total                             |       | $                                | 12,722     |       | $          | 11,094 |   | $ | 10,417 |   | $ | 1,628 |   | $ | 677 |   |

 

----

(1) Employee Stock Ownership Plan

(2) Management Recognition and Retention Plan

 

2005 vs. 2004

 

The increase in salaries was due primarily to an increase in the numberof employees and normal salary and merit increases.  Payroll taxes increased due to the increasein salaries.  The increase in employeestock ownership plan expense was due to an increase in the Company’s averagestock price from $20.58 in 2004 to $23.93 in 2005.  Defined benefit plan expense increased due toan increase in the required contribution to our multi-employer plan primarilyresulting from an increase in amortization cost.

 

41

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2004vs. 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. Definedbenefit plan expense decreased due to an unusual credit during 2004.

 

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

 
| ** **                                 | ** ** | **Year Ended December 31,** | ** ** | **Change** | ** ** |
|--------------------------------------------|------------|----------------------------------|------------|------------|------------|
| ** **                                 | ** ** | **2005**                         | ** ** | **2004**   | ** ** | **2003** | ** ** | **2005 vs 2004** | ** ** | **2004 vs 2003** | ** ** |
| Depreciation                               |       | $                                | 1,111      |       | $          | 1,103 |   | $ | 1,053 |   | $ | 8 |   | $ | 50 |   |
| Furniture, fixtures, and equipment expense |       | 235                              |       | 183        |       | 290 |   | 52 |   | (107 | ) |
| Utilities                                  |       | 242                              |       | 219        |       | 190 |   | 23 |   | 29 |   |
| Building  repairs and maintenance          |       | 237                              |       | 258        |       | 190 |   | (21 | ) | 68 |   |
| Taxes and  insurance                       |       | 187                              |       | 179        |       | 137 |   | 8 |   | 42 |   |
| Rent                                       |       | 67                               |       | 67         |       | 66 |   | — |   | 1 |   |
| Total                                      |       | $                                | 2,079      |       | $          | 2,009 |   | $ | 1,926 |   | $ | 70 |   | $ | 83 |   |

 

2005 vs. 2004

 

The increases in furniture, fixture, andequipment expense and utilities was due to the opening of one new full servicebranch office and remodeling several existing branch offices, along withgeneral utility cost increases.  Thedecrease in building repairs and maintenance is due to one-time repairs in2004.

 

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.

 

**Advertising and public relations.** Advertising and public relations increased for the years ended December 31,2005 and December 31, 2004 compared to the relevant prior periodsprimarily due to costs associated with the new checking account marketingprogram that began in 2004, including direct mail, “thank you” gifts, marketingbrochures, posters and billboards, and, with respect to 2005, the start-up ofthe business account marketing program during the year.

 

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

 
| ** **                      | ** ** | **Year Ended December 31,** | ** ** | **Change** | ** ** |
|---------------------------------|------------|----------------------------------|------------|------------|------------|
| ** **                      | ** ** | **2005**                         | ** ** | **2004**   | ** ** | **2003** | ** ** | **2005 vs 2004** | ** ** | **2004 vs 2003** | ** ** |
| Consultant  and management fees |       | $                                | 119        |       | $          | 234 |   | $ | 382 |   | $ | (115 | ) | $ | (148 | ) |
| Professional  fees              |       | 422                              |       | 466        |       | 329 |   | (44 | ) | 137 |   |
| Postage and  supplies           |       | 772                              |       | 695        |       | 737 |   | 77 |   | (42 | ) |
| Loan related  expenses          |       | 139                              |       | 152        |       | 194 |   | (13 | ) | (42 | ) |
| Real estate  owned expenses     |       | 83                               |       | 109        |       | 135 |   | (26 | ) | (26 | ) |
| Contributions                   |       | 41                               |       | 30         |       | 526 |   | 11 |   | (496 | ) |
| Telephone                       |       | 242                              |       | 214        |       | 228 |   | 28 |   | (14 | ) |
| Other                           |       | 1,450                            |       | 1,262      |       | 1,269 |   | 188 |   | (7 | ) |
| Total                           |       | $                                | 3,268      |       | $          | 3,162 |   | $ | 3,800 |   | $ | 106 |   | $ | (638 | ) |

 

42

----

 

2005 vs. 2004

 

Theincrease in postage and supplies was due to replacing supplies during 2005 withthe new corporate logo and stocking new branch offices.  Consultant and management fees decreased dueto fees paid in 2004 to start the new checking account marketing program.  Other expenses increased due primarily toincreases in employee training expenses and bank and Visa service fees.  Such fees increased during the year due toincreased customer use of the Visa cards as well as Visa raising their fees.

 

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 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 increase in professional fees was primarily dueto increased fees paid to our audit firm related to the requirements ofSarbanes-Oxley.

 

**Income Taxes.**

 

2005 vs. 2004

 

Theincrease in income tax expense was primarily due to an increase in taxableincome.  The effective tax rate remainedrelatively consistent at approximately 32%.

 

2004 vs. 2003

 

The increase in income tax expense was primarily due to an increase intaxable income 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.

 

**OFF-BALANCE SHEET ARRANGEMENTS**

 

See Note 13 to the Consolidated Financial Statements.

 

### **CONTRACTUALOBLIGATIONS**

 

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

 
| ** **                          | ** ** | **Less Than** | ** ** | ** **    | ** ** | ** **      | ** ** | **More Than** | ** ** | ** ** | ** ** |
|-------------------------------------|------------|---------------|------------|---------------|------------|-----------------|------------|---------------|------------|------------|------------|
| ** **                          | ** ** | **1 Year**    | ** ** | **1-3 Years** | ** ** | **3 - 5 Years** | ** ** | **5 Years**   | ** ** | **Total**  | ** ** |
|                                |       |          |       |          |       |            |       |          |       |       |       |
| Certificates  of deposit maturities |       | $             | 213,728    |          | $          | 138,941         |       | $             | 28,171     |       | $          | 10,888 |   | $ | 391,728 |   |
| FHLB  advances maturities           |       | $             | 60,766     |          | $          | 73,934          |       | $             | 15,789     |       | $          | 7,751 |   | $ | 158,240 |   |

 

### **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 investing activities.  As an additional source of funds, the Bankhas borrowed from the FHLB of Dallas. During 2005, the use of FHLB advances increased due to increased demandfor the Bank’s loan products.  At December 31,2005, available borrowing capacity with the FHLB was approximately $124million.

 

43

----

 

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, 2005, the Bank’sregulatory capital was in excess of all applicable regulatoryrequirements.  At December 31, 2005,the Bank’s tangible, core and risk-based capital ratios amounted to 8.78%, 8.78%and 12.06%, 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.

 

**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 interestrate-sensitive liabilities exceeds the amount of interest rate-sensitiveassets.  Generally, during a period ofrising interest rates, a negative gap within shorter maturities would adverselyaffect net interest income, while a positive gap within shorter maturitieswould result in an increase in net interest income, and during a period offalling interest rates, a negative gap within shorter maturities would resultin an increase in net interest income while a positive gap within shortermaturities would have the opposite effect. As of December 31, 2005, the Bank estimates that the ratio of itsone-year gap to total assets was a negative 19.0% and its ratio of interestearning assets to interest bearing liabilities maturing or repricing within oneyear was 67.6%.

 

The Bank focuses its residential lendingactivities for loans held in portfolio on the origination of one-, three-,five- and seven-year adjustable 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 31,2005, $206.4 million or 76.5% of the Bank’s portfolio of one- to four-familyresidential mortgage loans consisted of ARMs, including $52.5 million inseven-year ARMs.  ARMs subject to contractual repricing within one yeartotaled $37.6 million at December 31, 2005.

 

The Company’s investment portfolio, all ofwhich is classified as held to maturity, amounted to $56.7 million or 6.7% ofthe Company’s total assets at December 31, 2005.  Of such amount, no investments arecontractually due within one year and $625,000 or 1.10% is contractually due fromone year to five years.  However, actualmaturities can be shorter than contractual maturities due to the ability ofborrowers to call or prepay such obligations without call or prepaymentpenalties.  As of December 31, 2005,there was approximately $55.5 million of investment securities at an averageinterest rate of 4.75% with call options held by the issuer, of whichapproximately $41.0 million, at an average interest rate of 4.89%, are callablewithin one year.  In a rising rateenvironment, the Company believes the issuer will not call these investmentsecurities.

 

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 

 

44

----

 

growth strategy which would force the Bank tofocus exclusively on competitors’ rates rather than deposit affordability.  At December 31, 2005 the Bank had $391.7million in certificates of deposit of which $213.7 million mature in one yearor less.  At December 31, 2005, theBank had $158.2 million of FHLB advances of which $60.8 million is due in oneyear or less.

 

### **Net Portfolio Value**

### ** **

The value of the Bank’s loan and investmentportfolio will change as interest rates change. As a result of the Bank’s negative interest rate repricing gap, risinginterest rates will generally decrease the Bank’s net portfolio value (“NPV”),while falling interest rates will generally increase the value of thatportfolio.  NPV is the difference betweenincoming and outgoing discounted cash flows from assets, liabilities, andoff-balance sheet contracts.  Thefollowing tables set forth, quantitatively, as of December 31, 2005 and 2004,the OTS estimate of the projected changes in NPV in the event of a 100, 200 and300 basis point instantaneous and permanent increase in market interest rates anda 100 and 200 basis point instantaneous and permanent decrease in marketinterest rates as of December 31, 2005 and a 100 basis point instantaneousand permanent decrease in market interest rates as of December 31,2004.  Due to the low interest rateenvironments in 2005 and 2004, the changes in NPV are not estimated for adecrease in interest rates of 300 basis points in either year or for a decreasein interest rates of 200 basis points in 2004.

 
| **2005**                                         | ** ** |
|--------------------------------------------------|------------|
| **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                                             |       |   | $ | 86,342 |   | 10.24 | % | $ | (19,756 | ) | (19 | )% |
| +200                                             |       |   | 94,255 |   | 11.01 |   | (11,843 | ) | (11 | ) |
| +100                                             |       |   | 100,997 |   | 11.65 |   | (5,101 | ) | (5 | ) |
| 0                                                |       |   | 106,098 |   | 12.09 |   | — |   | — |   |
| -100                                             |       |   | 107,556 |   | 12.15 |   | 1,458 |   | 1 |   |
| -200                                             |       |   | 106,166 |   | 11.93 |   | 68 |   | 0 |   |
|                                             |       |   |   |   |   |   |   |   |   |
| **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 |   |

 

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

 

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 of adjustablerate loans in the Bank’s portfolio could decrease in future periods due torefinancing activity if market rates decrease. Further, in the event of a change in interest rates, prepayment andearly withdrawal levels could deviate significantly from those assumed in thetable.  Finally, the ability of manyborrowers to service their adjustable rate debt may decrease in the event of aninterest rate increase.

 

45

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

 

**MANAGEMENTREPORT ON INTERNAL CONTROL**

 

The management of First Federal Bancshares of Arkansas, Inc. andits subsidiary, First Federal Bank of Arkansas, FA (the “Bank”), (collectivelyreferred to as the “Company”) is responsible for the preparation, integrity,and fair presentation of its published financial statements and all otherinformation presented in this annual report. The financial statements have been prepared in accordance withaccounting principles generally accepted in the United States of America (“GAAP”)and, as such, include amounts based on informed judgments and estimates made bymanagement.

 

Management is responsible for establishing and maintaining adequateinternal control over financial reporting for financial presentations inconformity with GAAP. Pursuant to the rules and regulations of theSecurities and Exchange Commission, internal control over financial reportingis a process designed by, or under the supervision of, the company’s principalexecutive and principal financial officers, or persons performing similarfunctions, and effected by the company’s board of directors, management andother personnel, to provide reasonable assurance regarding the reliability offinancial reporting and the preparation of financial statements for externalpurposes in accordance with GAAP and includes those policies and proceduresthat:

 

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

 

Provide reasonable assurance thattransactions are recorded as necessary to permit preparation of financialstatements in accordance with GAAP, and that receipts and expenditures of thecompany are being made only in accordance with authorizations of management anddirectors of the Company; and

 

Provide reasonable assurance regardingprevention or timely detection of unauthorized acquisition, use or dispositionof the Company’s assets that could have a material effect on the financialstatements.

 

Management has evaluated the effectiveness of its internal control overfinancial reporting for financial presentations in conformity with GAAP as of December 31,2005 based on the control criteria established in a report entitled *Internal Control—Integrated Framework*,issued by the Committee of Sponsoring Organizations of the Treadway Commission.Based on such evaluation, we have concluded that the Company’s internal controlover financial reporting is effective as of December 31, 2005.

 

The independent registered public accounting firm of Deloitte &Touche LLP, as auditors of the Company’s consolidated financial statements, hasissued an attestation report on management’s assessment of the Company’sinternal control over financial reporting.

 

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

 

46

----

 

**REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTINGFIRM**

 

To the Board of Directors and Stockholders of

First Federal Bancshares of Arkansas, Inc.

Little Rock, Arkansas

 

We have audited the accompanying consolidated statements of financialcondition of First Federal Bancshares of Arkansas, Inc. and subsidiaries(the “Company”) as of December 31, 2005 and 2004, and the relatedconsolidated statements of income, stockholders’ equity, and cash flows foreach of the three years in the period ended December 31, 2005.  These financial statements are the responsibilityof the Company’s management.  Ourresponsibility is to express an opinion on these financial statements based onour audits.

 

We conducted our audits in accordance with the standards of the PublicCompany Accounting Oversight Board (United States).  Those standards require that we plan andperform the audit to obtain reasonable assurance about whether the financialstatements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting theamounts and disclosures in the financial statements.  An audit also includes assessing theaccounting principles used and significant estimates made by management, aswell as evaluating the overall financial statement presentation.  We believe that our audits provide a reasonablebasis for our opinion.

 

In our opinion, such consolidated financial statements present fairly,in all material respects, the financial position of First Federal Bancshares ofArkansas, Inc. and subsidiaries as of December 31, 2005 and 2004, andthe results of their operations and their cash flows for each of the threeyears in the period ended December 31, 2005, in conformity with accountingprinciples generally accepted in the United States of America.

 

We have also audited, in accordance with the standards of the PublicCompany Accounting Oversight Board (United States), the effectiveness of theCompany’s internal control over financial reporting as of December 31,2005, based on the criteria established in Internal Control—IntegratedFramework issued by the Committee of Sponsoring Organizations of the TreadwayCommission and our report dated February 27, 2006 expressed an unqualifiedopinion on management’s assessment of the effectiveness of the Company’sinternal control over financial reporting and an unqualified opinion on theeffectiveness of the Company’s internal control over financial reporting.

 

 
| /s/ Deloitte & Touche LLP |   |
|-------------------------------|--------|
|                          |
| Little Rock, Arkansas         |
| February 27, 2006        |

 

47

----

 

**REPORT OF INDEPENDENT REGISTERED PUBLICACCOUNTING FIRM**

 

To the Board of Directors andStockholders of

First Federal Bancshares ofArkansas, Inc.

Harrison, Arkansas

 

We have audited management’sassessment, included in the accompanying Management Report on Internal Control,that First Federal Bancshares of Arkansas, Inc. and its Subsidiary (the “Company”)maintained effective internal control over financial reporting as of December 31,2005, based on criteria established in Internal Control—Integrated Frameworkissued by the Committee of Sponsoring Organizations of the TreadwayCommission.  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 toexpress an opinion on management’s assessment and an opinion on theeffectiveness of the Company’s internal control over financial reporting basedon our audit.

 

We conducted ouraudit in accordance with the standards of the Public Company AccountingOversight Board (United States).  Thosestandards require that we plan and perform the audit to obtain reasonableassurance about whether effective internal control over financial reporting wasmaintained in all material respects.  Ouraudit included obtaining an understanding of internal control over financialreporting, evaluating management’s assessment, testing and evaluating thedesign and operating effectiveness of internal control, and performing suchother procedures as we considered necessary in the circumstances.  We believe that our audit provides areasonable basis for our opinions.

 

A company’s internalcontrol over financial reporting is a process designed by, or under thesupervision of, the company’s principal executive and principal financialofficers, or persons performing similar functions, and effected by the company’sboard of directors, management, and other personnel to provide reasonableassurance regarding the reliability of financial reporting and the preparationof financial statements for external purposes in accordance with generallyaccepted accounting principles.  Acompany’s internal control over financial reporting includes those policies andprocedures 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 reasonableassurance that transactions are recorded as necessary to permit preparation offinancial statements in accordance with generally accepted accountingprinciples, and that receipts and expenditures of the company are being madeonly in accordance with authorizations of management and directors of thecompany; and (3) provide reasonable assurance regarding prevention ortimely detection of unauthorized acquisition, use, or disposition of thecompany’s assets that could have a material effect on the financial statements.

 

Because of theinherent limitations of internal control over financial reporting, includingthe possibility of collusion or improper management override of controls,material misstatements due to error or fraud may not be prevented or detectedon a timely basis.  Also, projections ofany evaluation of the effectiveness of the internal control over financialreporting to future periods are subject to the risk that the controls maybecome inadequate because of changes in conditions, or that the degree ofcompliance with the policies or procedures may deteriorate.

 

In our opinion,management’s assessment that the Company maintained effective internal controlover financial reporting as of December 31, 2005, is fairly stated, in allmaterial respects, based on the criteria established in InternalControl—Integrated Framework issued by the Committee of SponsoringOrganizations of the Treadway Commission. Also in our opinion, the Company maintained, in all material respects,effective internal control over financial reporting as of December 31,2005, based on the criteria established in Internal Control—IntegratedFramework issued by the Committee of Sponsoring Organizations of the TreadwayCommission.

 

We have alsoaudited, in accordance with the standards of the Public Company AccountingOversight Board (United States), the consolidated financial statements as ofand for the year ended December 31, 2005 of the Company and our reportdated February 27, 2006 expressed an unqualified opinion on thosefinancial statements.

 

 
| /s/ Deloitte & Touche LLP |   |
|-------------------------------|--------|
|                          |
| Little Rock, Arkansas         |
| February 27, 2006        |

 

48

----

 

**FIRSTFEDERAL BANCSHARES OF ARKANSAS, INC.**

 

**CONSOLIDATEDSTATEMENTS OF FINANCIAL CONDITION**

**DECEMBER31, 2005 AND 2004**

**(Inthousands, except share data)**

 
| **ASSETS**                                                                                                                                                                         | ** ** | **2005** | ** ** | **2004** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|
|                                                                                                                                                                               |       |     |       |     |       |
| Cash and cash equivalents:                                                                                                                                                         |       |     |       |     |       |
| Cash and collection items                                                                                                                                                          |       | $        | 16,907     |     | $          | 12,080 |   |
| Interest bearing deposits with banks                                                                                                                                               |       | 4,202    |       | 3,923    |       |
|                                                                                                                                                                               |       |     |       |     |       |
| Total cash and cash equivalents                                                                                                                                                    |       | 21,109   |       | 16,003   |       |
|                                                                                                                                                                               |       |     |       |     |       |
| Investment securities—                                                                                                                                                        |       |     |       |     |       |
| Held to maturity, at amortized cost (fair  value at December 31, 2005 and 2004, of $55,784 and $56,426, respectively)                                                              |       | 56,695   |       | 56,660   |       |
| Federal Home Loan Bank stock—at cost                                                                                                                                          |       | 8,412    |       | 4,876    |       |
| Loans receivable, net of allowance at  December 31, 2005 and 2004, of $2,114 and $1,846, respectively                                                                              |       | 719,214  |       | 634,217  |       |
| Accrued interest receivable                                                                                                                                                        |       | 7,490    |       | 4,427    |       |
| Real estate acquired in settlement of loans—net                                                                                                                               |       | 892      |       | 563      |       |
| Office properties and equipment—net                                                                                                                                           |       | 18,522   |       | 15,295   |       |
| Cash surrender value of life insurance                                                                                                                                             |       | 18,654   |       | 17,897   |       |
| Prepaid expenses and other assets                                                                                                                                                  |       | 1,423    |       | 1,727    |       |
|                                                                                                                                                                               |       |     |       |     |       |
| TOTAL                                                                                                                                                                              |       | $        | 852,411    |     | $          | 751,665 |   |
|                                                                                                                                                                               |       |     |       |     |       |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                                                      |       |     |       |     |       |
|                                                                                                                                                                               |       |     |       |     |       |
| LIABILITIES:                                                                                                                                                                       |       |     |       |     |       |
| Deposits:                                                                                                                                                                          |       |     |       |     |       |
| Interest bearing                                                                                                                                                                   |       | $        | 574,772    |     | $          | 551,405 |   |
| Noninterest bearing                                                                                                                                                                |       | 36,895   |       | 31,019   |       |
|                                                                                                                                                                               |       |     |       |     |       |
| Total deposits                                                                                                                                                                     |       | 611,667  |       | 582,424  |       |
|                                                                                                                                                                               |       |     |       |     |       |
| Federal Home Loan Bank advances                                                                                                                                                    |       | 158,240  |       | 89,756   |       |
| Advance payments by borrowers for taxes and  insurance                                                                                                                             |       | 847      |       | 757      |       |
| Other liabilities                                                                                                                                                                  |       | 3,815    |       | 3,427    |       |
|                                                                                                                                                                               |       |     |       |     |       |
| Total liabilities                                                                                                                                                                  |       | $        | 774,569    |     | $          | 676,364 |   |
|                                                                                                                                                                               |       |     |       |     |       |
| 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; 5,048,662 and 5,094,020 shares  outstanding at December 31, 2005 and 2004, respectively |       | 103      |       | 103      |       |
| Additional paid-in capital                                                                                                                                                         |       | 56,252   |       | 54,427   |       |
| Employee stock benefit plans                                                                                                                                                       |       | (140     | )          | (582     | )          |
| Retained earnings—substantially restricted                                                                                                                                    |       | 83,584   |       | 78,261   |       |
|                                                                                                                                                                               |       | 139,799  |       | 132,209  |       |
| Treasury stock—at cost; 5,258,840 and  5,213,482 shares at December 31, 2005 and 2004, respectively                                                                           |       | (61,957  | )          | (56,908  | )          |
|                                                                                                                                                                               |       |     |       |     |       |
| Total stockholders’ equity                                                                                                                                                    |       | 77,842   |       | 75,301   |       |
|                                                                                                                                                                               |       |     |       |     |       |
| TOTAL                                                                                                                                                                              |       | $        | 852,411    |     | $          | 751,665 |   |

 

See notes to consolidated financialstatements.

 

49

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**FIRST FEDERAL BANCSHARES OF ARKANSAS, INC**

 

**CONSOLIDATED STATEMENTS OF INCOME**

**YEARS ENDED DECEMBER 31, 2005, 2004, 2003**

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

 
| ** **                                           | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| INTEREST INCOME:                                     |       |     |       |     |       |     |       |
| Loans receivable                                     |       | $        | 43,057     |     | $          | 35,685   |       | $ | 34,188 |   |
| Investment securities:                               |       |     |       |     |       |     |       |
| Taxable                                              |       | 2,181    |       | 2,837    |       | 3,422    |       |
| Nontaxable                                           |       | 721      |       | 696      |       | 516      |       |
| Other                                                |       | 126      |       | 152      |       | 619      |       |
| Total interest income                                |       | 46,085   |       | 39,370   |       | 38,745   |       |
|                                                 |       |     |       |     |       |     |       |
| INTEREST EXPENSE:                                    |       |     |       |     |       |     |       |
| Deposits                                             |       | 14,617   |       | 12,690   |       | 14,607   |       |
| Federal Home Loan Bank advances                      |       | 4,987    |       | 1,648    |       | 1,379    |       |
|                                                 |       |     |       |     |       |     |       |
| Total interest expense                               |       | 19,604   |       | 14,338   |       | 15,986   |       |
|                                                 |       |     |       |     |       |     |       |
| NET INTEREST INCOME                                  |       | 26,481   |       | 25,032   |       | 22,759   |       |
|                                                 |       |     |       |     |       |     |       |
| PROVISION FOR LOAN LOSSES                            |       | 1,101    |       | 1,020    |       | 690      |       |
|                                                 |       |     |       |     |       |     |       |
| NET INTEREST INCOME AFTER PROVISION FOR  LOAN LOSSES |       | 25,380   |       | 24,012   |       | 22,069   |       |
|                                                 |       |     |       |     |       |     |       |
| NONINTEREST INCOME:                                  |       |     |       |     |       |     |       |
| Deposit fee income                                   |       | 4,486    |       | 3,674    |       | 2,893    |       |
| Earnings on life insurance policies                  |       | 757      |       | 795      |       | 848      |       |
| Gain on sale of loans                                |       | 764      |       | 607      |       | 1,696    |       |
| Other                                                |       | 954      |       | 1,198    |       | 1,552    |       |
|                                                 |       |     |       |     |       |     |       |
| Total noninterest income                             |       | 6,961    |       | 6,274    |       | 6,989    |       |
|                                                 |       |     |       |     |       |     |       |
| NONINTEREST EXPENSES:                                |       |     |       |     |       |     |       |
| Salaries and employee benefits                       |       | 12,722   |       | 11,094   |       | 10,417   |       |
| Net occupancy expense                                |       | 2,079    |       | 2,009    |       | 1,926    |       |
| Data processing                                      |       | 1,562    |       | 1,546    |       | 1,507    |       |
| Professional fees                                    |       | 422      |       | 466      |       | 329      |       |
| Advertising and public relations                     |       | 1,137    |       | 972      |       | 613      |       |
| Postage and supplies                                 |       | 772      |       | 695      |       | 737      |       |
| Other                                                |       | 2,074    |       | 2,001    |       | 2,734    |       |
|                                                 |       |     |       |     |       |     |       |
| Total noninterest expenses                           |       | 20,768   |       | 18,783   |       | 18,263   |       |
|                                                 |       |     |       |     |       |     |       |
| INCOME BEFORE INCOME TAXES                           |       | 11,573   |       | 11,503   |       | 10,795   |       |
|                                                 |       |     |       |     |       |     |       |
| INCOME TAX PROVISION                                 |       | 3,723    |       | 3,698    |       | 3,339    |       |
|                                                 |       |     |       |     |       |     |       |
| NET INCOME                                           |       | $        | 7,850      |     | $          | 7,805    |       | $ | 7,456 |   |
|                                                 |       |     |       |     |       |     |       |
| EARNINGS PER SHARE:                                  |       |     |       |     |       |     |       |
| Basic                                                |       | $        | 1.57       |     | $          | 1.54     |       | $ | 1.46 |   |
|                                                 |       |     |       |     |       |     |       |
| Diluted                                              |       | $        | 1.50       |     | $          | 1.45     |       | $ | 1.38 |   |

 

See notes to consolidated financialstatements.

 

50

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**FIRSTFEDERAL BANCSHARES OF ARKANSAS, INC.**

 

## **CONSOLIDATED STATEMENTSOF STOCKHOLDERS’ EQUITY**

## **YEARS ENDED DECEMBER 31,2005, 2004, AND 2003**

 

**(Inthousands, except share data)**

 
| ** **                                                 | ** ** | **Issued**            | ** ** | **Additional** | ** ** | **Employee** | ** ** | ** **             | ** ** | ** **              | ** ** | ** **             | ** ** | **Total**  | ** ** |
|------------------------------------------------------------|------------|-----------------------|------------|----------------|------------|--------------|------------|------------------------|------------|-------------------------|------------|------------------------|------------|------------|------------|
| ** **                                                 | ** ** | **Common Stock** | ** ** | **Paid-In**    | ** ** | **Stock**    | ** ** | **Retained**           | ** ** | **Treasury Stock** | ** ** | **Stockholders’** | ** ** |
| ** **                                                 | ** ** | **Shares**            | ** ** | **Amount**     | ** ** | **Capital**  | ** ** | **Benefit Plans** | ** ** | **Earnings**            | ** ** | **Shares**             | ** ** | **Amount** | ** ** | **Equity** | ** ** |
|                                                       |       |                  |       |           |       |         |       |                   |       |                    |       |                   |       |       |       |   |   |
| BALANCE – January  1, 2003                            |       | 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 |   |
| Treasury shares  reissued                                  |       | —                |       | —         |       | 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                                  |       | —                |       | —         |       | (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 |   |
|                                                       |       |                  |       |           |       |         |       |                   |       |                    |       |                   |       |       |       |   |   |
| Net income                                                 |       | —                |       | —         |       | —       |       | —                 |       | 7,850                   |       | —                 |       | —     |       | 7,850 |   |
| Release of ESOP  shares                                    |       | —                |       | —         |       | 1,575        |       | 416                    |       | —                  |       | —                 |       | —     |       | 1,991 |   |
| Stock  compensation expense                                |       | —                |       | —         |       | —       |       | 26                     |       | —                  |       | —                 |       | —     |       | 26 |   |
| Tax effect of  stock compensation plans                    |       | —                |       | —         |       | 625          |       | —                 |       | —                  |       | —                 |       | —     |       | 625 |   |
| Purchase of  treasury stock – at cost                 |       | —                |       | —         |       | —       |       | —                 |       | —                  |       | 307,887                |       | (7,630     | )          | (7,630 | ) |
| Treasury shares  reissued                                  |       | —                |       | —         |       | (375         | )          | —                 |       | —                  |       | (262,529               | )          | 2,581      |       | 2,206 |   |
| Dividends paid  ($0.50 per share)                          |       | —                |       | —         |       | —       |       | —                 |       | (2,527                  | )          | —                 |       | —     |       | (2,527 | ) |
|                                                       |       |                  |       |           |       |         |       |                   |       |                    |       |                   |       |       |       |   |   |
| BALANCE –  December 31, 2005                          |       | 10,307,502            |       | $              | 103        |         | $          | 56,252                 |       | $                       | (140       | )                      | $          | 83,584     |       | 5,258,840 |   | $ | (61,957 | ) | $ | 77,842 |   |

 

See notes to consolidatedfinancial statements.

 

51

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

 

**CONSOLIDATED STATEMENTS OF CASH FLOWS**

**YEARS ENDED DECEMBER 31, 2005, 2004 AND 2003**

 

**(In thousands)**

 
| ** **                                                               | ** ** | **2005**   | ** ** | **2004**   | ** ** | **2003**   | ** ** |
|--------------------------------------------------------------------------|------------|------------|------------|------------|------------|------------|------------|
| ** **                                                               | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| OPERATING ACTIVITIES:                                                    |       |       |       |       |       |       |       |
| Net income                                                               |       | $          | 7,850      |       | $          | 7,805      |       | $ | 7,456 |   |
| Adjustments to reconcile net income to net  cash                         |       |       |       |       |       |       |       |
| provided by operating activities:                                        |       |       |       |       |       |       |       |
| Provision for loan losses                                                |       | 1,101      |       | 1,020      |       | 690        |       |
| Provision for real estate losses                                         |       | 29         |       | 45         |       | 35         |       |
| Deferred tax provision (benefit)                                         |       | (13        | )          | 350        |       | 60         |       |
| Accretion of discounts on investment  securities—net                |       | (2         | )          | (40        | )          | (111       | )          |
| Federal Home Loan Bank stock dividends                                   |       | (251       | )          | (69        | )          | (110       | )          |
| Loss (gain) on disposition of fixed assets                               |       | 9          |       | (70        | )          | 98         |       |
| Loss (gain) on sale of repossessed assets—net                       |       | (8         | )          | (42        | )          | 17         |       |
| Originations of loans held for sale                                      |       | (56,153    | )          | (63,041    | )          | (119,833   | )          |
| Proceeds from sales of loans originated to  sell                         |       | 55,899     |       | 63,712     |       | 128,106    |       |
| Gain on sale of mortgage loans originated  to sell                       |       | (764       | )          | (607       | )          | (1,696     | )          |
| Depreciation                                                             |       | 1,185      |       | 1,185      |       | 1,167      |       |
| Amortization (accretion) of deferred loan  fees—net                 |       | 167        |       | 91         |       | (384       | )          |
| Release of ESOP shares                                                   |       | 1,991      |       | 1,712      |       | 1,322      |       |
| Earnings on life insurance policies                                      |       | (757       | )          | (795       | )          | (848       | )          |
| Stock compensation expense                                               |       | 26         |       | 56         |       | 45         |       |
| Changes in operating assets and  liabilities:                            |       |       |       |       |       |       |       |
| Accrued interest receivable                                              |       | (3,063     | )          | (338       | )          | 291        |       |
| Prepaid expenses and other assets                                        |       | 304        |       | (427       | )          | (585       | )          |
| Other liabilities                                                        |       | 1,921      |       | 351        |       | (660       | )          |
|                                                                     |       |       |       |       |       |       |       |
| Net cash provided by operating activities                                |       | 9,471      |       | 10,898     |       | 15,060     |       |
|                                                                     |       |       |       |       |       |       |       |
| INVESTING ACTIVITIES:                                                    |       |       |       |       |       |       |       |
| Purchases of investment securities—held to  maturity                |       | (5,559     | )          | (87,039    | )          | (304,089   | )          |
| Proceeds from maturities of investment  securities—held to maturity |       | 4,626      |       | 111,798    |       | 338,292    |       |
| Purchase of Federal Home Loan Bank stock                                 |       | (3,285     | )          | (1,737     | )          | —     |       |
| Federal Home Loan Bank stock redeemed                                    |       | —     |       | 679        |       | 1,425      |       |
| Loan originations—net of repayments                                 |       | (87,939    | )          | (121,946   | )          | (37,458    | )          |
| Loan purchases                                                           |       | —     |       | (5,172     | )          | (3,140     | )          |
| Loan participations sold                                                 |       | 1,787      |       | 3,970      |       | 3,124      |       |
| Proceeds from sales of repossessed assets                                |       | 560        |       | 801        |       | 773        |       |
| Proceeds from sales of office properties  and equipment                  |       | 4          |       | 632        |       | 38         |       |
| Purchases of office properties and  equipment                            |       | (4,425     | )          | (2,475     | )          | (4,851     | )          |
|                                                                     |       |       |       |       |       |       |       |
| Net cash used in investing activities                                    |       | (94,231    | )          | (100,489   | )          | (5,886     | )          |
|                                                                          |            |            |            |            |            |            |            |  |  |  |

 

(Continued)

 

52

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| ** **                                                                         | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| FINANCING ACTIVITIES:                                                              |       |     |       |     |       |     |       |
| Net increase in deposits                                                           |       | $        | 29,243     |     | $          | 8,844    |       | $ | 4,818 |   |
| Advances from Federal Home Loan Bank                                               |       | 144,343  |       | 81,578   |       | 23,000   |       |
| Repayment of advances from Federal Home  Loan Bank                                 |       | (75,859  | )          | (31,384  | )          | (22,048  | )          |
| Net increase (decrease) in advance payments  by borrowers  for taxes and insurance |       | 90       |       | 32       |       | (35      | )          |
| Purchase of treasury stock                                                         |       | (7,630   | )          | (9,534   | )          | (2,805   | )          |
| Dividends paid                                                                     |       | (2,527   | )          | (2,178   | )          | (1,814   | )          |
| Stock options exercised                                                            |       | 2,206    |       | 2,035    |       | 1,418    |       |
|                                                                               |       |     |       |     |       |     |       |
| Net cash provided by financing activities                                          |       | 89,866   |       | 49,393   |       | 2,534    |       |
|                                                                               |       |     |       |     |       |     |       |
| NET INCREASE (DECREASE) IN CASH AND  CASH EQUIVALENTS                              |       | 5,106    |       | (40,198  | )          | 11,708   |       |
|                                                                               |       |     |       |     |       |     |       |
| CASH AND CASH EQUIVALENTS:                                                         |       |     |       |     |       |     |       |
| Beginning of year                                                                  |       | 16,003   |       | 56,201   |       | 44,493   |       |
|                                                                               |       |     |       |     |       |     |       |
| End of year                                                                        |       | $        | 21,109     |     | $          | 16,003   |       | $ | 56,201 |   |
|                                                                               |       |     |       |     |       |     |       |
| SUPPLEMENTAL DISCLOSURES OF CASH FLOW  INFORMATION—                           |       |     |       |     |       |     |       |
| Cash paid for:                                                                     |       |     |       |     |       |     |       |
| Interest                                                                           |       | $        | 19,034     |     | $          | 14,238   |       | $ | 16,073 |   |
|                                                                               |       |     |       |     |       |     |       |
| Income taxes                                                                       |       | $        | 2,914      |     | $          | 2,990    |       | $ | 3,394 |   |
|                                                                               |       |     |       |     |       |     |       |
| SUPPLEMENTAL SCHEDULE OF NONCASH  INVESTING ACTIVITIES:                            |       |     |       |     |       |     |       |
| Real estate and other assets acquired in  settlement of loans                      |       | $        | 935        |     | $          | 709      |       | $ | 1,933 |   |
|                                                                               |       |     |       |     |       |     |       |
| Loans to facilitate sales of real estate  owned                                    |       | $        | 30         |     | $          | 197      |       | $ | 620 |   |
|                                                                               |       |     |       |     |       |     |       |
| Investment securities purchased—not settled                                   |       | $        | 100        |     | $          | 1,000    |       | $ | — |   |

 

See notes to consolidated financialstatements.

 

(Concluded)

 

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** **

**FIRSTFEDERAL BANCSHARES OF ARKANSAS, INC.**

** **

**NOTESTO CONSOLIDATED FINANCIAL STATEMENTS**

**YEARS ENDED DECEMBER 31,2005, 2004, AND 2003**

** **

**1.       SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES**

***Nature of Operations and Principles ofConsolidation—***First Federal Bancshares ofArkansas, Inc. (the “Company”) is a unitary holding company which owns all ofthe stock of First Federal Bank of Arkansas, FA (the “Bank”). The Bank providesa broad line of financial products to individuals and small- to medium-sizedbusinesses. The consolidated financial statements also include the accounts ofthe Bank’s wholly owned subsidiary, First Harrison Service Corporation (“FHSC”),which is inactive. All material intercompany transactions have been eliminatedin 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 Cash Equivalents—***Forthe purpose of presentation in the consolidated statements of cash flows, cashand cash equivalents includes cash on hand and amounts due from depositoryinstitutions, which includes interest bearing amounts available upon demand.

 

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

 

Investment securities that theCompany intends to hold for indefinite periods of time are classified asavailable for sale and are recorded at fair value. Unrealized holding gains andlosses are excluded from earnings and reported net of tax in othercomprehensive income. Investment securities in the available for sale portfoliomay be used as part of the Company’s asset and liability management practicesand may be sold in response to changes in interest rate risk, prepayment risk,or other economic factors. At December 31, 2005 and 2004, the Company didnot own any investment securities classified as available for sale.

 

Premiums are amortized into interestincome using the interest method to the earlier of maturity or call date.Discounts are accreted into interest income using the interest method over theperiod to maturity. The specific identification method of accounting is used tocompute gains or losses on the sales of investment securities.

 

Declines in the fair value ofheld to maturity and available for sale securities below their cost that aredeemed to be other than temporary are reflected in earnings as realized losses.In estimating other than temporary impairment losses, management considersindependent price quotations and the financial condition of the issuer.

 

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

 

54

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Loans receivable that managementhas the intent and ability to hold for the foreseeable future or until maturityor pay-off are stated at unpaid principal balances adjusted for anycharge-offs, the allowance for loan losses, and any deferred loan fees orcosts. Deferred loan fees or costs and discounts on first mortgage loans areamortized or accreted to income using the level-yield method over the remainingperiod to contractual maturity.

 

Mortgage loans originated andcommitted for sale in the secondary market are carried at the lower of cost orestimated market value in the aggregate. Such loans are generally carried atcost due to the short period of time between funding and sale, generally two tothree weeks.

 

The accrual of interest on loansis generally discontinued when, in management’s opinion, the borrower may beunable to meet payments as they become due or when the loan becomes 90 dayspast due, whichever occurs first. When interest accrual is discontinued, allunpaid accrued interest is reversed against interest income. The interest onthese loans is accounted for on the cash basis until qualifying for return toaccrual. Loans are generally returned to accrual status when payments are madeto bring the loan under 90 days past due and, in the opinion of management,collection of the remaining balance can be reasonably expected.  The Company may continue to accrue intereston certain loans that are 90 days past due or more if such loans are in theprocess of collection and collection is reasonably assured.

 

***Allowance for Loan Losses—***Theallowance for loan losses is established as losses are estimated to haveoccurred through a provision for loan losses charged to earnings. Loan lossesare charged against the allowance when management believes it is likely that aloan balance is uncollectible. Subsequent recoveries, if any, are credited to the allowance.

 

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 isinherently subjective as it requires estimates that are susceptible tosignificant revision as more information becomes available or conditionschange.

 

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

 

A loan is considered impairedwhen, based on current information and events, it is probable that the Bankwill be unable to collect the scheduled payments of principal or interest whendue according to the contractual terms of 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 experience insignificant payment delays andpayment shortfalls generally are not classified as impaired. Managementdetermines the significance of payment delays and payment shortfalls on acase-by-case basis, taking into consideration all of the circumstancessurrounding the loan and the borrower, including the length of the delay, thereasons for the delay, the borrower’s prior payment record, and the amount ofthe 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.

 

Large groups of smaller balancehomogeneous loans are collectively evaluated for impairment. Accordingly, theBank does not 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 thecharacteristics of (1) one- to four-family residential first mortgage loans;(2) unsecured consumer loans; and (3) collateralized consumer loans to permitconsideration of the appropriateness of the allowance for losses of each groupof 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,

 

55

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and then applying a loss factorto the remaining pool balance based on several factors including past lossexperience, inherent risks, and economic conditions in the primary marketareas.

 

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

 

***Real Estate Acquired in Settlement of 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 the assetsare carried at the lower of carrying amount or fair value less costs to sell.Revenue and expenses from operations and changes in the valuation allowance areincluded in other noninterest expenses.

 

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

 

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

 

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

 

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

 

***Stock Compensation Plans—***Statementof Financial Accounting Standards No. 123, *Accounting for Stock-Based Compensation* (“SFAS 123”),provides that entities may adopt a fair value based method of accounting foremployee stock compensation plans, whereby compensation cost is measured at thegrant date based on the value of the award and is recognized over the serviceperiod, which is usually the vesting period. However, it also provides that anentity may measure compensation cost for those plans using the intrinsic valuebased method of accounting prescribed by Accounting Principles Board (“APB”)Opinion No. 25, *Accounting for StockIssued to Employees*, whereby compensation cost is the excess, ifany, of the quoted market price of the stock at the grant date (or othermeasurement date) over the amount an employee must pay to acquire the stock.The Company applies the provisions of APB Opinion No. 25 in accounting for itsstock option plan. No compensation cost has been recognized for options grantedto employees as all options granted had an exercise price equal to the marketprice of the underlying stock on the grant date. Had compensation cost forthese plans been determined based on the fair value at the grant dates forawards under those plans consistent with the methods of SFAS 123, theeffect on the Company’s pro forma net income and pro forma earnings per sharewould not have been significant.

 

56

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*** ***

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

 

***Stock Split—***OnNovember 25, 2003, the Board of Directors of the Company declared a two-for-onestock split payable December 31, 2003, to the stockholders of record onDecember 17, 2003. Stockholders’ equity, including shares, has beenretroactively restated to reflect the stock split as of the earliest datepresented in this report. All per share amounts and weighted average sharesoutstanding have been restated to reflect the stock split.

 

***Recent Accounting Pronouncements—***InDecember 2004, the FASB issued SFAS No. 123(R),*Share-Based Payment*, which establishes accounting standards for alltransactions in which an entity exchanges its equity instruments for goods and services.SFAS No. 123(R) focuses primarily on accounting for transactions withemployees, and carries forward without change prior guidance for share-basedpayments for transactions with non-employees. SFAS No. 123(R) eliminates theintrinsic value measurement objective in APB Opinion 25 and generally requiresmeasurement of the cost of employee services received in exchange for an awardof equity instruments based on the fair value of the award on the date of thegrant. The standard requires grant date fair value to be estimated using eitheran option-pricing model adjusted for the unique characteristics of the award oran observable market price, if such a price exists. Such cost must berecognized over the period during which an employee is required to provideservice in exchange for the award - the requisite service period (which isusually the vesting period).  As of the required effective date, all publicentities will apply this Statement using a modified version of prospectiveapplication. Under that transition method, compensation cost is recognized onor after the required effective date for the portion of outstanding awards forwhich the requisite service has not yet been rendered, based on the grant-datefair value of those awards calculated under Statement 123 for eitherrecognition or pro forma disclosures. For periods before the required effectivedate, entities may elect to apply a modified version of retrospectiveapplication under which financial statements for prior periods are adjusted ona basis consistent with the pro forma disclosures required for those periods byStatement 123.  SFAS 123(R) wasoriginally to be effective for all awards granted, modified or settled in ourfirst reporting period after June 15, 2005. However, on April 14, 2005, the SEC adopted a rule that changed therequired compliance date to the beginning of the next fiscal year instead ofthe next reporting period after June 15, 2005. Therefore we will adopt SFAS No. 123(R) as of January 1, 2006, using themodified prospective application.  Basedon our current activities, we estimate that the adoption of this Statement willnot have a material effect on the financial statements of the Company.

 

In December 2004, the FASBissued SFAS No. 153, *Exchanges ofNonmonetary Assets,* an amendment of APB No. 29.  This Statementamends Opinion 29 to eliminate the exception for nonmonetary exchanges ofsimilar productive assets and replaces it with a general exception forexchanges of nonmonetary assets that do not have commercial substance. The Statement specifies that a nonmonetary exchange has commercial substance ifthe future cash flows of the entity are expected to change significantly as aresult of the exchange.  This Statement is effective for nonmonetary assetexchanges occurring in fiscal periods beginning after June 15, 2005.   The adoption of this Statement did not have amaterial effect on the financial statements of the Company.

 

In May 2005, the FASB issuedSFAS No. 154, *Accounting Changes andError Corrections – A Replacement of APB Opinion No. 20 and FASB StatementNo. 3.*SFAS No. 154 requires the retrospective applicationto prior periods’ financial statements of changes in accounting principle,unless it is impracticable to determine either the period-specific effects orcumulative effect of the accounting change. SFAS No. 154 also requiresthat a change in depreciation, amortization, or depletion method for long-livednon-financial assets be accounted for as a change in accounting estimateaffected by a change in accounting principle. SFAS No. 154 is effectivefor accounting changes and corrections of errors made in fiscal years beginningafter December 15, 2005 and we will adopt this provision, as applicable,during fiscal year 2006.

 

***Reclassifications—***Certain amounts in the 2004and 2003 consolidated financial statements have been reclassified to conform tothe classifications adopted for reporting in 2005.

 

57

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** **

**2.       RESTRICTIONS ON CASH AND AMOUNTS DUE FROMBANKS**

The Bank is required to maintain average cash balances on hand or withthe Federal Reserve Bank. At December 31, 2005 and 2004, these reservebalances amounted to $485,000 and $571,000, respectively.

 

**3.**                      INVESTMENT SECURITIES

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

 
| ** **                              | ** ** | **2005**      | ** ** |
|-----------------------------------------|------------|---------------|------------|
| ** **                              | ** ** | ** **    | ** ** | **Gross** | ** ** | **Gross** | ** ** | ** ** | ** ** |
| ** **                              | ** ** | **Amortized** | ** ** | **Unrealized** | ** ** | **Unrealized** | ** ** | **Fair** | ** ** |
| **Held To Maturity**          | ** ** | **Cost**      | ** ** | **Gains** | ** ** | **Losses** | ** ** | **Value** | ** ** |
|                                    |       |          |       |   |   |   |   |   |   |
| Municipal securities                    |       | $             | 16,661     |   | $ | 144 |   | $ | 123 |   | $ | 16,682 |   |
| U.S. Government and  Agency obligations |       | 40,034        |       | — |   | 932 |   | 39,102 |   |
|                                    |       |          |       |   |   |   |   |   |   |
| Total                                   |       | $             | 56,695     |   | $ | 144 |   | $ | 1,055 |   | $ | 55,784 |   |

 
| ** **                              | ** ** | **2004**      | ** ** |
|-----------------------------------------|------------|---------------|------------|
| ** **                              | ** ** | ** **    | ** ** | **Gross** | ** ** | **Gross** | ** ** | ** ** | ** ** |
| ** **                              | ** ** | **Amortized** | ** ** | **Unrealized** | ** ** | **Unrealized** | ** ** | **Fair** | ** ** |
| **Held To Maturity**          | ** ** | **Cost**      | ** ** | **Gains** | ** ** | **Losses** | ** ** | **Value** | ** ** |
|                                    |       |          |       |   |   |   |   |   |   |
| 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 |   |

 

The following table showsgross unrealized losses and fair value aggregated by investment category andlength of time that individual securities have been in a continuous unrealizedloss position at December 31, 2005:

 
| ** **                              | ** ** | **Less than 12 Months** | ** ** | **12 Months or More** | ** ** | **Total** | ** ** |
|-----------------------------------------|------------|----------------------------------------|------------|--------------------------------------|------------|-----------|------------|
| ** **                              | ** ** | **Fair**                               | ** ** | **Unrealized**                       | ** ** | **Fair**  | ** ** | **Unrealized** | ** ** | **Fair** | ** ** | **Unrealized** | ** ** |
| ** **                              | ** ** | **Value**                              | ** ** | **Losses**                           | ** ** | **Value** | ** ** | **Losses** | ** ** | **Value** | ** ** | **Losses** | ** ** |
|                                    |       |                                   |       |                                 |       |      |       |   |   |   |   |   |   |
| Municipal securities                    |       | $                                      | 4,489      |                                 | $          | 51        |       | $ | 1,973 |   | $ | 72 |   | $ | 6,462 |   | $ | 123 |   |
| U.S. Government and  Agency obligations |       | 13,930                                 |       | 192                                  |       | 25,172    |       | 740 |   | 39,102 |   | 932 |   |
|                                    |       |                                   |       |                                 |       |      |       |   |   |   |   |   |   |
|                                    |       | $                                      | 18,419     |                                 | $          | 243       |       | $ | 27,145 |   | $ | 812 |   | $ | 45,564 |   | $ | 1,055 |   |

 

The Company has pledgedinvestment securities held to maturity with carrying values of approximately$48.4 million and $19.5 million at December 31, 2005 and 2004,respectively, as collateral for certain deposits in excess of $100,000.

 

58

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The scheduled maturities of debt securities at December 31, 2005,by contractual maturity are shown below (in thousands). Expected maturities maydiffer from contractual maturities because borrowers may have the right to callor prepay obligations with or without call or prepayment penalties.

 
| ** **                       | ** ** | **2005**      | ** ** |
|----------------------------------|------------|---------------|------------|
| ** **                       | ** ** | **Amortized** | ** ** | **Fair** | ** ** |
| ** **                       | ** ** | **Cost**      | ** ** | **Value** | ** ** |
|                             |       |          |       |   |   |
| Within one year                  |       | $             | —     |   | $ | — |   |
| Due from one year to five years  |       | 625           |       | 619 |   |
| Due from five years to ten years |       | 19,703        |       | 19,443 |   |
| Due after ten years              |       | 36,367        |       | 35,722 |   |
|                             |       |          |       |   |   |
| Total                            |       | $             | 56,695     |   | $ | 55,784 |   |

 

As of December 31, 2005 and 2004, investments with carrying valuesof approximately $55.5 million and $55.8 million, respectively, have calloptions held by the issuer, of which approximately $41.0 million and $41.8million, respectively, are callable within one year.

 

**4.**                      LOANS RECEIVABLE

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

 
| ** **                      | ** ** | **2005**   | ** ** | **2004**   | ** ** |
|---------------------------------|------------|------------|------------|------------|------------|
| ** **                      | ** ** | ** ** | ** ** | ** ** | ** ** |
| First mortgage loans:           |       |       |       |       |       |
| One- to four-family residences  |       | $          | 269,660    |       | $          | 282,144 |   |
| Commercial real estate          |       | 119,323    |       | 114,986    |       |
| Multi-family                    |       | 12,900     |       | 9,454      |       |
| Land                            |       | 38,355     |       | 30,923     |       |
| Construction                    |       | 239,062    |       | 159,111    |       |
|                            |       |       |       |       |       |
| Total first mortgage loans      |       | 679,300    |       | 596,618    |       |
|                            |       |       |       |       |       |
| Commercial loans                |       | 32,693     |       | 27,545     |       |
|                            |       |       |       |       |       |
| Consumer loans:                 |       |       |       |       |       |
| Home equity and second mortgage |       | 49,680     |       | 45,256     |       |
| Automobile                      |       | 15,748     |       | 19,101     |       |
| Other                           |       | 13,149     |       | 10,685     |       |
|                            |       |       |       |       |       |
| Total consumer and other loans  |       | 78,577     |       | 75,042     |       |
| Less:                           |       |       |       |       |       |
| Unearned discounts              |       | (81        | )          | (92        | )          |
| Undisbursed loan funds          |       | (69,086    | )          | (62,661    | )          |
| Deferred loan fees—net     |       | (75        | )          | (389       | )          |
| Allowance for loan losses       |       | (2,114     | )          | (1,846     | )          |
|                            |       |       |       |       |       |
| Loans receivable—net       |       | $          | 719,214    |       | $          | 634,217 |   |

 

At December 31, 2005 and 2004, loans receivable included loanscommitted to be sold with net book values of $2.6 million and $1.6 million,respectively.

 

59

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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, 2005 and2004 were $19.6 million and $18.9 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 endedDecember 31, 2005, 2004, and 2003 was $100,000, $159,000, and $36,000,respectively.

 

The following is a summary of information pertaining to impaired andnonaccrual loans:

 
| ** **                                                   | ** ** | **December 31** | ** ** |
|--------------------------------------------------------------|------------|----------------------|------------|
| ** **                                                   | ** ** | **2005**             | ** ** | **2004** | ** ** |
| ** **                                                   | ** ** | ** **           | ** ** | ** ** | ** ** |
| Impaired loans without a valuation  allowance                |       | $                    | 3,846      |   | $ | 3,370 |   |
| Impaired loans with a valuation allowance                    |       | —               |       | 420 |   |
|                                                         |       |                 |       |   |   |
| Total impaired loans                                         |       | $                    | 3,846      |   | $ | 3,790 |   |
|                                                         |       |                 |       |   |   |
| Valuation allowance related to impaired  loans               |       | $                    | —     |   | $ | 62 |   |
|                                                         |       |                 |       |   |   |
| Total nonaccrual loans                                       |       | $                    | 5,306      |   | $ | 4,162 |   |
|                                                         |       |                 |       |   |   |
| Total loans past-due ninety days or more  and still accruing |       | $                    | 1,600      |   | $ | — |   |

 
| ** **                                                    | ** ** | **Year Ended**  | ** ** |
|---------------------------------------------------------------|------------|----------------------|------------|
| ** **                                                    | ** ** | **December 31** | ** ** |
| ** **                                                    | ** ** | **2005**             | ** ** | **2004** | ** ** |
| ** **                                                    | ** ** | ** **           | ** ** | ** ** | ** ** |
| Average investment in impaired loans                          |       | $                    | 3,790      |   | $ | 1,298 |   |
|                                                          |       |                 |       |   |   |
| Interest income recognized on impaired  loans                 |       | $                    | 289        |   | $ | 270 |   |
|                                                          |       |                 |       |   |   |
| Interest income recognized on a cash basis  on impaired loans |       | $                    | —     |   | $ | — |   |

 

Interest income recorded during the years ended December 31, 2005, 2004and 2003 for nonaccrual loans was $35,000, $85,000, and $112,000,respectively.  Under the original terms,these loans would have reported approximately $169,000, $243,000, and $274,000,of interest income for the years ended December 31, 2005, 2004, and 2003,respectively.

 

**5.**                      ACCRUED INTEREST RECEIVABLE

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

 
| ** **            | ** ** | **2005** | ** ** | **2004** | ** ** |
|-----------------------|------------|----------|------------|----------|------------|
|                  |       |     |       |     |       |
| Loans                 |       | $        | 6,875      |     | $          | 3,861 |   |
| Investment securities |       | 615      |       | 566      |       |
|                  |       |     |       |     |       |
| Total                 |       | $        | 7,490      |     | $          | 4,427 |   |

 

60

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** **

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

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

 
| ** **                      | ** ** | **2005**  | ** ** | **2004**             | ** ** | **2003**  | ** ** |
|---------------------------------|------------|-----------|------------|----------------------|------------|-----------|------------|
| ** **                      | ** ** | **Loans** | ** ** | **Real Estate** | ** ** | **Loans** | ** ** | **Real Estate** | ** ** | **Loans** | ** ** | **Real Estate** | ** ** |
|                            |       |      |       |                 |       |      |       |   |   |   |   |   |   |
| Balance—beginning of year  |       | $         | 1,846      |                 | $          | —    |       | $ | 1,621 |   | $ | — |   | $ | 1,529 |   | $ | — |   |
|                            |       |      |       |                 |       |      |       |   |   |   |   |   |   |
| Provisions for estimated losses |       | 1,101     |       | 30                   |       | 1,020     |       | 45 |   | 690 |   | 35 |   |
| Recoveries                      |       | 123       |       | —               |       | 103       |       | — |   | 80 |   | — |   |
| Losses charged off              |       | (956      | )          | (30                  | )          | (898      | )          | (45 | ) | (678 | ) | (35 | ) |
|                            |       |      |       |                 |       |      |       |   |   |   |   |   |   |
| Balance—end of year        |       | $         | 2,114      |                 | $          | —    |       | $ | 1,846 |   | $ | — |   | $ | 1,621 |   | $ | — |   |

** **

**7.**                      OFFICE PROPERTIES AND EQUIPMENT

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

 
| ** **                               | ** ** | **2005** | ** ** | **2004** | ** ** |
|------------------------------------------|------------|----------|------------|----------|------------|
|                                     |       |     |       |     |       |
| Land and land improvements               |       | $        | 4,981      |     | $          | 4,001 |   |
| Buildings and improvements               |       | 13,649   |       | 11,712   |       |
| Furniture and equipment                  |       | 5,556    |       | 5,007    |       |
| Automobiles                              |       | 419      |       | 391      |       |
| Construction in progress                 |       | 985      |       | 303      |       |
|                                     |       |     |       |     |       |
| Total                                    |       | 25,590   |       | 21,414   |       |
|                                     |       |     |       |     |       |
| Accumulated depreciation                 |       | (7,068   | )          | (6,119   | )          |
|                                     |       |     |       |     |       |
| Office properties and equipment—net |       | $        | 18,522     |     | $          | 15,295 |   |

 

Depreciation expense for the years ended December 31, 2005, 2004,and 2003, amounted to approximately $1,185,000, $1,185,000, and $1,167,000,respectively.

 

**8.**                      DEPOSITS

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

 
| ** **                                                                                                              | ** ** | **2005**   | ** ** | **2004**   | ** ** |
|-------------------------------------------------------------------------------------------------------------------------|------------|------------|------------|------------|------------|
| ** **                                                                                                              | ** ** | ** ** | ** ** | ** ** | ** ** |
| Demand deposit accounts, including  noninterest bearing deposits of $36,895 and $31,019 in 2005 and 2004,  respectively |       | $          | 125,397    |       | $          | 109,772 |   |
| Money market                                                                                                            |       | 64,021     |       | 106,063    |       |
| Regular savings                                                                                                         |       | 30,521     |       | 31,611     |       |
| Certificates of deposit                                                                                                 |       | 391,728    |       | 334,978    |       |
|                                                                                                                    |       |       |       |       |       |
| Total                                                                                                                   |       | $          | 611,667    |       | $          | 582,424 |   |

 

61

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Overdrafts of demand deposit accounts of $312,000 and $574,000 atDecember 31, 2005 and 2004, respectively, have been reclassified for financialreporting and are reflected in net loans receivable on the consolidatedstatements of financial condition.

 

The aggregate amount of time deposits in denominations of $100 thousandor more was approximately $118 million and $87 million at December 31,2005 and 2004, respectively.

 

At December 31, 2005, scheduled maturities of certificates ofdeposit are as follows (in thousands):

 
| **Year Ending December 31** | ** ** | ** ** | ** ** |
|--------------------------------------------|------------|------------|------------|
| ** **                                 | ** ** | ** ** | ** ** |
| 2006                                       |       | 213,728    |       |
| 2007                                       |       | 101,357    |       |
| 2008                                       |       | 37,584     |       |
| 2009                                       |       | 10,908     |       |
| 2010                                       |       | 17,263     |       |
| 2011 and thereafter                        |       | 10,888     |       |
|                                       |       |       |       |
| Total                                      |       | $          | 391,728    |   |
|                                            |            |            |            |  |

 

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

 
| ** **                               | ** ** | **Year Ended December 31** | ** ** |
|------------------------------------------|------------|-------------------------------------------|------------|
| ** **                               | ** ** | **2005**                                  | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                     |       |                                      |       |   |   |   |   |
| Interest bearing checking accounts       |       | $                                         | 412        |   | $ | 281 |   | $ | 454 |   |
| Money market                             |       | 1,455                                     |       | 1,665 |   | 1,703 |   |
| Regular savings and certificate accounts |       | 12,854                                    |       | 10,812 |   | 12,536 |   |
| Early withdrawal penalties               |       | (104                                      | )          | (68 | ) | (86 | ) |
|                                     |       |                                      |       |   |   |   |   |
| Total                                    |       | $                                         | 14,617     |   | $ | 12,690 |   | $ | 14,607 |   |

 

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

 

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

The Bank is a member of the Federal Home Loan Bank System. As a memberof this system, it is required to maintain an investment in capital stock ofthe FHLB in an amount equal to the sum of 0.09% of total assets as of theprevious December 31 and 4.10% of outstanding advances. No ready marketexists for such stock and it has no quoted market value. The carrying value ofthe stock is its cost.

 

62

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The Bank pledges eligible collateral for its FHLB advances as definedin its blanket lien agreement with the FHLB as well as its FHLB demand depositaccount and FHLB stock. Eligible collateral under the blanket lien includesFirst Mortgage Collateral (as defined), multi-family residential mortgagesmeeting the requirements for eligibility as First Mortgage Collateral, U.S.Government and Agency Securities (as defined), privately issued mortgage-backedsecurities that qualify as eligible collateral under applicable regulations,Federal Home Loan Bank Term Deposit Accounts, and other non-securitized realestate related collateral. Advances at December 31, 2005 and 2004,consisted of the following (in thousands):

 
| ** **                                              | ** ** | **2005**     | ** ** | **2004**   | ** ** |
|---------------------------------------------------------|------------|--------------|------------|------------|------------|
| ** **                                              | ** ** | **Weighted** | ** ** | ** ** | ** ** | **Weighted** | ** ** | ** ** | ** ** |
| **Amounts Maturing in Year Ending** | ** ** | **Average**  | ** ** | ** ** | ** ** | **Average** | ** ** | ** ** | ** ** |
| **December 31**                                    | ** ** | **Rate**     | ** ** | **Amount** | ** ** | **Rate** | ** ** | **Amount** | ** ** |
| ** **                                              | ** ** | ** **   | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| 2005                                                    |       |         |       |       |       | 3.34 | % | $ | 31,187 |   |
| 2006                                                    |       | 4.03         | %          | $          | 60,766     |   | 2.68 |   | 28,363 |   |
| 2007                                                    |       | 4.07         |       | 51,585     |       | 3.46 |   | 15,786 |   |
| 2008                                                    |       | 4.09         |       | 22,349     |       | 3.35 |   | 5,029 |   |
| 2009                                                    |       | 4.09         |       | 11,051     |       | 3.62 |   | 3,006 |   |
| 2010                                                    |       | 4.33         |       | 4,738      |       | 3.64 |   | 317 |   |
| Thereafter                                              |       | 4.32         |       | 7,751      |       | 4.28 |   | 6,068 |   |
|                                                    |       |         |       |       |       |   |   |   |   |
| Total                                                   |       | 4.08         | %          | $          | 158,240    |   | 3.23 | % | $ | 89,756 |   |
|                                                         |            |              |            |            |            |  |  |  |  |  |  |  |

 

**10.**               INCOME TAXES

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

 
| ** **                      | ** ** | **Year Ended December 31** | ** ** |
|---------------------------------|------------|-------------------------------------------|------------|
| ** **                      | ** ** | **2005**                                  | ** ** | **2004** | ** ** | **2003** | ** ** |
|                            |       |                                      |       |   |   |   |   |
| Income tax provision (benefit): |       |                                      |       |   |   |   |   |
| Current:                        |       |                                      |       |   |   |   |   |
| Federal                         |       | $                                         | 3,275      |   | $ | 2,924 |   | $ | 2,882 |   |
| State                           |       | 461                                       |       | 424 |   | 397 |   |
| Total current                   |       | $                                         | 3,736      |   | $ | 3,348 |   | $ | 3,279 |   |
|                            |       |                                      |       |   |   |   |   |
| Deferred:                       |       |                                      |       |   |   |   |   |
| Federal                         |       | $                                         | (69        | ) | $ | 317 |   | $ | 84 |   |
| State                           |       | 56                                        |       | 33 |   | (24 | ) |
| Total deferred                  |       | $                                         | (13        | ) | $ | 350 |   | $ | 60 |   |
|                            |       |                                      |       |   |   |   |   |
| Total                           |       | $                                         | 3,723      |   | $ | 3,698 |   | $ | 3,339 |   |

 

63

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

 
| ** **                          | ** ** | **Year Ended December 31** | ** ** |
|-------------------------------------|------------|-------------------------------------------|------------|
| ** **                          | ** ** | **2005**                                  | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                |       |                                      |       |   |   |   |   |   |   |   |   |   |   |
| Taxes at statutory rate             |       | $                                         | 3,935      |   | 34.0 | % | $ | 3,911 |   | 34.0 | % | $ | 3,670 |   | 34.0 | % |
| Increase (decrease) resulting from: |       |                                      |       |   |   |   |   |   |   |   |   |   |   |
| State income tax—net           |       | 269                                       |       | 2.3 | % | 287 |   | 2.5 | % | 263 |   | 2.4 | % |
| Earnings on life insurance policies |       | (257                                      | )          | (2.2 | )% | (271 | ) | (2.4 | )% | (288 | ) | (2.7 | )% |
| Nontaxable investments              |       | (211                                      | )          | (1.8 | )% | (208 | ) | (1.8 | )% | (154 | ) | (1.4 | )% |
| Other—net                      |       | (13                                       | )          | (0.1 | )% | (21 | ) | (0.2 | )% | (152 | ) | (1.4 | )% |
|                                |       |                                      |       |   |   |   |   |   |   |   |   |   |   |
| Total                               |       | $                                         | 3,723      |   | 32.2 | % | $ | 3,698 |   | 32.1 | % | $ | 3,339 |   | 30.9 | % |

 

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

 
| ** **                     | ** ** | **2005** | ** ** | **2004** | ** ** |
|--------------------------------|------------|----------|------------|----------|------------|
|                           |       |     |       |     |       |
| Deferred tax assets:           |       |     |       |     |       |
| Stock based compensation       |       | $        | 18         |     | $          | 77 |   |
| Allowance for loan losses      |       | 810      |       | 709      |       |
|                           |       |     |       |     |       |
| Total deferred tax assets      |       | 828      |       | 786      |       |
|                           |       |     |       |     |       |
| Deferred tax liabilities:      |       |     |       |     |       |
| Office properties              |       | (724     | )          | (762     | )          |
| Federal Home Loan Bank stock   |       | (696     | )          | (601     | )          |
| Pension plan contribution      |       | (327     | )          | (436     | )          |
| Prepaid expenses               |       | (81      | )          | —   |       |
|                           |       |     |       |     |       |
| Total deferred tax liabilities |       | (1,828   | )          | (1,799   | )          |
|                           |       |     |       |     |       |
| Net deferred tax liability     |       | $        | (1,000     | )        | $          | (1,013 | ) |

 

Specifically exempted from deferred tax recognition requirements arebad debt reserves for tax purposes of U.S. savings and loans in the institution’sbase year, as defined. Base year reserves totaled approximately $4.2 million.Consequently, a deferred tax liability of approximately $1.6 million related tosuch reserves was not provided for in the consolidated statements of financialcondition at December 31, 2005 and 2004. Payment of dividends toshareholders out of retained earnings deemed to have been made out of earningspreviously set aside as bad debt reserves may create taxable income to theBank. No provision has been made for income tax on such a distribution as theBank does not anticipate making such distributions.

 

**11.**               BENEFIT PLANS

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

 

64

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

 
| ** **  | ** ** | ** **               | ** ** | **Weighted Average** | ** ** |
|-------------|------------|--------------------------|------------|---------------------------|------------|
| **Year**    | ** ** | **Range of**        | ** ** | **Remaining**             | ** ** |
| **Granted** | ** ** | **Exercise Prices** | ** ** | **Contract Life**    | ** ** |
| ** **  | ** ** | ** **               | ** ** | ** **                | ** ** |
| 1997        |       | $  9.63        | -          |  10.19               |       |   | 1.3 years |   |
| 1998        |       | 11.63                    | -          |  12.00               |       |   | 2.1 years |   |
| 1999        |       | 8.53                     | -          |  9.32                |       |   | 1.9 years |   |
| 2000        |       | 7.38                     | -          |  9.13                |       |   | 4.7 years |   |
| 2001        |       | 9.35                     | -          |  11.35               |       |   | 5.4 years |   |
| 2002        |       | 12.20                    | -          |  12.32               |       |   | 6.6 years |   |
| 2003        |       | 12.93                    | -          |  16.11               |       |   | 7.3 years |   |
| 2004        |       | 19.25                    | -          |  21.50               |       |   | 8.1 years |   |
| 2005        |       | 24.81                    |       | 9.9 years                 |       |

 

A summary of the status of the Company’s SOP as of December 31,2005, 2004, and 2003, and changes during the years ending on those dates arepresented below:

 
| ** **                                   | ** ** | ** ** | ** ** | **Weighted** | ** ** |
|----------------------------------------------|------------|------------|------------|--------------|------------|
| ** **                                   | ** ** | ** ** | ** ** | **Average**  | ** ** |
| ** **                                   | ** ** | ** ** | ** ** | **Exercise** | ** ** |
| ** **                                   | ** ** | **Shares** | ** ** | **Price**    | ** ** |
| ** **                                   | ** ** | ** ** | ** ** | ** **   | ** ** |
| Outstanding—January 1, 2003             |       | 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       |   |
|                                         |       |       |       |         |       |
| Exercised                                    |       | (283,456   | )          | 9.67         |       |
| Granted                                      |       | 1,000      |       | 24.81        |       |
| Expired                                      |       | (1,200     | )          | 9.63         |       |
| Forfeited                                    |       | (800       | )          | 12.32        |       |
|                                         |       |       |       |         |       |
| Outstanding—December 31, 2005           |       | 345,268    |       | $            | 9.98       |   |
| Options exercisable – December 31, 2005 |       | 338,316    |       | $            | 9.84       |   |

*** ***

***ManagementRecognition and Retention Plan—***The Management Recognitionand Retention Plan (“MRR Plan”) provides for a committee of the Company’s Boardof Directors to award restricted stock to key officers as well as non-employeedirectors. The MRR Plan authorizes the Company to grant up to 412,300 shares ofthe Company stock, of which 401,688 shares have been granted throughDecember 31, 2005. Compensation expense has been recognized over thevesting period based on the fair market value of the shares on the grant date.Shares granted will be deemed vested in the event of disability or death.Approximately $27,000, $27,000 and $45,000 in compensation expense wasrecognized during each of the years ended December 31, 2005, 2004 and2003.

 

65

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***Employee StockOwnership Plan—***The Company established an Employee StockOwnership Plan on May 3, 1996. During 1996, the ESOP borrowed $4.1 million fromthe Company to purchase shares of Company stock. The loan is collateralized bythe shares that were purchased with the proceeds of the loan. As the loan isrepaid, ESOP shares will be allocated to participants of the ESOP and areavailable for release to the participants subject to the vesting provisions ofthe ESOP.

 

Forfeitures of nonvested benefits will be reallocated among remainingparticipating employees in the same proportion as contributions. During each ofthe years ended December 31, 2005, 2004, and 2003, 83,208 shares werereleased by the ESOP to participant accounts. At December 31, 2005, therewere 653,044 shares allocated to participant accounts and 20,802 unallocatedshares. The fair value of the unallocated shares amounted to approximately$505,000 at December 31, 2005.

 

During the years ended December 31, 2005, 2004, and 2003, ESOPexpense was approximately $2.0 million, $1.7 million, and $1.2 million,respectively.

 

***OtherPostretirement Benefits—***The Bank is a participant in amulti-employer retirement plan and therefore separate information is notavailable. The plan is noncontributory and covers substantially all employees.The plan provides a retirement benefit and a death benefit. Retirement benefitsare payable in monthly installments for life and must begin not later than thefirst day of the month coincident with or the next month following theseventieth birthday or the participant may elect a lump-sum distribution. Deathbenefits are paid in a lump-sum distribution, the amount of which depends onyears of service. Net pension expense was approximately $660,000, $358,000 and$480,000 for the years ended December 31, 2005, 2004, and 2003,respectively.

 

**12.**               EARNINGS PER SHARE

 
| ** **                                                                        | ** ** | **Year Ended December 31, 2005** | ** ** |
|-----------------------------------------------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                                                                        | ** ** | **Income**                                           | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                                                        | ** ** | **(In Thousands)**                              | ** ** | **Shares** | ** ** | **Per Share** | ** ** |
| ** **                                                                        | ** ** | **(Numerator)**                                      | ** ** | **(Denominator)** | ** ** | **Amount** | ** ** |
| Basic EPS—Income available to common  stockholders                           |       | $                                                    | 7,850      |   | 4,989,041 |   | $ | 1.57 |   |
|                                                                              |       |                                                 |       |   |   |   |   |
| Effect of dilutive securities—Stock options                                  |       | —                                               |       | 238,692 |   |   |   |
|                                                                              |       |                                                 |       |   |   |   |   |
| Diluted EPS—Income available to common stockholders  and assumed conversions |       | $                                                    | 7,850      |   | 5,227,733 |   | $ | 1.50 |   |

 
| ** **                                                                        | ** ** | **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 |   |

 

66

----

 
| ** **                                                                        | ** ** | **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 |   |

** **

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

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

 

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

 

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

 

The funding period for construction loans is generally six to eighteenmonths and commitments to originate mortgage loans are generally outstandingfor 60 days or less.

 

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

 

•                  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

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

 

At December 31, 2005, the Bank’s off-balance sheet arrangementsprincipally included lending commitments, which are described below. AtDecember 31, 2005, the Company had no interests in non-consolidated specialpurpose entities.

 

At December 31, 2005, commitments included:

 

•                  totalapproved loan origination commitments outstanding amounting to $10.8 million,including $1.2 million of loans committed to sell;

•                  ratelock agreements with customers of $6.8 million, all of which have been lockedwith an investor;

•                  fundedmortgage loans committed to sell of $2.6 million;

•                  unadvancedportion of construction loans of $69.1 million;

•                  unusedlines of credit of $27.6 million;

 

67

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•                  outstandingstandby letters of credit of $800,000;

•                  totalpredetermined overdraft protection limits of $10.6 million; and

•                  certificatesof deposit scheduled to mature in one year or less totaling $213.7 million.

 

Total unfunded commitments to originate loans for sale and the relatedcommitments to sell of $6.8 million meet the definition of a derivativefinancial instrument. The related asset and liability are considered immaterialat December 31, 2005.

 

Historically, a very small percentage of predetermined overdraft limitshave been used. At December 31, 2005, overdrafts of accounts with BounceProtectionä represented usageof 2.6% of the limit.

 

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

 

**14.**               FAIR VALUE OF FINANCIAL INSTRUMENTS

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

 
| ** **                                             | ** ** | **December 31, 2005** | ** ** | **December 31, 2004** | ** ** |
|--------------------------------------------------------|------------|---------------------------------|------------|---------------------------------|------------|
| ** **                                             | ** ** | ** **                      | ** ** | **Estimated**                   | ** ** | ** ** | ** ** | **Estimated** | ** ** |
| ** **                                             | ** ** | **Carrying**                    | ** ** | **Fair**                        | ** ** | **Carrying** | ** ** | **Fair** | ** ** |
| ** **                                             | ** ** | **Value**                       | ** ** | **Value**                       | ** ** | **Value** | ** ** | **Value** | ** ** |
| ASSETS:                                                |       |                            |       |                            |       |   |   |   |   |
| Cash and cash equivalents                              |       | $                               | 21,109     |                            | $          | 21,109 |   | $ | 16,003 |   | $ | 16,003 |   |
| Investment securities—held to maturity            |       | 56,695                          |       | 55,784                          |       | 56,660 |   | 56,426 |   |
| Federal Home Loan Bank stock                           |       | 8,412                           |       | 8,412                           |       | 4,876 |   | 4,876 |   |
| Loans receivable—net                              |       | 719,214                         |       | 711,479                         |       | 634,217 |   | 636,424 |   |
| Cash surrender value of life insurance                 |       | 18,654                          |       | 18,654                          |       | 17,897 |   | 17,897 |   |
| Accrued interest receivable                            |       | 7,490                           |       | 7,490                           |       | 4,427 |   | 4,427 |   |
| Commitments                                            |       | 19                              |       | 19                              |       | 2 |   | 2 |   |
|                                                   |       |                            |       |                            |       |   |   |   |   |
| LIABILITIES:                                           |       |                            |       |                            |       |   |   |   |   |
| Deposits:                                              |       |                            |       |                            |       |   |   |   |   |
| Demand, NOW, money market and regular  savings         |       | 219,939                         |       | 219,939                         |       | 247,446 |   | 247,446 |   |
| Certificates of deposit                                |       | 391,728                         |       | 390,957                         |       | 334,978 |   | 336,508 |   |
| Federal Home Loan Bank advances                        |       | 158,240                         |       | 157,547                         |       | 89,756 |   | 89,670 |   |
| Accrued interest payable                               |       | 914                             |       | 914                             |       | 344 |   | 344 |   |
| Advance payments by borrowers for taxes and  insurance |       | 847                             |       | 847                             |       | 757 |   | 757 |   |
| Commitments                                            |       | 19                              |       | 19                              |       | 2 |   | 2 |   |
|                                                        |            |                                 |            |                                 |            |  |  |  |  |  |  |  |  |

 

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

 

68

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

 

The fair value estimates presented herein are based on pertinentinformation available to management as of December 31, 2005 and 2004.Although management is not aware of any factors that would significantly affectthe estimated fair value amounts, such amounts have not been comprehensivelyrevalued for purposes of these financial statements since the reporting dateand, therefore, current estimates of fair value may differ significantly fromthe amounts presented herein.

 

**15.**               CONTINGENCIES

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

 

**16.**               RETAINED EARNINGS—SUBSTANTIALLY RESTRICTED

Upon conversion, the Company established a special liquidation accountfor the benefit of eligible account holders and the supplemental eligibleaccount holders in an amount equal to the net worth of the Bank as of the dateof its latest statement of financial condition contained in the final offeringcircular used in connection with the conversion. The liquidation account willbe maintained for the benefit of eligible account holders and supplementaleligible account holders who continue to maintain their accounts in the Bankafter conversion. In the event of a complete liquidation (and only in suchevent), each eligible and supplemental eligible account holder will be entitledto receive a liquidation distribution from the liquidation account in an amountproportionate to the current adjusted qualifying balances for accounts thenheld.

 

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

 

**17.**               REGULATORY MATTERS

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

 

Quantitative measures established by regulation to ensure capitaladequacy require the Bank to maintain minimum amounts and ratios (set forth inthe following table) of tangible capital (as defined) to tangible assets (asdefined) and core capital (as defined) to adjusted tangible assets (asdefined), and of total risk-based capital (as defined) to risk-weighted assets(as defined). Management believes, as of December 31, 2005, that the Bankmeets all capital adequacy requirements to which it is subject.

 

At December 31, 2005 and 2004, the most recent notification fromthe OTS categorized the Bank as well capitalized under the regulatory frameworkfor prompt corrective action. To be categorized as well capitalized the Bankmust maintain minimum core (Tier I leverage), Tier I risk-based, and totalrisk-based ratios as set forth in the table. There are no conditions or eventssince that notification that management believes have changed the Bank’scategory.

 

69

----

 

The Bank’s actualcapital amounts (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, 2005:                 |       |       |       |                       |       |                       |       |                       |       |                            |       |   |   |
|                                     |       |       |       |                       |       |                       |       |                       |       |                            |       |   |   |
| Tangible Capital to Tangible Assets      |       | $          | 74,857     |                       | 8.78       | %                          | $          | 12,784                     |       | 1.50                            | %          | N/A |   | N/A |   |
|                                     |       |       |       |                       |       |                       |       |                       |       |                            |       |   |   |
| Core Capital to Adjusted Tangible Assets |       | 74,857     |       | 8.78                       | %          | 34,090                     |       | 4.00                       | %          | $                               | 42,612     |   | 5.00 | % |
|                                     |       |       |       |                       |       |                       |       |                       |       |                            |       |   |   |
| Total Capital to Risk-Weighted Assets    |       | 76,718     |       | 12.06                      | %          | 50,872                     |       | 8.00                       | %          | 63,590                          |       | 10.00 | % |
|                                     |       |       |       |                       |       |                       |       |                       |       |                            |       |   |   |
| Tier I Capital to Risk-Weighted Assets   |       | 74,857     |       | 11.77                      | %          | N/A                        |       | N/A                        |       | 38,154                          |       | 6.00 | % |
|                                     |       |       |       |                       |       |                       |       |                       |       |                            |       |   |   |
| 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 | % |

** **

**18.**               RELATED PARTY TRANSACTIONS

In the normal course of business, the Bank has made loans to its directors,officers, and their related business interests. In the opinion of management,related party loans are made on substantially the same terms, includinginterest rates and collateral, as those prevailing at the time for comparabletransactions with unrelated persons and do not involve more than the normalrisk of collectibility. The aggregate dollar amount of loans outstanding todirectors, officers, and their related business interests was approximately$1.5 and $2.6 million at December 31, 2005 and 2004, respectively.

 

Deposits from related parties held by the Bank at December 31,2005 and 2004 amounted to $3.6 million and $2.8 million, respectively.

 

70

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** **

**19.**               PARENT COMPANY ONLY FINANCIAL INFORMATION

The followingcondensed statements of financial condition, as of December 31, 2005 and2004, and condensed statements of income and of cash flows for each of thethree years in the period ended December 31, 2005, for First FederalBancshares of Arkansas, Inc. should be read in conjunction with theconsolidated financial statements and the notes herein.

 
| **FIRST  FEDERAL BANCSHARES OF ARKANSAS, INC.**  |   |   |   |
|--------------------------------------------------|--------|--------|--------|
| **(Parent  Company Only)**                       |   |   |   |
|                                             |   |   |   |
| **CONDENSED  STATEMENTS OF FINANCIAL CONDITION** |   |   |   |
| **DECEMBER  31, 2005 AND 2004**                  |   |   |   |
| **(In thousands)**                               |   |   |   |

 
| ** **                                    | ** ** | **2005** | ** ** | **2004** | ** ** |
|-----------------------------------------------|------------|----------|------------|----------|------------|
| **ASSETS**                                    |       |     |       |     |       |
| Cash and cash equivalents (deposits in  Bank) |       | $        | 327        |     | $          | 206 |   |
| Loan to Bank subsidiary                       |       | 2,046    |       | 1,001    |       |
| Accrued interest receivable                   |       | 5        |       | 3        |       |
| Investment in Bank                            |       | 75,056   |       | 73,426   |       |
| Other assets                                  |       | 553      |       | 702      |       |
|                                          |       |     |       |     |       |
| TOTAL                                         |       | $        | 77,987     |     | $          | 75,338 |   |
|                                          |       |     |       |     |       |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY** |       |     |       |     |       |
|                                          |       |     |       |     |       |
| Accrued expenses and other liabilities        |       | $        | 145        |     | $          | 37 |   |
| Stockholders’ equity                     |       | 77,842   |       | 75,301   |       |
|                                          |       |     |       |     |       |
| TOTAL                                         |       | $        | 77,987     |     | $          | 75,338 |   |

 

71

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| **FIRST  FEDERAL BANCSHARES OF ARKANSAS, INC.**    |       |       |       |       |       |
|----------------------------------------------------|------------|------------|------------|------------|------------|
| **(Parent  Company Only)**                         | ** ** | ** ** | ** ** | ** ** | ** ** |
|                                               |       |       |       |       |       |
| **CONDENSED  STATEMENTS OF INCOME**                | ** ** | ** ** | ** ** | ** ** | ** ** |
| **YEARS  ENDED DECEMBER 31, 2005, 2004, AND 2003** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **(In  thousands)**                                | ** ** | ** ** | ** ** | ** ** | ** ** |

 
| ** **                                                                                | ** ** | **2005**   | ** ** | **2004**   | ** ** | **2003**   | ** ** |
|-------------------------------------------------------------------------------------------|------------|------------|------------|------------|------------|------------|------------|
| ** **                                                                                | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| INCOME:                                                                                   |       |       |       |       |       |       |       |
| Dividends from the Bank                                                                   |       | $          | 7,000      |       | $          | 6,000      |       | $ | 3,000 |   |
| Interest income—loan to the Bank                                                     |       | 45         |       | 22         |       | 24         |       |
|                                                                                      |       |       |       |       |       |       |       |
| Total income                                                                              |       | 7,045      |       | 6,022      |       | 3,024      |       |
|                                                                                      |       |       |       |       |       |       |       |
| EXPENSES:                                                                                 |       |       |       |       |       |       |       |
| Management fees                                                                           |       | 66         |       | 66         |       | 66         |       |
| Other operating expenses                                                                  |       | 230        |       | 234        |       | 228        |       |
|                                                                                      |       |       |       |       |       |       |       |
| Total expenses                                                                            |       | 296        |       | 300        |       | 294        |       |
|                                                                                      |       |       |       |       |       |       |       |
| INCOME BEFORE INCOME TAX BENEFIT AND EQUITY  IN UNDISTRIBUTED EARNINGS OF BANK SUBSIDIARY |       | 6,749      |       | 5,722      |       | 2,730      |       |
|                                                                                      |       |       |       |       |       |       |       |
| INCOME TAX BENEFIT                                                                        |       | 96         |       | 107        |       | 103        |       |
|                                                                                      |       |       |       |       |       |       |       |
| INCOME BEFORE EQUITY IN UNDISTRIBUTED EARNINGS  OF BANK SUBSIDIARY                        |       | 6,845      |       | 5,829      |       | 2,833      |       |
|                                                                                      |       |       |       |       |       |       |       |
| EQUITY IN UNDISTRIBUTED EARNINGS OF BANK  SUBSIDIARY                                      |       | 1,005      |       | 1,976      |       | 4,623      |       |
|                                                                                      |       |       |       |       |       |       |       |
| NET INCOME                                                                                |       | $          | 7,850      |       | $          | 7,805      |       | $ | 7,456 |   |

 

72

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| **FIRST  FEDERAL BANCSHARES OF ARKANSAS, INC.**    |       |       |       |       |       |
|----------------------------------------------------|------------|------------|------------|------------|------------|
| **(Parent  Company Only)**                         | ** ** | ** ** | ** ** | ** ** | ** ** |
|                                               |       |       |       |       |       |
| **CONDENSED  STATEMENTS OF CASH FLOWS**            | ** ** | ** ** | ** ** | ** ** | ** ** |
| **YEARS  ENDED DECEMBER 31, 2005, 2004, AND 2003** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **(In  thousands)**                                | ** ** | ** ** | ** ** | ** ** | ** ** |

 
| ** **                                                                         | ** ** | **2005**   | ** ** | **2004**   | ** ** | **2003**   | ** ** |
|------------------------------------------------------------------------------------|------------|------------|------------|------------|------------|------------|------------|
| ** **                                                                         | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| OPERATING ACTIVITIES:                                                              |       |       |       |       |       |       |       |
| Net income                                                                         |       | $          | 7,850      |       | $          | 7,805      |       | $ | 7,456 |   |
| Adjustments to reconcile net income to net  cash provided by operating activities: |       |       |       |       |       |       |       |
| Equity in undistributed net earnings of  Bank                                      |       | (1,005     | )          | (1,976     | )          | (4,623     | )          |
| Release of ESOP shares                                                             |       | 1,991      |       | 1,712      |       | 1,322      |       |
| Stock compensation expense                                                         |       | 26         |       | 56         |       | 45         |       |
| Changes in operating assets and  liabilities:                                      |       |       |       |       |       |       |       |
| Accrued interest receivable                                                        |       | (2         | )          | (1         | )          |       |       |
| Other assets                                                                       |       | 149        |       | 235        |       | (190       | )          |
| Accrued expenses and other liabilities                                             |       | 108        |       | (378       | )          | 264        |       |
|                                                                               |       |       |       |       |       |       |       |
| Net cash provided by operating activities                                          |       | 9,117      |       | 7,453      |       | 4,274      |       |
|                                                                               |       |       |       |       |       |       |       |
| INVESTING ACTIVITIES—Loan to bank—net  of repayments                     |       | (1,045     | )          | 2,194      |       | (1,228     | )          |
|                                                                               |       |       |       |       |       |       |       |
| Net cash provided by (used in) investing  activities                               |       | (1,045     | )          | 2,194      |       | (1,228     | )          |
|                                                                               |       |       |       |       |       |       |       |
| FINANCING ACTIVITIES:                                                              |       |       |       |       |       |       |       |
| Purchase of treasury stock                                                         |       | (7,630     | )          | (9,534     | )          | (2,805     | )          |
| Dividends paid                                                                     |       | (2,527     | )          | (2,178     | )          | (1,814     | )          |
| Stock options exercised                                                            |       | 2,206      |       | 2,035      |       | 1,418      |       |
|                                                                               |       |       |       |       |       |       |       |
| Net cash used in financing activities                                              |       | (7,951     | )          | (9,677     | )          | (3,201     | )          |
|                                                                               |       |       |       |       |       |       |       |
| NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS                               |       | 121        |       | (30        | )          | (155       | )          |
|                                                                               |       |       |       |       |       |       |       |
| CASH AND CASH EQUIVALENTS:                                                         |       |       |       |       |       |       |       |
| Beginning of period                                                                |       | 206        |       | 236        |       | 391        |       |
|                                                                               |       |       |       |       |       |       |       |
| End of period                                                                      |       | $          | 327        |       | $          | 206        |       | $ | 236 |   |

 

******

 

73

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**SELECTED QUARTERLY OPERATING RESULTS(UNAUDITED)**

**(INTHOUSANDS, EXCEPT SHARE AND PER SHARE DATA)**

 
| **YEAR ENDED DECEMBER 31, 2005** | ** ** | **Fourth  Quarter** | ** ** | **Third  Quarter** | ** ** | **Second  Quarter** | ** ** | **First  Quarter** | ** ** |
|------------------------------------------------------|------------|---------------------|------------|--------------------|------------|---------------------|------------|--------------------|------------|
| Interest income                                      |       | $                   | 12,573     |               | $          | 11,916              |       | $                  | 11,001     |   | $ | 10,595 |   |
| Interest expense                                     |       | 5,754               |       | 5,135              |       | 4,588               |       | 4,127              |       |
| Net interest income                                  |       | 6,819               |       | 6,781              |       | 6,413               |       | 6,468              |       |
| Provision for loan losses                            |       | 280                 |       | 285                |       | 287                 |       | 249                |       |
| Net interest income after  provision for loan losses |       | 6,539               |       | 6,496              |       | 6,126               |       | 6,219              |       |
| Noninterest income                                   |       | 1,849               |       | 1,818              |       | 1,724               |       | 1,570              |       |
| Noninterest expense                                  |       | 5,580               |       | 5,313              |       | 4,979               |       | 4,896              |       |
| Income before income taxes                           |       | 2,808               |       | 3,001              |       | 2,871               |       | 2,893              |       |
| Provision for income taxes                           |       | 907                 |       | 965                |       | 922                 |       | 929                |       |
| Net income                                           |       | $                   | 1,901      |               | $          | 2,036               |       | $                  | 1,949      |   | $ | 1,964 |   |
| Earnings per share(1):                               |       |                |       |               |       |                |       |               |       |
| Basic                                                |       | $                   | 0.38       |               | $          | 0.41                |       | $                  | 0.39       |   | $ | 0.39 |   |
| Diluted                                              |       | $                   | 0.37       |               | $          | 0.39                |       | $                  | 0.37       |   | $ | 0.37 |   |
|                                                 |       |                |       |               |       |                |       |               |       |
| Selected Ratios  (Annualized):                       |       |                |       |               |       |                |       |               |       |
| Net interest margin                                  |       | 3.44                | %          | 3.55               | %          | 3.45                | %          | 3.61               | %          |
| Return on average assets                             |       | 0.89                |       | 1.00               |       | 0.98                |       | 1.01               |       |
| Return on average equity                             |       | 9.79                |       | 10.61              |       | 10.27               |       | 9.33               |       |
|                                                 |       |                |       |               |       |                |       |               |       |
| **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               |       |

 

----

(1)  Basicand diluted shares outstanding are summarized below.

 
| ** **                                       | ** ** | **Fourth  Quarter** | ** ** | **Third  Quarter** | ** ** | **Second  Quarter** | ** ** | **First  Quarter** | ** ** |
|--------------------------------------------------|------------|---------------------|------------|--------------------|------------|---------------------|------------|--------------------|------------|
| YEAR ENDED DECEMBER 31, 2005 |       |                |       |               |       |                |       |               |       |
| Basic weighted - average  shares                 |       | 5,002,779           |       | 4,990,081          |       | 4,975,893           |       | 4,987,228          |       |
| Effect of dilutive  securities                   |       | 201,359             |       | 222,985            |       | 250,552             |       | 280,357            |       |
| Diluted weighted - average  shares               |       | 5,204,138           |       | 5,213,066          |       | 5,226,445           |       | 5,267,585          |       |
|                                             |       |                |       |               |       |                |       |               |       |
| 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          |       |

 

74

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**Item 9.  Changes in andDisagreements with Accountants on Accounting and Financial Disclosure.**

 

Not Applicable.

 

**Item 9A.  Controls andProcedures.**

 

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’s annualreport on internal control over financial reporting and the attestation reportof the Company’s independent registered public accounting firm are included inItem 8 under the headings “Management Report on Internal Control” and “Reportof Independent Registered Public Accounting Firm,” respectively, and areincorporated 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, 2005 thathas materially affected, or is reasonably likely to materially affect, theCompany’s internal control over financial reporting.

 

**Item 9B.  OtherInformation.**

 

Not Applicable.

 

**PART III.**

 

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

 

The informationregarding directors and executive officers is incorporated herein by referencefrom the section entitled “Information with Respect to Nominees for Director,Continuing Directors and Executive Officers” in our definitive Proxy Statement(“2006 Proxy Statement”) to be filed pursuant to Regulation 14A of the SecuritiesExchange Act of 1934, as amended, for our Annual Meeting of Stockholders to beheld on April 25, 2006. The 2006 Proxy Statement will be filed within 120 daysafter the end of our fiscal year ended December 31, 2005.

 

The informationregarding compliance with Section 16(a) of the Securities and Exchange Act of1934 is incorporated herein by reference from the section entitled “Section16(a) Beneficial Ownership Reporting Compliance” of our 2006 Proxy Statement.

 

The informationregarding audit committee financial experts is incorporated by reference hereinfrom the subsection entitled “Committees and Meetings of the Board of theCompany and the Bank” in the section entitled “Information with Respect toNominee for Director, Continuing Directors and Executive Officers” in our 2006Proxy Statement.

 

The informationregarding the code of ethics applicable to our principal executive officer,principal financial officer and principal accounting officer is incorporatedherein by reference from the subsection entitled—”Code of Ethics for ExecutiveOfficers and Financial Professionals” in the section entitled “Information withRespect to Nominee for Director, Continuing Directors and Executive Officers”in our 2006 Proxy Statement.

 

**Item 11.  ExecutiveCompensation.**

 

Information regardingexecutive compensation is incorporated herein by reference from the sectionsentitled “Executive Compensation” and “Performance Graph” in our 2006 ProxyStatement.

 

75

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

 

Information regardingsecurity ownership of certain beneficial owners and management is incorporatedherein by reference from the section entitled “Beneficial Ownership of CommonStock By Certain Beneficial Owners and Management and Related StockholderMatters” and information regarding securities authorized for issuance underequity compensation plans is incorporated herein by reference from thesubsection entitled “Equity-Based Compensation Plans” in our 2006 ProxyStatement.

 

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

 

Information regardingcertain relationships and related transactions is incorporated herein byreference from the section entitled “Transactions with Certain Related Persons”in our 2006 Proxy Statement.

 

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

 

The informationregarding principal auditor fees and services is incorporated herein byreference from the section entitled “Relationship with Independent Auditors” inour 2006 Proxy Statement.

 

**PART IV.**

 

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

 

**(a)  Documents Filedas 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                                                                                                                       |
|    |   |                                                                                                                                                        |
|         |
| (*)     |   | Incorporated herein by  reference from the Company’s Registration Statement on Form S-1 (File No.  333-612) filed with the SEC.                        |
|    |   |                                                                                                                                                        |
| (**)    |   | Incorporated herein by  reference from the Company’s Registration Statement on Form 8-A filed with  the SEC.                                           |
|    |   |                                                                                                                                                        |
| (***)   |   | Incorporated herein by  reference from the Company’s Annual Report on Form 10-K for the fiscal year  ended December 31, 2002 filed with the SEC.       |

 

76

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**SIGNATURES**

 

Pursuant to the requirementsof Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registranthas duly caused this report to be signed on its behalf by the undersigned,thereunto duly authorized.

 

 

FIRSTFEDERAL BANCSHARES OF ARKANSAS, INC.

 
|   | By:                          | /s/ Larry J. Brandt |   |
|--------|----------------------------------------|---------------------|--------|
|   | Larry J. Brandt                        |
|   | President and Chief  Executive Officer |

 

Pursuant to the requirementsof the Securities Exchange Act of 1934, this report has been signed below bythe following persons on behalf of the Registrant and in the capacities and onthe dates indicated.

 

 
|  /s/ Larry J. Brandt           |   | February 28, 2006  |
|-------------------------------------|--------|--------------------|
| Larry J. Brandt                |   |               |
| President and Chief                 |   |               |
| Executive Officer                   |   |               |
|                                |   |               |
|  /s/ John P. Hammerschmidt     |   | February 28, 2006  |
| John P. Hammerschmidt               |   |               |
| Chairman                            |   |               |
|                                |   |               |
|  /s/ Jeff Brandt               |   | February 28, 2006  |
| Jeff Brandt                    |   |               |
| Director                            |   |               |
|                                |   |               |
|  /s/ Kenneth C. Savells        |   | February 28, 2006  |
| Kenneth C. Savells             |   |               |
| Director                            |   |               |
|                                |   |               |
|  /s/ Frank Conner              |   | February 28, 2006  |
| Frank Conner                   |   |               |
| Director                            |   |               |
|                                |   |               |
|  /s/ Sherri R. Billings        |   | February  28, 2006 |
| Sherri  R. Billings            |   |               |
| Executive  Vice President and Chief |   |               |
| Financial and Accounting Officer    |   |               |
|                                     |        |                    |  |  |  |  |

 

77

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