**UNITEDSTATESSECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

 

**FORM 10-K**

 

**(Mark One)**

 
| **x**                                                 | ** ** | **ANNUAL REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**     |
|-------------------------------------------------------|------------|---------------------------------------------------------------------------------------------------------|
| ** **                                            | ** ** | ** **                                                                                              |
| **For the  fiscal year ended December 31, 2007** |
| ** **                                            | ** ** | ** **                                                                                              |
| **OR**                                                |
| ** **                                            | ** ** | ** **                                                                                              |
| **o**                                                 | ** ** | **TRANSITION REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |

 

**For thetransition period from                 to                .**

** **

**Commissionfile number**** 0-28312**

** **

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

(Exactname of registrant as specified in its charter)

 

 

| **Texas**                                                         | ** ** | **71-0785261**                     |
|-------------------------------------------------------------------|------------|------------------------------------|
| (State or other  jurisdiction

of incorporation or  organization) |       | (IRS Employer

Identification No.) |

 

| **1401  Highway 62-65 North**

**Harrison,  Arkansas** | ** ** | **72601**  |
|--------------------------------------------------------|------------|------------|
| (Address of principal  executive offices)              |       | (Zip Code) |

 

 

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

 

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

 

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

 

Securitiesregistered pursuant to section 12(g) of the Act:  **None**

 

Indicate by check mark if the registrant is a well-known seasonedissuer, as defined in Rule 405 of the Securities Act. 

Yes oNox

 

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 x

 

Indicate by check mark whether the registrant: (1) has filed allreports required to be filed by Section 13 or 15(d) of the Securities

Exchange Act of 1934 during the preceding 12 months (or for suchshorter period that the registrant was required to file such reports), and (2)has been subject to such filing requirements for the past 90 days. Yes xNo o

 

Indicate by check mark if disclosure of delinquent filers pursuant toItem 405 of Regulation S-K (§ 229.405 of this chapter) is not contained herein,and will not be contained, to the best of registrant’s knowledge, in definitiveproxy or information statements incorporated by reference in Part III of thisForm 10-K or any amendment to this Form 10-K. x

 

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

 

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

 

Indicate by check mark whether the registrant is a shell company (asdefined in Rule 12b-2 of the Exchange Act). Yes oNo x

 

Asof June 30, 2007, the aggregate value of the 4,173,814 shares of CommonStock of the Registrant issued and outstanding on such date, which excludes689,475 shares held by directors and officers of the Registrant as a group, wasapproximately $99.4 million.  This figureis based on the last sales price of $23.82 per share of the Registrant’s CommonStock on June 30, 2007.

 

Numberof shares of Common Stock outstanding as of February 20, 2008:  4,848,385

 

# **DOCUMENTS INCORPORATED BY REFERENCE**

# ** **

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

 

Portions of the definitive proxystatement for the 2008 Annual Meeting of Stockholders are incorporated 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, 2007**

 

 
| **PART I.**   | ** **                                                                                                          | ** ** | ** ** | ** ** |
|--------------------|---------------------------------------------------------------------------------------------------------------------|------------|------------|------------|
|               |                                                                                                                |       |       |       |
| Item 1.            | Business                                                                                                            |       |       | 1          |
| Item 1A.           | Risk Factors                                                                                                        |       |       | 27         |
| Item  1B.          | Unresolved  Staff Comments                                                                                          |       |       | 29         |
| Item 2.            | Properties                                                                                                          |       |       | 30         |
| Item 3.            | Legal  Proceedings                                                                                                  |       |       | 30         |
| Item  4.           | Submission  of Matters to a Vote of Security Holders                                                                |       |       | 30         |
|               |                                                                                                                |       |       |       |
| **PART II.**  |                                                                                                                |       |       |       |
| Item  5.           | Market  for Registrant’s Common Equity, Related Stockholder Matters and Issuer  Purchases of Equity Securities |       |       | 31         |
| Item 6.            | Selected  Financial Data                                                                                            |       |       | 33         |
| Item  7.           | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                         |       |       | 35         |
| Item  7A.          | Quantitative  and Qualitative Disclosures About Market Risk                                                         |       |       | 46         |
| Item  8.           | Financial  Statements and Supplementary Data                                                                        |       |       | 48         |
| Item  9.           | Changes  in and Disagreements with Accountants on Accounting and Financial Disclosure                               |       |       | 76         |
| Item 9A.           | Controls  and Procedures                                                                                            |       |       | 76         |
| Item 9B.           | Other  Information                                                                                                  |       |       | 76         |
|               |                                                                                                                |       |       |       |
| **PART III.** |                                                                                                                |       |       |       |
| Item  10.          | Directors,  Executive Officers and Corporate Governance                                                             |       |       | 76         |
| Item 11.           | Executive  Compensation                                                                                             |       |       | 77         |
| Item  12.          | Security  Ownership of Certain Beneficial Owners and Management and Related Stockholder  Matters                    |       |       | 77         |
| Item  13.          | Certain  Relationships and Related Transactions, and Director Independence                                          |       |       | 77         |
| Item  14.          | Principal  Accountant Fees and Services                                                                             |       |       | 77         |
|               |                                                                                                                |       |       |       |
| **PART IV.**  |                                                                                                                |       |       |       |
| Item  15.          | Exhibits  and Financial Statement Schedules                                                                         |       |       | 78         |
|               |                                                                                                                |       |       |       |

 

 

 

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**PART I.**

 

**Item1.  Business**

 

**First Federal Bancshares of Arkansas, Inc. **First Federal Bancshares ofArkansas, Inc. (the “Company”) is a Texas corporation organized in January 1996by First Federal Bank (“First Federal” or the “Bank”) for the purpose of becominga unitary holding company of the Bank. The significant asset of the Company is the capital stock of theBank.  The business and management of theCompany consists of the business and management of the Bank.  The Company does not presently own or leaseany property, but instead uses the premises, equipment and furniture of theBank.  At the present time, the Companydoes not employ any persons other than officers of the Bank, and the Companyutilizes the support staff of the Bank from time to time.  Additional employees will be hired asappropriate to the extent the Company expands or changes its business in thefuture.  At December 31, 2007, theCompany had $792.0 million in total assets, $630.4 million in total depositsand $73.7 million in stockholders’ equity.

 

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

 

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

 

The Bank is a community-oriented financialinstitution offering a wide range of retail and business deposit accounts,including noninterest bearing and interest bearing checking, savings and moneymarket accounts, certificates of deposit, and individual retirementaccounts.  Loan products offered by theBank include residential real estate, consumer, construction, lines of credit,commercial real estate and commercial non-real estate.  Other financial services include investmentproducts offered through First Federal Investment Services, Inc.;automated teller machines; 24-hour telephone banking; internet banking,including account access, bill payment, e-statements and online loanapplications; Bounce ProtectionTM overdraft service; debit cards;and safe deposit boxes.

 

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

 

This Form 10-K contains certain forward-looking statements andinformation relating to the Company that are based on the beliefs of managementas well as assumptions made by and information currently available tomanagement.  In addition, in those andother portions of this document, the words “anticipate,” “believe,” “estimate,”“expect,” “intend,” “should” and similar expressions, or the negative thereof,as they relate to the Company or the Company’s management, are intended toidentify forward-looking statements. Such statements reflect the current views of the Company with respect tofuture looking events and are subject to certain risks, uncertainties andassumptions.  Should one or more of theserisks or uncertainties materialize or should underlying assumptions proveincorrect, actual results may vary materially from those described herein asanticipated, believed, estimated, expected or intended.  The Company does not intend to update theseforward-looking statements.

 

## **Employees**

 

The Bank had 279 full-time employees and 50 part-time employees at December 31,2007 and 2006.   None of these employeesis represented by a collective bargaining agent, and the Bank believes that itenjoys good relations with its personnel.

 

## **Available Information**

 

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

 

 

 

1

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## **Competition**

 

The Bank faces strong competition both in attractingdeposits and making loans.  Its mostdirect 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.  Inaddition, the Bank has faced additional significant competition for investors’funds from short-term money market securities, mutual funds and other corporateand government securities.  The abilityof the Bank to attract and retain savings and certificates of deposit dependson its ability to generally provide a rate of return, liquidity and riskcomparable to that offered by competing investment opportunities.  The Bank’s ability to increase checkingdeposits depends on offering competitive checking accounts and promoting theseproducts through effective channels. Additionally, the Bank offers convenient hours, locations and onlineservices to maintain and attract customers.

 

The Bank experiences strong competition for loans principally fromsavings associations, community banks, commercial banks and mortgagecompanies.  Banks new to the market, aswell as those institutions who are well-established in the market, such as ourbank, continue to open branches in their respective branch networks, albeit ata slower pace than in previous years. The Bank competes for loans principallythrough the interest rates and loan fees it charges and the efficiency andquality of services it provides borrowers.

 

With eighteen offices located in eleven cities and towns in Northwestand Northcentral Arkansas, the Bank is positioned to be a leader in providingfinancial services. In our combined market area of Washington, Marion, Carroll,Boone, Benton, and Baxter Counties, we had a 5.94% of the deposit market shareat June 30, 2007. Of the 38 banks in this market area, we are the thirdlargest in our combined market area. At June 30, 2007, the Bank had thelargest deposit market share for the Harrison and Boone County market area, andwe are striving to make gains in market share at our other locations with ourbranching operations.

 

 

 

2

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**LendingActivities**

 

**General. **At December 31,2007, the Bank’s portfolio of net loans receivable amounted to $601.3 millionor 75.9% of the Company’s total assets. The Bank has traditionally concentrated its lending activities on loanscollateralized by real estate.  Consistentwith such approach, $596.2 million or 92.72% of the Bank’s total portfolio ofloans receivable (“total loan portfolio”) consisted of loans collateralized bymortgage loans at December 31, 2007.

 

The table below summarizes the changes in the composition of the loanportfolio between December 31, 2003, which is the earliest year presentedin the loan composition table, and December 31, 2007 (dollars inthousands):

 
| ** **                       | ** ** | **2007 vs 2003**        | ** ** | **December 31,**    | ** ** |
|----------------------------------|------------|-------------------------|------------|--------------------------|------------|
| ** **                       | ** ** | **Increase (Decrease)** | ** ** | **2007**                 | ** ** | **2003** | ** ** |
| ** **                       | ** ** | **Amount**              | ** ** | **Percentage  of Loans** | ** ** | **Amount** | ** ** | **Percentage  of Loans** | ** ** | **Amount** | ** ** | **Percentage  of Loans** | ** ** |
| Mortgage  loans:                 |       |                    |       |                     |       |   |   |   |   |   |   |   |   |
| One-to  four-family residences   |       | $                       | (39,780    | )                        | (13.26     | )% | $ | 230,005 |   | 35.77 | % | $ | 269,785 |   | 49.03 | % |
| Home  equity and second mortgage |       | 10,278                  |       | 0.97                     |       | 34,315 |   | 5.34 |   | 24,037 |   | 4.37 |   |
| Multifamily  residential         |       | 7,943                   |       | 1.04                     |       | 15,616 |   | 2.43 |   | 7,673 |   | 1.39 |   |
| Commercial  real estate          |       | 18,882                  |       | 0.30                     |       | 119,681 |   | 18.62 |   | 100,799 |   | 18.32 |   |
| Land  loans                      |       | 28,087                  |       | 3.98                     |       | 42,843 |   | 6.66 |   | 14,756 |   | 2.68 |   |
| Construction  loans              |       | 64,392                  |       | 7.66                     |       | 153,724 |   | 23.90 |   | 89,332 |   | 16.24 |   |
| Total mortgage loans             |       | 89,802                  |       | 0.69                     |       | 596,184 |   | 92.72 |   | 506,382 |   | 92.03 |   |
|                             |       |                    |       |                     |       |   |   |   |   |   |   |   |   |
| Commercial  loans                |       | 11,747                  |       | 1.55                     |       | 22,713 |   | 3.54 |   | 10,966 |   | 1.99 |   |
|                             |       |                    |       |                     |       |   |   |   |   |   |   |   |   |
| Consumer  loans                  |       | (8,799                  | )          | (2.24                    | )          | 24,068 |   | 3.74 |   | 32,867 |   | 5.98 |   |
|                             |       |                    |       |                     |       |   |   |   |   |   |   |   |   |
| Total  (1)                       |       | $                       | 92,750     |                     | 0.00       | % | $ | 642,965 |   | 100.00 | % | $ | 550,215 |   | 100.00 | % |

 

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 (1) Gross of undisbursedloan funds, unearned discounts and net deferred loan fees and the allowance forloan losses.

 

Since 2003, mortgage loans as a percentage ofthe loan portfolio is relatively unchanged. However, the composition of mortgage loans has shifted, with a decreasein one- to four-family residential loans and an increase in land loans andconstruction loans.  This shift hasoccurred for several reasons.  The one-to four-family portfolio as a percentage of the total loan portfolio has beengradually declining since 1997, when such loans comprised approximately 83% ofthe loan portfolio.  This decline can beattributed to a number of factors such as increased competition in theNorthwest and Northcentral Arkansas market and the growth of secondary market lendingand related securitizations of mortgage loans, which allow qualifying borrowersto obtain a longer term and lower rate than the Bank would be willing to holdin its portfolio for interest rate risk and other reasons.  Further, webelieve the borrowers who did not qualify for the secondary market who mightotherwise have obtained loans from us which we would have held in portfoliowere likely able to obtain option ARMs, teaser rates, or other alternativefinancing products at other institutions who were willing to take the risksthat these loans present.  Our Bank doesnot and has not originated these types of loans. The Bank is still activelyseeking quality one- to four-family residential loans for portfolio and plansto continue to originate these loans as prudent opportunities arise.  However, based on economic conditionsnationally and the changes in the market brought on by competition and thesecondary market, we do not anticipate these loans to grow significantly as apercentage of the loan portfolio in the future. During the 2001 and 2002 timeframe, opportunities began to arise in theNorthwest Arkansas market for construction, land, and commercial real estateloans and these loans as a percentage of our total loan portfolio began to growsignificantly.  These types of lendingare generally considered to involve a higher degree of risk than residentialreal estate 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.  TheBank has attempted to reduce such risk by evaluating the credit history andpast performance of the borrower, the quality of the borrower’s management, thedebt service ratio, the quality and characteristics of the income streamgenerated by the business or the property and appraisals supporting theproperty’s valuation as applicable. However, these types of loans have largely been the reason for theBank’s significant increase in nonaccrual loans between 2005 and 2007.  See “Asset Quality.”

 

 

 

3

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**LoanComposition.** The followingtable sets forth certain data relating to the composition of the Bank’s loanportfolio by type of loan at the dates indicated.

 
|                                                   |   | **December 31,**   |    |
|--------------------------------------------------------|--------|-------------------------|---------|
|                                                   |   | **2007**                |    | **2006** |   | **2005** |   | **2004** |   | **2003** |   |
|                                                   |   | **Amount**              |    | **Percentage  of Loans** |   | **Amount** |   | **Percentage  of Loans** |   | **Amount** |   | **Percentage  of Loans** |   | **Amount** |   | **Percentage  of Loans** |   | **Amount** |   | **Percentage  of Loans** |   |
|                                                   |   | (Dollars  in Thousands) |    |
| Mortgage  loans:                                       |   |                    |    |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| One-to  four-family residences                         |   | $                       | 230,005 |   | 35.77 | % | $ | 257,867 |   | 35.05 | % | $ | 280,900 |   | 35.53 | % | $ | 292,228 |   | 41.79 | % | $ | 269,785 |   | 49.03 | % |
| Home  equity and second mortgage                       |   | 34,315                  |    | 5.34 |   | 35,192 |   | 4.78 |   | 29,210 |   | 3.69 |   | 27,059 |   | 3.87 |   | 24,037 |   | 4.37 |   |
| Multifamily  residential                               |   | 15,616                  |    | 2.43 |   | 12,203 |   | 1.66 |   | 12,900 |   | 1.63 |   | 9,454 |   | 1.35 |   | 7,673 |   | 1.39 |   |
| Commercial  real estate                                |   | 119,681                 |    | 18.62 |   | 134,647 |   | 18.30 |   | 131,181 |   | 16.59 |   | 126,151 |   | 18.04 |   | 100,799 |   | 18.32 |   |
| Land  loans                                            |   | 42,843                  |    | 6.66 |   | 47,590 |   | 6.48 |   | 47,585 |   | 6.02 |   | 39,036 |   | 5.58 |   | 14,756 |   | 2.68 |   |
| Total permanent loans                                  |   | 442,460                 |    | 68.82 |   | 487,499 |   | 66.27 |   | 501,776 |   | 63.46 |   | 493,928 |   | 70.63 |   | 417,050 |   | 75.79 |   |
| Construction  loans                                    |   |                    |    |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| One- to four-family  residences                        |   | 20,815                  |    | 3.23 |   | 32,146 |   | 4.37 |   | 51,579 |   | 6.52 |   | 29,006 |   | 4.15 |   | 23,825 |   | 4.33 |   |
| Speculative one- to  four-family residences            |   | 40,893                  |    | 6.35 |   | 80,311 |   | 10.92 |   | 104,001 |   | 13.16 |   | 82,709 |   | 11.83 |   | 38,207 |   | 6.94 |   |
| Multifamily residential                                |   | 18,632                  |    | 2.90 |   | 14,120 |   | 1.92 |   | 20,919 |   | 2.65 |   | 21,938 |   | 3.14 |   | 15,121 |   | 2.75 |   |
| Commercial real estate                                 |   | 31,239                  |    | 4.86 |   | 21,896 |   | 2.98 |   | 22,331 |   | 2.83 |   | 11,436 |   | 1.64 |   | 12,179 |   | 2.22 |   |
| Land development                                       |   | 42,145                  |    | 6.56 |   | 47,439 |   | 6.45 |   | 40,232 |   | 5.09 |   | 14,022 |   | 2.01 |   | — |   | — |   |
| Total construction loans                               |   | 153,724                 |    | 23.90 |   | 195,912 |   | 26.64 |   | 239,062 |   | 30.25 |   | 159,111 |   | 22.77 |   | 89,332 |   | 16.24 |   |
| Total mortgage loans                                   |   | 596,184                 |    | 92.72 |   | 683,411 |   | 92.91 |   | 740,838 |   | 93.71 |   | 653,039 |   | 93.40 |   | 506,382 |   | 92.03 |   |
|                                                   |   |                    |    |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Commercial  loans                                      |   | 22,713                  |    | 3.54 |   | 26,281 |   | 3.57 |   | 20,835 |   | 2.64 |   | 16,380 |   | 2.34 |   | 10,966 |   | 1.99 |   |
|                                                   |   |                    |    |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Consumer  loans:                                       |   |                    |    |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Automobile                                             |   | 9,531                   |    | 1.48 |   | 12,086 |   | 1.64 |   | 15,748 |   | 1.99 |   | 19,101 |   | 2.73 |   | 22,087 |   | 4.01 |   |
| Other consumer                                         |   | 14,537                  |    | 2.26 |   | 13,815 |   | 1.88 |   | 13,149 |   | 1.66 |   | 10,685 |   | 1.53 |   | 10,780 |   | 1.97 |   |
| Total consumer loans                                   |   | 24,068                  |    | 3.74 |   | 25,901 |   | 3.52 |   | 28,897 |   | 3.65 |   | 29,786 |   | 4.26 |   | 32,867 |   | 5.98 |   |
|                                                   |   |                    |    |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Total loans receivable                                 |   | 642,965                 |    | 100.00 | % | 735,593 |   | 100.00 | % | 790,570 |   | 100.00 | % | 699,205 |   | 100.00 | % | 550,215 |   | 100.00 | % |
|                                                   |   |                    |    |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Less:                                                  |   |                    |    |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Undisbursed loan funds                                 |   | (36,868                 | )       |   |   | (40,069 | ) |   |   | (69,086 | ) |   |   | (62,661 | ) |   |   | (35,181 | ) |   |   |
| Unearned discounts and net  deferred loan costs (fees) |   | 321                     |    |   |   | 143 |   |   |   | (156 | ) |   |   | (481 | ) |   |   | (657 | ) |   |   |
| Allowance for losses                                   |   | (5,162                  | )       |   |   | (2,572 | ) |   |   | (2,114 | ) |   |   | (1,846 | ) |   |   | (1,621 | ) |   |   |
| Total loans receivable,  net                           |   | $                       | 601,256 |   |   |   | $ | 693,095 |   |   |   | $ | 719,214 |   |   |   | $ | 634,217 |   |   |   | $ | 512,756 |   |   |   |

 

 

 

4

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**LoanMaturity and Interest Rates. **The following table sets forth certaininformation at December 31, 2007, regarding the dollar amount of loansmaturing in the Bank’s loan portfolio based on their contractual terms tomaturity.  Demand loans and loans havingno stated schedule of repayments and no stated maturity are reported as due inone year or less. All other loans are included in the period in which the finalcontractual repayment is due.

 
| ** **                      | ** ** | **Within********One Year** | ** ** | **One Year**

**Through**

**Five Years** | ** ** | **After Five**

**Years** | ** ** | **Total** | ** ** |
|---------------------------------|------------|----------------------------|------------|-------------------------------------------|------------|---------------------------|------------|-----------|------------|
| ** **                      | ** ** | (In Thousands)             | ** ** | ** **                                |
| Mortgage loans:                 |       |                       |       |                                      |       |                      |       |      |       |
| One- to four-family residential |       | $                          | 7,140      |                                      | $          | 17,981                    |       | $         | 204,884    |   | $ | 230,005 |   |
| Home equity and second mortgage |       | 18,518                     |       | 13,454                                    |       | 2,343                     |       | 34,315    |       |
| Multifamily residential         |       | 1,472                      |       | 11,544                                    |       | 2,600                     |       | 15,616    |       |
| Commercial real estate          |       | 38,208                     |       | 68,299                                    |       | 13,174                    |       | 119,681   |       |
| Land loans                      |       | 31,334                     |       | 10,229                                    |       | 1,280                     |       | 42,843    |       |
| Construction                    |       | 124,178                    |       | 29,546                                    |       | —                    |       | 153,724   |       |
| Commercial loans                |       | 15,761                     |       | 6,117                                     |       | 835                       |       | 22,713    |       |
| Consumer loans                  |       | 7,834                      |       | 14,709                                    |       | 1,525                     |       | 24,068    |       |
| Total (1)                       |       | $                          | 244,445    |                                      | $          | 171,879                   |       | $         | 226,641    |   | $ | 642,965 |   |

 

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

 

The followingtable sets forth the dollar amount of the Bank’s loans at December 31,2007, due after one year from such date which have fixed interest rates orwhich have floating or adjustable interest rates.

 
| ** **                      | ** ** | **Fixed Rates** | ** ** | **Floating or****Adjustable Rates** | ** ** | **Total** | ** ** |
|---------------------------------|------------|-----------------|------------|-------------------------------------|------------|-----------|------------|
| ** **                      | ** ** | (In  Thousands) | ** ** |
| Mortgage  loans:                |       |            |       |                                |       |      |       |
| One- to four-family residential |       | $               | 48,301     |                                | $          | 174,564   |       | $ | 222,865 |   |
| Home equity and second mortgage |       | 9,642           |       | 6,155                               |       | 15,797    |       |
| Multifamily residential         |       | 13,124          |       | 1,020                               |       | 14,144    |       |
| Commercial real estate          |       | 73,400          |       | 8,073                               |       | 81,473    |       |
| Land loans                      |       | 10,223          |       | 1,286                               |       | 11,509    |       |
| Construction                    |       | 15,462          |       | 14,084                              |       | 29,546    |       |
| Commercial  loans               |       | 6,591           |       | 361                                 |       | 6,952     |       |
| Consumer  loans                 |       | 14,496          |       | 1,738                               |       | 16,234    |       |
| Total                           |       | $               | 191,239    |                                | $          | 207,281   |       | $ | 398,520 |   |

 

Scheduled contractual maturities of loans do not necessarily reflectthe actual term of the Bank’s loan portfolio. The average life of mortgageloans is substantially less than their average contractual terms because ofloan prepayments and refinancing.  Theaverage life of mortgage loans tends to increase, however, when currentmortgage loan rates substantially exceed rates on existing mortgage loans and,conversely, decrease when rates on existing mortgage loans substantially exceedcurrent mortgage loan rates.

 

**Origination,Purchase and Sale of Loans.**  The lendingactivities of the Bank are subject to the written, non-discriminatory underwritingstandards and policies established by the Bank’s board of directors andmanagement.  Loan originations areobtained from a variety of sources, including realtor referrals, walk-incustomers to the Bank’s branch locations, solicitation by loan officers, radio,television and newspaper advertising, and to a lesser extent, through theBank’s Internet website.  The Bankcontinually 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 it provides exceptionalpersonalized service to its customers. The Bank requires hazard insurance, title insurance, and, to the extentapplicable, flood insurance on all secured real property.

 

Applications are initially received by loanofficers or from the Bank’s secure website.  Applications received over the Bank’s website are forwarded to loanofficers.  All loans exceeding anindividual officer’s approval authority are subject to review by members of theappropriate loan committee. The Bank has three loan committees (Senior LoanCommittee, Executive Loan Committee, and Director Loan Committee) that reviewand make a decision based upon type, size, and classification.

 

 

 

5

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During 2007, the Bank purchased participations in four commercialconstruction loans with a total commitment amount of $18.7 million as well as a$1.6 million participation in a commercial loan.  During 2006, the Bank purchased a commercialconstruction loan with a commitment amount of $100,000.  During 2005, the Bank purchased a $397,000participation in a commercial real estate loan.

 

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 servicesuch loans are typically sold with the loans. This allows the Bank to provideits customers competitive long-term fixed rate mortgage products, which arevery popular financing products for homebuyers in today’s market, while notexposing the Bank to undue interest rate risk. These loans are originated subject to Fannie Mae, Freddie Mac and thespecific investor’s underwriting guidelines and are typically underwritten andvalidated by a third party prior to loan closing.  The Secondary Market Department of the Banktypically locks and confirms the purchase price of the loan on the day of theloan application, which protects the Bank from market price movements andensures that the Bank will receive a fair and reasonable price on the sale ofthe respective loan.  Due to the loansbeing underwritten by a third party, the underwriter substantially assumes therepurchase risk associated with these loans. The Bank believes it has minimalrisk of repurchase of these loans based upon the contracts with the specificinvestors.  This risk typically involvespotential early prepayments of the mortgage or an early default of a loan.  In 2007, 2006, and 2005, the Bank’s secondarymarket loan sales amounted to $58.1 million, $69.4 million, and $55.4 million, respectively.  The Bank is not involved in loan hedging orother speculative mortgage loan origination activities.

 

In addition to sales of loans on the secondary market, the Bankperiodically sells larger commercial loans or participations in such loans inorder to comply with the Bank’s loans to one borrower limit or for creditconcentration purposes.  In such situationsthe loans are typically sold with servicing retained.  During the years ended December 31,2007, 2006, and 2005, such loans sold amounted to approximately $7.2 million,$3.4 million, and $1.8 million, respectively. At December 31, 2007, 2006, and 2005, the balances of loans soldwith servicing retained were approximately $27.8 million, $22.2 million, and$19.6 million, respectively.   Loanservicing fee income for the years ended December 31, 2007, 2006, and2005, was approximately $110,000, $121,000, and $100,000, respectively.

 

The followingtable shows the Bank’s originations, sales, purchases, and repayments of loansduring the periods indicated.

 
| ** **                               | ** ** | **Year Ended December 31,** | ** ** |
|------------------------------------------|------------|----------------------------------|------------|
| ** **                               | ** ** | **2007**                         | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                               | ** ** | (In  Thousands)                  | ** ** |
|                                     |       |                             |       |   |   |   |   |
| Loans  receivable at beginning of period |       | $                                | 735,593    |   | $ | 790,570 |   | $ | 699,205 |   |
| Loan  originations:                      |       |                             |       |   |   |   |   |
| Mortgage loans:                          |       |                             |       |   |   |   |   |
| One- to four-family  residential         |       | 86,814                           |       | 119,859 |   | 121,270 |   |
| Home equity and second  mortgage loans   |       | 20,914                           |       | 46,258 |   | 41,661 |   |
| Multifamily residential                  |       | 6,427                            |       | 3,034 |   | 6,341 |   |
| Commercial real estate                   |       | 18,356                           |       | 46,370 |   | 61,248 |   |
| Land loans                               |       | 5,880                            |       | 8,583 |   | 7,867 |   |
| Construction                             |       | 39,016                           |       | 93,557 |   | 195,784 |   |
| Commercial loans                         |       | 12,395                           |       | 21,861 |   | 29,862 |   |
| Consumer:                                |       |                             |       |   |   |   |   |
| Automobile                               |       | 5,916                            |       | 7,678 |   | 9,537 |   |
| Other                                    |       | 13,347                           |       | 13,008 |   | 11,710 |   |
| Total loan originations                  |       | 209,065                          |       | 360,208 |   | 485,280 |   |
| Loan  purchases                          |       | 20,365                           |       | 100 |   | 397 |   |
| Repayments                               |       | (242,230                         | )          | (336,927 | ) | (336,427 | ) |
| Loan  sales                              |       | (65,287                          | )          | (72,857 | ) | (57,150 | ) |
| Transfers  to real estate owned          |       | (13,037                          | )          | (6,284 | ) | (1,002 | ) |
| Other                                    |       | (1,504                           | )          | 783 |   | 267 |   |
| Net  loan activity                       |       | (92,628                          | )          | (54,977 | ) | 91,365 |   |
| Loans  receivable at end of period (1)   |       | $                                | 642,965    |   | $ | 735,593 |   | $ | 790,570 |   |

 

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

 

 

 

6

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**Loansto One Borrower. **A savings institution generally may notmake loans to one borrower and related entities in an amount which exceeds 15%of its 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, 2007, the Bank’s limiton loans to one borrower was approximately $11.3 million.  At December 31, 2007, the Bank’s largestloan or group of loans to one borrower, including persons or entities relatedto the borrower, amounted to $10.9 million, including undisbursed loanfunds.  The Bank’s ten largest loans orgroups of loans to one borrower, including persons or entities related to theborrower, including unfunded commitments, totaled $92.6 million at December 31,2007.  None of these loans were 90 daysor more past due at December 31, 2007.

 

**One-to Four-Family Residential Real Estate Loans. **At December 31,2007, $230.0 million or 35.8% of the Bank’s total loan portfolio consisted ofone- to four-family residential real estate loans.   Of the $230.0 million of such loans at December 31,2007, $175.4 million or 76.2% had adjustable rates of interest (including $37.9million of seven-year adjustable rate loans) and $54.6 million or 23.8% hadfixed rates of interest.

 

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

 

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

 

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 100% of the appraised value of the property securing a one- to four-familyresidential loan with private mortgage insurance to protect the portion of theloan that exceeds 80% of the appraised value. The Bank may, on occasion, extend a loan up to 90% of the appraisedvalue of the secured property without private mortgage insurance coverage.  However, these exceptions are minimal and areonly approved on loans with exceptional credit scores, sizeable asset reserves,or other compensating factors.  At December 31,2007, the Bank had $6.8 million of nonaccrual one- to four-family residentialloans.  See “Asset Quality.”

 

**HomeEquity and Second Mortgage Loans. ** AtDecember 31, 2007, $34.3 million or 5.3% of the Bank’s total loanportfolio consisted of home equity and second mortgage loans.  At December 31, 2007, the unused portionof home equity lines of credit was $12.5 million.  At December 31, 2007, the Bank hadnonaccrual home equity and second mortgage loans totaling $1.2 million.  The increase in nonaccrual home equity and secondmortgage loans relates primarily to borrowers in the constructionindustry.  See “Asset Quality.”

 

The Bank’s homeequity and second mortgage loans are fixed rate loans with fully amortizedterms of up to fifteen years, variable rate interest-only loans with terms upto three years, or home equity lines of credit. The variable rate loans are typically tied to Wall Street Journal Prime,plus a margin commensurate with the risk as determined by the borrower’s creditscore.  Longer-term amortizing loans typicallyhave a balloon feature in five, seven, or ten years.  The home equity lines of credit are typicallyeither fixed rate for a term of no longer than one year or variable rate withterms typically up to three years.  TheBank generally limits the total loan-to-value on these mortgages to 90% of thevalue of the secured property.

 

 

 

7

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**MultifamilyResidential Real Estate Loans. **The Bank offers mortgage loans for theacquisition and refinancing of multifamily residential properties.  At December 31, 2007, $15.6 million or2.4% of the Bank’s total loan portfolio consisted of loans collateralized byexisting multifamily residential real estate properties.

 

The Bank currently originates both fixed rate and adjustable ratemultifamily loans.  Fixed rate loans aregenerally originated with amortization periods not to exceed 30 years, andtypically have balloon periods of three, five or seven years.  Adjustable rate loans are typically amortizedover terms up to 30 years, with interest rate adjustments every three to sevenyears.  Loan-to-value ratios on theBank’s multifamily real estate loans are currently limited to 80%.  It is also the Bank’s general policy toobtain corporate or personal guarantees, as applicable, on its multifamilyresidential real estate loans from the principals of the borrower.

 

Multifamily real estate lending entails significant additional risks ascompared with one- to four-family residential property lending.  Such loans typically involve large loanbalances to single borrowers or groups of related borrowers.  The payment experience on such loans istypically dependent on the successful operation of the real estate project.  The success of such projects is sensitive tochanges in supply and demand conditions in the market for multifamily realestate as well as regional and economic conditions generally.  At December 31, 2007, the Bank did nothave any nonaccrual multifamily real estate loans.  See “Asset Quality.”

 

**CommercialReal Estate Loans. **The Bankoriginates mortgage loans for the acquisition and refinancing of commercialreal estate properties.  At December 31,2007, $119.7 million or 18.6% of the Bank’s total loan portfolio consisted ofloans collateralized by existing commercial real estate properties.

 

Many of the Bank’s commercial real estate loans are collateralized byproperties such as office buildings, convenience stores, service stations,mini-storage facilities, motels, churches, small shopping malls, and stripcenters.  The Bank  underwrites commercial real estate loansspecifically in relation to the type of property being collateralized.  Cash flows and occupancy 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 also typically personally guaranteedby the principals of the respective entity. The financial strength of the individuals who are personallyguaranteeing the loan is also a primary underwriting factor.

 

The Bank’s policy requires real estate appraisals of all propertiessecuring commercial real estate loans by licensed real estate appraiserspursuant to state licensing requirements. The Bank considers the quality and location of the real estate, thecreditworthiness of the borrower, the cash flow of the project, and the qualityof management involved with the property. The Bank’s commercial real estate loans are generally originated withamortization periods not to exceed 25 years and typically have three-, five-,or seven-year balloon terms.  As part ofthe criteria for underwriting multifamily and commercial real estate loans, theBank generally estimates a cash flow analysis that includes a vacancy rateprojection, expenses for taxes, insurance, maintenance and repair reserves aswell as debt coverage ratios.  Thisinformation is also estimated and included in commercial real estateappraisals.

 

Commercial real estate lending entails additional risks as compared tothe Bank’s one- to four-family residential property loans. Commercial realestate loans generally involve larger loan balances to single borrowers orgroups of related borrowers.  The paymentexperience on such loans is typically dependent on the successful operation ofthe real estate project. The success of such projects is sensitive to changesin supply and demand conditions in the market for commercial real estate, aswell as regional and economic conditions generally.  Within the last several years, reports haveranked the Northwest Arkansas as one of the top performing economic areas inthe country.   During these periods of economic expansion the Bankfocused on commercial real estate activities within the market in order to takeadvantage of growth. More recently, this economic expansion resulted in asevere oversupply of residential lots, and to a lesser degree residentialhousing.    The region is currently in a correction mode but is stillan economically viable area for the future, in the Bank’s opinion.  Thisregion is the home of the world’s largest retailer, Wal-Mart; as well as thenation’s largest meat company, Tyson Foods; the trucking firm J. B. Hunt; andthe University of Arkansas.   Population growth, job growth and lowunemployment rates in this region add additional support to the Bank’s lendingin the area.  At December 31, 2007,the Bank had $6.2 million of nonaccrual commercial real estate loans. See“Asset Quality.”

 

**Land loans. **Land loansinclude loans for the acquisition or refinancing of land for consumer orcommercial purposes.  This segment of theportfolio totaled $42.8 million, or 6.7% of the Bank’s total loan portfolio, asof December 31, 2007, and was comprised of $13.3 million of developedresidential lots, $9.2 million of land acquired for future development, $7.0million of developed commercial land, and $13.3 million of other improved andunimproved land.  The Bank hasexperienced an aggregate increase in this loan portfolio since 2003, primarilydue to opportunities resulting from the growth and development of the Bentonand Washington county areas.  Generally,these loans are collateralized by properties in the Bank’s market areas.  At December 31, 2007, the Bank hadnonaccrual land loans totaling $1.3 million. See “Asset Quality.”

 

 

 

8

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**LandDevelopment Loans. **The Bank has also offered loans for theacquisition and development of land into residential subdivisions. At December 31,2007, $42.1 million or 6.6% of the Bank’s total loan portfolio consisted ofland development loans.  However, no newland development loans have been originated since the fourth quarter of 2006due to local real estate market conditions. This segment of the market in Northwest Arkansas has been heavilyimpacted by the housing market slowdown. According to market data estimates, as of the end of the third quarterof 2007, it would take 72 months and 54 months to absorb lots currently in thepipeline in Benton County and Washington County, respectively.   As a result of slowing lot sales, borrowershave been unable to rely on lot sales to repay their loans and have had to relyon secondary sources of repayment.  Forthe most part, borrowers have been able to pay the interest due at maturity andthe Bank has extended the loan maturity upon payment of interest.  As long as these borrowers are willing towork with the Bank on a plan to repay their loans, the Bank intends to attemptto accommodate borrowers’ workout plans. So far, except for the nonaccrual land development loans described in“Asset Quality”, the borrowers in our land development portfolio havedemonstrated a willingness to work with the Bank.  However, given the current market conditions,it is possible at any time for any one of these borrowers to default on theirloans.  At December 31, 2007, theBank had nonaccrual land development loans totaling $11.4 million representingthree subdivisions in the Benton and Washington county area.  See “Asset Quality.”

 

Some of the larger loans in the landdevelopment portfolio are described in more detail below.  None of these loans was adversely classifiedat December 31, 2007.  The tablerepresents accruing land development loans over $1 million as of December 31,2007 (dollars in thousands).  These loansrepresent approximately 90% of the accruing land development loans based oncommitment amount.

 
| **Origination Date** | ** ** | **Maturity**

**Date** | ** ** | **Commitment Amount** | ** ** | **Funded**

**Amount** | ** ** | **Accrued**

** Interest** | ** ** | **Number of**

**Lots** | ** ** | **Status** | ** ** | **County** | ** ** |
|----------------------|------------|------------------------|------------|-----------------------|------------|------------------------|------------|---------------------------------|------------|-------------------------|------------|------------|------------|------------|------------|
| 01/03/2006           |       | 01/03/2008             |       | $                     | 6,720      |                   | $          | 6,519                           |       | $                       | 498        |       | 208        |       | (1)        |   | Washington |   |
| 06/06/2005           |       | 06/06/2008             |       | 5,570                 |       | 5,570                  |       | 270                             |       | 137                     |       | Complete   |       | Benton     |       |
| 06/03/2005           |       | 06/03/2008             |       | 4,860                 |       | 2,185                  |       | 111                             |       | 80                      |       | (2)        |       | Washington |       |
| 12/28/2006           |       | 12/28/2008             |       | 3,413                 |       | 3,238                  |       | 229                             |       | 124                     |       | (3)        |       | Washington |       |
| 08/05/2005           |       | 08/05/2008             |       | 2,617                 |       | 2,617                  |       | 97                              |       | 43                      |       | Complete   |       | Washington |       |
| 04/10/2006           |       | 04/10/2008             |       | 2,216                 |       | 644                    |       | 41                              |       | 76                      |       | (4)        |       | Washington |       |
| 08/05/2005           |       | 08/05/2008             |       | 2,102                 |       | 2,102                  |       | 76                              |       | 48                      |       | Complete   |       | Benton     |       |
|                      |            |                        |            |                       |            |                        |            |                                 |            |                         |            |            |            |            |            |  |  |  |

 

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(1)    This loan represents twophases of a 208-lot subdivision containing 116 lots nearing completion in phaseone and 92 lots in phase two.  Theprincipals are attempting to obtain financing to fund the interest payment. Thelots in this subdivision were pre-sold to an investor who is now attempting towithdraw from the contract.

 

(2)    The development of lots iscurrently on hold.  The balance primarilyrepresents land acquisition and engineering costs.

 

(3)    This subdivision is notcomplete.  Completion money for theproject is held in escrow pending clearing of liens, which the borrower istrying to settle.  Interest was paidafter December 31, 2007, $174,000 of which was funded from the loan and$53,000 paid in cash.

 

(4)    This subdivision is on holdand the borrower has informed the Bank of their intention to move the loan toanother financial institution for a better rate.

 

**ConstructionLoans. **The Bank originates one- tofour-family residential, multifamily, and commercial real estate constructionloans.  However, the Bank’s primaryemphasis has been residential construction lending.  The Bank’s construction lending activitiesare typically limited to the Bank’s primary market areas.  At December 31, 2007, constructionloans, including land development loans, amounted to $153.7 million or 23.9% ofthe Bank’s total loan portfolio.  Asdiscussed previously, our market areas of Benton and Washington counties haveexperienced tremendous growth over the past several years and provided the Bankwith increased lending opportunities, which can be demonstrated by thesignificant growth in construction lending over the past five to sevenyears.  However, beginning in late 2005,the Bank began to note an oversupply of homes and lots in the Northwest Arkansasmarket and limited its construction loan origination activity accordingly.  Construction loan originations dropped from$195.8 million in 2005 to $93.6 million in 2006 and $39.0 million in 2007.  Our speculative single-family portfoliopeaked during the year ended December 31, 2005, and by December 31,2007, had dropped to a level comparable to December 31, 2003.

 

The Bank’s construction loans generally havefixed interest rates or variable rates that float with Wall Street JournalPrime and are typically issued for terms of six to eighteen months. However,the Bank is permitted to originate construction loans with terms up to twoyears 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 typically made with a maximum loan-to-value ratioof 80% on an as-completed basis.

 

 

 

9

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The Bank originates construction loans to individual homeowners andlocal builders and developers for the purpose of constructing one- tofour-family residences.  The Banktypically requires that permanent financing with the Bank or some other lenderbe in place prior to closing any non-speculative construction loan.  Interest on construction/permanent loans isdue upon completion of the construction phase of the loan.  At such time, the loan will convert to apermanent loan at the interest rate established at the initial closing of theconstruction/permanent loan.

 

The Bank makes construction loans to local buildersfor the purpose of construction of speculative (or unsold) residentialproperties, and for the construction of pre-sold one- to four-familyhomes.  These loans are subject to creditreview, 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.  Loanproceeds are disbursed after a satisfactory inspection of the project has beenmade based upon percentage of completion. Interest on these construction loans is due upon maturity.  The Bank may extend the term of aconstruction loan upon payment of interest accrued if the property has not beensold by the maturity date.  During 2006the Bank began to experience an increase in the incidence of builders who wereunable to pay their interest at maturity due to a softening of the housingmarket in Northwest Arkansas.  Marketdata indicates an overall decrease in the number of home sales in Benton andWashington counties in 2007 compared to 2006.

 

Construction lending is generally considered to involve a higher levelof risk as compared to one- to four-family residential loans.  This is due, in part, to the concentration ofprincipal in a limited number of loans and borrowers, and the effects ofgeneral economic conditions on developers and builders.  In addition, construction loans to a builderfor construction of homes that are not pre-sold possess a greater potentialrisk to the Bank than construction loans to individuals on their personalresidences or on houses that are pre-sold prior to the inception of the loan.  The Bankanalyzes each borrower involved in speculative building and limits theprincipal amount and number of unsold speculative homes at any one time withsuch borrower.  At December 31,2007, the Bank’s portfolio of speculative single-family loans consisted of 195loans with an average balance of approximately $210,000.  Thirty-five percent of the Bank’s $40.9million in speculative single-family loans was concentrated with five borrowerswho had 76 loans totaling $14.3 million. None of the top five borrowers’ loans was adversely classified or onnonaccrual status at December 31, 2007. At December 31, 2007, the Bank had nonaccrual speculative one- tofour-family construction loans totaling $4.9 million.  See “Asset Quality.”

 

**CommercialLoans. **The Bank also offers commercial loans, which primarilyconsist of equipment and inventory loans that are typically cross-collateralizedby commercial real estate.  At December 31,2007, such loans amounted to $22.7 million or 3.5% of the total loanportfolio.  At December 31, 2007,the Bank had nonaccrual commercial loans totaling $1.2 million.  See “Asset Quality.”

 

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

 

**ConsumerLoans. **The Bank offers consumer loans in order to provide afull range of financial services to its customers while increasing the yield onits overall loan portfolio and decreasing its interest rate risk due to therelatively shorter-term nature of consumer loans. The consumer loans offered bythe Bank primarily include automobile loans, deposit account secured loans, andunsecured loans.  Consumer loans amountedto $24.1 million or 3.7% of the total loan portfolio at December 31, 2007,of which $9.5 million and $14.6 million consisted of automobile loans and otherconsumer loans, respectively.  The Bankintends to continue its emphasis on consumer loans in furtherance of its roleas a community-oriented financial institution.

 

The Bank’sautomobile loans are typically originated for the purchase of new and used carsand trucks.  Such loans are generallyoriginated with a maximum term of five years. The Bank does offer extended terms on automobile loans to some customersbased upon their creditworthiness.

 

Other consumerloans consist primarily of deposit account loans and unsecured loans.  Loans secured by deposit accounts are originatedfor up to 95% of the deposit account balance, with a hold placed on the accountrestricting the withdrawal of the deposit account balance.

 

Consumer loans entail greater risk than do residential mortgage loans,particularly in the case of consumer loans that are unsecured or secured byrapidly depreciating assets such as automobiles.  In such cases, any repossessed collateral fora defaulted consumer loan may not provide an adequate source of repayment ofthe outstanding loan balance as a result of the greater likelihood of damage,loss or depreciation.  In addition,consumer loan collections are dependent on the borrower’s continuing financialstability, and thus are more likely to be adversely affected by job loss,divorce, illness or personal bankruptcy. Furthermore, the application of various federal and state laws,including federal and state bankruptcy and insolvency laws, may limit theamount which can be recovered on such loans. At December 31, 2007, the Bank had $268,000 of nonaccrual consumerloans.  See “Asset Quality.”

 

 

 

10

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## **Asset Quality**

## ** **

Generally, when a borrower fails to make a loan payment before theexpiration of the loan’s assigned grace period, a late charge is assessed and alate charge notice is mailed. Collection personnel review all delinquentaccounts and attempt to cure the delinquency by contacting the borrower.  The Bank’s policies and procedures providefor frequent contact with borrower until the delinquency is cured or until anacceptable repayment plan has been agreed upon. Contact, by phone and mail, with delinquent borrowers begins immediatelyafter the expiration of the loan’s assigned grace days.  The Bank’s collectors also have weekly phoneconferences with loan officers to review the respective officer’s delinquentlists. Generally, when a consumer loan is 60 days past due and the borrower hasnot indicated a willingness to work with the bank to bring the account currentwithin a reasonable period of time, the collector will mail a letter giving theborrower 10 days to bring the account current or make acceptablearrangements.  If they fail to cure thedefault, the collateral will be repossessed. We attempt to work with troubled borrowers to return their loans toperforming status where possible.  Thedecision on when to proceed with foreclosure action is made on a case-by-casebasis.  The Bank recognizes that thiswill cause the delinquency rate on the mortgage portfolio to be elevated for anextended period of time.

 

Loans are placed on nonaccrual status when, in the judgment ofmanagement, the probability of collection of interest is deemed to beinsufficient to warrant further accrual. When a loan is placed on nonaccrual status, previously accrued butunpaid interest is deducted from interest income.  The Bank generally does not accrue intereston loans past due 90 days or more.  Loansmay be reinstated to accrual status when payments are made to bring the loanless than 90 days past due and, in the opinion of management, collection of theremaining balance can be reasonably expected. The Bank may continue to accrue interest on certain loans that are 90days past due or more if such loans are in the process of collection and collectionis reasonably assured.

 

Real estate properties acquired through foreclosure are initiallyrecorded at fair value less estimated selling costs.   Fair value is typically determined based onthe lower of appraised value or the anticipated listing price of the property.Valuations of real estate owned are performed at least quarterly.  Real estate is carried at the lower ofcarrying amount or fair value less cost to sell.

 

**DelinquentLoans. **The following table sets forth information concerningdelinquent loans at December 31, 2007 and 2006, in dollar amounts and as apercentage of the Bank’s total loan portfolio. The amounts presented represent the total outstanding principal balancesof the related loans, rather than the actual payment amounts that are pastdue.  The increase in delinquent loansbetween 2006 and 2007 was primarily due to an increase in loans over 90 dayspast due.  This increase was primarily inthe categories of one- to four-family residential, commercial real estate, andconstruction loans.  Such increases aredescribed in more detail under the nonperforming assets table that follows.

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

 
| ** **                       | ** ** | **Loans Delinquent at December 31, 2006** | ** ** |
|----------------------------------|------------|------------------------------------------------|------------|
| ** **                       | ** ** | **30-59 Days**                                 | ** ** | **60-89 Days** | ** ** | **Over 90 Days** | ** ** | **Total** | ** ** |
| One-  to four-family residential |       | $                                              | 3,480      |   | $ | 1,062 |   | $ | 2,305 |   | $ | 6,847 |   |
| Home  equity and second mortgage |       | 173                                            |       | 210 |   | 724 |   | 1,107 |   |
| Commercial  real estate          |       | 2,221                                          |       | 301 |   | 20 |   | 2,542 |   |
| Land                             |       | 258                                            |       | 168 |   | 825 |   | 1,251 |   |
| Construction                     |       | 2,351                                          |       | 1,666 |   | 9,853 |   | 13,870 |   |
| Commercial                       |       | 251                                            |       | 113 |   | 721 |   | 1,085 |   |
| Consumer                         |       | 351                                            |       | 54 |   | 199 |   | 604 |   |
| Total                            |       | $                                              | 9,085      |   | $ | 3,574 |   | $ | 14,647 |   | $ | 27,306 |   |
| Percentage  of total loans       |       | 1.24                                           | %          | 0.49 | % | 1.99 | % | 3.71 | % |

 

 

 

11

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Interest income that would have been recordedunder the original terms of the Bank’s nonaccruing loans for the year ended December 31,2007, amounted to $2.6 million, and the interest recognized during this periodamounted to $458,000.

 

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

 
| ** **                                    | ** ** | **December 31,**   | ** ** |
|-----------------------------------------------|------------|-------------------------|------------|
| ** **                                    | ** ** | **2007**                | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                    | ** ** | (Dollars  in Thousands) | ** ** |
| Nonaccrual  loans:                            |       |                    |       |   |   |   |   |   |   |   |   |
| One- to four-family  residential              |       | $                       | 6,800      |   | $ | 3,689 |   | $ | 2,630 |   | $ | 2,619 |   | $ | 1,537 |   |
| Home equity and second  mortgage              |       | 1,194                   |       | 994 |   | 269 |   | 406 |   | 341 |   |
| Multifamily residential                       |       | —                  |       | — |   | — |   | — |   | — |   |
| Commercial real estate                        |       | 6,160                   |       | 738 |   | 707 |   | — |   | 99 |   |
| Land                                          |       | 1,311                   |       | 1,372 |   | — |   | — |   | — |   |
| Speculative one- to  four-family construction |       | 4,934                   |       | 5,417 |   | 1,177 |   | 634 |   | — |   |
| Land development                              |       | 11,428                  |       | 5,324 |   | — |   | — |   | — |   |
| Commercial                                    |       | 1,234                   |       | 1,268 |   | 236 |   | 186 |   | 131 |   |
| Consumer                                      |       | 268                     |       | 213 |   | 287 |   | 317 |   | 223 |   |
| Total nonaccrual loans                        |       | 33,329                  |       | 19,015 |   | 5,306 |   | 4,162 |   | 2,331 |   |
|                                          |       |                    |       |   |   |   |   |   |   |   |   |
| Accruing  loans 90 days or more past due      |       | 2,412                   |       | 668 |   | 1,600 |   | — |   | — |   |
| Restructured  loans                           |       | —                  |       | — |   | 6,264 |   | 3,790 |   | 1,352 |   |
| Real  estate owned                            |       | 8,120                   |       | 3,858 |   | 892 |   | 563 |   | 822 |   |
|                                          |       |                    |       |   |   |   |   |   |   |   |   |
| Total nonperforming assets                    |       | $                       | 43,861     |   | $ | 23,541 |   | $ | 14,062 |   | $ | 8,515 |   | $ | 4,505 |   |
|                                          |       |                    |       |   |   |   |   |   |   |   |   |
| Total  nonaccrual, accruing loans 90 days     |       |                    |       |   |   |   |   |   |   |   |   |
| or more past due and  restructured loans      |       |                    |       |   |   |   |   |   |   |   |   |
| as a percentage of total  loans receivable    |       | 5.56                    | %          | 2.68 | % | 1.67 | % | 1.14 | % | 0.67 | % |
|                                          |       |                    |       |   |   |   |   |   |   |   |   |
| Total  nonperforming assets as a percentage   |       |                    |       |   |   |   |   |   |   |   |   |
|  of total assets                         |       | 5.54                    | %          | 2.76 | % | 1.65 | % | 1.13 | % | 0.65 | % |

 

The increase in nonaccrualloans from December 31, 2006 to December 31, 2007 is primarilyrelated to increases of $6.1 million in nonaccrual land development loans, $5.4million in nonaccrual commercial real estate loans and $3.1 million innonaccrual one- to four-family residential loans, offset by a decrease of$483,000 in nonaccrual speculative one- to four-family construction loans.  The Northwest Arkansas market continues toexperience an oversupply of lots and speculative homes. Certain of the Bank’shomebuilders and developers are experiencing extended marketing times for thesale of their homes and lots which has resulted in inadequate cash flow toservice the interest carry on their loans. Further, we have begun to see developers experiencing longer marketingtimes for lots as well as lower lot prices than projected at the time theprojects were begun.  Developers who weredependent on the sale of lots to pay the interest due on their loans have alsobeen unable to service the interest carry on their loans. The specific loanloss allowance related to loans tobuilders and developers wasapproximately $2.6 million, or 90% of total specific loan loss allowances, at December 31,2007.

 

The level of nonaccrual speculative construction loans, landdevelopment loans and commercial real estate loans is attributable primarily tosix loan relationships totaling $19.5 million, or 58% of nonaccrual loans.  Approximately $11.2 million of these loansare new to nonaccrual in 2007.  Theserelationships are described in more detail in the paragraphs that follow.

 

The first relationship totaled $5.9 millionat December 31, 2007, and iscomprised of two subdivision loans totaling $5.4 million and the borrower’sprimary residence totaling approximately $520,000.  Foreclosure proceedings have begun on thesubdivision and the borrower has filed for bankruptcy protection.  The subdivision loans represent two phases ofthe same subdivision located in Lowell, Arkansas, one of which is complete andthe other is approximately 10% complete. At December 31, 2006, we estimated no loss on the subdivision basedon estimated sales prices of the lots and the estimated costs to complete theincomplete phase of the subdivision. Since that time, market conditions have deteriorated and a subdivisionacross the street from this subdivision has gone into default.  We are aware that the financial institutionthat obtained those lots liquidated them in bulk at a substantial discount,which had an adverse effect 

 

 

 

12

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on the value of the lots in thissubdivision.  As a result, we obtainednew appraisals on both phases of the subdivision which used discounted cashflow analysis for the complete phase, given the extended selling period thatwould be necessary under current market conditions, and a land only valuationon the incomplete phase given the decreasing likelihood that these lots wouldbe developed.  The new appraisalsresulted in a specific loan loss allowance totaling $1.4 million on thissubdivision recorded in the first quarter of 2007.  These subdivision loans are also the subjectof litigation alleging fraud and negligence, among other complaints, that theBank has filed against various parties to the loan.  The Bank may be able to recover some of itsloss through this litigation, although at this time the Bank cannot give anyassurances as to the amount of a recovery, if any.  Due to the nature of these loans, theuncertain nature of the legal process, and the possibility of continued adversechanges in market conditions, we may incur losses in the future in excess ofthe amount estimated as of December 31, 2007.

 

The second relationship totaled $2.2 million at December 31, 2007, and is comprised of a subdivisionlocated in Cave Springs, Arkansas.  Thesubdivision is 100% complete.  The Bankobtained an updated valuation on the subdivision using discounted cash flowanalysis.  Due to the market conditionsand the oversupply of lots in Northwest Arkansas, the valuation indicated lowerlot prices and an extended marketing time over that in the original appraisalobtained when the loan was originated. Based on the estimated fair value of the collateral, a specific loanloss allowance totaling $885,000 was recorded during the third quarter of2007.  Based on the nature of this loanand the possibility of continued adverse changes in the market conditions, wemay incur losses in the future in excess of the amount estimated as of December 31, 2007.

 

The third relationship totaled $2.4 million at December 31, 2007, and is comprised of $840,000 ofspeculative single-family construction loans on two properties, a $560,000single-family construction loan, approximately $395,000 of land and lot loans,approximately $280,000 of commercial loans and the borrower’s primary residencetotaling $360,000.  All of the realestate loans are in foreclosure.  The commercialloans consist of a fully reserved unsecured loan of approximately $75,000, andjunior liens on the lots and speculative homes totaling approximately $205,000,with an estimated loss allowance of $90,000. Additionally, there is an approximate $15,000 loss allowance on the landand lot loans.  Based on factors such asthe complexity of this relationship, the difficulty in estimating completioncosts, and potential adverse changes in market conditions, we may incur lossesin the future in excess of the amount estimated at December 31, 2007.

 

The fourth relationship totaled $2.8 million, $2.2 million of which wason nonaccrual status at December 31, 2007. The loans in this relationshipbecame over 90 days past due during the third quarter of 2007.  Based on the borrower’s workout plans, theseloans were maintained on accrual status at that time.  However, due to passage of time with noprogress on the workout plan, we placed certain of the loans on nonaccrual statusduring the fourth quarter of 2007.  Weare still hopeful the liquidation plans will work out and expect to be paid infull for all principal and interest due if the workout plan is successful.  The nonaccrual loans consist of a commercialloan secured by commercial real estate, franchise rights, inventory andequipment and an unsecured loan.  Theborrower’s residence was kept on accrual status due to the existence of largejunior liens behind the Bank’s first lien. However, since that time we have learned that it is likely the juniorlien holders will not buy the Bank’s note. The total loan-to-value ratio, including accrued interest and latecharges due, is approximately 81% using the most recent appraisal.  As of December 31, 2007, a $21,000specific reserve was recorded, for this relationship, which represents thebalance of the unsecured loan.

 

The fifth relationship totaled $2.1 millionand represents a single commercial real estate loan secured by a conveniencestore, car wash, and retail space.  Thisloan became over 90 days past due during the third quarter of 2007.  Based on our expectation that the guarantorswould cooperate with us on a workout plan and our assessment of their financialstrength, these loans were maintained on accrual status at that time.  However, due to passage of time with noprogress on a workout plan, we placed this loan on nonaccrual status during thefourth quarter of 2007.  In the event ofa foreclosure and a possible deficiency judgment, we believe sufficient networth exists among the guarantors to satisfy their obligation.  As of December 31, 2007, based on thethen current estimated fair value of the collateral, the Bank estimates it willincur no loss.

 

The sixth relationship totaled $4.7 million at December 31, 2007,and is comprised primarily of $3.8 million in land development loans for a 110lot subdivision in Springdale, Arkansas, as well as 7 loans totalingapproximately $935,000 for a speculative single-family residence, a pre-soldcustom home, a single family residence, a rental property, and land. Thisborrower has filed for bankruptcy protection. We have estimated losses of$10,000 at December 31, 2007. However, based on factors such as thepotential adverse changes in market conditions, we may incur losses greaterthan that amount.

 

Accruing loans 90 days or more past due at December 31, 2007,primarily consisted of loans whose past due interest was paid after December 31,2007.

 

The increase in real estate owned was primarily due to foreclosures onproperties related to three borrowers. The first borrower had properties totaling $3.0 million, which wascomprised of $1.3 million in single-family rental properties and $1.7 millionin speculative single-family homes under construction.  The speculative homes are in various stagesof 

 

 

 

13

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completion ranging from approximately 85% to 100%.  Of the $3.0 million added, $1.6 million wassold prior to December 31, 2007. The second borrower had properties totaling $2.2 million comprised of 18speculative single-family construction loans. The homes are complete and the Bank is actively selling theseproperties.  Of the $2.2 million added,approximately $600,000 was sold prior to December 31, 2007.  The third borrower had loans totaling $1.1million comprised of three speculative single-family construction loans invarious stages of completion ranging from approximately 85% to 100%.  Construction costs on the real estate ownedare added to the real estate balance to the extent that the resulting balancedoes not exceed the estimated fair value of the property less estimated sellingcosts.  Since December 31, 2006,approximately $12.6 million was added to real estate owned, $6.0 million wassold, and $2.6 million was transferred to office properties and equipment for afuture branch location.  The propertytransferred is a shopping center in Lowell, Arkansas.  The Bank plans to occupy approximately 25% ofthe space and lease the rest to tenants.  As discussed above, certain nonaccrual loans are in various stages ofthe foreclosure process at December 31, 2007.  To the extent that these loans are foreclosedand ownership transferred to the Bank, real estate owned and associatedexpenses could continue to increase in the future.

 

The Bank isdiligently working to dispose of its REO and has dedicated an experiencedspecial assets officer who is working full-time to liquidate the Bank’sproperties in the Northwest Arkansas market. Each property is evaluated on acase-by-case basis to determine the best course of action with respect toliquidation.  Properties are marketed directly by the Bank or listed withlocal real estate agents utilizing appraisals, market information fromrealtors, the Streetsmart report, and our own market evaluations to makepricing and selling decisions.   The Bank’s Chief Lending Officer,loan officer, credit manager, special assets officer, and team members in thecollections department all work together in this endeavor.   TheBank’s goal is to liquidate these properties as soon as possible withoutincurring extraordinary losses due to quick sale pricing.

 

**Classified Assets. **Federal regulations require that each insured savings associationclassify its assets on a regular basis. In addition, in connection with examinations of insured institutions,federal examiners have authority to identify problem assets and, ifappropriate, classify them.  There arethree classifications for problem assets: “substandard,” “doubtful” and “loss.”  Substandard assets have one or more definedweaknesses and are characterized by the distinct possibility that the insuredinstitution will sustain some loss if the deficiencies are not corrected.  Doubtful assets have the weaknesses ofsubstandard assets with the additional characteristic that the weaknesses makecollection or liquidation in full on the basis of currently existing facts,conditions and values questionable, and there is a high possibility ofloss.  An asset classified loss isconsidered uncollectible and of such little value that continuance as an assetof the institution is not warranted.  At December 31,2007, the Bank had $41.4 million of classified assets, $38.5 million of whichwere classified as substandard and $2.9 million of which were classified asloss, consisting of $33.3 million of nonaccrual loans and $8.1 million of realestate owned.  In addition, at such date,the Bank had $8.4 million of assets designated as special mention. Specialmention assets have potential weaknesses that deserve management’s closeattention.  If left uncorrected, thesepotential weaknesses may result in deterioration of the repayment prospects forthe asset or the institution’s credit position at some future date.

 

**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 arecharged against the allowance when management believes it is likely that a loanbalance is uncollectible.  Subsequentrecoveries, if any, are credited to the allowance.

 

The allowance for loan losses represents management’s estimate ofincurred credit losses inherent in the Company’s loan portfolio as of thebalance sheet date.  The estimation ofthe allowance is based on a variety of factors, including past loan loss experience,the current credit profile of the Company’s borrowers, adverse situations thathave occurred that may affect the borrowers’ ability to repay, the estimatedvalue of underlying collateral, and general economic conditions.  Losses are recognized when availableinformation indicates that it is probable that a loss has been incurred and theamount of the loss can be reasonably estimated. This evaluation is inherentlysubjective as it requires estimates that are susceptible to significantrevision as more information becomes available or conditions change.

 

In determining the allowance for loan losses, the Company allocates aportion of the allowance to its various loan categories based on an analysis ofindividual loans and pools of loans. However, the entire allowance is available to absorb credit lossesinherent in the total loan portfolio as of the balance sheet date.

 

A loan is considered impaired when, based on current information andevents, it is probable that the Bank will be unable to collect the scheduledpayments of principal or interest when due according to the contractual termsof the loan agreement. Factors considered by management in determiningimpairment include payment status, collateral value, and the probability ofcollecting scheduled principal and interest payments when due. Loans thatexperience insignificant payment delays and payment shortfalls generally arenot classified as impaired. Management determines the significance of paymentdelays and payment shortfalls on a case-by-case basis, taking intoconsideration all of the circumstances surrounding the loan and the borrower,including the length of the delay, the reasons for the delay, the borrower’sprior payment record, and the amount of the short fall in relation to the principaland interest owed. Impairment is measured on 

 

 

 

14

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a loan by loan basis by either the present value of expected futurecash flows discounted at the loan’s effective interest rate, the loan’sobtainable market price, or the fair value of the collateral if the loan iscollateral dependent.  Multifamilyresidential, commercial real estate, land and land development, and commercialloans that are delinquent or where the borrower’s total loan relationship exceeds$1 million are evaluated on a loan-by-loan basis at least annually.

 

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

 

Inestimating the amount of credit losses inherent in our loan portfolio, variousjudgments and assumptions are made.  Forexample, when assessing the condition of the overall economic environment,assumptions are made regarding market conditions and their impact on the loanportfolio.  In the event the national orlocal economy were to sustain a prolonged downturn, the loss factors applied toour 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 in the event that the Bank has to foreclose orrepossess the collateral.

 

Although we consider theallowance for loan losses of approximately $5.2 million adequate to coverlosses inherent in our loan portfolio at December 31, 2007, no assurancecan be given that we will not sustain loan losses that are significantlydifferent from the amount recorded, or that subsequent evaluations of the loanportfolio, in light of factors then prevailing, would not result in asignificant change in the allowance for loan losses.

 

 

 

15

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The following table summarizes changes in the allowance for loan lossesand other selected statistics for the periods indicated.

 
| ** **                                                                              | ** ** | **Year Ended December 31,** | ** ** |
|-----------------------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                                              | ** ** | **2007**                         | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                                                              | ** ** | (Dollars  in Thousands)          | ** ** |
|                                                                                    |       |                             |       |   |   |   |   |   |   |   |   |
|                                                                                    |       |                             |       |   |   |   |   |   |   |   |   |
| Total loans outstanding at  end of period                                               |       | $                                | 642,965    |   | $ | 735,593 |   | $ | 790,570 |   | $ | 699,205 |   | $ | 550,215 |   |
| Average  loans outstanding                                                              |       | $                                | 649,062    |   | $ | 726,642 |   | $ | 687,373 |   | $ | 573,520 |   | $ | 492,492 |   |
| Allowance  at beginning of period                                                       |       | $                                | 2,572      |   | $ | 2,114 |   | $ | 1,846 |   | $ | 1,621 |   | $ | 1,529 |   |
| Charge-offs:                                                                            |       |                             |       |   |   |   |   |   |   |   |   |
| One- to four-family  residential                                                        |       | (75                              | )          | (25 | ) | (74 | ) | (152 | ) | (73 | ) |
| Home equity and second  mortgage                                                        |       | (175                             | )          | (2 | ) | (49 | ) | (3 | ) | (11 | ) |
| Multifamily residential                                                                 |       | —                           |       | — |   | — |   | — |   | — |   |
| Commercial real estate                                                                  |       | (18                              | )          | — |   | — |   | (71 | ) | — |   |
| Land                                                                                    |       | (20                              | )          | — |   | — |   | — |   | — |   |
| Cnstruction                                                                             |       | (401                             | )          | (239 | ) | (77 | ) | — |   | — |   |
| Commercial                                                                              |       | (132                             | )          | (234 | ) | (41 | ) | (184 | ) | (109 | ) |
| Consumer (1)                                                                            |       | (798                             | )          | (695 | ) | (715 | ) | (488 | ) | (485 | ) |
| Total charge-offs                                                                       |       | (1,619                           | )          | (1,195 | ) | (956 | ) | (898 | ) | (678 | ) |
| Recoveries:                                                                             |       |                             |       |   |   |   |   |   |   |   |   |
| One- to four-family  residential                                                        |       | 5                                |       | — |   | — |   | 2 |   | 1 |   |
| Home equity and second  mortgage                                                        |       | —                           |       | — |   | 2 |   | — |   | — |   |
| Multifamily residential                                                                 |       | —                           |       | — |   | — |   | — |   | — |   |
| Commercial real estate                                                                  |       | —                           |       | — |   | 1 |   | 2 |   | — |   |
| Land                                                                                    |       | —                           |       | — |   | — |   | — |   | — |   |
| Construction                                                                            |       | 5                                |       | 7 |   | — |   | — |   | — |   |
| Commercial                                                                              |       | —                           |       | — |   | — |   | — |   | — |   |
| Consumer (1)                                                                            |       | 171                              |       | 164 |   | 120 |   | 99 |   | 79 |   |
| Total recoveries                                                                        |       | 181                              |       | 171 |   | 123 |   | 103 |   | 80 |   |
| Net  charge-offs                                                                        |       | (1,438                           | )          | (1,024 | ) | (833 | ) | (795 | ) | (598 | ) |
| Total  provisions for losses                                                            |       | 4,028                            |       | 1,482 |   | 1,101 |   | 1,020 |   | 690 |   |
| Allowance  at end of period                                                             |       | $                                | 5,162      |   | $ | 2,572 |   | $ | 2,114 |   | $ | 1,846 |   | $ | 1,621 |   |
|                                                                                    |       |                             |       |   |   |   |   |   |   |   |   |
| Allowances for loan losses  as a percentage of total loans outstanding at end of period |       | 0.80                             | %          | 0.35 | % | 0.27 | % | 0.26 | % | 0.29 | % |
|                                                                                    |       |                             |       |   |   |   |   |   |   |   |   |
| Net loans charge-off as a  percentage of average loans outstanding                      |       | 0.22                             | %          | 0.14 | % | 0.12 | % | 0.14 | % | 0.12 | % |

 

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(1)          Consumer loan charge-offs include overdraftcharge-offs of  $575,000, $600,000,$522,000, $323,000, and $182,000 for the years ended December 31, 2007,2006, 2005, 2004, and 2003, respectively. Consumer loan recoveries include recoveries of overdraft charge-offs of$162,000, $151,000, $114,000, $85,000, and $50,000, for the years ended December 31,2007, 2006, 2005, 2004, and 2003, respectively.

 

 

 

16

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

** **
| ** **                                        | ** ** | **December 31,**   |
|---------------------------------------------------|------------|-------------------------|
| ** **                                        | ** ** | **2007**                | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                        | ** ** | **Amount**              | ** ** | **Percentage  of Loans** | ** ** | **Amount** | ** ** | **Percentage  of Loans** | ** ** | **Amount** | ** ** | **Percentage  of Loans** | ** ** | **Amount** | ** ** | **Percentage  of Loans** | ** ** | **Amount** | ** ** | **Percentage  of Loans** | ** ** |
| ** **                                        | ** ** | (Dollars  in Thousands) |
|                                              |       |                    |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| One-to-four  family residences                    |       | $                       | 221 |   | 35.77 | % | $ | 204 |   | 35.05 | % | $ | 173 |   | 35.53 | % | $ | 301 |   | 41.79 | % | $ | 227 |   | 49.03 | % |
| Home  equity and second mortgage                  |       | 160                     |   | 5.34 |   | 222 |   | 4.78 |   | 136 |   | 3.69 |   | 96 |   | 3.87 |   | 82 |   | 4.37 |   |
| Speculative  one- to four-family construction (1) |       | 405                     |   | 6.35 |   | 589 |   | 10.92 |   | 295 |   | 13.16 |   | — |   | 11.83 |   | — |   | 6.94 |   |
| Multifamily  residential                          |       | 19                      |   | 2.43 |   | 15 |   | 1.66 |   | 16 |   | 1.63 |   | 12 |   | 1.35 |   | 12 |   | 1.39 |   |
| Commercial  real estate (2)                       |       | 309                     |   | 18.62 |   | 413 |   | 18.30 |   | 372 |   | 16.59 |   | 356 |   | 18.04 |   | 226 |   | 18.32 |   |
| Land                                              |       | 105                     |   | 6.66 |   | 48 |   | 6.48 |   | — |   | 6.02 |   | — |   | 5.58 |   | — |   | 2.68 |   |
| Land  development (3)                             |       | 2,658                   |   | 6.56 |   | 211 |   | 6.45 |   | 101 |   | 5.09 |   | 35 |   | 2.01 |   | — |   | — |   |
| Construction                                      |       | 118                     |   | 10.99 |   | 92 |   | 9.27 |   | 113 |   | 12.00 |   | 73 |   | 8.93 |   | 61 |   | 9.30 |   |
| Commercial  (4)                                   |       | 628                     |   | 3.54 |   | 452 |   | 3.57 |   | 371 |   | 2.64 |   | 509 |   | 2.34 |   | 404 |   | 1.99 |   |
| Consumer  (5)                                     |       | 539                     |   | 3.74 |   | 326 |   | 3.52 |   | 437 |   | 3.65 |   | 412 |   | 4.26 |   | 546 |   | 5.98 |   |
| Unallocated                                       |       | —                  |   | — |   | — |   | — |   | 100 |   | — |   | 52 |   | — |   | 63 |   | — |   |
| Total                                             |       | $                       | 5,162 |   | 100.00 | % | $ | 2,572 |   | 100.00 | % | $ | 2,114 |   | 100.00 | % | $ | 1,846 |   | 100.00 | % | $ | 1,621 |   | 100.00 | % |

 

----

(1)          The decrease from 2006to 2007 was primarily due to a decrease in specific loan loss allowances.  The increase from 2005 to 2006 was primarilydue to an increase in specific loan loss allowances as well as an increase inthe loss factor applied to such loans. In 2004 and 2003, speculative one- to four-family residentialconstruction loans were pooled with permanent one- to four-family residencesfor the determination of the allowance for loan losses.

(2)**         **The allowance allocated tocommercial real estate loans decreased between 2006 and 2007 primarily due to adecrease in the related loan balances. The allowance increased between 2003 and 2004 primarily due to loan growth.

(3)          Theallowance allocated to land development loans increased between 2006 and 2007primarily due to an increase in specific loan loss allowances in this categoryof $2.4 million.

(4)          Theallowance allocated to commercial loans increased from 2005 to 2006 and from2006 to 2007 primarily due to increases in specific loan loss allowances inthis category.

(5)          Consumerloan loss allowances increased from 2006 to 2007 primarily due to an increasein the loss factor applied to such loans.

 

 

 

17

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## **InvestmentActivities**

## ** **

**Investment Securities. **The investment policy of the Bank, as established by the board ofdirectors, is designed primarily to provide and maintain liquidity, to providecollateral for pledging requirements, to complement the Bank’s interest raterisk strategy and to generate a favorable return on investments.  The Bank’s investment policy is currentlyimplemented by the Bank’s Chief Executive Officer within the parameters set bythe asset/liability management committee and the board of directors.  The Bank is authorized to invest inobligations issued or fully guaranteed by the U.S. Government, certain federalagency obligations, certain time deposits, negotiable certificates of depositissued by commercial banks and other insured financial institutions, municipalsecurities, and other specified investments.

 

Investment securities that management has the positive intent andability to hold to maturity are classified as held to maturity and are reportedat amortized cost.  Investment securitiesclassified as available for sale are reported at fair value, with unrealizedgains and losses excluded from earnings and reported net of tax in othercomprehensive income.  At December 31,2007, all of the Bank’s investment securities were classified as held tomaturity.  At December 31, 2007,approximately $46.7 million of the Bank’s investment securities were pledged ascollateral for certain deposits in excess of $100,000.  In addition, certain U.S. Government andagency securities were pledged as collateral for FHLB advances under the FHLB’sblanket lien.  At December 31, 2007,investments in the debt and/or equity securities of any one issuer, other thanthose issued by U.S. Government agencies, did not exceed more than 10% of theCompany’s stockholders’ equity.

 

The following table sets forth the amount of investment securities heldto maturity that contractually mature during each of the periods indicated andthe weighted average yields for each range of maturities at December 31,2007.  Weighted average yields formunicipal obligations have not been adjusted to a tax-equivalent basis.  Expected maturities may differ fromcontractual maturities because issuers may have the right to call or prepay theobligation without prepayment penalties.

 
| ** **                               | ** ** | **Less than One Year** | ** ** | **One to Five  Years** | ** ** | **Five to Ten  Years** | ** ** | **After Ten  Years** | ** ** | **Total**  | ** ** |      |
|------------------------------------------|------------|------------------------|------------|------------------------|------------|------------------------|------------|----------------------|------------|------------|------------|-----------|
| ** **                               | ** ** | **Amount**             | ** ** | **Yield**              | ** ** | **Amount**             | ** ** | **Yield**            | ** ** | **Amount** | ** ** | **Yield** | ** ** | **Amount** | ** ** | **Yield** | ** ** | **Amount** | ** ** | **Yield** | ** ** |   |
|                                     |       |                   |       |                   |       |                   |       |                 |       |       |       |      |   |   |   |   |   |   |   |   |   |   |
| Municipal  securities                    |       | $                      | —     |                   | —     | %                      | $          | 1,580                |       | 3.96       | %          | $         | 7,403 |   | 4.43 | % | $ | 8,106 |   | 4.55 | % | $ | 17,089 |   | 4.44 | % |
| U.  S. Government and agency obligations |       | 3,390                  |       | 5.86                   | %          | 6,000                  |       | 5.07                 | %          | 7,402      |       | 4.83      | % | 61,709 |   | 5.76 | % | 78,501 |   | 5.62 | % |   |
| Total                                    |       | $                      | 3,390      |                   | 5.86       | %                      | $          | 7,580                |       | 4.84       | %          | $         | 14,805 |   | 4.63 | % | $ | 69,815 |   | 5.62 | % | $ | 95,590 |   | 5.41 | % |
|                                          |            |                        |            |                        |            |                        |            |                      |            |            |            |           |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

As of December 31,2007, there were approximately $95.0 million of investment securities at anaverage interest rate of 5.42% with issuer call options, of which approximately$87.5 million at an average interest rate of 5.50% are callable within oneyear.

 

The followingtable sets forth the carrying value of the Company’s investment securitiesclassified as held to maturity.  TheCompany held no investment securities as available for sale at the datesindicated.

 
| ** **                               | ** ** | **December 31,** | ** ** |
|------------------------------------------|------------|-----------------------|------------|
| ** **                               | ** ** | **2007**              | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                               | ** ** | (In  Thousands)       | ** ** |
| Investment  securities held to maturity: |       |                  |       |   |   |   |   |
| Municipal securities                     |       | $                     | 17,089     |   | $ | 16,889 |   | $ | 16,661 |   |
| U.S. Government and agency  obligations  |       | 78,501                |       | 43,857 |   | 40,034 |   |
| Total                                    |       | $                     | 95,590     |   | $ | 60,746 |   | $ | 56,695 |   |

 

As a member of the FHLB of Dallas, the Bank is required to maintain aninvestment in FHLB stock.  At December 31,2007, the Bank’s investment in FHLB stock amounted to $4.4 million.  No ready market exists for such stock and ithas no quoted market value.

 

 

 

18

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**Sourcesof Funds**

 

**General. **Deposits are the primary source of the Bank’s fundsfor lending and other investment purposes. In addition to deposits, the Bank derives funds from loan principalrepayments and prepayments and interest payments, maturities and calls ofinvestment securities and advances from the FHLB of Dallas.  Loan repayments are a relatively stablesource of funds, while deposit inflows and outflows are significantlyinfluenced by general interest rates and money market conditions.  Borrowings are used when funds from loan anddeposit sources are insufficient to meet funding needs.  They may also be used on a longer-term basisfor general business purposes.  FHLBadvances are the primary source of borrowings.

 

**Deposits. **The Bank’s deposit products include a broad selectionof deposit instruments, including checking accounts, money market accounts,savings accounts and term certificate accounts. Deposit account terms vary, with the principal differences being theminimum balance required, the time period the funds must remain on deposit,early withdrawal penalties and the interest rate.

 

The Bank considersits primary market area to be Northcentral and Northwest Arkansas.  The Bank utilizes traditional marketingmethods to attract new customers and savings deposits.  The Bank does not advertise for depositsoutside of its primary market area and management believes that non-residentsof Arkansas held an insignificant number of deposit accounts at December 31,2007.  Services of deposit brokers have beenused on a limited basis with less than 1% of certificates of deposit at December 31,2007, obtained through a broker.

 

The Bank has been competitive in the types of accounts and in interestrates it has offered on its deposit products but does not necessarily seek tomatch the highest rates paid by competing institutions.  Although market demand generally dictateswhich deposit maturities and rates will be accepted by the public, the Bankintends to continue to offer longer-term deposits to the extent possible andconsistent with its asset and liability management goals.

 

The following table shows the distribution of, and certain otherinformation relating to, the Bank’s deposits by type of deposit, as of thedates indicated.

 
| ** **                 | ** ** | **December 31,**   | ** ** |
|----------------------------|------------|-------------------------|------------|
| ** **                 | ** ** | **2007**                | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                 | ** ** | **Amount**              | ** ** | **%** | ** ** | **Amount** | ** ** | **%** | ** ** | **Amount** | ** ** | **%** | ** ** |
| ** **                 | ** ** | (Dollars  in Thousands) | ** ** |
| Certificate  accounts:     |       |                    |       |   |   |   |   |   |   |   |   |   |   |
| Less than 3.00%            |       | $                       | 2,063      |   | 0.3 | % | $ | 4,173 |   | 0.6 | % | $ | 62,689 |   | 10.2 | % |
| 3.00% - 3.99%              |       | 66,897                  |       | 10.6 |   | 98,932 |   | 15.2 |   | 164,600 |   | 26.9 |   |
| 4.00% - 5.99%              |       | 353,534                 |       | 56.1 |   | 327,311 |   | 50.2 |   | 156,224 |   | 25.5 |   |
| 6.00% - 7.99%              |       | 3,917                   |       | 0.6 |   | 3,826 |   | 0.6 |   | 7,757 |   | 1.3 |   |
| 8.00% and over             |       | —                  |       | — |   | — |   | — |   | 458 |   | 0.1 |   |
| Total certificate accounts |       | 426,411                 |       | 67.6 |   | 434,242 |   | 66.6 |   | 391,728 |   | 64.0 |   |
|                       |       |                    |       |   |   |   |   |   |   |   |   |   |   |
| Transaction  accounts:     |       |                    |       |   |   |   |   |   |   |   |   |   |   |
| Savings                    |       | 25,088                  |       | 4.0 |   | 26,824 |   | 4.1 |   | 30,521 |   | 5.0 |   |
| Money market accounts      |       | 51,424                  |       | 8.2 |   | 51,827 |   | 7.9 |   | 64,021 |   | 10.5 |   |
| Checking accounts          |       | 127,491                 |       | 20.2 |   | 139,372 |   | 21.4 |   | 125,397 |   | 20.5 |   |
| Total transaction accounts |       | 204,003                 |       | 32.4 |   | 218,023 |   | 33.4 |   | 219,939 |   | 36.0 |   |
| Total  deposits            |       | $                       | 630,414    |   | 100.0 | % | $ | 652,265 |   | 100.0 | % | $ | 611,667 |   | 100.0 | % |

 

 

 

19

----

 

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,** | ** ** |                    |
|----------------------------------|------------|--------------------------------------|------------|-------------------------|
| ** **                       | ** ** | **2007**                             | ** ** | **2006**                | ** ** | **2005** | ** ** |   |
| ** **                       | ** ** | **Average  Balance**                 | ** ** | **Average  Rate  Paid** | ** ** | **Average  Balance** | ** ** | **Average  Rate  Paid** | ** ** | **Average  Balance** | ** ** | **Average  Rate  Paid** | ** ** |
| ** **                       | ** ** | (Dollars  in Thousands)              | ** ** |                    |
| Savings  accounts                |       | $                                    | 26,512     |                    | 0.57 | % | $ | 29,018 |   | 0.59 | % | $ | 31,276 |   | 0.50 | % |   |
| Money  market accounts           |       | 51,484                               |       | 2.89                    |   | 56,984 |   | 2.64 |   | 82,492 |   | 1.76 |   |   |
| Checking  accounts with interest |       | 102,406                              |       | 1.83                    |   | 96,095 |   | 1.47 |   | 82,522 |   | 0.50 |   |   |
| Checking  accounts - noninterest |       | 33,298                               |       | —                  |   | 36,133 |   | — |   | 35,387 |   | — |   |   |
| Certificates  of deposit         |       | 425,024                              |       | 4.81                    |   | 412,000 |   | 4.31 |   | 359,076 |   | 3.54 |   |   |
| Total deposits                   |       | $                                    | 638,724    |                    | 3.74 | % | $ | 630,230 |   | 3.28 | % | $ | 590,753 |   | 2.47 | % |   |
|                                  |            |                                      |            |                         |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The following table presents, by various interest rate categories,certificates of deposit at December 31, 2007 and 2006, and theamounts at December 31, 2007, which mature during the periods indicated.

 
| ** **                 | ** ** | **December 31,** | ** ** | **Amounts at December 31, 2007  Maturing in the 12 Months Ending December 31,** | ** ** |
|----------------------------|------------|-----------------------|------------|-------------------------------------------------------------------------------------------|------------|
| ** **                 | ** ** | **2007**              | ** ** | **2006**                                                                                  | ** ** | **2008** | ** ** | **2009** | ** ** | **2010** | ** ** | **Thereafter** | ** ** |
| ** **                 | ** ** | (In  Thousands)       | ** ** |
| Certificate  accounts:     |       |                  |       |                                                                                      |       |   |   |   |   |   |   |   |   |
| Less than 3.00%            |       | $                     | 2,063      |                                                                                      | $          | 4,173 |   | $ | 2,050 |   | $ | 13 |   | $ | — |   | $ | — |   |
| 3.00% - 3.99%              |       | 66,897                |       | 98,932                                                                                    |       | 57,005 |   | 8,687 |   | — |   | 1,205 |   |
| 4.00% - 5.99%              |       | 353,534               |       | 327,311                                                                                   |       | 281,775 |   | 17,519 |   | 20,800 |   | 33,440 |   |
| 6.00% - 7.99%              |       | 3,917                 |       | 3,826                                                                                     |       | 1,029 |   | 2,888 |   | — |   | — |   |
| Total certificate accounts |       | $                     | 426,411    |                                                                                      | $          | 434,242 |   | $ | 341,859 |   | $ | 29,107 |   | $ | 20,800 |   | $ | 34,645 |   |

 

The followingtable sets forth maturities of the Bank’s certificates of deposit of $100,000or more at December 31, 2007 by time remaining to maturity.

 

| ** **                                                        | ** ** | **Amount**     | ** ** |
|-------------------------------------------------------------------|------------|----------------|------------|
|                                                              |       | (In Thousands) |       |
| Period  Ending:                                                   |       |           |       |
| March 31,  2008                                              |       | $              | 27,748     |   |
| June 30,  2008                                               |       | 45,674         |       |
| September 30,  2008                                          |       | 22,916         |       |
| December 31,  2008                                           |       | 9,141          |       |
| After  December 31, 2008                                     |       | 20,397         |       |
| Total certificates of  deposit with  balances of $100,000 or more |       | $              | 125,876    |   |

 

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

 

 

 

20

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Advances at December 31,2007, have maturity dates and weighted average rates as follows:

 

| **Year Ending  December 31,** | ** ** | **Weighted  Average  Rate** | ** ** | **Amount**              | ** ** |
|------------------------------------|------------|-----------------------------|------------|-------------------------|------------|
| ** **                         | ** ** |                        | ** ** | (Dollars  in Thousands) | ** ** |
| 2008                               |       | 4.48                        | %          | $                       | 35,905     |   |
| 2009                               |       | 4.54                        |       | 26,636                  |       |
| 2010                               |       | 4.61                        |       | 9,353                   |       |
| 2011                               |       | 4.61                        |       | 7,514                   |       |
| 2012                               |       | 4.56                        |       | 1,570                   |       |
| Thereafter                         |       | 4.26                        |       | 1,109                   |       |
| Total                              |       | 4.53                        | %          | $                       | 82,087     |   |

 

The followingtable sets forth information with respect to the Company’s FHLB advances at andduring the periods indicated.

 

| ** **                       | ** ** | **At or For the Year Ended December 31,** | ** ** |
|----------------------------------|------------|------------------------------------------------|------------|
| ** **                       | ** ** | **2007**                                       | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                       | ** ** | (Dollars  in Thousands)                        | ** ** |
| Maximum  balance                 |       | $                                              | 120,305    |   | $ | 171,375 |   | $ | 171,203 |   |
| Average  balance                 |       | 94,481                                         |       | 154,186 |   | 135,636 |   |
| Year  end balance                |       | 82,087                                         |       | 120,305 |   | 158,240 |   |
| Weighted  average interest rate: |       |                                           |       |   |   |   |   |
| At end of year                   |       | 4.53                                           | %          | 4.58 | % | 4.08 | % |
| During the year                  |       | 4.56                                           | %          | 4.50 | % | 3.68 | % |
|                                  |            |                                                |            |  |  |  |  |  |  |  |

 

## **Subsidiaries**

## ** **

The Bank ispermitted to invest up to 2% of its assets in the capital stock of, or securedor unsecured loans to, subsidiary corporations, with an additional investmentof 1% of assets when such additional investment is utilized primarily forcommunity development purposes.  TheBank’s only subsidiary, First Harrison Service Corporation (the “ServiceCorporation”), was formed in 1971.  At December 31,2007, the Service Corporation was inactive.

 

**REGULATION**

** **

*Setforth below is a brief description of those laws and regulations which,together with the descriptions of laws and regulations contained elsewhereherein, are deemed material to an investor’s understanding of the extent to whichthe Company and the Bank are regulated. The description of the laws and regulations hereunder, as well asdescriptions of laws and regulations contained elsewhere herein, does notpurport to be complete and is qualified in its entirety by reference to applicablelaws and regulations.*

 

**The Company**

 

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

 

**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 also prohibit, among otherthings, any director or officer of a savings and loan holding company, or anyindividual who owns or controls more than 25% of the voting shares of suchholding company, from acquiring control of any savings institution not asubsidiary of such savings and loan holding company, unless the acquisition isapproved 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 “grandfathered holding company”). However, if the Director of the OTS determines that there is reasonablecause to believe that the continuation by a savings and loan holding company ofan activity constitutes a serious risk to the financial safety, soundness orstability of its subsidiary savings association, the Director may impose suchrestrictions as it deems necessary to address such risk, including limiting (i) paymentof dividends by the savings association; (ii) 

 

 

 

21

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transactions between the savings association and its affiliates; and (iii) anyactivities of the savings association that might create a serious risk that theliabilities of the holding company and its affiliates may be imposed on thesavings association.  Notwithstanding theabove rules as to permissible business activities of unitary savings andloan holding companies, if the savings association subsidiary of such a holdingcompany fails to meet the qualified thrift lender (“QTL”) test, then suchunitary holding company also shall become subject to the activitiesrestrictions applicable to multiple savings and loan holding companies and,unless the savings association requalifies as a QTL within one year thereafter,shall register as, and become subject to the restrictions applicable to, a bankholding company.

 

If a savings and loan holding company acquires control of a secondsavings association and holds it as a separate institution, the holding companybecomes a multiple savings and loan holding company.  As a general rule, multiple savings and loanholding companies are subject to restrictions on their activities that are notimposed on a grandfathered holding company. They are restricted to activities traditionally permitted to multiplesavings and loan holding companies and to financial holding companies underprovisions of the Bank Holding Company Act. Multiple savings and loan holding companies may:

 

·                  furnish or performmanagement services for a savings association subsidiary of a savings and loanholding company;

·                  hold, manage or liquidateassets owned or acquired from a savings association subsidiary of a savings andloan holding company;

·                  hold or manage propertiesused or occupied by a savings association subsidiary of a savings and loanholding company;

·                  engage in activitiesdetermined by the Federal Reserve to be closely related to banking and a properincident thereto; and

·                  engage in services andactivities previously determined by the Federal Home Loan Bank Board byregulation to be permissible for a multiple savings and loan holding company asof March 5, 1987.

 

The activities financial holding companies may engage in include:

 

·                  lending, exchanging,transferring or investing for others, or safeguarding money or securities;

·                  insuring, guaranteeing orindemnifying others, issuing annuities, and acting as principal, agent orbroker for purposes of the foregoing;

·                  providing financial,investment or economic advisory services, including advising an investmentcompany;

·                  issuing or selling interestsin pooled assets that a bank could hold directly;

·                  underwriting, dealing in ormaking a market in securities; and

·                  merchant banking activities.

 

Every savings institution subsidiary of a savings and loan holdingcompany is required to give the OTS at least 30 days’ advance notice of anyproposed dividends to be made on its guaranteed, permanent or othernon-withdrawable stock, or else such dividend will be invalid.

 

**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.  Affiliates of a savings institution generallyinclude, among other entities, the savings institution’s holding company andcompanies that are controlled by or under common control with the savingsinstitution.  Generally, Section 23A(i) limits the extent to which the savings association or its subsidiariesmay engage in “covered transactions” with any one affiliate to an amount equalto 10% of such association’s capital stock and surplus, and contain anaggregate limit on all such transactions with all affiliates to an amount equalto 20% of such capital stock and surplus. Section 23B applies to “covered transactions” as well as certainother transactions and requires that all transactions be on terms substantiallythe same, or at least favorable, to the association or subsidiary as thoseprovided to a non-affiliate.  The term“covered transaction” includes the making of loans to, purchase of assets from,issuance of a guarantee to an affiliate and similar transactions.  Section 23B transactions also apply tothe provision of services and the sale of assets by a savings association to anaffiliate.  In addition to therestrictions imposed by Sections 23A and 23B, Section 11 of the HOLAprohibits a savings association from (i) making a loan or other extensionof credit to an affiliate, except for any affiliate which engages only incertain activities which are permissible for bank holding companies, or (ii) purchasingor investing in any stocks, bonds, debentures, notes or similar obligations ofany affiliate, except for affiliates which are subsidiaries of the savingsassociation.

 

In addition, Sections 22(g) and (h) ofthe Federal Reserve Act place restrictions on loans to executive officers,directors and principal stockholders. Under Section 22(h), loans to a director, an executive officer andto a greater than 10% stockholder of a savings institution (“a principalstockholder”), and certain affiliated interests of either, may not exceed,together with all other outstanding loans to such person and affiliatedinterests, the savings institution’s loans to one borrower limit (generallyequal to 15% of the institution’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 

 

 

 

22

----

 

comparable transactions to other personsunless the loans are made pursuant to a benefit or compensation program that (i) iswidely available to employees of the institution and (ii) does not givepreference to any director, executive officer or principal stockholder, orcertain affiliated interests of either, over other employees of the savingsinstitution.  Section 22(h) alsorequires prior board approval for certain loans.  In addition, the aggregate amount ofextensions of credit by a savings institution to all insiders cannot exceed theinstitution’s unimpaired capital and surplus. Furthermore, Section 22(g) places additional restrictions onloans to executive officers.  At December 31,2007, the Bank was in compliance with the above restrictions.

 

**Federal Securities Law.*** *The common stock of the Company is registered with theSEC under the Securities Exchange Act of 1934, as amended. The Company issubject to the information, proxy solicitation, insider trading restrictionsand other requirements of the SEC under the Securities Exchange Act of 1934.

 

Company stock heldby persons who are affiliates of the Company may not be resold withoutregistration unless sold in accordance with certain resale restrictions.Affiliates are generally considered to be officers, directors and principalstockholders. If the Company meets specified current public informationrequirements, each affiliate of the Company will be able to sell in the publicmarket, without registration, a limited number of shares in any three-monthperiod.

 

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

 

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

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

·                  enhanced requirements for auditor independence and the types ofnon-audit services that auditors can provide;

·                  enhanced requirements for controls and procedures;

·                  accelerated filing requirements for SECreports;

·                  disclosure of a code of ethics; and

·                  increased disclosure and reporting obligations forcompanies, their directors and their executive officers.

 

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

 

## **The Bank**

## ** **

**General.**  The OTS has extensive authority over the operations offederally chartered savings institutions. As part of this authority, savings institutions are required to fileperiodic reports with the OTS and are subject to periodic examinations by theOTS and the FDIC.  The last regulatoryexamination of the Bank by the OTS was completed in March 2007.  The Bank was not required to make anymaterial changes to its operations as a result of such examination.  Federal laws and regulations prescribe theinvestment and lending authority of savings institutions, and such institutionsare prohibited from engaging in any activities not permitted by such laws andregulations.

 

The OTS’ enforcement authority over all savings institutions and theirholding companies includes, among other things, the ability to assess civilmoney penalties, to issue cease and desist or removal orders and to initiateinjunctive actions.  In general, these enforcementactions may be initiated for violations of laws and regulations and unsafe orunsound practices.  Other actions orinactions may provide the basis for enforcement action, including misleading oruntimely reports filed with the OTS.

 

**Insuranceof Accounts.**  On February 8,2006, President Bush signed into law legislation that merges the Bank InsuranceFund (“BIF”) and the Savings Association Insurance Fund (“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 alsogives the FDIC greater discretion to identify the relative risks allinstitutions present to the deposit insurance fund and set risk-based premiums.

 

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, whichmay be used to offset future premiums with certain limitations; requiring thepayment of dividends of 100% of the amount 

 

 

 

23

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 that the insurance fund exceeds1.5% of the estimated insured deposits; requiring the payment of dividends of50% of the amount that the insurance fund exceeds 1.35% of the estimatedinsured deposits (when the reserve is greater than 1.35% but no more than1.5%); and requiring that the merger of the SAIF and BIF occur no later than July 1,2006.

 

The FDIC mergedthe BIF and the SAIF to form the DIF on March 31, 2006 in accordance withthe Federal Deposit Insurance Reform Act of 2005. The FDIC maintains the DIF byassessing depository institutions an insurance premium. The FDIC Board approveda new risk-based premium system in November 2006, effective January 1,2007. The FDIC’s new regulations for risk-based deposit insurance assessmentsestablish four Risk Categories. Risk Category I, for well-capitalizedinstitutions that are financially sound with only a few minor weaknesses,includes approximately 95% of FDIC-insured institutions. Risk Categories II, III,and IV present progressively greater risks to the deposit insurance fund.Effective January 1, 2007, Risk Category I institutions pay quarterlyassessments for deposit insurance at annual rates of five to seven basispoints. The rates for Risk Categories II, III, and IV are seven, 28, and43 basis points, respectively. Rates are subject to change with advance noticeto insured institutions.

 

Within RiskCategory I, the precise rate for an individual institution with less than $10billion in assets is generally determined by a formula using CAMELS ratings,which are assigned in regulatory examinations, and financial ratios. Adifferent method applies for larger institutions. The rate for an individualinstitution is applied to its assessment base, which is generally its depositliabilities subject to certain adjustments. An institution insured by the FDICon December 31, 1996 which had previously paid assessments (or itssuccessor) is eligible for certain credit against deposit insuranceassessments. As a result of the assessment credit, the Bank recognized nopremium expense during calendar year 2007 and anticipates no premium expenseduring the first quarter of 2008.

 

The Bank, likeother former SAIF insured institutions and BIF insured institutions, isrequired to pay a Financing Corporation (“FICO”) assessment in order to fundthe interest on bonds issued to resolve thrift failures in the 1980s. For thefirst quarter of fiscal year 2008, the annual rate for this assessment is 1.14basis points for each $100 in domestic deposits. These assessments, which maybe revised based upon the level of BIF and former SAIF classified insuredinstitution’s deposits, will continue until the bonds mature in 2017 through2019.

 

The deposits of the Bank are insured to the maximum extent permitted bythe DIF, which is administered by the FDIC, and are backed by the full faithand credit of the U.S. Government.  Asinsurer, the FDIC is authorized to conduct examinations of, and to requirereporting by, FDIC-insured institutions. It also may prohibit any FDIC-insured institution from engaging in anyactivity the FDIC determines by regulation or order to pose a serious threat tothe FDIC.  The FDIC also has theauthority to initiate enforcement actions against savings institutions, aftergiving the OTS an opportunity to take such action.

 

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

 

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

 

Current OTS capital standards require savings institutions to satisfythree different capital requirements. Under these standards, savings institutions must maintain “tangible”capital equal to at least 1.5% of adjusted total assets, “core” capital equalto at least 4.0% of adjusted total assets and “total” capital (a combination ofcore and “supplementary” capital) equal to at least 8.0% of “risk-weighted”assets.  For purposes of the regulation,core capital generally consists of common stockholders’ equity (includingretained earnings), noncumulative perpetual preferred stock and relatedsurplus, minority interests in the equity accounts of fully consolidatedsubsidiaries, certain nonwithdrawable accounts and pledged deposits and “qualifyingsupervisory goodwill.”  Tangible capitalis given the same definition as core capital but does not include qualifyingsupervisory goodwill and is reduced by the amount of all the savingsinstitution’s intangible assets, with only a limited exception for purchasedmortgage servicing rights.  Both core andtangible capital are further reduced by an amount equal to a 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).  These adjustments do not materially affectthe Bank’s regulatory capital.  At December 31,2007, the Bank exceeded its tangible, core and risk-based capital requirements.

 

 

 

24

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In determining compliance with the risk-basedcapital requirement, a savings institution is allowed to include both corecapital and supplementary capital in its total capital, provided that theamount of supplementary capital included does not exceed the savingsinstitution’s core capital. Supplementary capital generally consists of hybrid capital instruments;perpetual preferred stock, which is not eligible to be included as corecapital; subordinated debt and intermediate-term preferred stock; and generalallowances for loan losses up to a maximum of 1.25% of risk-weightedassets.  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 bythe OTS for principal categories of assets are (i) 0% for cash andsecurities issued by the U.S. Government or unconditionally backed by the fullfaith and credit of the U.S. Government; (ii) 20% for securities (otherthan equity securities) issued by U.S. Government-sponsored agencies andmortgage-backed securities issued by, or fully guaranteed as to principal andinterest by, the FNMA or the FHLMC, except for those classes with residualcharacteristics or stripped mortgage-related securities; (iii) 50% forprudently underwritten permanent one- to four-family first lien mortgage loansnot more than 90 days delinquent and having a loan-to-value ratio of not morethan 90% at origination unless insured to such ratio by an insurer approved bythe FNMA or the FHLMC, qualifying residential bridge loans made directly forthe construction of one- to four-family residences and qualifying multifamilyresidential loans; and (iv) 100% for all other loans and investments,including consumer loans, commercial loans, and one- to four-family residentialreal estate loans more than 90 days delinquent, and for repossessed assets.

 

**QualifiedThrift 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 activityor make any new investment, directly or indirectly, unless such activity orinvestment is permissible for a national bank; (ii) the branching powersof the institution shall be restricted to those of a national bank; and (iii) paymentof dividends by the institution shall be subject to the rules regardingpayment of dividends by a national bank.  Upon the expiration of threeyears from the date the savings institution ceases to be a QTL, it must ceaseany activity and not retain any investment not permissible for a national bank.

 

Currently, the QTLtest requires either (i) that a savings association qualifies as adomestic building and loan association as defined in Section 7701 (a)(19)of the Internal Revenue Code of 1986, as amended, (“Code”) or (ii) that65% of an institution’s “portfolio assets” (as defined) consist of certainhousing and consumer-related assets on a monthly average basis in nine out ofevery 12 months.  Assets that qualifywithout limit for inclusion as part of the 65% requirement are loans made topurchase, refinance, construct, improve or repair domestic residential housingand manufactured housing; home equity loans; educational loans; small businessloans; loans made through credit cards or credit card accounts; mortgage-backedsecurities (where the mortgages are secured by domestic residential housing ormanufactured housing); stock issued by the FHLB of Dallas; and direct orindirect obligations of the FDIC.  Inaddition, the following assets, among others, may be included in meeting thetest subject to an overall limit of 20% of the savings institution’s portfolioassets: 50% of residential mortgage loans originated and sold within 90 days oforigination; investments in a service corporation that derives at least 80% ofits gross revenues from activities related to domestic or manufacturedresidential housing; 200% of the amount of loans and investments in “starterhomes”; 200% of the amount of certain loans in “credit-needy” areas; loans forthe purchase, construction, development, or improvements of “community servicefacilities” not in credit-needy areas; loans for personal, family, or householdpurchases (other than those in the includable without limit category); andstock issued by the FHLMC or the FNMA. Portfolio assets consist of total assets minus the sum of (i) goodwilland other intangible assets, (ii) property used by the savings institutionto conduct its business, and (iii) liquid assets up to 20% of theinstitution’s total assets.  At December 31,2007, the qualified thrift investments of the Bank were approximately 76.9% ofits portfolio assets.

 

**FederalHome Loan Bank System. **The Bank is a member of the FHLB ofDallas, which is one of 12 regional FHLBs that administers the home financingcredit function of savings institutions. Each FHLB serves as a reserve or central bank for its members within itsassigned region.  It is funded primarilyfrom proceeds derived from the sale of consolidated obligations of the FHLBSystem.  It makes loans to members (i.e.,advances) in accordance with policies and procedures established by the boardof directors of the FHLB.  At December 31,2007, the Bank had $82.1 million of outstanding FHLB advances.

 

As a member, theBank is required to purchase and maintain stock in the FHLB of Dallas in anamount equal to the sum of 0.06% of total assets as of the previous December 31and 4.10% of outstanding advances.  At December 31,2007, the Bank had $4.4 million in FHLB stock, which was in compliance withthis requirement.  No ready market existsfor such stock and it has no quoted market value.

 

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

 

 

 

25

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**Federal Reserve System. **The FRB requires alldepository institutions to maintain reserves against their transaction accountsand non-personal time deposits.  As of December 31,2007, no reserves were required to be maintained on the first $8.5 million oftransaction accounts, reserves of 3% were required to be maintained against thenext $45.8 million of net transaction accounts (with such dollar amountssubject to adjustment by the FRB), and a reserve of 10% against all remainingnet transaction accounts.  Because requiredreserves must be maintained in the form of vault cash or a noninterest bearingaccount at a Federal Reserve Bank, the effect of this reserve requirement is toreduce an institution’s earning assets.

 

**TAXATION**

** **

**Federal Taxation**

 

**General. **The Company andthe Bank are subject to the generally applicable corporate tax provisions ofthe Code, and the Bank is subject to certain additional provisions of the Codethat apply to thrift and other types of financial institutions. The followingdiscussion of federal taxation is intended only to summarize certain pertinentfederal income tax matters material to the taxation of the Company and the Bankand is not a comprehensive discussion of the tax rules applicable to theCompany and Bank.

 

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

 

**Bad Debt Reserves. **Prior to the enactment of the Small Business Jobs Protection Act (the“Act”), which was signed into law on August 21, 1996, certain thriftinstitutions, such as the Bank, were allowed deductions for bad debts undermethods more favorable than those granted to other taxpayers.  Qualified thrift institutions could computedeductions for bad debts using either the specific charge-off method of Section 166of the Code or the reserve method of Section 593 of the Code.  As a result of the 1996 Act, the Bank was required to use the specificcharge off method in computing its bad debt deduction beginning with its 1996federal tax return. Savings institutions were required to recapture any excessreserves over those established as of December 31, 1987 (base yearreserve).

 

The balance of the pre-1988 reserves is subject to the provisions of Section 593(e),as modified by the Act, which requires recapture in the case of certainexcessive distributions to shareholders. The pre-1988 reserves may not be utilized for payment of cash dividendsor other distributions to a shareholder (including distributions in dissolutionor liquidation) or for any other purpose (except to absorb bad debtlosses).  Distribution of a cash dividendby a thrift institution to a shareholder is treated as made:  first, out of the institution’s post-1951accumulated earnings and profits; second, out of the pre-1988 reserves; andthird, out of such other accounts as may be proper.  To the extent a distribution by the Bank tothe Company is deemed paid out of its pre-1988 reserves under these rules, thepre-1988 reserves would be reduced and the Bank’s gross income for tax purposeswould be increased by the amount which, when reduced by the income tax, if any,attributable to the inclusion of such amount in its gross income, equals theamount deemed paid out of the pre-1988 reserves.  As of December 31, 2007, the Bank’spre-1988 reserves for tax purposes totaled approximately $4.2 million.

 

**Minimum Tax. **The Codeimposes an alternative minimum tax at a rate of 20%.  The alternative minimum tax generally appliesto a base of regular taxable income plus certain tax preferences (“alternativeminimum taxable income” or “AMTI”) and is payable to the extent such AMTI is inexcess of an exemption amount.  Items oftax preference that constitute AMTI include (a) tax-exempt interest onnewly issued (generally, issued on or after August 8, 1986) privateactivity bonds other than certain qualified bonds and (b) 75% of theexcess (if any) of (i) adjusted current earnings as defined in the Code,over (ii) AMTI (determined without regard to this preference and prior toreduction by net operating losses).

 

**NetOperating Loss Carryovers. **A financialinstitution may, for federal income tax purposes, carry back net operatinglosses (“NOLs”) to the preceding two taxable years and forward to thesucceeding 20 taxable years.  Thisprovision applies to losses incurred in taxable years beginning after1997.  The Job Creation and WorkerAssistance Act of 2002 temporarily increased the general NOL carryback periodfrom two years to five years for NOLs arising in taxable years ending in 2001and 2002.  At December 31, 2007, theBank had no NOL carryforwards for federal income tax purposes.

 

**Capital Gains and Corporate Dividends-ReceivedDeduction. **Corporate netcapital gains are taxed at a maximum rate of 35%.  The corporate dividends-received deduction is80% in the case of dividends received from a “20-percent-owned corporation”,i.e., a corporation having at least twenty percent (but generally less than 80percent) of its stock owned by the recipient corporation and corporations whichown less than 20% of the stock of a corporation distributing a dividend maydeduct only 70% of dividends received or accrued on their behalf.  However, a corporation may deduct 100% ofdividends from a member of the same affiliated group of corporations.

 

**Other Matters. **Federallegislation is introduced from time to time that would limit the ability ofindividuals to deduct interest paid on mortgage loans.  Individuals are currently not permitted todeduct interest on consumer loans. Significant increases in tax rates or further restrictions on thedeductibility of mortgage interest could adversely affect the Bank.

 

 

 

26

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The Bank’s federal income tax returns for the tax years ended December 31,2004 forward are open under the statute of limitations and are subject toreview by the IRS.

 

**State Taxation**

 

The Bank is subject to the Arkansas corporation income tax, which is aprogressive rate up to a maximum of 6.5% of all taxable earnings.

 

**The Company is incorporated under Texas law and, accordingly, issubject to the New Texas Franchise Tax.  The New Texas Franchise Tax isbased on taxable margin apportioned to Texas pursuant to its grossreceipts based upon where the Company conducts business.  The Companycurrently has no Texas Gross Receipts.**

 

**Item1A.  Risk Factors**

 

*In analyzing whether to make or to continue an investment in oursecurities, investors should consider, among other factors, the following riskfactors.*

 

**Our results of operations are significantly dependent on economicconditions and related uncertainties.**

 

Banking is affected, directly and indirectly, by domestic andinternational 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 that 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 a material adverse effect on ouroperations.**

 

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 and repricing of our interest earning assetscurrently are fairly well balanced in relation to the estimated maturities andrepricing of our interest bearing liabilities (which involves various estimatesas to how changes in the general level of interest rates will impact theseassets and liabilities), there can be no assurance that our profitability wouldnot be adversely affected during any period of changes in interest rates due toa number of factors which can have a material impact on the Bank’s interestrate risk position.  Such factors includeamong other items, call features and interest rate caps and floors on variousassets and liabilities, prepayments, the current interest rates on assets andliabilities to be repriced in each period, and the relative changes in interestrates on different types of assets and liabilities.

 

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

 

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,machinery and other corporate assets, and a wide variety of consumer loans,including automobile loans, deposit account secured loans and unsecuredloans.  Although commercial businessloans and 

 

 

 

27

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consumer loans generally have shorter terms and higher interest ratesthan mortgage loans, they generally involve more risk than mortgage loansbecause of the nature of, or in certain cases the absence of, the collateralwhich secures such loans.

 

At December 31, 2007, total nonaccrualloans amounted to $33.3 million, a $14.3 million or 75.3% increase compared tononaccrual loans of $19.0 million at December 31, 2006.  Such increase was primarily due to a $6.1million increase in nonaccrual land development loans, a $3.1 million increasein nonaccrual one- to four-family residential loans and a $5.4 million increasein nonaccrual commercial real estate loans. Such increases are primarily related to loans to local builders for theconstruction of speculative residential homes and lots and for the constructionof pre-sold one- to four-family homes. The Northwest Arkansas market has experienced an oversupply of lots andspeculative homes and certain of the Bank’s builders are experiencing extendedmarketing times for the sale of their homes, resulting in inadequate cash flowto service the interest carry on their loan. As a result, the Bank has substantially curtailed such lending.

 

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

 

**Our allowance for losses on loans may not be adequate to cover probablelosses.**

 

We have established an allowance for loan losses that we believe isadequate to offset probable losses on our existing loans.  There can be no assurance that any furtherdeclines 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.

 

**Weare subject to extensive regulation that could adversely affect our businessand 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 that may adversely affectour profitability.**

 

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

 

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

 

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 ourcustomers.  Many of our competitors havefar greater resources than we have to invest in technology.

 

**We and our banking subsidiary are subject to capitaland other requirements that 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 no preemptive rightsand 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 voting securities,shareholders may be unable to maintain their pro rata voting or ownershipinterest in us.

 

 

 

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**Wemay incur increased employee benefit costs.**

 

Our pensionbenefits are dependent upon multiple factors resulting from actual plan experienceand assumptions of future experience. Fluctuations in market performance andchanges in interest rates may result in increased or decreased pension costs infuture periods. Changes in assumptions regarding expected long-term rate ofreturn on plan assets, changes in our discount rate or expected compensationlevels could also increase or decrease pension costs. Future pension fundingrequirements, and the timing of funding payments, may be subject to changes inlegislation.

 

**We are subject to securityand operational risks relating to our use of technology that could damage ourreputation and our business.**

 

Security breaches in our internet banking activities could expose us topossible liability and damage our reputation. Any compromise of our securityalso could deter customers from using our internet banking services thatinvolve the transmission of confidential information. We rely on standardinternet security systems to provide the security and authentication necessaryto effect secure transmission of data. These precautions may not protect oursystems from compromises or breaches of our security measures that could resultin damage to our reputation and our business. Additionally, we outsource ourdata processing to a third party. If our third party provider encountersdifficulties or if we have difficulty in communicating with such third party,it could significantly affect our ability to adequately process and account forcustomer transactions, which could significantly affect our business operations.

 

**The building of market sharethrough our branching strategy could cause our expenses to increase faster thanrevenues.**

 

We intend to continue to build market share in Northwest andNorthcentral Arkansas through our branching strategy. We plan to open at leasttwo new branches during calendar year 2008. There are considerable costsinvolved in opening branches and new branches generally require a period oftime to generate sufficient revenues to offset their costs, especially in areasin which we do not have an established presence. Accordingly, any new branchcan be expected to negatively impact our earnings for some period of time untilthe branch reaches certain economies of scale. We have no assurance our newbranches will be successful even after they have been established.

 

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

 

We primarily rely on depositsand Federal Home Loan Bank advances to fund our operations. Although we havehistorically been able to replace maturing deposits if desired, no assurancecan be given that we will be able to replace such funds in the future if ourfinancial condition or market conditions were to change. Although we considerthe sources of existing funds adequate for our current liquidity needs, we mayseek brokered deposits or debt in the future to achieve our long-term businessobjectives. There can be no assurance additional funds, if sought, would beavailable to us or, if available, would be on favorable terms. If additionalfinancing sources are unavailable or are not available on reasonable terms, ourgrowth and future prospects could be adversely affected.

 

**Item1B.  Unresolved Staff Comments**

 

None

 

 

 

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

 

At December 31,2007, the Bank conducted its business from its executive office in Harrison,Arkansas, and seventeen full service offices, all of which are located inNorthcentral and Northwest Arkansas.

 

The followingtable sets forth information with respect to the offices and other propertiesof the Bank at December 31, 2007.

 
|  

**Description/Address**                              | ** ** | **Leased/**

**Owned** | ** ** |  

**Description/Address**                                   | ** ** | **Leased/**

**Owned**       |
|--------------------------------------------------------------|------------|------------------------|------------|-------------------------------------------------------------------|------------|------------------------------|
|                                                         |       |                   |       |                                                              |       |                         |
| 1401 Highway  62-65 North

Harrison,  AR  72601         |       | Owned                  |       | 2501 E. Central  Ave., Suite 2

Bentonville,  AR  72712 |       |     Leased(1) |
|                                                         |       |                   |       |                                                              |       |                         |
| 200 West  Stephenson

Harrison, AR  72601                    |       | Owned                  |       | 3460 North  College

Fayetteville,  AR  72703                |       | Owned                        |
|                                                         |       |                   |       |                                                              |       |                         |
| Corner Central &  Willow

Harrison,  AR  72601 |       | Owned                  |       | 1303 Hudson Road

Rogers, AR  72756                          |       | Owned                        |
|                                                         |       |                   |       |                                                              |       |                         |
| 324 Hwy. 62-65  Bypass

Harrison,  AR  72601            |       | Owned                  |       | 201 East Henri  De Tonti Blvd.

Tontitown,  AR  72764        |       | Owned                        |
|                                                         |       |                   |       |                                                              |       |                         |
| 210 South Main

Berryville,  AR  72616                  |       | Owned                  |       | 2025 North  Crossover Road

Fayetteville, AR  72703               |       | Owned                        |
|                                                         |       |                   |       |                                                              |       |                         |
| 668 Highway 62  East

Mountain Home,  AR  72653         |       | Owned                  |       | 191 West Main  Street

Farmington, AR  72730                      |       | Owned                        |
|                                                         |       |                   |       |                                                              |       |                         |
| 1337 Highway 62  SW

Mountain Home,  AR 72653                |       | Owned                  |       | 2030 West Elm

Rogers, AR 72756                                   |       | Owned                        |
|                                                         |       |                   |       |                                                              |       |                         |
| 301 Highway 62  West

Yellville,  AR  72687             |       | Owned                  |       | 1023 East  Millsap Road

Fayetteville,  AR  72703            |       | Owned                        |
|                                                         |       |                   |       |                                                              |       |                         |
| 307 North Walton  Blvd.

Bentonville,  AR  72712        |       | Owned                  |       | 3027 Highway 62  East

Mountain Home,  AR 72653                   |       | Owned                        |
|                                                         |       |                   |       |                                                              |       |                         |
| 3300 West Sunset

Springdale,  AR  72762                |       | Owned                  |       | 1190 East  Centerton Boulevard

Centerton,  AR  72719        |       | Leased (2)                   |
|                                                         |       |                   |       |                                                              |       |                         |
|                                                         |       |                   |       |                                                              |       |                         |

 

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

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

 

At December 31,2007, the Bank had two branch locations under construction expected to open in2008.  The location at 2000 PromenadeBoulevard in Rogers, Arkansas, is expected to open in the first quarter of2008.  This will be a leased office undera ten-year lease with three five-year renewal options.  The location at 225 N. Bloomington, Suite H,in Lowell, Arkansas, is expected to open late in the second quarter or early inthe third quarter of 2008.

 

**Item3.  Legal Proceedings.**

 

Neither theCompany nor the Bank is involved in any pending legal proceedings other thannonmaterial legal proceedings occurring in the ordinary course of business.

 

**Item4.  Submission of Matters to Vote ofSecurity Holders.**

 

No matters weresubmitted to a vote of security holders during the fourth quarter of 2007.

 

** **

** **

**30**

----

** **

**PART II.**

** **

**Item5.  Market for Registrant’s CommonEquity, Related Stockholder Matters, and Issuer Purchases of Equity Securities.**

 

Shares of the Company’s common stock are traded under the symbol “FFBH”on the Nasdaq Global Market.  At February 20,2008, the Company had 4,848,385 shares of common stock outstanding and hadapproximately 1,827 beneficial holders of common stock.

 

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

 

| **Quarter Ended**     | ** ** | **Year Ended********December 31, 2007** | ** ** | **Year Ended********December 31, 2006** | ** ** |
|-----------------------|------------|----------------------------------------------|------------|----------------------------------------------|------------|
| ** **            | ** ** | **High**                                     | ** ** | **Low**                                      | ** ** | **Dividend** | ** ** | **High** | ** ** | **Low** | ** ** | **Dividend** | ** ** |
| **March 31**     |       | $                                            | 25.24      |                                         | $          | 23.25 |   | $ | 0.16 |   | $ | 25.95 |   | $ | 23.02 |   | $ | 0.14 |   |
| **June 30**      |       | $                                            | 25.05      |                                         | $          | 23.43 |   | $ | 0.16 |   | $ | 25.74 |   | $ | 22.10 |   | $ | 0.14 |   |
| **September 30** |       | $                                            | 23.95      |                                         | $          | 17.60 |   | $ | 0.16 |   | $ | 24.00 |   | $ | 22.00 |   | $ | 0.15 |   |
| **December 31**  |       | $                                            | 18.05      |                                         | $          | 14.00 |   | $ | 0.16 |   | $ | 25.00 |   | $ | 22.86 |   | $ | 0.15 |   |

 

 

 

31

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The following graph demonstrates comparison of the cumulative totalreturns for the common stock of the Company, the SNL Securities $500 million to$1 Billion Thrift Asset Size Index, and the NASDAQ Stock Market Index since theclose of trading of the Company’s common stock on December 31, 2002.  The graph represents $100 invested in theCompany’s common stock at $12.70 per share, the closing price per share as of December 31,2002, adjusted for the December 31, 2003 two-for-one stock split.  The cumulative total returns include thepayment of dividends by the Company.

 
| *** ***                                     | *** *** | **Period Ending** | *** *** |
|--------------------------------------------------|--------------|-------------------|--------------|
| ***Index***                                      | ** **   | **12/31/02**      | ** **   | **12/31/03** | ** ** | **12/31/04** | ** ** | **12/31/05** | ** ** | **12/31/06** | ** ** | **12/31/07** | ** ** |
| First  Federal Bancshares of Arkansas, Inc. |         | 100.00            |         | 164.89 |   | 184.77 |   | 203.47 |   | 208.61 |   | 124.99 |   |
| NASDAQ  Composite                                |         | 100.00            |         | 150.01 |   | 162.89 |   | 165.13 |   | 180.85 |   | 198.60 |   |
| SNL  Thrift $500M-$1B Index                      |         | 100.00            |         | 142.39 |   | 157.50 |   | 149.68 |   | 183.40 |   | 144.99 |   |
|                                             |         |              |         |   |   |   |   |   |   |   |   |   |   |

----

| **Source  : SNL Financial LC, Charlottesville, VA**

**©  2008** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
|-----------------------------------------------------------------------|------------|------------|------------|------------|------------|------------|------------|------------|------------|------------|------------|------------|------------|

** **
| **ISSUER PURCHASES OF EQUITY SECURITIES**  | ** ** |
|--------------------------------------------|------------|
| ** **                                 | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Period**                                 | ** ** | **Total Number of Shares**

**Purchased** | ** ** | **Average Price**

** Paid per**

**Share** | ** ** | **Total Number of Shares Purchased as Part of  Publicly Announced Plans or Programs** | ** ** | **Maximum Number of Shares that May **

**Yet Be Purchased Under the Plans or**

**Programs** | ** ** |
| ** **                                 | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| October 1  to October 31, 2007   |       | — |   | — |   | — |   | — |   |
| November 1  to November 30, 2007 |       | 21,016 |   | $14.95 |   | 21,016 |   | 30,610 |   |
| December 1  to December 31, 2007 |       | — |   | —- |   | — |   | — |   |

 

The Company is in its nineteenth announcedrepurchase program that was approved by the board of directors on July 25,2006, and publicly announced on November 8, 2006. Total shares approved tobe purchased in this program are 245,197, of which 214,587 had been purchasedas of December 31, 2007.  Alltreasury stock purchases are made under publicly announced repurchase programs.

 

 

 

32

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**Item6.  Selected Financial Data****.**

 

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

 
| ** **                                            | ** ** | **At or For the  Year Ended December 31,** | ** ** |
|-------------------------------------------------------|------------|-------------------------------------------------|------------|
| ** **                                            | ** ** | **2007**                                        | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                            | ** ** | (In Thousands, Except Per Share Data)           | ** ** |
| **Selected Financial Condition Data:**                |       |                                            |       |   |   |   |   |   |   |   |   |
| Total assets                                          |       | $                                               | 791,978    |   | $ | 852,475 |   | $ | 852,411 |   | $ | 751,665 |   | $ | 690,653 |   |
| Cash and cash equivalents                             |       | 27,387                                          |       | 35,518 |   | 21,109 |   | 16,003 |   | 56,201 |   |
| Investment securities                                 |       | 95,590                                          |       | 60,746 |   | 56,695 |   | 56,660 |   | 80,379 |   |
| Loans receivable, net                                 |       | 601,256                                         |       | 693,095 |   | 719,214 |   | 634,217 |   | 512,756 |   |
| Allowance for loan losses                             |       | 5,162                                           |       | 2,572 |   | 2,114 |   | 1,846 |   | 1,621 |   |
| Deposits                                              |       | 630,414                                         |       | 652,265 |   | 611,667 |   | 582,424 |   | 573,580 |   |
| Federal Home Loan Bank advances                       |       | 82,087                                          |       | 120,305 |   | 158,240 |   | 89,756 |   | 39,562 |   |
| Stockholders’ equity                             |       | 73,663                                          |       | 75,573 |   | 77,842 |   | 75,301 |   | 75,078 |   |
|                                                  |       |                                            |       |   |   |   |   |   |   |   |   |
| **Selected Operating Data:**                          |       |                                            |       |   |   |   |   |   |   |   |   |
| Interest income                                       |       | $                                               | 50,426     |   | $ | 54,119 |   | $ | 46,085 |   | $ | 39,370 |   | $ | 38,745 |   |
| Interest expense                                      |       | 28,184                                          |       | 27,576 |   | 19,604 |   | 14,338 |   | 15,986 |   |
| Net interest income                                   |       | 22,242                                          |       | 26,543 |   | 26,481 |   | 25,032 |   | 22,759 |   |
| Provision for loan losses                             |       | 4,028                                           |       | 1,482 |   | 1,101 |   | 1,020 |   | 690 |   |
| Net interest income after provision 

for loan losses |       | 18,214                                          |       | 25,061 |   | 25,380 |   | 24,012 |   | 22,069 |   |
| Noninterest income                                    |       | 7,769                                           |       | 8,222 |   | 6,936 |   | 6,201 |   | 6,961 |   |
| Noninterest expense                                   |       | 22,995                                          |       | 22,521 |   | 20,743 |   | 18,710 |   | 18,235 |   |
| Income before income taxes                            |       | 2,988                                           |       | 10,762 |   | 11,573 |   | 11,503 |   | 10,795 |   |
| Provision for income taxes                            |       | 345                                             |       | 3,379 |   | 3,723 |   | 3,698 |   | 3,339 |   |
| Net income                                            |       | $                                               | 2,643      |   | $ | 7,383 |   | $ | 7,850 |   | $ | 7,805 |   | $ | 7,456 |   |
|                                                  |       |                                            |       |   |   |   |   |   |   |   |   |
| **Earnings per Share (1):**                           |       |                                            |       |   |   |   |   |   |   |   |   |
| Basic                                                 |       | $                                               | 0.54       |   | $ | 1.48 |   | $ | 1.57 |   | $ | 1.54 |   | $ | 1.46 |   |
| Diluted                                               |       | $                                               | 0.54       |   | $ | 1.44 |   | $ | 1.50 |   | $ | 1.45 |   | $ | 1.38 |   |
|                                                  |       |                                            |       |   |   |   |   |   |   |   |   |
| **Cash Dividends Declared per Share (1)**             |       | $                                               | 0.64       |   | $ | 0.58 |   | $ | 0.50 |   | $ | 0.42 |   | $ | 0.34 |   |

 

----

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

 

 

 

33

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| ****                                                                        | ** ** | **At or For the Year  Ended December 31,** | ** ** |
|-----------------------------------------------------------------------------|------------|-------------------------------------------------|------------|
| ** **                                                                  | ** ** | **2007**                                        | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
| **Selected Operating Ratios (1):**                                          | ** ** | ** **                                      | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Return on average assets                                                    |       | 0.32                                            | %          | 0.85 | % | 0.97 | % | 1.09 | % | 1.08 | % |
| Return on average equity                                                    |       | 3.52                                            |       | 9.40 |   | 10.27 |   | 10.37 |   | 10.25 |   |
| Average equity to average assets                                            |       | 9.21                                            |       | 9.04 |   | 9.46 |   | 10.53 |   | 10.52 |   |
| Interest rate spread (2)                                                    |       | 2.92                                            |       | 3.19 |   | 3.41 |   | 3.64 |   | 3.40 |   |
| Net interest margin (2)                                                     |       | 2.98                                            |       | 3.29 |   | 3.51 |   | 3.75 |   | 3.52 |   |
| Net interest income after provision for loan losses to noninterest  expense |       | 79.21                                           |       | 111.28 |   | 122.35 |   | 128.34 |   | 121.03 |   |
| Noninterest expense to average assets                                       |       | 2.82                                            |       | 2.59 |   | 2.57 |   | 2.62 |   | 2.64 |   |
| Average interest earning assets to average interest bearing  liabilities    |       | 101.68                                          |       | 102.92 |   | 103.80 |   | 105.12 |   | 105.08 |   |
| Operating efficiency (3)                                                    |       | 76.62                                           |       | 64.78 |   | 62.07 |   | 59.90 |   | 61.36 |   |
|                                                                        |       |                                            |       |   |   |   |   |   |   |   |   |
| **Asset Quality Ratios (4):**                                               |       |                                            |       |   |   |   |   |   |   |   |   |
| Nonaccrual and restructured loans to total  loans (5)                       |       | 5.55                                            |       | 2.68 |   | 1.67 |   | 1.14 |   | 0.67 |   |
| Nonperforming assets to total assets (5)                                    |       | 5.54                                            |       | 2.76 |   | 1.65 |   | 1.13 |   | 0.66 |   |
| Allowance for loan losses to non- performing  loans (5)                     |       | 14.44                                           |       | 13.07 |   | 16.06 |   | 23.21 |   | 44.01 |   |
| Allowance for loan losses to total loans                                    |       | 0.80                                            |       | 0.35 |   | 0.27 |   | 0.26 |   | 0.29 |   |
|                                                                        |       |                                            |       |   |   |   |   |   |   |   |   |
| **Capital Ratios (6):**                                                     |       |                                            |       |   |   |   |   |   |   |   |   |
| Tangible capital to adjusted total assets                                   |       | 9.22                                            |       | 8.76 |   | 8.78 |   | 9.74 |   | 10.27 |   |
| Core capital to adjusted total assets                                       |       | 9.22                                            |       | 8.76 |   | 8.78 |   | 9.74 |   | 10.27 |   |
| Risk-based capital to risk-weighted assets                                  |       | 13.20                                           |       | 11.94 |   | 12.06 |   | 13.75 |   | 16.25 |   |
|                                                                        |       |                                            |       |   |   |   |   |   |   |   |   |
| Other Data:                                                                 | ** ** | ** **                                      | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Dividend payout ratio (7)                                                   |       | 117.71                                          | %          | 39.26 | % | 32.19 | % | 27.91 | % | 24.32 | % |
| Full service offices at end of period                                       |       | 18                                              |       | 18 |   | 16 |   | 15 |   | 15 |   |

 

----

(1)          Ratiosare based on average daily balances.

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

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

(4)          Assetquality ratios are end of period ratios.

(5)          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 owned.

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

(7)          Dividend payout ratio is thetotal dividends declared divided by net income.

 

 

 

34

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**Item7.  Management’s Discussions and Analysisof Financial Condition and Results of Operations****.**

 

**GENERAL**

 

Management’s discussion and analysisof financial condition and results of operations is intended to assist a readerinunderstanding the consolidatedfinancial condition and results of operations of the Company for the periodspresented.  The information contained inthis section should be read in conjunction with the Consolidated FinancialStatements and the accompanying Notes to Consolidated Financial Statements andthe other sections contained herein.

 

The Bank is a federally charteredstock savings and loan association that was formed in 1934.  First Federal conducts business from its mainoffice and seventeen 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; debitcards; and safe deposit boxes.

 

First Federal’s lending focus hastraditionally been on permanent residential real estate.  However, in recent years, an increasedemphasis has been placed on commercial real estate lending and constructionlending based on opportunities in Washington and Benton counties.  Beginning in late 2005, we reduced our focuson construction lending due to an oversupply of homes and lots in NorthwestArkansas.  While oversupply continues tobe a significant issue, the market in Northwest Arkansas continues tooutperform the national and state economies with low unemployment and continuedpopulation growth. Washington and Benton County are the headquarters of thestate’s two largest employers, Wal-Mart and Tyson Foods.  These employers attract suppliers whoestablish offices in the area and create jobs, which fosters demand for housingand office space.  As of November 2007,unemployment in the Fayetteville/Springdale/Rogers metro area was 3.6%,compared to the Arkansas rate of 5.2% and the U.S. rate of 4.5%.

 

Certificates of deposit continue tocomprise the majority of our deposit accounts. However, in recent years, increased emphasis has been placed on growthin checking accounts.   This emphasiswill continue with plans to attract checking accounts through the utilizationof targeted direct mail throughout our market area and “thank you” gifts.   Checking accounts offer low interestdeposits, fee income potential, and the opportunity to cross-sell otherfinancial services. In January 2008, the Bank introduced a higher ratechecking account that requires electronic transactions to qualify.  The Bank believes this product will expandits customer base and provide cost savings and fee income due to the electronicrequirements.

 

The Company’s results of operations depend primarily on its netinterest income, which is the difference between interest income on interestearning assets, such as loans and investments, and interest expense on interestbearing liabilities, such as deposits and borrowings.  Net interest income is affected by the levelof nonperforming assets as they provide no interest earnings to the Bank.  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 primarily through deposit account feeincome, profit on sale of loans, loan fee income, and earnings on lifeinsurance policies.

 

Noninterest expense consists primarily of employee compensation andbenefits, office occupancy expense, data processing expense, real estate ownedexpense, net, and other operating expense.

 

Like mostbanks, First Federal Bank’s two greatest challenges are managing interest raterisk and maintaining asset quality.  TheBank’s current interest rate risk position as measured by our regulator, theOTS, is at a minimal level as defined by Thrift Bulletin 13a.  The movement of interest rates impacts the levelof interest rate risk and the timing and magnitude of assets repricing comparedto liabilities repricing.  The Bankattempts to reduce the impact of changes in interest rates on its net interestincome by managing the repricing gap as described in the “Asset and LiabilityManagement” section.  We strive tomaintain the asset quality of our loan portfolio at acceptable levels throughsound underwriting procedures, including the use of credit scoring; a thoroughloan review function; active collection procedures for delinquent loans; and,in the event of repossession, prompt and efficient liquidation of real estate,automobiles and other forms of collateral.  We have experienced an increase in nonperforming assets, primarily dueto a downturn in the housing market in Northwest Arkansas.  We attempt to work with troubled borrowers toreturn their loans to performing status where possible. However, given currentmarket conditions, the trend of increasing nonperforming assets may 

 

 

 

35

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continue forthe foreseeable future.  Both the boardof directors and senior management place a high priority on managing interestrate risk and asset quality.

 

## **CRITICAL ACCOUNTING POLICIES**

## ** **

Various elements of our accounting policies, by their nature, areinherently subject to estimation techniques, valuation assumptions and othersubjective assessments.  In particular,the methodology for the determination of our allowance for loan losses, due tothe judgments, estimates and assumptions inherent in that policy, is criticalto preparation 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.

 

In estimating the amount of credit losses inherent in our loanportfolio, various judgments and assumptions are made.  For example, when assessing the condition ofthe overall economic environment, assumptions are made regarding marketconditions and their impact on the loan portfolio.  In the event the economy were to sustain aprolonged downturn, the loss factors applied to our portfolios may need to berevised, which may significantly impact the measurement of the allowance forloan 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.

 

## **CHANGES IN FINANCIALCONDITION**

## ** **

Changes in financial condition betweenDecember 31, 2007 and 2006 are presented in the following table (dollarsin thousands).  Material changes betweenperiods are discussed in the sections that follow the table.

 
| ** **                                     | ** ** | **December 31,** | ** ** | **Increase** | ** ** | ** **     | ** ** |
|------------------------------------------------|------------|-----------------------|------------|--------------|------------|----------------|------------|
| ** **                                     | ** ** | **2007**              | ** ** | **2006**     | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
|                                           |       |                  |       |         |       |           |       |   |   |
| **ASSETS**                                     | ** ** | ** **            | ** ** | ** **   | ** ** | ** **     | ** ** | ** ** | ** ** |
| Cash and cash equivalents                      |       | $                     | 27,387     |         | $          | 35,518         |       | $ | (8,131 | ) | (22.9 | )% |
| Investment securities held  to maturity        |       | 95,590                |       | 60,746       |       | 34,844         |       | 57.4 |   |
| FHLB Stock                                     |       | 4,433                 |       | 7,089        |       | (2,656         | )          | (37.5 | ) |
| Loans receivable, net                          |       | 601,256               |       | 693,095      |       | (91,839        | )          | (13.3 | ) |
| Accrued interest  receivable                   |       | 9,042                 |       | 9,999        |       | (957           | )          | (9.6 | ) |
| Real estate owned, net                         |       | 8,120                 |       | 3,858        |       | 4,262          |       | 110.5 |   |
| Office properties and  equipment, net          |       | 24,263                |       | 20,384       |       | 3,879          |       | 19.0 |   |
| Prepaid expenses and other  assets             |       | 21,887                |       | 21,786       |       | 101            |       | 0.5 |   |
|                                           |       |                  |       |         |       |           |       |   |   |
| TOTAL                                          |       | $                     | 791,978    |         | $          | 852,475        |       | $ | (60,497 | ) | (7.1 | )% |
|                                           |       |                  |       |         |       |           |       |   |   |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY** | ** ** | ** **            | ** ** | ** **   | ** ** | ** **     | ** ** | ** ** | ** ** |
| LIABILITIES:                                   | ** ** | ** **            | ** ** | ** **   | ** ** | ** **     | ** ** | ** ** | ** ** |
| Deposits                                       |       | $                     | 630,414    |         | $          | 652,265        |       | $ | (21,851 | ) | (3.4 | )% |
| FHLB advances                                  |       | 82,087                |       | 120,305      |       | (38,218        | )          | (31.8 | ) |
| Other liabilities                              |       | 5,814                 |       | 4,332        |       | 1,482          |       | 34.2 |   |
| Total liabilities                              |       | 718,315               |       | 776,902      |       | (58,587        | )          | (7.5 | ) |
|                                           |       |                  |       |         |       |           |       |   |   |
| STOCKHOLDERS’  EQUITY                     |       | 73,663                |       | 75,573       |       | (1,910         | )          | (2.5 | ) |
| TOTAL                                          |       | $                     | 791,978    |         | $          | 852,475        |       | $ | (60,497 | ) | (7.1 | )% |
|                                           |       |                  |       |         |       |           |       |   |   |
| BOOK  VALUE PER SHARE                          |       | $                     | 15.21      |         | $          | 15.62          |       |   |   |   |   |
|                                           |       |                  |       |         |       |           |       |   |   |
| EQUITY  TO ASSETS                              |       | 9.3                   | %          | 8.9          | %          |           |       |   |   |

 

 

 

36

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**Loans Receivable. **Changes in loan composition between December 31, 2007 and 2006are presented in the following table 

(dollars in thousands).

 
| ** **                                             | ** ** | **December 31,** | ** ** | **Increase** | ** ** | ** **     | ** ** |
|--------------------------------------------------------|------------|-----------------------|------------|--------------|------------|----------------|------------|
| ** **                                             | ** ** | **2007**              | ** ** | **2006**     | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
|                                                   |       |                  |       |         |       |           |       |   |   |
| One-  to four-family residences                        |       | $                     | 230,005    |         | $          | 257,867        |       | $ | (27,862 | ) | (10.8 | )% |
| Home  equity and second mortgage                       |       | 34,315                |       | 35,192       |       | (877           | )          | (2.5 | ) |
| Multifamily                                            |       | 15,616                |       | 12,203       |       | 3,413          |       | 28.0 |   |
| Commercial  real estate                                |       | 119,681               |       | 134,647      |       | (14,966        | )          | (11.1 | ) |
| Land                                                   |       | 42,843                |       | 47,590       |       | (4,747         | )          | (10.0 | ) |
| Construction:                                          |       |                  |       |         |       |           |       |   |   |
| One- to four-family  residences                        |       | 20,815                |       | 32,146       |       | (11,331        | )          | (35.2 | ) |
| Speculative one- to  four-family residences            |       | 40,893                |       | 80,311       |       | (39,418        | )          | (49.1 | ) |
| Multifamily                                            |       | 18,632                |       | 14,120       |       | 4,512          |       | 32.0 |   |
| Commercial real estate                                 |       | 31,239                |       | 21,896       |       | 9,343          |       | 42.7 |   |
| Land development                                       |       | 42,145                |       | 47,439       |       | (5,294         | )          | (11.2 | ) |
| Total mortgage loans                                   |       | 596,184               |       | 683,411      |       | (87,227        | )          | (12.8 | ) |
|                                                   |       |                  |       |         |       |           |       |   |   |
| Commercial                                             |       | 22,713                |       | 26,281       |       | (3,568         | )          | (13.6 | ) |
|                                                   |       |                  |       |         |       |           |       |   |   |
| Automobile                                             |       | 9,531                 |       | 12,086       |       | (2,555         | )          | (21.1 | ) |
| Other                                                  |       | 14,537                |       | 13,815       |       | 722            |       | 5.2 |   |
| Total consumer                                         |       | 24,068                |       | 25,901       |       | (1,833         | )          | (7.1 | ) |
|                                                   |       |                  |       |         |       |           |       |   |   |
| Total  loans receivable                                |       | 642,965               |       | 735,593      |       | (92,628        | )          | (12.6 | ) |
| Less:                                                  |       |                  |       |         |       |           |       |   |   |
| Undisbursed  loan funds                                |       | (36,868               | )          | (40,069      | )          | 3,201          |       | (8.0 | ) |
| Unearned  discounts and net deferred loan costs (fees) |       | 321                   |       | 143          |       | 178            |       | 124.5 |   |
| Allowance  for loan losses                             |       | (5,162                | )          | (2,572       | )          | (2,590         | )          | 100.7 |   |
|                                                   |       |                  |       |         |       |           |       |   |   |
| Loans  receivable, net                                 |       | $                     | 601,256    |         | $          | 693,095        |       | $ | (91,839 | ) | (13.3 | )% |

 

The decrease in the Bank’s loan portfolio was primarily due tocontinued softening of the housing market in the Bank’s market area.  Market data indicates an overall decrease inhome sales in Benton and Washington counties in 2007 and 2006 compared to2005.   The Bank’s loan originations weredown 43.6% for the year ended December 31, 2007, compared to the sameperiod in 2006.  Although the NorthwestArkansas region continues to experience a strong job market and populationgrowth, the supply of new residential lots and new speculative homes for salehas outpaced demand for the past several years. We expect this trend to continue for the foreseeable future given thelevel of oversupply in the market.

 

**Allowance for Loan Losses**.  Changes in the composition of the allowancefor loan losses between December 31, 2007 and 2006 are presented in thefollowing table (in thousands).

 

| ** ** | ** ** | **December 31,** | ** ** | **Increase** | ** ** |
|------------|------------|-----------------------|------------|--------------|------------|
| ** ** | ** ** | **2007**              | ** ** | **2006**     | ** ** | **(Decrease)** | ** ** |
| General    |       | $                     | 2,267      |         | $          | 1,966 |   | $ | 301 |   |
| Specific   |       | 2,895                 |       | 606          |       | 2,289 |   |
|       |       | $                     | 5,162      |         | $          | 2,572 |   | $ | 2,590 |   |

 

The general component of the allowance for loan losses increasedprimarily due to an increase in the estimated loss rates applied to speculativeone- to four-family residential construction loans and land developmentloans.  These increases were partiallyoffset by decreases in the related loan balances.  Such loss rates were increased due to ourloss experience with these types of loans.   The increase in the specificallowance for loan losses was primarily due to specific allowances on asubdivision in Lowell, Arkansas, and a subdivision in Cave Springs, Arkansas,as discussed in “Asset Quality” in Item 1 previously.

 

 

 

37

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**Investment Securities. **Changes in thecomposition of investment securities held to maturity between December 31,2007 and 2006 are presented in the following table (in thousands).

 
| ** **                              | ** ** | **December 31,** | ** ** | **Increase** | ** ** |
|-----------------------------------------|------------|-----------------------|------------|--------------|------------|
| ** **                              | ** ** | **2007**              | ** ** | **2006**     | ** ** | **(Decrease)** | ** ** |
| U.S.  Government and agency obligations |       | $                     | 78,501     |         | $          | 43,857 |   | $ | 34,644 |   |
| Municipal  securities                   |       | 17,089                |       | 16,889       |       | 200 |   |
| Total                                   |       | $                     | 95,590     |         | $          | 60,746 |   | $ | 34,844 |   |

 

During 2007, investment securities totaling approximately $44.7 millionwere purchased and $9.9 million matured or were called.   Due to lower loan demand, the Bank usedfunds from loan repayments to purchase investment securities.

 

**Federal Home Loan Bank Stock. **FHLB stock decreasedby approximately $2.7 million due to lower balance requirements related to thedecrease in FHLB advances.

 

**Accrued Interest Receivable. **The decrease inaccrued interest receivable was primarily due to the increase in nonaccrualloans.

 

**Real Estate Owned, Net. **The increase in realestate owned was primarily due to an increase in the number of foreclosures onspeculative homes.

 

**Office Properties and Equipment, Net.  **The increase inoffice properties and equipment of $3.9 million was due primarily to additionsfor future branches in Lowell and Rogers, as well as renovation of certainexisting branch locations.  The Lowellproperty is a shopping center transferred to office properties and equipment inthe fourth quarter of 2007 from real estate owned.  The Bank plans to occupy approximately 25% ofthe space and lease the rest to tenants.

 

**Deposits. **Changesin the composition of deposits between December 31, 2007 and 2006 arepresented in the following table (dollars in thousands).

 
| ** **               | ** ** | **December 31,** | ** ** | **Increase** | ** ** | ** **     | ** ** |
|--------------------------|------------|-----------------------|------------|--------------|------------|----------------|------------|
| ** **               | ** ** | **2007**              | ** ** | **2006**     | ** ** | **(Decrease)** | ** ** | **%****Change** | ** ** |
|                     |       |                  |       |         |       |           |       |   |   |
| Checking  accounts       |       | $                     | 127,491    |         | $          | 139,372        |       | $ | (11,881 | ) | (8.5 | )% |
| Money  market accounts   |       | 51,424                |       | 51,827       |       | (403           | )          | (0.8 | ) |
| Savings  accounts        |       | 25,088                |       | 26,824       |       | (1,736         | )          | (6.5 | ) |
| Certificates  of deposit |       | 426,411               |       | 434,242      |       | (7,831         | )          | (1.8 | ) |
|                     |       |                  |       |         |       |           |       |   |   |
| Total  deposits          |       | $                     | 630,414    |         | $          | 652,265        |       | $ | (21,851 | ) | (3.3 | )% |

 

The decrease in checking account balances was primarily due to adecrease in business deposits.  Thedecrease in certificates of deposit was primarily due to a decrease in publicunit deposits.

 

**FHLB Advances.**  The Bank experienced a $38.2 million or 31.8%decrease in FHLB of Dallas advances during the year. The Bank was able to usefunds from loan repayments to repay FHLB of Dallas advances during 2007.  The balance of advances at December 31,2007 of $82.1 million consisted of $69.1 million of fixed rate advances with anaverage cost of 4.43% and $13.0 million of floating rate advances with anaverage cost of 5.03%.

 

**Stockholders’ Equity. **Stockholders’ equity decreasedapproximately $1.9 million from December 31, 2006 to December 31,2007.  The decrease in stockholders’equity was primarily due to the purchase of 101,542 shares of treasury stocktotaling $2.3 million in connection with the Company’s stock repurchase programand, to a lesser extent, the payment of quarterly cash dividends in the amountof $3.1 million.  Such decreases werepartially offset by net income in the amount of $2.6 million resulting fromcontinued profitable operations, as well as the issuance of 106,965 shares oftreasury stock totaling $350,000 as a result of the exercise of stock options.  See the Consolidated Statements ofStockholders’ Equity for the years ended December 31, 2007, 2006 and 2005contained herein for more detail.

 

 

38

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**Average Balance Sheets**

 

The following table sets forth certain information relating to theCompany’s average balance sheets and reflects the average yield on assets andaverage cost of liabilities for the periods indicated.  Such yields and costs are derived by dividinginterest income or interest expense by the average balance of assets orliabilities, respectively, for the periods presented.  Average balances are based on daily balancesduring the periods.

 
| ** **                                                        | ** ** | **Year Ended December 31,** | ** ** |
|-------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                        | ** ** | **2007**                         | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                                                        | ** ** | **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)                                              |       | $                                | 649,062    |   | $ | 45,473 |   | 7.01 | % | $ | 726,642 |   | $ | 50,185 |   | 6.91 | % | $ | 687,373 |   | $ | 43,057 |   | 6.26 | % |
| Investment securities (2)                                         |       | 78,831                           |       | 4,071 |   | 5.16 |   | 67,395 |   | 3,270 |   | 4.85 |   | 62,761 |   | 2,902 |   | 4.62 |   |
| Other interest earning assets                                     |       | 17,630                           |       | 882 |   | 5.00 |   | 13,288 |   | 664 |   | 5.00 |   | 3,875 |   | 126 |   | 3.25 |   |
| Total interest earning assets                                     |       | 745,523                          |       | 50,426 |   | 6.76 |   | 807,325 |   | 54,119 |   | 6.70 |   | 754,009 |   | 46,085 |   | 6.11 |   |
| Noninterest earning assets                                        |       | 68,478                           |       |   |   |   |   | 61,841 |   |   |   |   |   | 54,388 |   |   |   |   |   |
| Total assets                                                      |       | $                                | 814,001    |   |   |   |   |   | $ | 869,166 |   |   |   |   |   | $ | 808,397 |   |   |   |   |   |
| Interest bearing liabilities:                                     |       |                             |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Deposits                                                          |       | $                                | 638,724    |   | 23,873 |   | 3.74 |   | $ | 630,230 |   | 20,643 |   | 3.28 |   | $ | 590,753 |   | 14,617 |   | 2.47 |   |
| FHLB advances                                                     |       | 94,481                           |       | 4,311 |   | 4.56 |   | 154,186 |   | 6,933 |   | 4.50 |   | 135,636 |   | 4,987 |   | 3.68 |   |
| Total interest bearing liabilities                                |       | 733,205                          |       | 28,184 |   | 3.84 |   | 784,416 |   | 27,576 |   | 3.51 |   | 726,389 |   | 19,604 |   | 2.70 |   |
| Noninterest bearing liabilities                                   |       | 5,787                            |       |   |   |   |   | 6,182 |   |   |   |   |   | 5,543 |   |   |   |   |   |
| Total liabilities                                                 |       | 738,992                          |       |   |   |   |   | 790,598 |   |   |   |   |   | 731,932 |   |   |   |   |   |
| Stockholders’ equity                                         |       | 75,009                           |       |   |   |   |   | 78,568 |   |   |   |   |   | 76,465 |   |   |   |   |   |
| Total liabilities and stockholders’ equity                   |       | $                                | 814,001    |   |   |   |   |   | $ | 869,166 |   |   |   |   |   | $ | 808,397 |   |   |   |   |   |
|                                                              |       |                             |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Net interest income                                               |       |                             |       | $ | 22,242 |   |   |   |   |   | $ | 26,543 |   |   |   |   |   | $ | 26,481 |   |   |   |
| Net earning assets                                                |       | $                                | 12,318     |   |   |   |   |   | $ | 22,909 |   |   |   |   |   | $ | 27,620 |   |   |   |   |   |
| Interest rate spread                                              |       |                             |       |   |   | 2.92 | % |   |   |   |   | 3.19 | % |   |   |   |   | 3.41 | % |
| Net interest margin                                               |       |                             |       |   |   | 2.98 | % |   |   |   |   | 3.29 | % |   |   |   |   | 3.51 | % |
| Ratio of interest earning assets to interest  bearing liabilities |       |                             |       |   |   | 101.68 | % |   |   |   |   | 102.92 | % |   |   |   |   | 103.80 | % |

 

----

(1)  Includes nonaccrual loans.

(2)  Includes FHLB of Dallas stock.

 

 

 

39

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## **Rate/VolumeAnalysis**

## ** **

The table below sets forth certain information regarding changes ininterest income and interest expense of the Company for the periodsindicated.  For each category of interestearning assets and interest bearing liabilities, information is provided onchanges attributable 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,** | ** ** |
|------------------------------------|------------|----------------------------------|------------|
| ** **                         | ** ** | **2007 vs. 2006**                | ** ** |
| ** **                         | ** ** | **Increase (Decrease) Due to**   | ** ** | ** ** | ** ** |
|                               | ** ** | **Volume**                       | ** ** | **Rate** | ** ** | **Rate/ Volume** | ** ** | **Total  Increase   (Decrease)** | ** ** |
|                               |       | (In Thousands)                   |       |
| Interest income:                   |       |                             |       |   |   |   |   |   |   |
| Loans receivable                   |       | $                                | (5,358     | ) | $ | 723 |   | $ | (77 | ) | $ | (4,712 | ) |
| Investment securities              |       | 555                              |       | 210 |   | 36 |   | 801 |   |
| Other interest earning assets      |       | 217                              |       | 1 |   | — |   | 218 |   |
| Total interest earning assets      |       | (4,586                           | )          | 934 |   | (41 | ) | (3,693 | ) |
|                               |       |                             |       |   |   |   |   |   |   |
| Interest expense:                  |       |                             |       |   |   |   |   |   |   |
| Deposits                           |       | 278                              |       | 2,913 |   | 39 |   | 3,230 |   |
| FHLB advances                      |       | (2,684                           | )          | 101 |   | (39 | ) | (2,622 | ) |
| Total interest bearing liabilities |       | (2,406                           | )          | 3,014 |   | — |   | 608 |   |
| Net change in net interest income  |       | $                                | (2,180     | ) | $ | (2,080 | ) | $ | (41 | ) | $ | (4,301 | ) |

** **
| ** **                         | ** ** | **Year Ended December 31,** | ** ** |
|------------------------------------|------------|----------------------------------|------------|
| ** **                         | ** ** | **2006 vs. 2005**                | ** ** |
| ** **                         | ** ** | **Increase (Decrease)  Due to**  | ** ** | ** ** | ** ** |
| ** **                         | ** ** | **Volume**                       | ** ** | **Rate** | ** ** | **Rate/  Volume** | ** ** | **Total  Increase  (Decrease)** | ** ** |
|                               |       | (In Thousands)                   |       |
| Interest income:                   |       |                             |       |   |   |   |   |   |   |
| Loans receivable                   |       | $                                | 2,460      |   | $ | 4,416 |   | $ | 252 |   | $ | 7,128 |   |
| Investment securities              |       | 214                              |       | 143 |   | 11 |   | 368 |   |
| Other interest earning assets      |       | 306                              |       | 68 |   | 164 |   | 538 |   |
| Total interest earning assets      |       | 2,980                            |       | 4,627 |   | 427 |   | 8,034 |   |
|                               |       |                             |       |   |   |   |   |   |   |
| Interest expense:                  |       |                             |       |   |   |   |   |   |   |
| Deposits                           |       | 977                              |       | 4,733 |   | 316 |   | 6,026 |   |
| FHLB advances                      |       | 682                              |       | 1,112 |   | 152 |   | 1,946 |   |
| Total interest bearing liabilities |       | 1,659                            |       | 5,845 |   | 468 |   | 7,972 |   |
| Net change in net interest income  |       | $                                | 1,321      |   | $ | (1,218 | ) | $ | (41 | ) | $ | 62 |   |

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

40

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**CHANGES IN RESULTS OF OPERATIONS**

 

The table below presents a comparisonof results of operations for the years ended December 31, 2007, 2006, and2005 (dollars in thousands).  Specificchanges in captions are discussed following the table.

 
| ** **                                           | ** ** | **Year Ended December 31,** | ** ** | **Dollar  Change** | ** ** | **Percentage  Change** | ** ** |
|------------------------------------------------------|------------|----------------------------------|------------|--------------------|------------|------------------------|------------|
| ** **                                           | ** ** | **2007**                         | ** ** | **2006**           | ** ** | **2005**               | ** ** | **2007 vs 2006** | ** ** | **2006 vs 2005** | ** ** | **2007 vs 2006** | ** ** | **2006 vs 2005** | ** ** |
| Interest income:                                     |       |                             |       |               |       |                   |       |   |   |   |   |   |   |   |   |
| Loans receivable                                     |       | $45,473                          |       | $50,185            |       | $43,057                |       | $(4,712 | ) | $7,128 |   | (9.4 | )% | 16.6 | % |
| Investment securities                                |       | 4,071                            |       | 3,270              |       | 2,902                  |       | 801 |   | 368 |   | 24.5 |   | 12.7 |   |
| Other                                                |       | 882                              |       | 664                |       | 126                    |       | 218 |   | 538 |   | 32.8 |   | 427.0 |   |
| Total interest income                                |       | 50,426                           |       | 54,119             |       | 46,085                 |       | (3,693 | ) | 8,034 |   | (6.8 | ) | 17.4 |   |
| Interest expense:                                    |       |                             |       |               |       |                   |       |   |   |   |   |   |   |   |   |
| Deposits                                             |       | 23,873                           |       | 20,643             |       | 14,617                 |       | 3,230 |   | 6,026 |   | 15.6 |   | 41.2 |   |
| FHLB advances                                        |       | 4,311                            |       | 6,933              |       | 4,987                  |       | (2,622 | ) | 1,946 |   | (37.8 | ) | 39.0 |   |
| Total interest expense                               |       | 28,184                           |       | 27,576             |       | 19,604                 |       | 608 |   | 7,972 |   | 2.2 |   | 40.7 |   |
| Net interest income before provision for loan losses |       | 22,242                           |       | 26,543             |       | 26,481                 |       | (4,301 | ) | 62 |   | (16.2 | ) | 0.2 |   |
| Provision for loan  losses                           |       | 4,028                            |       | 1,482              |       | 1,101                  |       | 2,546 |   | 381 |   | 171.8 |   | 34.6 |   |
| Net interest income afterprovision for loan losses   |       | 18,214                           |       | 25,061             |       | 25,380                 |       | (6,847 | ) | (319 | ) | (27.3 | ) | (1.3 | ) |
| Noninterest income:                                  |       |                             |       |               |       |                   |       |   |   |   |   |   |   |   |   |
| Deposit fee income                                   |       | 4,989                            |       | 4,839              |       | 4,486                  |       | 150 |   | 353 |   | 3.1 |   | 7.9 |   |
| Gain on sale of loans                                |       | 823                              |       | 924                |       | 764                    |       | (101 | ) | 160 |   | (10.9 | ) | 20.9 |   |
| Other                                                |       | 1,957                            |       | 2,459              |       | 1,686                  |       | (502 | ) | 773 |   | (20.4 | ) | 45.8 |   |
| Total noninterest income                             |       | 7,769                            |       | 8,222              |       | 6,936                  |       | (453 | ) | 1,286 |   | (5.5 | ) | 18.5 |   |
| Noninterest expenses:                                |       |                             |       |               |       |                   |       |   |   |   |   |   |   |   |   |
| Salaries and employee benefits                       |       | 13,231                           |       | 13,464             |       | 12,722                 |       | (233 | ) | 742 |   | (1.7 | ) | 5.8 |   |
| Net occupancy expense                                |       | 2,325                            |       | 2,405              |       | 2,079                  |       | (80 | ) | 326 |   | (3.3 | ) | 15.7 |   |
| Real estate owned, net                               |       | 1,162                            |       | 191                |       | 58                     |       | 971 |   | 133 |   | 508.4 |   | 229.3 |   |
| Data processing                                      |       | 1,513                            |       | 1,474              |       | 1,546                  |       | 39 |   | (72 | ) | 2.7 |   | (4.7 | ) |
| Advertising and public relations                     |       | 1,145                            |       | 1,338              |       | 1,137                  |       | (193 | ) | 201 |   | (14.4 | ) | 17.7 |   |
| Other                                                |       | 3,619                            |       | 3,649              |       | 3,201                  |       | (30 | ) | 448 |   | (0.8 | ) | 14.0 |   |
| Total noninterest expenses                           |       | 22,995                           |       | 22,521             |       | 20,743                 |       | 474 |   | 1,778 |   | 2.1 |   | 8.6 |   |
| Income before provision for income taxes             |       | 2,988                            |       | 10,762             |       | 11,573                 |       | (7,774 | ) | (811 | ) | (72.2 | ) | (7.0 | ) |
| Income tax provision                                 |       | 345                              |       | 3,379              |       | 3,723                  |       | (3,034 | ) | (344 | ) | (89.8 | ) | (9.2 | ) |
| Net income                                           |       | $2,643                           |       | $7,383             |       | $7,850                 |       | $(4,740 | ) | $(467 | ) | (64.2 | )% | (5.9 | )% |
|                                                 |       |                             |       |               |       |                   |       |   |   |   |   |   |   |   |   |
| Basic earnings per share                             |       | $0.54                            |       | $1.48              |       | $1.57                  |       | $(0.94 | ) | $(0.09 | ) | (63.3 | )% | (5.7 | )% |
| Diluted earnings per  share                          |       | $0.54                            |       | $1.44              |       | $1.50                  |       | $(0.90 | ) | $(0.06 | ) | (62.5 | )% | (4.0 | )% |
|                                                 |       |                             |       |               |       |                   |       |   |   |   |   |   |   |   |   |
| Interest rate spread                                 |       | 2.92                             | %          | 3.19               | %          | 3.41                   | %          |   |   |   |   |   |   |   |   |
| Net interest margin                                  |       | 2.98                             | %          | 3.29               | %          | 3.51                   | %          |   |   |   |   |   |   |   |   |
|                                                 |       |                             |       |               |       |                   |       |   |   |   |   |   |   |   |   |
| Average full-time  equivalents                       |       | 303                              |       | 306                |       | 270                    |       |   |   |   |   |   |   |   |   |
| Full service offices                                 |       | 18                               |       | 18                 |       | 16                     |       |   |   |   |   |   |   |   |   |

 

 

 

 

 

 

 

 

 

 

 

 

 

 

41

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**Net Interest Income. **Net interest income is determined by the Company’s interest rate spread(i.e., the difference between the yields earned on its interest earning assetsand the rates paid on its interest bearing liabilities) and the relativeamounts of interest earning assets and interest bearing liabilities.  The decrease in net interest income in 2007compared to 2006 was primarily due to the level of nonperforming loans, theCompany’s negative gap position and the more rapid increase in rates paid ondeposits compared to the yield on the Company’s interest earning assets.

 

**InterestIncome and Interest Expense**

 

Dollar and percentage changes in interest income and interest expensefor the comparison periods are presented in the rate/volume analysis table thatappears on a previous page.

 

**Interest Income.**  The decrease in interest income in the 2007vs. 2006 period was primarily due to a decrease in the average balance of loansreceivable and an increase in the level of deferred interest on nonperformingloans, offset by an increase in the average yield earned on loansreceivable.  The increase in averageyield earned during the year was due primarily to increases in market interestrates.  The average balance of loansreceivable decreased due to repayments and maturities as well as a decrease inloan originations.

 

The increase in the 2006 vs. 2005 period was primarily due to anincrease in the average balance of loans receivable, an increase in the averageyield earned on loans, and an increase in the average balance of otherinterest-earning assets.  The increase inthe average yield earned on loans was due to increased rates on new loans inconjunction with recent increases in market interest rates.  The average balance of loans increasedprimarily due to an increase in the average principal balance of constructionloans.   The average balance of otherinterest-earning assets increased due to an increase in the average balance ofour FHLB demand deposit account, which occurred primarily as a result of fundsgenerated from the increase in deposits.

 

**Interest Expense.**   The increase in interest expense in the 2007vs. 2006 period was primarily due to an increase in the average rate paid on deposits,offset by a decrease in the average balance of FHLB advances.  The decrease in FHLB advances was due to theuse of funds generated from loan repayments to pay down maturing advances.  The increase in the average rates paid ondeposit accounts reflects increases in market interest rates.

 

The increase in the 2006 vs. 2005 period was primarily due to anincrease in the average rates paid on deposits and FHLB advances as well as anincrease in the average balances of deposits and FHLB advances.  The increase in the average rates paid on depositaccounts reflects both the shift in deposits from money market accounts tohigher rate certificates of deposit as well as increases in market interestrates.  The rates paid on FHLBadvances increased due to increases in market interest rates.  The average balance of deposits increased dueto growth in certificates of deposit. The average balance of FHLB advances increased due to the use ofadvances to fund loan growth.

 

**Provision for Loan Losses.**  The provision for loan losses is determinedby management as the amount to bring the allowance for loan losses to a levelthat is considered adequate to absorb probable losses inherent in the loanportfolio.  Such provision and theadequacy of the allowance for loan losses is evaluated quarterly by managementof the Bank based on the Bank’s past loan loss experience, known and inherentrisks in the portfolio, adverse situations that may affect the borrower’sability to repay, the estimated value of any underlying collateral and currenteconomic conditions.

 

Factors influencing management’s decision to increase the provision inthe 2007 vs. 2006 periods include an increase in nonaccrual loans, conditionsin the speculative single-family real estate market in Northwest Arkansas, andspecific loan loss allowances of $1.4 million on two phases of a subdivision inLowell, Arkansas and $885,000 on a subdivision located in Cave Springs,Arkansas, as discussed in “Asset Quality” previously.  Factors influencing management’s decision toincrease the provision in the 2006 vs. 2005 period include an increase innonaccrual loans and conditions in the speculative single-family real estatemarket in Northwest Arkansas.  Thespeculative single-family construction market demonstrated weakness in late2005 and we began reducing our exposure in this area at that time.  However, the continued oversupply ofavailable housing has impacted the value of speculative single-family homes anddevelopment projects, as discussed above. Further deterioration in this market segment may impact the value ofexisting single-family home values as well as our provision for loan losses inthe future.

 

**NoninterestIncome. **Deposit fee income increased in 2007 as a result of anincrease in debit card usage and insufficient funds fee income.  This increase resulted from an increase inthe number of checking accounts with overdrawn balances and a 4.2% increase inthe per item charge effective February 1, 2007.  The increase in 2006 was related to thenumber of checking accounts, which increased approximately 3.1% from December 31,2005 to December 31, 2006.  The Bankplans to continue to aggressively promote checking accounts in 2008 throughdirect mail campaigns and offering “thank you” gifts to further expand itschecking accounts and increase deposit fee income.  InJanuary 2008, the Bank introduced a higher rate checking account thatrequires electronic transactions to qualify. The Bank believes this product will expand its customer base and providecost savings and fee income due to the electronic requirements.

 

 

 

42

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Gain on sale ofloans changed in relation to increases or decreases in originations of loansfor sale during the comparison periods. The activity in loans held for sale is summarized below (in thousands):

** **
| ** **                                | ** ** | **Year Ended December 31,** | ** ** |
|-------------------------------------------|------------|----------------------------------|------------|
| ** **                                | ** ** | **2007**                         | ** ** | **2006** | ** ** | **2005** | ** ** |
| Loans  held for sale, beginning of period |       | $                                | 1,099      |   | $ | 2,641 |   | $ | 1,623 |   |
| Originations  of loans held for sale      |       | 59,813                           |       | 67,896 |   | 56,381 |   |
| Sales                                     |       | (58,080                          | )          | (69,438 | ) | (55,363 | ) |
| Loans  held for sale, end of period       |       | $                                | 2,832      |   | $ | 1,099 |   | $ | 2,641 |   |
|                                      |       |                             |       |   |   |   |   |
| Gain  on sale of loans                    |       | $                                | 823        |   | $ | 924 |   | $ | 764 |   |

 

Other noninterest income fluctuated during the period between 2005 and2007 due to nonrecurring gains on the sales of two properties totaling$528,000, recognized in 2006.  Theseproperties represented excess land and a building adjacent to two existingbranches.

 

**NoninterestExpense**

 

**Salariesand Employee Benefits. **The changes in the composition of thisline item are presented below (in thousands):

 
| ** **                         | ** ** | **Year Ended December 31,** | ** ** | **Change** | ** ** |
|------------------------------------|------------|----------------------------------|------------|------------|------------|
| ** **                         | ** ** | **2007**                         | ** ** | **2006**   | ** ** | **2005** | ** ** | **2007 vs 2006** | ** ** | **2006 vs 2005** | ** ** |
| Salaries                           |       | $                                | 10,419     |       | $          | 10,237 |   | $ | 8,516 |   | 182 |   | $ | 1,721 |   |
| Payroll  taxes                     |       | 868                              |       | 866        |       | 773 |   | 2 |   | 93 |   |
| Insurance                          |       | 673                              |       | 696        |       | 630 |   | (23 | ) | 66 |   |
| ESOP  expense (1)                  |       | —                           |       | 508        |       | 1,965 |   | (508 | ) | (1,457 | ) |
| 401(k)                             |       | 309                              |       | 174        |       | — |   | 135 |   | 174 |   |
| Stock  compensation (2)            |       | 39                               |       | 81         |       | 27 |   | (42 | ) | 54 |   |
| Defined  benefit plan contribution |       | 761                              |       | 745        |       | 660 |   | 16 |   | 85 |   |
| Other                              |       | 162                              |       | 157        |       | 151 |   | 5 |   | 6 |   |
| Total                              |       | $                                | 13,231     |       | $          | 13,464 |   | $ | 12,722 |   | $ | (233 | ) | $ | 742 |   |
|                                    |            |                                  |            |            |            |  |  |  |  |  |  |  |  |  |  |  |

----

(1)   EmployeeStock Ownership Plan.

(2)   Includesstock options and Management Recognition and Retention Plan (“MRP”) expense.

 

2007 vs. 2006

 

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

 

2006 vs. 2005

 

The increase in salaries was primarily related to an increase in thenumber of employees and normal salary and merit increases.  Payroll taxes increased due to the increasein salaries.  The increase in insuranceexpense was due to an increase in the number of employees.  The decrease in employee stock ownership planexpense was due to the plan shares becoming fully allocated as of March 31,2006.  Defined benefit plan expenseincreased due to an increase in the required contribution to our multi-employerplan primarily resulting from an increase in amortization cost.  The Company implemented a 401(k) Plan onJune 1, 2006.  The 401(k) expenseabove relates to employer matching of employee 401(k) contributions.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

43

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**Netoccupancy expense. **The changes in the composition of thisline item are presented below (in thousands):

 
| ** **                          | ** ** | **Year Ended December 31,** | ** ** | **Change** | ** ** |
|-------------------------------------|------------|----------------------------------|------------|------------|------------|
| ** **                          | ** ** | **2007**                         | ** ** | **2006**   | ** ** | **2005** | ** ** | **2007 vs 2006** | ** ** | **2006 vs 2005** | ** ** |
| Depreciation                        |       | $                                | 1,205      |       | $          | 1,224 |   | $ | 1,111 |   | $ | (19 | ) | $ | 113 |   |
| Furniture,  fixtures, and equipment |       | 225                              |       | 261        |       | 235 |   | (36 | ) | 26 |   |
| Utilities                           |       | 283                              |       | 290        |       | 242 |   | (7 | ) | 48 |   |
| Building  repairs and maintenance   |       | 299                              |       | 313        |       | 237 |   | (14 | ) | 76 |   |
| Taxes  and insurance                |       | 217                              |       | 220        |       | 187 |   | (3 | ) | 33 |   |
| Rent                                |       | 96                               |       | 97         |       | 67 |   | (1 | ) | 30 |   |
| Total                               |       | $                                | 2,325      |       | $          | 2,405 |   | $ | 2,079 |   | $ | (80 | ) | $ | 326 |   |

 

2007 vs. 2006

 

The decrease infurniture, fixtures and equipment is primarily related to branch remodelingexpenses incurred during 2006.

 

2006 vs. 2005

 

The increases indepreciation, furniture, fixtures and equipment expense, and utilities were dueto two new branches that opened during the first quarter of 2006 as well asremodeling several existing branches during the year.  The increase in building repairs andmaintenance consisted of expenses related to new branches as well as anincrease in maintenance expenses for the corporate office.

 

**Realestate owned, net. **The changes in the composition of thisline item are presented below (in thousands):

 
| ** **                | ** ** | **Year Ended December 31,** | ** ** | **Change** | ** ** |
|---------------------------|------------|----------------------------------|------------|------------|------------|
| ** **                | ** ** | **2007**                         | ** ** | **2006**   | ** ** | **2005** | ** ** | **2007 vs 2006** | ** ** | **2006 vs 2005** | ** ** |
| Loss  provisions          |       | $                                | 494        |       | $          | 93 |   | $ | 30 |   | $ | 401 |   | $ | 63 |   |
| Net  loss (gain) on sales |       | 188                              |       | (51        | )          | (8 | ) | 239 |   | (43 | ) |
| Taxes  and insurance      |       | 201                              |       | 94         |       | 12 |   | 107 |   | 82 |   |
| Other                     |       | 279                              |       | 55         |       | 24 |   | 224 |   | 31 |   |
| Total                     |       | $                                | 1,162      |       | $          | 191 |   | $ | 58 |   | $ | 971 |   | $ | 133 |   |

 

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

 

**Advertisingand public relations.**  The decrease in 2007 vs. 2006was primarily due to a decrease in direct mail advertising as well as adecrease in expenses associated with branch openings.

 

Advertising andpublic relations increased for the year ended December 31, 2006 comparedto the prior period primarily due to costs associated with the new checkingaccount marketing program that began in 2005, including direct mail, “thankyou” gifts, marketing brochures, posters and billboards, and the start-up ofthe business account marketing program. The Bank also had additional start up costs related to a new marketingfirm and advertising campaign.

 

**IncomeTaxes.**

 

2007 vs. 2006

 

The decrease inincome tax expense was primarily due to a decrease in taxable income andcertain nontaxable income amounts remaining relatively constant and thereforerepresenting a larger percentage of taxable income.

 

2006 vs. 2005

 

The decrease inincome tax expense was primarily due to the decrease in taxable income.  The effective tax rate decreased slightly toapproximately 31%.

 

**OFF-BALANCESHEET ARRANGEMENTS**

 

See Note 14 to theConsolidated Financial Statements.

 

 

 

44

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**CONTRACTUAL OBLIGATIONS**

** **

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

 
| ** **                          | ** ** | **Less Than** | ** ** | **More Than** | ** ** |
|-------------------------------------|------------|---------------|------------|---------------|------------|
| ** **                          | ** ** | **1 Year**    | ** ** | **1-3 Years** | ** ** | **3 - 5 Years** | ** ** | **5 Years** | ** ** | **Total** | ** ** |
|                                |       |          |       |          |       |   |   |   |   |   |   |
| Certificates  of deposit maturities |       | $             | 341,859    |          | $          | 49,907 |   | $ | 26,742 |   | $ | 7,903 |   | $ | 426,411 |   |
| FHLB  advances maturities           |       | $             | 35,905     |          | $          | 35,989 |   | $ | 9,084 |   | $ | 1,109 |   | $ | 82,087 |   |

 

**LIQUIDITY AND CAPITAL RESOURCES**

** **

The Bank’s liquidity, represented bycash and cash equivalents and eligible investment securities, is a product ofits operating, investing and financing activities.  The Bank’s primary sources of funds aredeposits, borrowings, payments on outstanding loans, maturities and calls ofinvestment securities and other short-term investments and funds provided fromoperations.  While scheduled loan amortizationand maturing 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 that provide liquidity to meet lendingrequirements.  The Bank has generally beenable to generate enough cash through the retail deposit market, its traditionalfunding source, to offset the cash utilized in investing activities.  As an additional source of funds, the Bankhas borrowed from the FHLB of Dallas. During 2007, the use of FHLB advances decreased due to the Bank usingfunds from loan repayments to repay FHLB of Dallas advances.  At December 31, 2007, availableborrowing capacity with the FHLB was approximately $207.0 million.  In addition, brokered deposits may be used toaugment the Bank’s primary funding sources. At December 31, 2007, the Bank had outstanding brokered deposits of$2.3 million.

 

Liquidity management is both a daily and long-term function ofbusiness management.  Excess liquidity isgenerally invested in short-term investments such as overnight deposits andcertificates of deposit.  On alonger-term basis, the Bank maintains a strategy of investing in variouslending products.   The Bank uses itssources 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.

 

In 2007 and 2006, the Company paid dividends of $0.64 and $0.58 pershare, respectively.  In 2007, thedividend per share was $0.16 in all four quarters.  The determination of future dividends on theCompany’s common stock will depend on conditions existing at that time withconsideration given to the Company’s earnings, capital, and liquidity needs.

 

As of December 31, 2007, the Bank’s regulatory capital was inexcess of all applicable regulatory requirements.  At December 31, 2007, the Bank’stangible, core and risk-based capital ratios amounted to 9.22%, 9.22% and 13.20%,respectively, compared to regulatory requirements of 1.5%, 4.0% and 8.0%,respectively.

** **

**IMPACT OF INFLATION AND CHANGING PRICES**

 

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

 

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

 

**IMPACT OF NEW ACCOUNTING STANDARDS**

** **

See Note 1 to the Consolidated Financial Statements.

 

 

 

45

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**Item7A. Quantitative and Qualitative Disclosures about Market Risk****.**

 

**ASSET AND LIABILITY MANAGEMENT**

 

The ability to maximize net interest income is largely dependent uponthe achievement of a positive interest rate spread that can be sustained duringfluctuations in prevailing interest rates. Interest rate sensitivity is a measure of the difference between amountsof interest earning assets and interest bearing liabilities that either repriceor mature within a given period of time. The difference, or the interest rate repricing “gap”, provides anindication of the extent to which an institution’s interest rate spread will beaffected by changes in interest rates.  Agap is considered positive when the amount of interest rate-sensitive assetsexceeds the amount of interest rate-sensitive liabilities, and is considerednegative when the amount of interest rate-sensitive liabilities exceeds theamount of interest rate-sensitive assets. Generally, during a period of rising interest rates, a negative gapwithin shorter maturities would adversely affect net interest income, while apositive gap within shorter maturities would result in an increase in netinterest income, and during a period of falling interest rates, a negative gapwithin shorter maturities would result in an increase in net interest incomewhile a positive gap within shorter maturities would have the oppositeeffect.  As of December 31, 2007,the Bank estimates that the ratio of its one-year gap to total assets was a negative15.9% and its ratio of interest earning assets to interest bearing liabilitiesmaturing or repricing within one year was 74.4%.  Due to inherent limitations in any static gapanalysis and since conditions change on a daily basis, these measurements maynot reflect future results.  A static gapanalysis does not include such factors as loan prepayments, interest ratefloors and caps on various assets and liabilities, the current interest rateson assets and liabilities to be repriced in each period, and the relativechanges in interest rates on different types of assets and liabilities.

 

The Bank focuses its residential lending activities for loans held inportfolio on the origination of one-, three-, five- and seven-year adjustablerate residential mortgage loans (“ARMs”). Although adjustable rate loans involve certain risks, includingincreased payments and the potential for default in an increasing interest rateenvironment, such loans decrease the risks associated with changes in interestrates.  As of December 31, 2007, $175.4million or 76.2% of the Bank’s portfolio of one- to four-family residentialmortgage loans consisted of ARMs, including $37.9 million in seven-year ARMs. ARMssubject to contractual repricing within one year totaled $60.8 million at anaverage interest rate of 6.55% at December 31, 2007.

 

At December 31, 2007, the Bank’s portfolio of variable rateloans tied primarily to the Wall Street Journal Prime Rate (“Prime Rate”)amounted to $86.5 million with an average interest rate of 7.67%.  The interest rate on these loans adjusts atany time the Prime Rate adjusts, subject to interest rate caps or floors on theloans.  Of the $86.5 million,approximately 72% have interest rate floors below 6.0%.  The Prime Rate at December 31, 2007, was7.25% but has adjusted downward in January 2008 by 125 basis points as aresult of rate cuts by the Federal Reserve.

 

The Company’s investment portfolio, all of which is classified asheld to maturity, amounted to $95.6 million or 12.1%of the Company’s totalassets at December 31, 2007.  Ofsuch amount, $3.4 million or 3.5% is contractually due within one year and $7.6million or 7.9% is contractually due from one year to five years.  However, actual maturities can be shorterthan contractual maturities due to the ability of borrowers to call or prepaysuch obligations without call or prepayment penalties.  As of December 31, 2007, there wereapproximately $95.0 million of investment securities at an average interestrate of 5.42% with call options held by the issuer, of which approximately $87.5million, at an average interest rate of 5.50% are callable within oneyear.  In the current declining interestrate environment, it is projected that approximately 60% of the $87.5 millionin investment securities callable within one year will actually be calledwithin one year.

 

Deposits are the Bank’s primary funding source and the Bank pricesits deposit accounts based upon competitive factors and the availability ofprudent lending and investment opportunities. The Bank seeks to lengthen the maturities of its deposits by offeringlonger-term certificates of deposit when market conditions have createdopportunities to attract such deposits. However, the Bank does not solicit highrate jumbo certificates of deposit and does not pursue an aggressive growth strategythat would force the Bank to focus exclusively on competitors’ rates ratherthan deposit affordability.  At December 31,2007, the Bank had $426.4 million in certificates of deposit of which $341.9million at an average interest rate of 4.76% mature in one year or less.  At December 31, 2007, the Bank hadapproximately $51.4 million of money market deposit accounts at an average rateof 2.71%.  These accounts are subject torepricing at the discretion of the Bank.

 

At December 31, 2007, the Bank had $82.1 million of FHLBadvances, of which $13 million at an average interest rate of 5.03% arevariable with the interest rate floating either monthly or quarterly based onmovements in the London Interbank Offering Rate (“ LIBOR”).  Fixed rate advances of $23.9 million at anaverage interest rate of 4.23% are due in one year or less.

 

 

 

 

 

 

 

 

 

46

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**Net Portfolio Value**

 

The value of the Bank’s loan andinvestment portfolio will change as interest rates change.  As a result of the Bank’s negative interestrate repricing gap, rising interest rates will generally decrease the Bank’snet portfolio value (“NPV”), while falling interest rates will generallyincrease the value of that portfolio. NPV is the difference between incoming and outgoing discounted cashflows from assets, liabilities, and off-balance sheet contracts.  The following tables set forth,quantitatively, as of December 31, 2007 and 2006, the OTS estimate of theprojected changes in NPV in the event of a 100, 200 and 300 basis pointinstantaneous and permanent increase in market interest rates and a 100 and 200basis point instantaneous and permanent decrease in market interest rates as ofDecember 31, 2006 and 2005.  Due tothe low interest rate environments in 2007 and 2006, the changes in NPV are notestimated for a decrease in interest rates of 300 basis points in either year.

 
| **2007**                                        |
|-------------------------------------------------|
| **Change in   Interest Rates   (basis points)** | ** ** | **Estimated NPV** | ** ** | **Estimated NPV as  a Percentage of  Present Value  of Assets** | ** ** | **Amount  of Change** | ** ** | **Percent  of Change** | ** ** |
| ** **                                      | ** ** | (Dollars in Thousands) | ** ** | ** ** | ** ** |
| +300                                            |   | $ | 72,640 |   | 9.25 | % | $ | (22,353 | ) | (24 | )% |
| +200                                            |   | 81,976 |   | 10.28 |   | (13,017 | ) | (14 | ) |
| +100                                            |   | 89,825 |   | 11.11 |   | (5,168 | ) | (5 | ) |
|         0         |   | 94,993 |   | 11.62 |   | — |   | — |   |
|  -100                                      |   | 96,430 |   | 11.72 |   | 1,437 |   | 2 |   |
|  -200                                      |   | 92,894 |   | 11.28 |   | (2,099 | ) | (2 | ) |
|                                                 |  |  |  |  |  |  |  |  |  |  |  |

 
| **2006**                                        |
|-------------------------------------------------|
| **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                                            |   | $ | 91,757 |   | 10.76 | % | $ | (15,438 | ) | (14 | )% |
| +200                                            |   | 98,765 |   | 11.43 |   | (8,430 | ) | (8 | ) |
| +100                                            |   | 104,404 |   | 11.95 |   | (2,791 | ) | (3 | ) |
|         0         |   | 107,195 |   | 12.17 |   | — |   | — |   |
|  -100                                      |   | 108,537 |   | 12.24 |   | 1,342 |   | 1 |   |
|  -200                                      |   | 108,749 |   | 12.19 |   | 1,554 |   | 1 |   |
|                                                 |  |  |  |  |  |  |  |  |  |  |  |

 

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

 

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

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

47

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**Item8.  Financial Statements andSupplementary Data.**

 

**MANAGEMENTREPORT ON INTERNAL CONTROL**

 

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

 

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 31,2007 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, 2007.

 

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

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

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

48

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**REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTINGFIRM**

 

To the Board of Directors and Stockholders of

First Federal Bancshares of Arkansas, Inc.

Harrison, Arkansas

 

 

We have audited theaccompanying consolidated statements of financial condition of First FederalBancshares of Arkansas, Inc. and subsidiaries (the “Company”) as of December 31,2007 and 2006, and the related consolidated statements of income, stockholders’equity, and cash flows for each of the three years in the period ended December 31,2007. These financial statements are the responsibility of the Company’smanagement.  Our responsibility is to express an opinion on the financialstatements based on our audits.

 

We conducted our audits inaccordance with the standards of the Public Company Accounting Oversight Board(United States).  Those standards require that we plan and perform theaudit to obtain reasonable assurance about whether the financial statements arefree of material misstatement.  An audit includes examining, on a testbasis, evidence supporting the amounts and disclosures in the financialstatements.  An audit also includes assessing the accounting principlesused and significant estimates made by management, as well as evaluating theoverall financial statement presentation.  We believe that our auditsprovide a reasonable basis for our opinion.

 

In our opinion, suchconsolidated financial statements present fairly, in all material respects, thefinancial position of First Federal Bancshares of Arkansas, Inc. andsubsidiaries as of December 31, 2007 and 2006, and the results of theiroperations and their cash flows for each of the three years in the period endedDecember 31, 2007, in conformity with accounting principles generallyaccepted in the United States of America.

 

We have also audited, inaccordance with the standards of the Public Company Accounting Oversight Board(United States), the Company’s internal control over financial reporting as of December 31,2007, based on the criteria established in *InternalControl—Integrated Framework* issued by the Committee of SponsoringOrganizations of the Treadway Commission and our report dated February 26,2008 expressed an unqualified opinion on the Company’s internal control overfinancial reporting.

 

 

 

/s/ Deloitte &Touche LLP

 

Little Rock, Arkansas

February 26, 2008

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

49

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** **

**REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTINGFIRM**

 

To the Board of Directors and Stockholders of

First Federal Bancshares of Arkansas, Inc.

Harrison, Arkansas

 

 

We have audited the internalcontrol over financial reporting of First Federal Bancshares of Arkansas, Inc.and subsidiaries (the “Company”) as of December 31, 2007, based oncriteria established in *InternalControl—Integrated Framework*issued by the Committee of SponsoringOrganizations of the Treadway Commission.  The Company’s management isresponsible for maintaining effective internal control over financial reportingand for its assessment of the effectiveness of internal control over financialreporting, included in the accompanying Management Report on Internal Control.Our responsibility is to express an opinion on the Company’s internal controlover financial reporting based on our audit.

 

We conducted our audit inaccordance with the standards of the Public Company Accounting Oversight Board(United States).  Those standards require that we plan and perform theaudit to obtain reasonable assurance about whether effective internal controlover financial reporting was maintained in all material respects.  Ouraudit included obtaining an understanding of internal control over financial reporting,assessing the risk that a material weakness exists, testing and evaluating thedesign and operating effectiveness of internal control based on the assessedrisk, and performing such other procedures as we considered necessary in thecircumstances.  We believe that our audit provides a reasonable basis forour opinion.

 

A company’s internal controlover financial reporting is a process designed by, or under the supervision of,the company’s principal executive and principal financial officers, or personsperforming similar functions, and effected by the company’s board of directors,management, and other personnel to provide reasonable assurance regarding thereliability of financial reporting and the preparation of financial statementsfor external purposes in accordance with generally accepted accountingprinciples.  A company’s internal control over financial reportingincludes those policies and procedures that (1) pertain to the maintenanceof records that, in reasonable detail, accurately and fairly reflect thetransactions and dispositions of the assets of the company; (2) providereasonable assurance that transactions are recorded as necessary to permitpreparation of financial statements in accordance with generally acceptedaccounting principles, and that receipts and expenditures of the company arebeing made only in accordance with authorizations of management and directorsof the company; and (3) provide reasonable assurance regarding preventionor timely detection of unauthorized acquisition, use, or disposition of thecompany’s assets that could have a material effect on the financial statements.

 

Because of the inherentlimitations of internal control over financial reporting, including thepossibility of collusion or improper management override of controls, materialmisstatements due to error or fraud may not be prevented or detected on atimely basis.  Also, projections of any evaluation of the effectiveness ofthe internal control over financial reporting to future periods are subject tothe risk that the controls may become inadequate because of changes inconditions, or that the degree of compliance with the policies or proceduresmay deteriorate.

 

In our opinion, the Companymaintained, in all material respects, effective internal control over financialreporting as of December 31, 2007, based on the criteria established in *Internal Control—Integrated Framework*issuedby the Committee of Sponsoring Organizations of the Treadway Commission.

 

We have also audited, inaccordance with the standards of the Public Company Accounting Oversight Board(United States), the consolidated financial statements as of and for the year ended December 31, 2007 of the Companyand our report dated February 26,2008 expressed an unqualified opinion on those financial statements.

 

 

 

/s/ Deloitte & Touche LLP

 

Little Rock, Arkansas

February 26, 2008

 

 

 

 

 

 

 

 

 

 

 

50

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

 

**CONSOLIDATEDSTATEMENTS OF FINANCIAL CONDITION**

**DECEMBER 31, 2007 AND 2006**

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

 
| **ASSETS**                                                                                                                                                                                                                                                            | ** ** | **2007**   | ** ** | **2006**   | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------|------------|------------|------------|
|                                                                                                                                                                                                                                                                  |       |       |       |       |       |
| Cash  and cash equivalents:                                                                                                                                                                                                                                           |       |       |       |       |       |
| Cash and collection items                                                                                                                                                                                                                                             |       | $          | 12,578     |       | $          | 17,731 |   |
| Interest bearing deposits  with banks                                                                                                                                                                                                                                 |       | 13,809     |       | 17,787     |       |
| Federal funds sold                                                                                                                                                                                                                                                    |       | 1,000      |       | —     |       |
|                                                                                                                                                                                                                                                                  |       |       |       |       |       |
| Total cash and cash  equivalents                                                                                                                                                                                                                                      |       | 27,387     |       | 35,518     |       |
|                                                                                                                                                                                                                                                                  |       |       |       |       |       |
| Investment  securities—                                                                                                                                                                                                                                          |       |       |       |       |       |
| Held to maturity, at  amortized cost (fair value at December 31, 2007 and 2006, of $95,811 and  $59,689, respectively)                                                                                                                                           |       | 95,590     |       | 60,746     |       |
| Federal  Home Loan Bank stock—at cost                                                                                                                                                                                                                            |       | 4,433      |       | 7,089      |       |
| Loans receivable, net of  allowance at December 31, 2007and 2006, of $5,162 and $2,572, respectively                                                                                                                                                             |       | 601,256    |       | 693,095    |       |
| Accrued  interest receivable                                                                                                                                                                                                                                          |       | 9,042      |       | 9,999      |       |
| Real  estate owned—net                                                                                                                                                                                                                                           |       | 8,120      |       | 3,858      |       |
| Office  properties and equipment—net                                                                                                                                                                                                                             |       | 24,263     |       | 20,384     |       |
| Cash  surrender value of life insurance                                                                                                                                                                                                                               |       | 20,159     |       | 19,396     |       |
| Prepaid  expenses and other assets                                                                                                                                                                                                                                    |       | 1,728      |       | 2,390      |       |
|                                                                                                                                                                                                                                                                  |       |       |       |       |       |
| TOTAL                                                                                                                                                                                                                                                                 |       | $          | 791,978    |       | $          | 852,475 |   |
|                                                                                                                                                                                                                                                                  |       |       |       |       |       |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                                                                                                                                                                        | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                                                                                                                                                                                                                                            | ** ** | ** ** | ** ** | ** ** | ** ** |
| LIABILITIES:                                                                                                                                                                                                                                                          |       |       |       |       |       |
| Deposits:                                                                                                                                                                                                                                                             |       |       |       |       |       |
| Interest bearing                                                                                                                                                                                                                                                      |       | $          | 602,618    |       | $          | 612,937 |   |
| Noninterest bearing                                                                                                                                                                                                                                                   |       | 27,796     |       | 39,328     |       |
|                                                                                                                                                                                                                                                                  |       |       |       |       |       |
| Total deposits                                                                                                                                                                                                                                                        |       | 630,414    |       | 652,265    |       |
|                                                                                                                                                                                                                                                                  |       |       |       |       |       |
| Federal Home Loan Bank  advances                                                                                                                                                                                                                                      |       | 82,087     |       | 120,305    |       |
| Advance payments by  borrowers for taxes and insurance                                                                                                                                                                                                                |       | 575        |       | 666        |       |
| Other liabilities                                                                                                                                                                                                                                                     |       | 5,239      |       | 3,666      |       |
|                                                                                                                                                                                                                                                                  |       |       |       |       |       |
| Total liabilities                                                                                                                                                                                                                                                     |       | $          | 718,315    |       | $          | 776,902 |   |
|                                                                                                                                                                                                                                                                  |       |       |       |       |       |
| STOCKHOLDERS’  EQUITY:                                                                                                                                                                                                                                           |       |       |       |       |       |
| Preferred stock, no par  value—5,000,000 shares authorized, none issued

Common stock, $.01 par  value—20,000,000 shares authorized; 10,307,502 shares issued; 4,844,385 and  4,838,962 shares outstanding at December 31, 2007 and 2006, respectively |       | 103        |       | 103        |       |
| Additional paid-in capital                                                                                                                                                                                                                                            |       | 56,653     |       | 56,617     |       |
| Employee stock benefit  plans                                                                                                                                                                                                                                         |       | (42        | )          | (72        | )          |
| Retained  earnings—substantially restricted                                                                                                                                                                                                                      |       | 87,600     |       | 88,068     |       |
|                                                                                                                                                                                                                                                                  |       | 144,314    |       | 144,716    |       |
| Treasury stock—at cost;  5,463,117 and 5,468,540 shares at December 31, 2007 and 2006,  respectively                                                                                                                                                        |       | (70,651    | )          | (69,143    | )          |
|                                                                                                                                                                                                                                                                  |       |       |       |       |       |
| Total stockholders’ equity                                                                                                                                                                                                                                       |       | 73,663     |       | 75,573     |       |
|                                                                                                                                                                                                                                                                  |       |       |       |       |       |
| TOTAL                                                                                                                                                                                                                                                                 |       | $          | 791,978    |       | $          | 852,475 |   |
|                                                                                                                                                                                                                                                                  |       |       |       |       |       |
| See  notes to consolidated financial statements.                                                                                                                                                                                                                      |       |       |       |       |       |

 

 

 

 

51

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**FIRST FEDERAL BANCSHARES OFARKANSAS, INC**

** **

**CONSOLIDATED STATEMENTS OF INCOME**

**YEARS ENDED DECEMBER 31, 2007,2006, AND 2005**

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

** **
| ** **                                           | ** ** | **2007** | ** ** | **2006** | ** ** | **2005** | ** ** |
|------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| INTEREST  INCOME:                                    |       |     |       |     |       |     |       |
| Loans receivable                                     |       | $        | 45,473     |     | $          | 50,185   |       | $ | 43,057 |   |
| Investment securities:                               |       |     |       |     |       |     |       |
| Taxable                                              |       | 3,350    |       | 2,526    |       | 2,181    |       |
| Nontaxable                                           |       | 721      |       | 744      |       | 721      |       |
| Other                                                |       | 882      |       | 664      |       | 126      |       |
| Total interest income                                |       | 50,426   |       | 54,119   |       | 46,085   |       |
|                                                 |       |     |       |     |       |     |       |
| INTEREST  EXPENSE:                                   |       |     |       |     |       |     |       |
| Deposits                                             |       | 23,873   |       | 20,643   |       | 14,617   |       |
| Federal Home Loan Bank  advances                     |       | 4,311    |       | 6,933    |       | 4,987    |       |
|                                                 |       |     |       |     |       |     |       |
| Total interest expense                               |       | 28,184   |       | 27,576   |       | 19,604   |       |
|                                                 |       |     |       |     |       |     |       |
| NET  INTEREST INCOME                                 |       | 22,242   |       | 26,543   |       | 26,481   |       |
|                                                 |       |     |       |     |       |     |       |
| PROVISION  FOR LOAN LOSSES                           |       | 4,028    |       | 1,482    |       | 1,101    |       |
|                                                 |       |     |       |     |       |     |       |
| NET  INTEREST INCOME AFTER PROVISION FOR LOAN LOSSES |       | 18,214   |       | 25,061   |       | 25,380   |       |
|                                                 |       |     |       |     |       |     |       |
| NONINTEREST  INCOME:                                 |       |     |       |     |       |     |       |
| Deposit fee income                                   |       | 4,989    |       | 4,839    |       | 4,486    |       |
| Earnings on life insurance  policies                 |       | 763      |       | 742      |       | 757      |       |
| Gain on sale of loans                                |       | 823      |       | 924      |       | 764      |       |
| Other                                                |       | 1,194    |       | 1,717    |       | 929      |       |
|                                                 |       |     |       |     |       |     |       |
| Total noninterest income                             |       | 7,769    |       | 8,222    |       | 6,936    |       |
|                                                 |       |     |       |     |       |     |       |
| NONINTEREST  EXPENSES:                               |       |     |       |     |       |     |       |
| Salaries and employee  benefits                      |       | 13,231   |       | 13,464   |       | 12,722   |       |
| Net occupancy expense                                |       | 2,325    |       | 2,405    |       | 2,079    |       |
| Real estate owned, net                               |       | 1,162    |       | 191      |       | 58       |       |
| Data processing                                      |       | 1,513    |       | 1,474    |       | 1,546    |       |
| Professional fees                                    |       | 513      |       | 381      |       | 422      |       |
| Advertising and public  relations                    |       | 1,145    |       | 1,338    |       | 1,137    |       |
| Postage and supplies                                 |       | 857      |       | 836      |       | 772      |       |
| Other                                                |       | 2,249    |       | 2,432    |       | 2,007    |       |
|                                                 |       |     |       |     |       |     |       |
| Total noninterest expenses                           |       | 22,995   |       | 22,521   |       | 20,743   |       |
|                                                 |       |     |       |     |       |     |       |
| INCOME  BEFORE INCOME TAXES                          |       | 2,988    |       | 10,762   |       | 11,573   |       |
|                                                 |       |     |       |     |       |     |       |
| INCOME  TAX PROVISION                                |       | 345      |       | 3,379    |       | 3,723    |       |
|                                                 |       |     |       |     |       |     |       |
| NET  INCOME                                          |       | $        | 2,643      |     | $          | 7,383    |       | $ | 7,850 |   |
|                                                 |       |     |       |     |       |     |       |
| EARNINGS  PER SHARE:                                 |       |     |       |     |       |     |       |
| Basic                                                |       | $        | 0.54       |     | $          | 1.48     |       | $ | 1.57 |   |
|                                                 |       |     |       |     |       |     |       |
| Diluted                                              |       | $        | 0.54       |     | $          | 1.44     |       | $ | 1.50 |   |
|                                                 |       |     |       |     |       |     |       |
| See  notes to consolidated financial statements.     |       |     |       |     |       |     |       |

 

 

 

52

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

** **

**CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY**

**YEARS ENDED DECEMBER 31, 2007, 2006, AND 2005**

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

 
| ** **                               | ** ** | **Issued**        | ** ** | ** **     | ** ** | **Employee**         | ** ** | ** **          | ** ** | ** **               | ** ** | ** ** | ** ** | ** ** | ** ** |
|------------------------------------------|------------|-------------------|------------|----------------|------------|----------------------|------------|---------------------|------------|--------------------------|------------|------------|------------|------------|------------|
| ** **                               | ** ** | **Common  Stock** | ** ** | **Additional** | ** ** | **Stock**            | ** ** | ** **          | ** ** | **Treasury  Stock**      | ** ** | **Total**  | ** ** |
| ** **                               | ** ** | **Shares**        | ** ** | **Amount**     | ** ** | **Paid-In  Capital** | ** ** | **Benefit   Plans** | ** ** | **Retained    Earnings** | ** ** | **Shares** | ** ** | **Amount** | ** ** | **Stockholders’    Equity** | ** ** |
|                                     |       |              |       |           |       |                 |       |                |       |                     |       |       |       |       |       |   |   |
| BALANCE—January 1,  2005       |       | 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 |   |
|                                     |       |              |       |           |       |                 |       |                |       |                     |       |       |       |       |       |   |   |
| Net income                               |       | —            |       | —         |       | —               |       | —              |       | 7,383                    |       | —     |       | —     |       | 7,383 |   |
| Release of ESOP shares                   |       | —            |       | —         |       | 408                  |       | 104                 |       | —                   |       | —     |       | —     |       | 512 |   |
| Stock compensation expense               |       | —            |       | —         |       | 70                   |       | (36                 | )          | —                   |       | (4,000     | )          | 47         |       | 81 |   |
| Tax effect of stock  compensation plans  |       | —            |       | —         |       | 274                  |       | —              |       | —                   |       | —     |       | —     |       | 274 |   |
| Purchase of treasury stock—at  cost |       | —            |       | —         |       | —               |       | —              |       | —                   |       | 354,266    |       | (8,574     | )          | (8,574 | ) |
| Treasury shares reissued                 |       | —            |       | —         |       | (387                 | )          | —              |       | —                   |       | (140,566   | )          | 1,341      |       | 954 |   |
| Dividends paid ($0.58 per  share)        |       | —            |       | —         |       | —               |       | —              |       | (2,899                   | )          | —     |       | —     |       | (2,899 | ) |
|                                     |       |              |       |           |       |                 |       |                |       |                     |       |       |       |       |       |   |   |
| BALANCE—December 31,  2006     |       | 10,307,502        |       | 103            |       | 56,617               |       | (72                 | )          | 88,068                   |       | 5,468,540  |       | (69,143    | )          | 75,573 |   |
|                                     |       |              |       |           |       |                 |       |                |       |                     |       |       |       |       |       |   |   |
| Net income                               |       | —            |       | —         |       | —               |       | —              |       | 2,643                    |       | —     |       | —     |       | 2,643 |   |
| Stock compensation expense               |       | —            |       | —         |       | 9                    |       | 30                  |       | —                   |       | —     |       | —     |       | 39 |   |
| Tax effect of stock  compensation plans  |       | —            |       | —         |       | 481                  |       | —              |       | —                   |       | —     |       | —     |       | 481 |   |
| Purchase of treasury stock—at  cost |       | —            |       | —         |       | —               |       | —              |       | —                   |       | 101,542    |       | (2,312     | )          | (2,312 | ) |
| Treasury shares reissued                 |       | —            |       | —         |       | (454                 | )          | —              |       | —                   |       | (106,965   | )          | 804        |       | 350 |   |
| Dividends paid ($0.64 per  share)        |       | —            |       | —         |       | —               |       | —              |       | (3,111                   | )          | —     |       | —     |       | (3,111 | ) |
|                                     |       |              |       |           |       |                 |       |                |       |                     |       |       |       |       |       |   |   |
| BALANCE—December 31,  2007     |       | 10,307,502        |       | $              | 103        |                 | $          | 56,653              |       | $                        | (42        | )          | $          | 87,600     |       | 5,463,117 |   | $ | (70,651 | ) | $ | 73,663 |   |

 

See notes to consolidated financial statements.

 

53

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

 

**CONSOLIDATED STATEMENTS OF CASH FLOWS**

**YEARS ENDED DECEMBER 31, 2007, 2006AND 2005**

**(In thousands)**

 
| ** **                                                                                                    | ** ** | **2007** | ** ** | **2006**    | ** ** | **2005** | ** ** |
|---------------------------------------------------------------------------------------------------------------|------------|----------|------------|-------------|------------|----------|------------|
|                                                                                                          |       |     |       |        |       |     |       |
| OPERATING  ACTIVITIES:                                                                                        |       |     |       |        |       |     |       |
| Net income                                                                                                    |       | $        | 2,643      |        | $          | 7,383    |       | $ | 7,850 |   |
| Adjustments to reconcile  net income to net cash provided by operating activities:  Provision for loan losses |       | 4,028    |       | 1,482       |       | 1,101    |       |
| Provision for real estate  losses                                                                             |       | 494      |       | 92          |       | 29       |       |
| Deferred tax provision  (benefit)                                                                             |       | (1,585   | )          | 137         |       | (13      | )          |
| Accretion of discounts on  investment securities, net                                                         |       | (16      | )          | (8          | )          | (2       | )          |
| Federal Home Loan Bank  stock dividends                                                                       |       | (303     | )          | (403        | )          | (251     | )          |
| Loss (gain) on disposition  of fixed assets                                                                   |       | (3       | )          | (522        | )          | 9        |       |
| Loss (gain) on sale of  repossessed assets, net                                                               |       | 188      |       | (51         | )          | (8       | )          |
| Originations of loans held  for sale                                                                          |       | (59,813  | )          | (67,896     | )          | (56,381  | )          |
| Proceeds from sales of  loans                                                                                 |       | 58,903   |       | 70,362      |       | 56,127   |       |
| Gain on sale of loans  originated to sell                                                                     |       | (823     | )          | (924        | )          | (764     | )          |
| Depreciation                                                                                                  |       | 1,399    |       | 1,304       |       | 1,185    |       |
| Amortization of deferred  loan fees, net                                                                      |       | 435      |       | 280         |       | 167      |       |
| Release of ESOP shares                                                                                        |       | —   |       | 512         |       | 1,991    |       |
| Earnings on life insurance  policies                                                                          |       | (763     | )          | (742        | )          | (757     | )          |
| Stock compensation expense                                                                                    |       | 39       |       | 81          |       | 26       |       |
| Changes in operating  assets and liabilities:                                                                 |       |     |       |        |       |     |       |
| Accrued interest  receivable                                                                                  |       | 957      |       | (2,509      | )          | (3,063   | )          |
| Prepaid expenses and other  assets                                                                            |       | 699      |       | (953        | )          | 304      |       |
| Other liabilities                                                                                             |       | 437      |       | 283         |       | 1,921    |       |
|                                                                                                          |       |     |       |        |       |     |       |
| Net cash provided by  operating activities                                                                    |       | 6,916    |       | 7,908       |       | 9,471    |       |
|                                                                                                          |       |     |       |        |       |     |       |
| INVESTING  ACTIVITIES:                                                                                        |       |     |       |        |       |     |       |
| Purchases of investment  securities, held to maturity                                                         |       | (41,488  | )          | (7,533      | )          | (5,559   | )          |
| Proceeds from  maturities/calls of investment securities, held to maturity                                    |       | 9,850    |       | 3,490       |       | 4,626    |       |
| Purchase of Federal Home  Loan Bank stock                                                                     |       | —   |       | —      |       | (3,285   | )          |
| Federal Home Loan Bank  stock redeemed                                                                        |       | 2,959    |       | 1,726       |       | —   |       |
| Loan originations, net of  repayments                                                                         |       | 76,070   |       | 13,762      |       | (87,939  | )          |
| Loan purchases                                                                                                |       | (4,763   | )          | (363        | )          | —   |       |
| Loan participations sold                                                                                      |       | 7,208    |       | 3,419       |       | 1,787    |       |
| Proceeds from sales of  repossessed assets                                                                    |       | 3,740    |       | 3,700       |       | 560      |       |
| Improvements to real  estate owned                                                                            |       | (763     | )          | (724        | )          | —   |       |
| Proceeds from sales of office  properties and equipment                                                       |       | 10       |       | 251         |       | 4        |       |
| Purchases of office  properties and equipment                                                                 |       | (2,637   | )          | (3,190      | )          | (4,425   | )          |
|                                                                                                          |       |     |       |        |       |     |       |
| Net cash provided by (used  in) investing activities                                                          |       | 50,186   |       | 14,538      |       | (94,231  | )          |
|                                                                                                          |       |     |       |        |       |     |       |
|                                                                                                          |       |     |       | (Continued) |       |
|                                                                                                               |            |          |            |             |            |          |            |  |  |  |

 

 

 

 

 

 

 

 

 

 

 

 

 

 

54

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

** **

**CONSOLIDATED STATEMENTS OF CASH FLOWS**

**YEARS ENDED DECEMBER 31, 2007, 2006AND 2005**

**(In thousands)**

** **
| ** **                                                                        | ** ** | **2007** | ** ** | **2006**    | ** ** | **2005** | ** ** |
|-----------------------------------------------------------------------------------|------------|----------|------------|-------------|------------|----------|------------|
| FINANCING  ACTIVITIES:                                                            |       |     |       |        |       |     |       |
| Net increase (decrease) in  deposits                                              |       | $        | (21,851    | )           | $          | 40,598   |       | $ | 29,243 |   |
| Advances from Federal Home  Loan Bank                                             |       | 25,200   |       | 55,000      |       | 144,343  |       |
| Repayment of advances from  Federal Home Loan Bank                                |       | (63,418  | )          | (92,935     | )          | (75,859  | )          |
| Net increase (decrease) in  advance payments by borrowers for taxes and insurance |       | (91      | )          | (181        | )          | 90       |       |
| Purchase of treasury stock                                                        |       | (2,312   | )          | (8,574      | )          | (7,630   | )          |
| Dividends paid                                                                    |       | (3,111   | )          | (2,899      | )          | (2,527   | )          |
| Stock options exercised                                                           |       | 350      |       | 954         |       | 2,206    |       |
|                                                                              |       |     |       |        |       |     |       |
| Net cash provided by (used  in) financing activities                              |       | (65,233  | )          | (8,037      | )          | 89,866   |       |
|                                                                              |       |     |       |        |       |     |       |
| NET  INCREASE (DECREASE) IN CASH AND                                              |       |     |       |        |       |     |       |
| CASH EQUIVALENTS                                                                  |       | (8,131   | )          | 14,409      |       | 5,106    |       |
|                                                                              |       |     |       |        |       |     |       |
| CASH  AND CASH EQUIVALENTS:                                                       |       |     |       |        |       |     |       |
| Beginning of year                                                                 |       | 35,518   |       | 21,109      |       | 16,003   |       |
|                                                                              |       |     |       |        |       |     |       |
| End of year                                                                       |       | $        | 27,387     |        | $          | 35,518   |       | $ | 21,109 |   |
|                                                                              |       |     |       |        |       |     |       |
| SUPPLEMENTAL  DISCLOSURES OF CASH FLOW                                            |       |     |       |        |       |     |       |
| INFORMATION—                                                                 |       |     |       |        |       |     |       |
| Cash paid for:                                                                    |       |     |       |        |       |     |       |
| Interest                                                                          |       | $        | 28,483     |        | $          | 26,883   |       | $ | 19,034 |   |
|                                                                              |       |     |       |        |       |     |       |
| Income taxes                                                                      |       | $        | 1,157      |        | $          | 3,494    |       | $ | 2,914 |   |
|                                                                              |       |     |       |        |       |     |       |
| SUPPLEMENTAL  SCHEDULE OF NONCASH                                                 |       |     |       |        |       |     |       |
| INVESTING ACTIVITIES:                                                             |       |     |       |        |       |     |       |
| Real estate and other  assets acquired in settlement of loans                     |       | $        | 12,283     |        | $          | 5,997    |       | $ | 935 |   |
|                                                                              |       |     |       |        |       |     |       |
| Loans to facilitate sales  of real estate owned                                   |       | $        | 1,689      |        | —     |     | $          | 30 |   |
|                                                                              |       |     |       |        |       |     |       |
| Investment securities  purchased—not settled                                 |       | $        | 3,190      |        | —     |     | $          | 100 |   |
|                                                                              |       |     |       |        |       |     |       |
| Transfer of real estate  owned to office properties and equipment                 |       | $        | 2,648      |        | —     |     | —     |   |
|                                                                              |       |     |       |        |       |     |       |
| See  notes to consolidated financial statements.                                  |       |     |       | (Concluded) |       |

 

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**55**

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** **

**FIRST FEDERAL BANCSHARESOF ARKANSAS, INC.**

**NOTES TO CONSOLIDATEDFINANCIAL STATEMENTS**

**YEARS ENDED DECEMBER 31,2007, 2006, AND 2005**

** **

**1.       SUMMARYOF SIGNIFICANT ACCOUNTING POLICIES**

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

 

***Use of Estimates—***The preparation of financialstatements in conformity with accounting principles generally accepted in theUnited States of America requires management to make estimates and assumptionsthat affect the reported amounts of assets and liabilities and disclosure ofcontingent assets and liabilities at the date of the financial statements andthe reported amounts of revenues and expenses during the reporting period.Actual results could differ from those estimates and such differences could besignificant. The allowance for loan losses is a material estimate that isparticularly susceptible to significant change in the near term.

 

***Cash and Cash Equivalents—***For the purpose ofpresentation in the consolidated statements of cash flows, cash and cashequivalents includes cash on hand and amounts due from depository institutions,which includes interest bearing amounts available upon demand.

 

***Investment Securities—***The Company classifiesinvestment securities into one of two categories: held to maturity or availablefor sale. The Company does not engage in trading activities. Debt securitiesthat the Company has the positive intent and ability to hold to maturity areclassified as held to maturity and recorded at cost, adjusted for theamortization of premiums and the accretion of discounts.

 

Investment securities that the Companyintends to hold for indefinite periods of time are classified as available forsale and are recorded at fair value. Unrealized holding gains and losses areexcluded from earnings and reported net of tax in other comprehensive income.Investment securities in the available for sale portfolio may be used as partof the Company’s asset and liability management practices and may be sold inresponse to changes in interest rate risk, prepayment risk, or other economicfactors. At December 31, 2007 and 2006, the Company did not own anyinvestment securities classified as available for sale.

 

Premiums are amortized into interest incomeusing the interest method to the earlier of maturity or call date. Discountsare accreted into interest income using the interest method over the period tomaturity. The specific identification method of accounting is used to computegains or losses on the sales of investment securities.

 

Declines in the fair value of held tomaturity and available for sale securities below their cost that are deemed tobe other than temporary are reflected in earnings as realized losses. Inestimating other than temporary impairment losses, management considersindependent price quotations and the financial condition of the issuer.

 

***Loans Receivable—***The Bank originates andmaintains loans receivable that are substantially concentrated in its lendingterritory (primarily Northwest and Northcentral Arkansas). The majority of theBank’s loans are residential mortgage loans, commercial real estate loans, andconstruction loans for residential property. The Bank’s policy calls forcollateral or other forms of repayment assurance to be received from theborrower at the time of loan origination. Such collateral or other form of repaymentassurance is subject to changes in economic value due to various factors beyondthe control of the Bank.

 

Loans receivable that management has theintent and ability to hold for the foreseeable future or until maturity orpay-off are stated at unpaid principal balances adjusted for any charge-offs,the allowance for loan losses, and any deferred loan fees or costs. Deferredloan fees or costs and discounts on first mortgage loans are amortized oraccreted to income using the level-yield method over the remaining period tocontractual maturity.

 

Mortgage loans originated and committed forsale in the secondary market are carried at the lower of cost or estimatedmarket value in the aggregate. Such loans are generally carried at cost due tothe short period of time between funding and sale, generally two to threeweeks.

 

 

 

 

 

 

 

56

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

 

***Allowance for Loan Losses—***The allowance for loanlosses is established as losses are estimated to have occurred through aprovision for loan losses charged to earnings. Loan losses are charged againstthe allowance when management believes it is likely that a loan balance isuncollectible.  Subsequent recoveries, ifany, are credited to the allowance.

 

The allowance for loan losses representsmanagement’s estimate of incurred credit losses inherent in the Company’s loanportfolio as of the balance sheet date. The estimation of the allowance is based on a variety of factors, includingpast loan loss experience, the current credit profile of the Company’sborrowers, adverse situations that have occurred that may affect the borrowers’ability to repay, the estimated value of underlying collateral, and generaleconomic conditions.  Losses arerecognized when available information indicates that it is probable that a losshas been incurred and the amount of the loss can be reasonably estimated. Thisevaluation is inherently subjective as it requires estimates that aresusceptible to significant revision as more information becomes available orconditions change.

 

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

 

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

 

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

 

***Rate Lock Commitments—***The Bank enters intocommitments to originate loans whereby the interest rate on the loan isdetermined prior to funding (rate lock commitments). Rate lock commitments onmortgage loans that are intended to be sold are considered to be derivatives.Accordingly, such commitments, along with any related fees received frompotential borrowers, are recorded at fair value in derivative assets or liabilities,with changes in fair value recorded in the net gain or loss on sale of mortgageloans. Fair value is based on fees currently charged to enter into similaragreements, and for fixed rate commitments also considers the differencebetween current levels of interest rates and the committed rates.

 

***Real Estate Owned, Net—***Real estate owned representsforeclosed assets held for sale and is initially recorded at estimated fairvalue less estimated costs to sell, establishing a new cost basis. Subsequent toforeclosure, management periodically performs valuations and the assets arecarried at the lower of carrying amount or fair 

 

 

 

 

 

 

57

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value less costs to sell. Adjustments forestimated losses are charged to operations when any decline reduces the fairvalue to less than the carrying value. Costs and expenses related to major additions and improvements arecapitalized while maintenance and repairs that do not extend the lives of therespective assets are expensed.

 

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

 

***Cash Surrender Value of Life Insurance—***Cash surrendervalue of life insurance represents life insurance purchased by the Bank on aqualifying group of officers with the Bank designated as owner and beneficiaryof the policies.  The yield on thesepolicies is used to offset a portion of employment benefit costs.  The policies are recorded on the consolidatedstatements of financial condition at their cash surrender values with changesin cash surrender values reported in noninterest income.  Death benefits in excess of the cashsurrender value are recorded in noninterest income at the time of death.

 

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

 

***Interest Rate Risk—***The Bank’s asset base isexposed to risk including the risk resulting from changes in interest rates andchanges in the timing of cash flows. The Bank monitors the effect of such risksby considering the mismatch of the maturities of its assets and liabilities inthe current interest rate environment and the sensitivity of assets andliabilities to changes in interest rates. The Bank’s management has consideredthe effect of significant increases and decreases in interest rates andbelieves such changes, if they occurred, would be manageable and would notaffect the ability of the Bank to hold its assets as planned. However, the Bankis exposed to significant market risk in the event of significant and prolongedinterest rate changes.

 

***Employee Stock Ownership Plan—***Compensation expense for theEmployee Stock Ownership Plan (“ESOP”) is determined based on the average fairvalue of shares committed to be released during the period and is recognized asthe shares are committed to be released. For the purpose of earnings per share,ESOP shares are included in weighted-average common shares outstanding as theshares are committed to be released.

 

***Earnings Per Common Share—***Basic earnings per sharerepresents income available to common stockholders divided by theweighted-average number of common shares outstanding during the period. Dilutedearnings per share reflects additional common shares that would have beenoutstanding if dilutive potential common shares had been issued, as well as anyadjustment to income that would result from the assumed issuance. Potentialcommon shares that may be issued by the Company relate solely to outstandingstock options, and are determined using the treasury stock method.

 

***Recent Accounting Pronouncements—***In February 2006, theFASB issued SFAS No. 155, *Accountingfor Certain Hybrid Financial Instruments*. SFAS No. 155 amendsSFAS No. 133, *Accounting for DerivativeInstruments and Hedging Activities* and SFAS No. 140, *Accounting for Transfers and Servicing of FinancialAssets and Extinguishments of Liabilities.* SFAS No. 155 permitsfair value remeasurement for any hybrid financial instrument that contains anembedded derivative that would otherwise require bifurcation, if the holderirrevocably elects to account for the whole instrument on a fair value basis,and clarifies various aspects of SFAS No. 133 and SFAS No. 140relating to derivative financial instruments and qualifying special-purposeentities holding derivative financial instruments. SFAS No. 155 iseffective for all financial instruments acquired or issued for fiscal yearsbeginning after September 15, 2006. The adoption of this statement did not have a material effect on thefinancial statements of the Company.

 

In March 2006, FASB issued SFAS No. 156,*Accounting for Servicing of Financial Assets*—anamendment of FASB Statement No. 140. SFAS No. 156 requires an entityto recognize a servicing asset or servicing liability each time it undertakesan obligation to service a financial asset by entering into a servicingcontract as defined in the SFAS. It requires all separately recognizedservicing assets and servicing liabilities to be initially measured at fairvalue, if practicable, and allows an entity to choose between amortization orfair value measurement methods for each class of separately recognizedservicing assets and servicing liabilities. It also permits a one-timereclassification of available-for-sale securities to trading without tainting theinvestment portfolio, provided the available-for-sale securities are identifiedin some manner as offsetting the entity’s exposure to changes in fair value ofservicing assets or servicing liabilities. SFAS No. 156 is effective forfiscal years beginning after September 15, 2006.  The adoption of this statement did not have amaterial effect on the financial statements of the Company.

 

 

 

 

 

 

58

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InJuly 2006, the FASB issued FinancialInterpretation (FIN) No. 48, *Accountingfor Uncertainty in Income Taxes*— aninterpretation of FASB Statement No. 109, which is effective for fiscalyears beginning after December 15, 2006. FIN No. 48 provides guidanceregarding the recognition, measurement, presentation and disclosure in thefinancial statements of tax positions taken or expected to be taken on a taxreturn, including the decision whether to file or not file in a particularjurisdiction.  The cumulative effect of the changes arising from theinitial application of FIN 48 is required to be reported as an adjustment tothe opening balance of retained earnings in the period of adoption.  The adoption of thisstatement did not have a material effect on the financial statements of theCompany.

 

InSeptember 2006, the FASB issued SFAS No. 157, *Fair Value Measurements*. SFAS No. 157defines fair value, establishes a framework for measuring fair value, andexpands disclosures regarding fair value measurements. The statement applieswhenever other standards require or permit that assets or liabilities bemeasured at fair value. The statement does not require new fair valuemeasurements, but rather provides a definition and framework for measuring fairvalue, which will result in greater consistency and comparability among financialstatements prepared under accounting principles generally accepted in theUnited States of America. The statement is effective for financial statementsissued for fiscal years beginning after November 15, 2007.  We adopted SFAS No. 157 effective January 1,2008 for financial assets and liabilities and do not expect this adoption tohave a material effect on the financial statements of the Company but toenhance the level of disclosure for assets and liabilities for which fair valuedisclosures are required.

 

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

 

In December 2007, the FASB issued SFAS No. 160,*Noncontrolling Interests in ConsolidatedFinancial Statements*, an amendment of ARB No. 51.  This Statement applies to allentities that prepare consolidated financial statements, except not-for-profitorganizations, but will affect only those entities that have an outstandingnoncontrolling interest in one or more subsidiaries or that deconsolidate asubsidiary.  As a result, this Statementis not applicable to us.

 

In December 2007, the FASB issued SFAS No. 141R,*Business Combinations.*The objective ofthis Statement is to improve the relevance, representational faithfulness, andcomparability of the information that a reporting entity provides in itsfinancial reports about a business combination and its effects. To accomplishthat, this Statement establishes principles and requirements for how the acquirer:

 

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

 

b. Recognizes and measures the goodwillacquired in the business combination or a gain from a bargain purchase

 

c. Determines what information to disclose toenable users of the financial statements to evaluate the nature and financialeffects of the business combination.

 

This Statement applies prospectively tobusiness combinations for which the acquisition date is on or after thebeginning of the first annual reporting period beginning on or after December 15,2008. An entity may not apply it before that date.  The effective date of this Statement is thesame as that of the related FASB Statement No. 160, *Noncontrolling Interests in Consolidated FinancialStatements.*  Based on ourcurrent activities, we estimate that the adoption of this Statement will nothave a material effect on the financial statements of the Company.

 

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

 

The Bank is required to maintain average cash balances on hand or withthe Federal Reserve Bank. At December 31, 2007 and 2006, these reservebalances amounted to $436,000 and $508,000, respectively.

 

 

 

 

 

 

 

 

 

59

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**3.       INVESTMENTSECURITIES**

 

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

 
| ** **            | ** ** | **2007**      | ** ** |
|-----------------------|------------|---------------|------------|
| ** **            | ** ** | ** **    | ** ** | **Gross** | ** ** | **Gross** | ** ** | ** ** | ** ** |
| ** **            | ** ** | **Amortized** | ** ** | **Unrealized** | ** ** | **Unrealized** | ** ** | **Fair** | ** ** |
| **Held  To Maturity** | ** ** | **Cost**      | ** ** | **Gains** | ** ** | **Losses** | ** ** | **Value** | ** ** |
|                  |       |          |       |   |   |   |   |   |   |
| Municipal  securities |       | $             | 17,089     |   | $ | 85 |   | $ | 92 |   | $ | 17,082 |   |
| U.S.  Government and  |       |          |       |   |   |   |   |   |   |
| Agency obligations    |       | 78,501        |       | 259 |   | 31 |   | 78,729 |   |
|                  |       |          |       |   |   |   |   |   |   |
| Total                 |       | $             | 95,590     |   | $ | 344 |   | $ | 123 |   | $ | 95,811 |   |
|                  |       |          |       |   |   |   |   |   |   |
|                  | ** ** | **2006**      | ** ** |
| ** **            | ** ** | ** **    | ** ** | **Gross** | ** ** | **Gross** | ** ** | ** ** | ** ** |
| ** **            | ** ** | **Amortized** | ** ** | **Unrealized** | ** ** | **Unrealized** | ** ** | **Fair** | ** ** |
| **Held To Maturity**  | ** ** | **Cost**      | ** ** | **Gains** | ** ** | **Losses** | ** ** | **Value** | ** ** |
|                  |       |          |       |   |   |   |   |   |   |
| Municipal  securities |       | $             | 16,889     |   | $ | 110 |   | $ | 76 |   | $ | 16,923 |   |
| U.S.  Government and  |       |          |       |   |   |   |   |   |   |
| Agency obligations    |       | 43,857        |       | — |   | 1,091 |   | 42,766 |   |
|                  |       |          |       |   |   |   |   |   |   |
| Total                 |       | $             | 60,746     |   | $ | 110 |   | $ | 1,167 |   | $ | 59,689 |   |
|                  |       |          |       |   |   |   |   |   |   |

 

The following tables summarize the gross unrealized losses and fairvalue of the Company’s investments with unrealized losses that are not deemedto be other-than-temporarily impaired (in thousands), aggregated by investmentcategory and length of time that individual securities have been in acontinuous unrealized loss position at December 31, 2007 and 2006:

 
| ** **            | ** ** | **2007**                | ** ** |
|-----------------------|------------|-------------------------|------------|
| ** **            | ** ** | **Less than 12 Months** | ** ** | **12 Months or More** | ** ** | **Total** | ** ** |
| ** **            | ** ** | **Fair**                | ** ** | **Unrealized** | ** ** | **Fair** | ** ** | **Unrealized** | ** ** | **Fair** | ** ** | **Unrealized** | ** ** |
| ** **            | ** ** | **Value**               | ** ** | **Losses** | ** ** | **Value** | ** ** | **Losses** | ** ** | **Value** | ** ** | **Losses** | ** ** |
|                  |       |                    |       |   |   |   |   |   |   |   |   |   |   |
| Municipal  securities |       | $                       | 1,367      |   | $ | 45 |   | $ | 2,153 |   | $ | 47 |   | $ | 3,520 |   | $ | 92 |   |
| U.S.  Government and  |       |                    |       |   |   |   |   |   |   |   |   |   |   |
| Agency obligations    |       | —                  |       | — |   | 9,891 |   | 31 |   | 9,891 |   | 31 |   |
|                  |       |                    |       |   |   |   |   |   |   |   |   |   |   |
|                  |       | $                       | 1,367      |   | $ | 45 |   | $ | 12,044 |   | $ | 78 |   | $ | 13,411 |   | $ | 123 |   |

 
| ** **            | ** ** | **2006**                | ** ** |
|-----------------------|------------|-------------------------|------------|
| ** **            | ** ** | **Less than 12 Months** | ** ** | **12 Months or More** | ** ** | **Total** | ** ** |
| ** **            | ** ** | **Fair**                | ** ** | **Unrealized** | ** ** | **Fair** | ** ** | **Unrealized** | ** ** | **Fair** | ** ** | **Unrealized** | ** ** |
| ** **            | ** ** | **Value**               | ** ** | **Losses** | ** ** | **Value** | ** ** | **Losses** | ** ** | **Value** | ** ** | **Losses** | ** ** |
|                  |       |                    |       |   |   |   |   |   |   |   |   |   |   |
| Municipal  securities |       | $                       | 1,914      |   | $ | 19 |   | $ | 3,247 |   | $ | 57 |   | $ | 5,161 |   | $ | 76 |   |
| U.S.  Government and  |       |                    |       |   |   |   |   |   |   |   |   |   |   |
| Agency obligations    |       | 2,795                   |       | 22 |   | 39,971 |   | 1,069 |   | 42,766 |   | 1,091 |   |
|                  |       |                    |       |   |   |   |   |   |   |   |   |   |   |
|                  |       | $                       | 4,709      |   | $ | 41 |   | $ | 43,218 |   | $ | 1,126 |   | $ | 47,927 |   | $ | 1,167 |   |

 

The unrealized losses in 2006 are primarily a result of an increase ininterest rates during the applicable periods. The contractual terms of those investments do not permit the issuer tosettle the securities at a price less than the amortized cost of theinvestment.  Because the Company has the ability and intent to hold thoseinvestments until a recovery of fair value, which may be maturity, the Companydoes not consider those investments to be other-than-temporarily impaired at December 31,2007.

 

 

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The Company has pledged investment securities held to maturity withcarrying values of approximately $46.7 million and $50.2 million at December 31,2007 and 2006, respectively, as collateral for certain deposits in excess of$100,000.

 

The scheduled maturities of debt securities at December 31, 2007,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.

 

| ** **                        | ** ** | **2007**      | ** ** |
|-----------------------------------|------------|---------------|------------|
| ** **                        | ** ** | **Amortized** | ** ** | **Fair** | ** ** |
| ** **                        | ** ** | **Cost**      | ** ** | **Value** | ** ** |
|                              |       |          |       |   |   |
| Within  one year                  |       | $             | 3,390      |   | $ | 3,389 |   |
| Due  from one year to five years  |       | 7,580         |       | 7,576 |   |
| Due  from five years to ten years |       | 14,805        |       | 14,823 |   |
| Due  after ten years              |       | 69,815        |       | 70,023 |   |
|                              |       |          |       |   |   |
| Total                             |       | $             | 95,590     |   | $ | 95,811 |   |

 

As of December 31, 2007 and 2006, investments with carrying valuesof approximately $95.0 million and $60.2 million, respectively, have calloptions held by the issuer, of which approximately $87.5 million and $50.0million, respectively, are or were callable within one year.

 

**4.       LOANS RECEIVABLE**

 

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

 

| ** **                                      | ** ** | **2007** | ** ** | **2006** | ** ** |
|-------------------------------------------------|------------|----------|------------|----------|------------|
|                                            |       |     |       |     |       |
| Mortgage  loans:                                |       |     |       |     |       |
| One- to four-family  residences                 |       | $        | 230,005    |     | $          | 257,867 |   |
| Home equity and second  mortgage                |       | 34,315   |       | 35,192   |       |
| Commercial real estate                          |       | 119,681  |       | 134,647  |       |
| Multifamily                                     |       | 15,616   |       | 12,203   |       |
| Land                                            |       | 42,843   |       | 47,590   |       |
| Construction                                    |       | 153,724  |       | 195,912  |       |
|                                            |       |     |       |     |       |
| Total  mortgage loans                           |       | 596,184  |       | 683,411  |       |
|                                            |       |     |       |     |       |
| Commercial  loans                               |       | 22,713   |       | 26,281   |       |
|                                            |       |     |       |     |       |
| Consumer  loans:                                |       |     |       |     |       |
| Automobile                                      |       | 9,531    |       | 12,086   |       |
| Other                                           |       | 14,537   |       | 13,815   |       |
|                                            |       |     |       |     |       |
| Total  consumer and other loans                 |       | 24,068   |       | 25,901   |       |
| Less:                                           |       |     |       |     |       |
| Undisbursed loan funds                          |       | (36,868  | )          | (40,069  | )          |
| Unearned discounts and net  deferred loan costs |       | 321      |       | 143      |       |
| Allowance  for loan losses                      |       | (5,162   | )          | (2,572   | )          |
|                                            |       |     |       |     |       |
| Loans  receivable—net                      |       | $        | 601,256    |     | $          | 693,095 |   |

 

At December 31, 2007 and 2006, loans receivable included loanscommitted to be sold with net book values of $2.8 million and $1.1 million,respectively.

 

 

 

 

 

 

 

 

 

 

61

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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, 2007and 2006 were $27.8 million and $22.2 million, respectively.  Servicing loans for others generally consistsof collecting mortgage payments, maintaining escrow accounts, disbursingpayments to investors, and foreclosure processing.   Servicing income for the years ended December 31,2007, 2006, and 2005 was $110,000, $121,000, and $100,000, respectively.

 

The following is a summary of information pertaining to impaired andnonaccrual loans (in thousands):

 

| ** **                                                   | ** ** | **December 31** |
|--------------------------------------------------------------|------------|----------------------|
| ** **                                                   | ** ** | **2007**             | ** ** | **2006** |
| ** **                                                   | ** ** | ** **           | ** ** | ** ** |
| Impaired  loans without a valuation allowance                |       | $                    | 9,269 |   | $ | 5,324 |
| Impaired  loans with a valuation allowance                   |       | $                    | 7,932 |   | $ | — |
|                                                         |       |                 |   |   |
| Total  impaired loans                                        |       | $                    | 17,201 |   | $ | 5,324 |
|                                                         |       |                 |   |   |
| Total  nonaccrual loans                                      |       | $                    | 33,329 |   | $ | 19,015 |
|                                                         |       |                 |   |   |
| Total  loans past-due ninety days or more and still accruing |       | $                    | 2,412 |   | $ | 668 |

 

| ** **                                                    | ** ** | **Year Ended**       |
|---------------------------------------------------------------|------------|----------------------|
| ** **                                                    | ** ** | **December 31** |
| ** **                                                    | ** ** | **2007**             | ** ** | **2006** |
|                                                          |       |                 |   |   |
| Average  investment in impaired loans                         |       | $                    | 9,760 |   | $ | 3,188 |
|                                                          |       |                 |   |   |
| Interest  income recognized on impaired loans                 |       | $                    | 195 |   | $ | 135 |
|                                                          |       |                 |   |   |
| Interest  income recognized on a cash basis on impaired loans |       | $                    | — |   | $ | — |

 

Interest income recorded during the years ended December 31, 2007,2006, and 2005 for nonaccrual loans was $458,000, $403,000, and $35,000, respectively.  Under the original terms, these loans wouldhave reported approximately $2.6 million, $1.5 million, and $169,000, ofinterest income for the years ended December 31, 2007, 2006, and 2005,respectively.

 

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

 

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

 
| ** **             | ** ** | **2007** | ** ** | **2006** |
|------------------------|------------|----------|------------|----------|
|                   |       |     |       |     |
| Loans                  |       | $        | 7,899      |     | $ | 9,309 |
| Investment  securities |       | 1,143    |       | 690      |
|                   |       |     |       |     |
| Total                  |       | $        | 9,042      |     | $ | 9,999 |

 

**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):

 
| ** **                       | ** ** | **2007**  | ** ** | **2006**         | ** ** | **2005**  | ** ** |
|----------------------------------|------------|-----------|------------|------------------|------------|-----------|------------|
| ** **                       | ** ** | **Loans** | ** ** | **Real  Estate** | ** ** | **Loans** | ** ** | **Real  Estate** | ** ** | **Loans** | ** ** | **Real  Estate** | ** ** |
|                             |       |      |       |             |       |      |       |   |   |   |   |   |   |
| Balance—beginning  of year  |       | $         | 2,572      |             | $          | —    |       | $ | 2,114 |   | $ | — |   | $ | 1,846 |   | $ | — |   |
|                             |       |      |       |             |       |      |       |   |   |   |   |   |   |
| Provisions for estimated  losses |       | 4,028     |       | 494              |       | 1,482     |       | 93 |   | 1,101 |   | 30 |   |
| Recoveries                       |       | 181       |       | —           |       | 171       |       | — |   | 123 |   | — |   |
| Losses charged off               |       | (1,619    | )          | (494             | )          | (1,195    | )          | (93 | ) | (956 | ) | (30 | ) |
|                             |       |      |       |             |       |      |       |   |   |   |   |   |   |
| Balance—end  of year        |       | $         | 5,162      |             | $          | —    |       | $ | 2,572 |   | $ | — |   | $ | 2,114 |   | $ | — |   |

 

 

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** **

**7.       OFFICE PROPERTIES AND EQUIPMENT**

 

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

 
| ** **                                | ** ** | **2007** | ** ** | **2006** | ** ** |
|-------------------------------------------|------------|----------|------------|----------|------------|
|                                      |       |     |       |     |       |
| Land  and land improvements               |       | $        | 6,318      |     | $          | 4,993 |   |
| Buildings  and improvements               |       | 16,842   |       | 15,436   |       |
| Furniture  and equipment                  |       | 6,324    |       | 6,006    |       |
| Automobiles                               |       | 484      |       | 466      |       |
| Construction  in progress                 |       | 3,376    |       | 1,344    |       |
|                                      |       |     |       |     |       |
| Total                                     |       | 33,344   |       | 28,245   |       |
|                                      |       |     |       |     |       |
| Accumulated  depreciation                 |       | (9,081   | )          | (7,861   | )          |
|                                      |       |     |       |     |       |
| Office  properties and equipment—net |       | $        | 24,263     |     | $          | 20,384 |   |

 

Depreciation expense for the years ended December 31, 2007, 2006,and 2005, amounted to approximately $1.4 million, $1.3 million and $1.2million, respectively.

 

**8.       DEPOSITS**

 

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

 
| ** **                                                                                                        | ** ** | **2007** | ** ** | **2006** |
|-------------------------------------------------------------------------------------------------------------------|------------|----------|------------|----------|
|                                                                                                              |       |     |       |     |
| Checking accounts,  including noninterest bearing deposits of $27,796 and $39,328 in 2007 and  2006, respectively |       | $        | 127,491    |     | $ | 139,372 |
| Money  market accounts                                                                                            |       | 51,424   |       | 51,827   |
| Savings  accounts                                                                                                 |       | 25,088   |       | 26,824   |
| Certificates  of deposit                                                                                          |       | 426,411  |       | 434,242  |
|                                                                                                              |       |     |       |     |
| Total                                                                                                             |       | $        | 630,414    |     | $ | 652,265 |

 

Overdrafts of checking accounts of $698,000 and $425,000 at December 31,2007 and 2006, respectively, have been reclassified for financial reporting andare reflected in net loans receivable on the consolidated statements offinancial condition.

 

The aggregate amount of time deposits in denominations of $100 thousandor more was approximately $125.9 million and $137.2 million at December 31,2007 and 2006, respectively.

 

At December 31, 2007, scheduled maturities of certificates ofdeposit are as follows (in thousands):

 

| **Year  Ending December 31** | ** ** | ** ** |
|-----------------------------------|------------|------------|
|                              |       |       |
| 2008                              |       | $          | 341,859 |
| 2009                              |       | 29,107     |
| 2010                              |       | 20,800     |
| 2011                              |       | 16,264     |
| 2012                              |       | 10,478     |
| 2013  and thereafter              |       | 7,903      |
|                              |       |       |
| Total                             |       | $          | 426,411 |

 

 

 

 

 

 

 

 

 

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

 
| ** **                          | ** ** | **Year Ended December 31** | ** ** |
|-------------------------------------|------------|---------------------------------|------------|
| ** **                          | ** ** | **2007**                        | ** ** | **2006** | ** ** | **2005** | ** ** |
|                                |       |                            |       |   |   |   |   |
| Interest  bearing checking accounts |       | $                               | 1,877      |   | $ | 1,394 |   | $ | 412 |   |
| Money  market accounts              |       | 1,486                           |       | 1,503 |   | 1,455 |   |
| Savings  and certificate accounts   |       | 20,608                          |       | 17,925 |   | 12,854 |   |
| Early  withdrawal penalties         |       | (98                             | )          | (179 | ) | (104 | ) |
|                                |       |                            |       |   |   |   |   |
| Total                               |       | $                               | 23,873     |   | $ | 20,643 |   | $ | 14,617 |   |
|                                     |            |                                 |            |  |  |  |  |  |  |  |  |

 

Eligible deposits of the Bank are insured up to $100,000 by the DepositInsurance Fund of the FDIC.  Effective April 1,2006, the FDIC increased the federal insurance coverage limit to $250,000 forretirement accounts.

 

**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 0.06% of total assets as of theprevious December 31 and 4.10% of outstanding advances. No ready marketexists for such stock and it has no quoted market value. The carrying value ofthe stock is its cost.

 

The Bank pledges 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), multifamily 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, 2007 and 2006,consisted of the following (in thousands):

 
| ** **                           | ** ** | **2007**              | ** ** | **2006**   | ** ** |
|--------------------------------------|------------|-----------------------|------------|------------|------------|
| **Amounts  Maturing in Year Ending** | ** ** | **Weighted  Average** | ** ** | ** ** | ** ** | **Weighted  Average** | ** ** | ** ** | ** ** |
| **December 31**                 | ** ** | **Rate**              | ** ** | **Amount** | ** ** | **Rate** | ** ** | **Amount** | ** ** |
|                                 |       |                  |       |       |       |   |   |   |   |
| 2007                                 |       | —                | %          | $          | —     |   | 4.68 | % | $ | 59,818 |   |
| 2008                                 |       | 4.48                  |       | 35,905     |       | 4.50 |   | 30,594 |   |
| 2009                                 |       | 4.54                  |       | 26,636     |       | 4.48 |   | 16,308 |   |
| 2010                                 |       | 4.61                  |       | 9,353      |       | 4.36 |   | 5,008 |   |
| 2011                                 |       | 4.61                  |       | 7,514      |       | 4.49 |   | 6,151 |   |
| 2012                                 |       | 4.56                  |       | 1,570      |       | 4.44 |   | 1,317 |   |
| Thereafter                           |       | 4.26                  |       | 1,109      |       | 4.26 |   | 1,109 |   |
|                                 |       |                  |       |       |       |   |   |   |   |
| Total                                |       | 4.53                  | %          | $          | 82,087     |   | 4.58 | % | $ | 120,305 |   |
|                                      |            |                       |            |            |            |  |  |  |  |  |  |  |

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

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** **

**10.     INCOME TAXES**

 

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

 
| ** **                       | ** ** | **Year Ended December 31** | ** ** |
|----------------------------------|------------|---------------------------------|------------|
| ** **                       | ** ** | **2007**                        | ** ** | **2006** | ** ** | **2005** | ** ** |
|                             |       |                            |       |   |   |   |   |
| Income  tax provision (benefit): |       |                            |       |   |   |   |   |
| Current:                         |       |                            |       |   |   |   |   |
| Federal                          |       | $                               | 1,800      |   | $ | 2,851 |   | $ | 3,275 |   |
| State                            |       | 130                             |       | 391 |   | 461 |   |
| Total current                    |       | 1,930                           |       | 3,242 |   | 3,736 |   |
|                             |       |                            |       |   |   |   |   |
| Deferred:                        |       |                            |       |   |   |   |   |
| Federal                          |       | (1,328                          | )          | 102 |   | (69 | ) |
| State                            |       | (257                            | )          | 35 |   | 56 |   |
| Total deferred                   |       | (1,585                          | )          | 137 |   | (13 | ) |
|                             |       |                            |       |   |   |   |   |
| Total                            |       | $                               | 345        |   | $ | 3,379 |   | $ | 3,723 |   |
|                                  |            |                                 |            |  |  |  |  |  |  |  |  |

 

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** | ** ** |
|-------------------------------------------|------------|---------------------------------|------------|
| ** **                                | ** ** | **2007**                        | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                                | ** ** | ** **                      | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Taxes  at statutory rate                  |       | $1,016                          |       | 34.0 | % | $3,659 |   | 34.0 | % | $3,935 |   | 34.0 | % |
| Increase (decrease)  resulting from:      |       |                            |       |   |   |   |   |   |   |   |   |   |   |
| State  income tax—net                |       | (141                            | )          | (4.7 | ) | 260 |   | 2.4 |   | 269 |   | 2.3 |   |
| Earnings on life  insurance policies |       | (259                            | )          | (8.7 | ) | (252 | ) | (2.3 | ) | (257 | ) | (2.2 | ) |
| Nontaxable  investments                   |       | (203                            | )          | (6.8 | ) | (207 | ) | (1.9 | ) | (211 | ) | (1.8 | ) |
| Other—net                            |       | (68                             | )          | (2.3 | ) | (81 | ) | (0.8 | ) | (13 | ) | (0.1 | ) |
|                                      |       |                            |       |   |   |   |   |   |   |   |   |   |   |
| Total                                     |       | $345                            |       | 11.5 | % | $3,379 |   | 31.4 | % | $3,723 |   | 32.2 | % |

 

The Company’s net deferred tax asset (liability) account was comprisedof the following at December 31 (in thousands):

 
| ** **                          | ** ** | **2007** | ** ** | **2006** | ** ** |
|-------------------------------------|------------|----------|------------|----------|------------|
|                                |       |     |       |     |       |
| Deferred  tax assets:               |       |     |       |     |       |
| Allowance for loan losses           |       | $        | 1,977      |     | $          | 985 |   |
| Real estate owned                   |       | 147      |       | 30       |       |
|                                |       |     |       |     |       |
| Total  deferred tax assets          |       | 2,124    |       | 1,015    |       |
|                                |       |     |       |     |       |
| Deferred  tax liabilities:          |       |     |       |     |       |
| Office properties                   |       | (853     | )          | (854     | )          |
| Federal Home Loan Bank  stock       |       | (509     | )          | (692     | )          |
| Pension plan contribution           |       | (208     | )          | (500     | )          |
| Prepaid expenses                    |       | (106     | )          | (106     | )          |
|                                |       |     |       |     |       |
| Total deferred tax  liabilities     |       | (1,676   | )          | (2,152   | )          |
|                                |       |     |       |     |       |
| Net  deferred tax asset (liability) |       | $        | 448        |     | $          | (1,137 | ) |

 

 

 

 

 

 

 

65

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Specifically exempted from deferred tax recognition requirements arebad debt reserves for tax purposes of U.S. savings and loans in theinstitution’s base year, as defined. Base year reserves totaled approximately$4.2 million. Consequently, a deferred tax liability of approximately $1.6million related to such reserves was not provided for in the consolidatedstatements of financial condition at December 31, 2007 and 2006. Paymentof dividends to shareholders out of retained earnings deemed to have been madeout of earnings previously set aside as bad debt reserves may create taxableincome to the Bank. No provision has been made for income tax on such adistribution as the Bank does not anticipate making such distributions.

 

The Company files income tax returns in the U.S. federal jurisdictionand the state of Arkansas. The Company is subject to U.S. federal and stateincome tax examinations by tax authorities for tax years endingDecember 31, 2004 and forward.

 

**11.     STOCK BASED COMPENSATION**

 

In December 2004, FASB issued SFAS No. 123(R), Share-BasedPayment. SFAS No. 123(R) amended SFAS No. 123, Accounting forStock-Based Compensation and superseded Accounting Principles Board(“APB”) Opinion No. 25, Accounting for Stock Issued to Employees. InMarch 2005, the SEC issued SAB No. 107 to provide its guidance on thevaluation of share-based payments for public companies. SFASNo. 123(R) requires companies to recognize all share-basedpayments, which include stock options and restricted stock, in compensationexpense over the service period of the share-based payment award. SFASNo. 123(R) establishes fair value as the measurement objective inaccounting for share-based  paymentarrangements and requires all entities to apply a fair-value-basedmeasurement method in accounting for share-based payment transactionswith employees, except for equity instruments held by employee share ownershipplans. At December 31, 2007, the Company had stock awards outstandingunder a Stock Option Plan (the “SOP”) and a Management Recognition andRetention Plan (the “MRR Plan”).

 

The Company adopted SFAS No. 123(R) on January 1, 2006using the modified prospective method in which compensation cost is recognizedover the service period for all awards granted subsequent to the Company’sadoption of SFAS No. 123(R) as well as for the unvested portion ofawards outstanding as of the Company’s adoption of SFAS No. 123(R). Inaccordance with the modified prospective method, results for prior periods havenot been restated.

 

Compensation expense related to the amortization of MRR Plan awards wasrecognized in the income statement prior to the implementation of SFAS No. 123(R).Compensation expense attributable to stock options during the years ended December 31,2007 and 2006 totaled approximately $10,000 and $16,000, respectively.  Prior to the adoption of SFAS No. 123(R),the Company applied the recognition and measurement principles of APB No. 25,Accounting for Stock Issued to Employees as allowed by SFAS No. 123 andSFAS No. 148, Accounting for Stock-Based Compensation—Transition andDisclosure. Accordingly, no stock based compensation was recognized in netincome for stock options for the year ended December 31, 2005 as alloptions granted had an exercise price equal to the market value of theunderlying common stock on the date of the grant and the related number ofoptions granted were fixed at that point in time.  Had compensation cost for the SOP beendetermined based on the fair value at the grant dates for awards under the SOPconsistent with the methods of SFAS No. 123, the effect on the Company’spro forma net income and pro forma earnings per share would not have beensignificant.

 

**Stock Option Plan**—The Stock Option Plan provided for acommittee of the Company’s Board of Directors to award incentive stock options,non-qualified or compensatory stock options and stock appreciation rightsrepresenting up to 1,030,750 shares of Company stock. One-fifth of the optionsgranted vested immediately upon grant, with the balance vesting in equalamounts on the four subsequent anniversary dates of the grant. Options grantedvest immediately in the event of retirement, disability, or death. Stockoptions granted expire in ten years unless grantee terminates employment, inwhich case the award expires five years after termination date or ten yearsafter grant date, whichever comes first. The SOP expired during 2007, so no further option grants will be made.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

66

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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:

 
| ** **         | ** ** | ** **                     | ** ** | **Options Outstanding  December 31, 2007** | ** ** | **Options Exercisable  December 31, 2007**             |
|--------------------|------------|--------------------------------|------------|-------------------------------------------------|------------|-------------------------------------------------------------|
| **Year   Granted** | ** ** | **Range of   Exercise Prices** | ** ** | **Number of  Options  Outstanding**   | ** ** | **Weighted   Average   Remaining   Contractual  Life** | ** ** | **Weighted   Average  Exercise  Price Per   Share** | ** ** | **Number of   Options   Exercisable** | ** ** | **Weighted  Average  Exercise  Price Per   Share** |
| 1998               |       | 11.63                          |       | 4,000                                           |       | 0.1  years                                                  |   | 11.63 |   | 4,000 |   | 11.63 |
| 1999               |       | 9.31                           |       | 1,600                                           |       | 0.1  years                                                  |   | 9.31 |   | 1,600 |   | 9.31 |
| 2000               |       | 9.13                           |       | 450                                             |       | 2.7  years                                                  |   | 9.13 |   | 450 |   | 9.13 |
| 2001               |       | 9.34  - 11.35                  |       | 9,200                                           |       | 3.3  years                                                  |   | 10.67 |   | 9,200 |   | 10.67 |
| 2002               |       | 12.32                          |       | 1,200                                           |       | 2.4  years                                                  |   | 12.32 |   | 1,200 |   | 12.32 |
| 2003               |       | 12.93  - 16.11                 |       | 1,712                                           |       | 5.4  years                                                  |   | 15.41 |   | 1,712 |   | 15.41 |
| 2004               |       | 19.25  - 21.50                 |       | 2,680                                           |       | 6.1  years                                                  |   | 20.29 |   | 2,096 |   | 20.26 |
| 2005               |       | 24.81                          |       | 1,000                                           |       | 7.9  years                                                  |   | 24.81 |   | 600 |   | 24.81 |
| 2006               |       | 22.40  - 25.50                 |       | 1,200                                           |       | 7.6  years                                                  |   | 24.21 |   | 600 |   | 24.47 |
|               |       |                           |       | 23,042                                          |       | 3.3  years                                                  |   | 13.59 |   | 21,458 |   | 12.90 |

 

A summary of the status of the Company’s SOP as of December 31,2007, 2006, and 2005, and changes during the years ending on those dates arepresented below:

 
| ** **                               | ** ** | ** ** | ** ** | **Weighted** |
|------------------------------------------|------------|------------|------------|--------------|
| ** **                               | ** ** | ** ** | ** ** | **Average**  |
| ** **                               | ** ** | ** ** | ** ** | **Exercise** |
| ** **                               | ** ** | **Shares** | ** ** | **Price**    |
| ** **                               | ** ** | ** ** | ** ** | ** **   |
| Outstanding—January 1,  2005   |       | 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 |
|                                     |       |       |       |         |
| Exercised                                |       | (166,997   | )          | 9.74         |
| Granted                                  |       | 1,500      |       | 24.47        |
| Expired                                  |       | —     |       | —       |
| Forfeited                                |       | (412       | )          | 14.66        |
|                                     |       |       |       |         |
| Outstanding—December 31,  2006 |       | 179,359    |       | $            | 10.30 |
|                                     |       |       |       |         |
| Exercised                                |       | (154,817   | )          | 9.80         |
| Granted                                  |       | —     |       |         |
| Expired                                  |       | (1,200     | )          | 8.53         |
| Forfeited                                |       | (300       | )          | 25.50        |
|                                     |       |       |       |         |
| Outstanding—December 31,  2007 |       | 23,042     |       | $            | 13.59 |

 

***Management Recognition and RetentionPlan—***The MRR Plan provided for a committee of theCompany’s Board of Directors to award restricted stock to key officers as wellas non-employee directors. The MRR Plan authorized the Company to grant up to412,300 shares of the Company stock, of which 405,688 shares have been grantedthrough December 31, 2007. The MRR Plan expired during 2007, so no furtherawards will be made.  Compensationexpense has been recognized over the vesting period based on the fair market value of the shareson the grant date. Shares granted will be deemed vested in the event ofdisability or death. Approximately $29,000, $66,000, and $27,000 incompensation expense was recognized during each of the years ended December 31,2007, 2006 and 2005.

 

 

 

67

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**12.     EMPLOYEE BENEFIT PLANS**

 

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

 

Effective June 1, 2006, the Companyadopted the First Federal Bancshares of Arkansas, Inc. Employees’ Savings &Profit Sharing Plan and Trust (the “401(k) Plan”).  The Company merged the ESOP into the 401(k) Planeffective June 1, 2006.  Participantaccounts under the ESOP will be maintained as a separate source under the 401(k) Planwith ESOP provisions concerning matters such as vesting, withdrawals, loans,dividends, and distributions remaining in effect.  During the years ended December 31,2006, and 2005, ESOP expense was approximately $508,000, and $2.0 million,respectively.  There was no expenseincurred related to the ESOP during 2007.

 

***401(k) Plan******—***The Company has establisheda 401(k) Plan whereby substantially all employees participate in thePlan.  Employees may contribute up to 75%of their salary subject to certain limits based on federal tax laws.  The Company makes matching contributionsequal to 100% of the first 3% plus 50% of contributions between 3% and 5% of anemployee’s compensation contributed to the Plan.  Matching contributions vest immediately tothe employee upon enrollment in the Plan. During the year ended December 31, 2007 and 2006, 401(k) Planexpense was approximately $309,000 and $174,000, respectively.

 

***Other Postretirement Benefits—***The Bank is a participant ina multi-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 $761,000, $745,000 and$660,000 for the years ended December 31, 2007, 2006, and 2005,respectively.

 

**13.     EARNINGS PER SHARE**

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

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

 

 

 

 

 

 

 

 

 

 

 

68

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

 

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

** **

The Bank is a party to financial instrumentswith off-balance sheet risk in the normal course of business to meet thefinancing needs of its customers. These financial instruments includecommitments to extend credit and standby letters of credit. Those instrumentsinvolve, to varying degrees, elements of credit risk in excess of the amountrecognized in the consolidated statements of financial condition.

 

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

 

Commitments to extend credit are agreementsto lend to a customer as long as there is no violation of any conditionestablished in the contract. Commitments generally have fixed expiration datesor other termination clauses. The Bank evaluates each customer’screditworthiness on a case-by-case basis. The amount of collateral obtained, ifdeemed necessary by the Bank upon extension of credit, is based on management’scredit evaluation of the counterparty. Such collateral consists primarily ofresidential properties. Standby letters of credit are conditional commitmentsissued by the Bank to guarantee the performance of a customer to a third party.The credit risk involved in issuing letters of credit is essentially the sameas that involved in extending loan facilities to customers.

 

Thefunding period for construction loans is generally six to eighteen months andcommitments to originate mortgage loans are generally outstanding for 60 daysor less.

 

The Company, in the normal course ofbusiness, makes commitments to buy or sell assets or to incur or fundliabilities. Commitments include, but are not limited to:

 

·                  theorigination, purchase or sale of loans;

 

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

 

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

 

At December 31, 2007, the Bank’soff-balance sheet arrangements principally included lending commitments, whichare described )below. At December 31, 2007, the Company had no interestsin non-consolidated special purpose entities.

 

At December 31, 2007, commitmentsincluded:

 

·                  total approvedloan origination commitments outstanding amounting to $6.1 million, includingapproximately $660,000 of loans committed to sell;

 

·                  rate lockagreements with customers of $3.9 million, all of which have been locked withan investor;

 

·                  funded mortgageloans committed to sell of $2.8 million;

 

·                  unadvancedportion of construction loans of $36.9 million;

 

·                  unused lines ofcredit of $22.4 million;

 

·                  outstandingstandby letters of credit of $110,000;

 

·                  totalpredetermined overdraft protection limits of $13.6 million; and

 

·                  certificates ofdeposit scheduled to mature in one year or less totaling $341.9 million.

 

Total unfunded commitments to originate loansfor sale and the related commitments to sell of $3.9 million meet thedefinition of a derivative financial instrument. The related asset andliability are considered immaterial at December 31, 2007.

 

 

69

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Historically, a very small percentage ofpredetermined overdraft limits have been used. At December 31, 2007,overdrafts of accounts with Bounce Protectionä represented usage of 4.62%of the limit.

 

Based on historical experience, managementbelieves that a significant portion of maturing deposits will remain with theBank. Management anticipates that the Bank will continue to have sufficientfunds, through repayments, deposits and borrowings, to meet our currentcommitments.

 

**15.     FAIR VALUE OF FINANCIAL INSTRUMENTS**

** **

The estimated fair value amounts have beendetermined by the Company using available market information and appropriatevaluation methodologies. However, considerable judgment is required tointerpret market data to develop the estimates of fair value. Accordingly, theestimates presented herein are not necessarily indicative of the amounts theCompany could realize in a current market exchange. The use of different marketassumptions and/or estimation methodologies may have a material effect on theestimated fair value amounts. The estimated fair values of financialinstruments are as follows (in thousands):

 
| ** **                                             | ** ** | **December 31, 2007** | ** ** | **December 31, 2006** |
|--------------------------------------------------------|------------|----------------------------|------------|----------------------------|
| ** **                                             | ** ** | ** **                 | ** ** | **Estimated**              | ** ** | ** ** | ** ** | **Estimated** |
| ** **                                             | ** ** | **Carrying**               | ** ** | **Fair**                   | ** ** | **Carrying** | ** ** | **Fair** |
| ** **                                             | ** ** | **Value**                  | ** ** | **Value**                  | ** ** | **Value** | ** ** | **Value** |
| ASSETS:                                                |       |                       |       |                       |   |   |   |   |
| Cash and cash equivalents                              |       | $                          | 27,387     |                       | $ | 27,387 |   | $ | 35,518 |   | $ | 35,518 |
| Investment securities—held  to maturity           |       | 95,590                     |       | 95,811                     |   | 60,746 |   | 59,689 |
| Federal Home Loan Bank  stock                          |       | 4,433                      |       | 4,433                      |   | 7,089 |   | 7,089 |
| Loans receivable—net                              |       | 601,256                    |       | 605,171                    |   | 693,095 |   | 691,367 |
| Cash surrender value of  life insurance                |       | 20,159                     |       | 20,159                     |   | 19,396 |   | 19,396 |
| Accrued interest  receivable                           |       | 9,042                      |       | 9,042                      |   | 9,999 |   | 9,999 |
| Commitments                                            |       | 7                          |       | 7                          |   | 21 |   | 21 |
|                                                   |       |                       |       |                       |   |   |   |   |
| LIABILITIES:                                           |       |                       |       |                       |   |   |   |   |
| Deposits:                                              |       |                       |       |                       |   |   |   |   |
| Checking, money market and  savings accounts           |       | 204,003                    |       | 204,003                    |   | 218,023 |   | 218,023 |
| Certificates of deposit                                |       | 426,411                    |       | 428,859                    |   | 434,242 |   | 433,211 |
| Federal Home Loan Bank  advances                       |       | 82,087                     |       | 82,379                     |   | 120,305 |   | 119,803 |
| Accrued interest payable                               |       |                       |       |                       |   |   |   |   |
| Advance payments by  borrowers for taxes and insurance |       | 575                        |       | 575                        |   | 666 |   | 666 |
| Commitments                                            |       | 7                          |       | 7                          |   | 21 |   | 21 |
|                                                        |            |                            |            |                            |  |  |  |  |  |  |  |  |

 

For cash and cash equivalents, Federal HomeLoan Bank stock, cash surrender value of life insurance and accrued interestreceivable, the carrying value is a reasonable estimate of fair value,primarily because of the short-term nature of the instruments or, as to FederalHome Loan Bank stock, the ability to sell the stock back to the Federal HomeLoan Bank at cost. The fair value of investment securities is based on quotedmarket prices, dealer quotes and prices obtained from independent pricingservices. The fair value of variable rate loans is based on repricing dates.Fixed rate loans were valued using discounted cash flows. The discount ratesused to determine the present value of these loans were based on interest ratescurrently being charged by the Bank on comparable loans as to credit risk andterm.

 

The fair value of checking 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 arebased on pertinent information available to management as of December 31,2007 and 2006. Although management is not aware of any factors that wouldsignificantly affect the estimated fair value amounts, such amounts have notbeen comprehensively revalued for purposes of these financial statements sincethe reporting date and, therefore, current estimates of fair value may differsignificantly from the amounts presented herein.

 

 

 

 

 

 

 

70

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**16.    ****CONTINGENCIES**

 

The Company is a defendant in certain claimsand legal actions arising in the ordinary course of business. In the opinion ofmanagement, after consultation with legal counsel, the ultimate disposition ofthese matters is not expected to have a material adverse effect on theconsolidated financial statements of the Company.

 

**17.     RETAINED EARNINGS—SUBSTANTIALLY RESTRICTED**

 

Upon conversion, the Company established aspecial liquidation account for the benefit of eligible account holders and thesupplemental eligible account holders in an amount equal to the net worth ofthe Bank as of the date of its latest statement of financial conditioncontained in the final offering circular used in connection with theconversion. The liquidation account will be maintained for the benefit ofeligible account holders and supplemental eligible account holders who continueto maintain their accounts in the Bank after conversion. In the event of acomplete liquidation (and only in such event), each eligible and supplementaleligible account holder will be entitled to receive a liquidation distributionfrom the liquidation account in an amount proportionate to the current adjustedqualifying balances for accounts then held.

 

The Company may not declare or pay cashdividends on its shares of common stock if the effect thereof would cause theCompany’s stockholders’ equity to be reduced below applicable regulatorycapital maintenance requirements for insured institutions or below the specialliquidation account referred to above.

 

**18.     REGULATORY MATTERS**

** **

The Bank is subject to various regulatorycapital requirements administered by the OTS. Failure to meet minimum capitalrequirements can initiate certain mandatory—and possible additionaldiscretionary—actions by regulators that, if undertaken, could have a directand material effect on the Bank’s financial statements. Under capital adequacyguidelines and the regulatory framework for prompt corrective action, the Bankmust meet specific capital guidelines that involve quantitative measures of theBank’s assets, liabilities, and certain off-balance sheet items as calculatedunder regulatory accounting practices. The Bank’s capital amounts andclassification are also subject to qualitative judgments by the regulatorsabout components, risk weightings, and other factors.

 

Quantitative measures established byregulation to ensure capital adequacy require the Bank to maintain minimumamounts and ratios (set forth in the following table) of tangible capital (asdefined) to tangible assets (as defined) and core capital (as defined) toadjusted tangible assets (as defined), and of total risk-based capital (as defined)to risk-weighted assets (as defined). Management believes, as of December 31,2007, that the Bank meets all capital adequacy requirements to which it issubject.

 

At December 31, 2007 and 2006, the mostrecent notification from the OTS categorized the Bank as well capitalized underthe regulatory framework for prompt corrective action. To be categorized aswell capitalized the Bank must maintain minimum core (Tier I leverage), Tier Irisk-based, and total risk-based ratios as set forth in the table. There are noconditions or events since that notification that management believes havechanged the Bank’s category.

 

The Bank’s actual capital amounts (inthousands) and ratios are also presented in the table:

 
| ** **                                | ** ** | **Actual** | ** ** | **For Capital  Adequacy Purposes** | ** ** | **To be Categorized   as Well   Capitalized Under   Prompt Corrective   Action Provisions** | ** ** |
|-------------------------------------------|------------|------------|------------|------------------------------------|------------|---------------------------------------------------------------------------------------------|------------|
| ** **                                | ** ** | **Amount** | ** ** | **Ratio**                          | ** ** | **Amount**                                                                                  | ** ** | **Ratio** | ** ** | **Amount** | ** ** | **Ratio** | ** ** |
|                                      |       |       |       |                               |       |                                                                                        |       |   |   |   |   |   |   |
| As  of December 31, 2007:            |       |       |       |                               |       |                                                                                        |       |   |   |   |   |   |   |
|                                      |       |       |       |                               |       |                                                                                        |       |   |   |   |   |   |   |
| Tangible Capital to  Tangible Assets      |       | $          | 72,996     |                               | 9.22       | %                                                                                           | $          | 11,875 |   | 1.50 | % | N/A |   | N/A |   |
|                                      |       |       |       |                               |       |                                                                                        |       |   |   |   |   |   |   |
| Core Capital to Adjusted  Tangible Assets |       | 72,996     |       | 9.22                               | %          | 31,666                                                                                      |       | 4.00 | % | $ | 39,582 |   | 5.00 | % |
|                                      |       |       |       |                               |       |                                                                                        |       |   |   |   |   |   |   |
| Total Capital to  Risk-Weighted Assets    |       | 75,185     |       | 13.20                              | %          | 45,550                                                                                      |       | 8.00 | % | 56,937 |   | 10.00 | % |
|                                      |       |       |       |                               |       |                                                                                        |       |   |   |   |   |   |   |
| Tier I Capital to  Risk-Weighted Assets   |       | 72,996     |       | 12.82                              | %          | N/A                                                                                         |       | N/A |   | 34,162 |   | 6.00 | % |
|                                      |       |       |       |                               |       |                                                                                        |       |   |   |   |   |   |   |
| As  of December 31, 2006:            |       |       |       |                               |       |                                                                                        |       |   |   |   |   |   |   |
|                                      |       |       |       |                               |       |                                                                                        |       |   |   |   |   |   |   |
| Tangible Capital to  Tangible Assets      |       | $          | 74,625     |                               | 8.76       | %                                                                                           | $          | 12,779 |   | 1.50 | % | N/A |   | N/A |   |
|                                      |       |       |       |                               |       |                                                                                        |       |   |   |   |   |   |   |
| Core Capital to Adjusted  Tangible Assets |       | 74,625     |       | 8.76                               | %          | 34,078                                                                                      |       | 4.00 | % | $ | 42,597 |   | 5.00 | % |
|                                      |       |       |       |                               |       |                                                                                        |       |   |   |   |   |   |   |
| Total Capital to  Risk-Weighted Assets    |       | 76,500     |       | 11.94                              | %          | 51,235                                                                                      |       | 8.00 | % | 64,044 |   | 10.00 | % |
|                                      |       |       |       |                               |       |                                                                                        |       |   |   |   |   |   |   |
| Tier I Capital to  Risk-Weighted Assets   |       | 74,625     |       | 11.65                              | %          | N/A                                                                                         |       | N/A |   | 38,426 |   | 6.00 | % |
|                                           |            |            |            |                                    |            |                                                                                             |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

** **

 

71

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**19.     RELATED PARTY TRANSACTIONS**

** **

In the normal course of business, the Bankhas made loans to its directors, officers, and their related businessinterests. In the opinion of management, related party loans are made onsubstantially the same terms, including interest rates and collateral, as thoseprevailing at the time for comparable transactions with unrelated persons anddo not involve more than the normal risk of collectibility. The aggregatedollar amount of loans outstanding to directors, officers, and their relatedbusiness interests was approximately $1.2 and $1.0 million at December 31,2007 and 2006, respectively.

 

Deposits from related parties held by theBank at December 31, 2007 and 2006 amounted to $6.1 million and $5.2million, respectively.

 

**20.     PARENT COMPANY ONLY FINANCIAL INFORMATION**

 

The following condensed statements offinancial condition, as of December 31, 2007 and 2006, and condensedstatements of income and of cash flows for each of the three years in theperiod ended December 31, 2007, for First Federal Bancshares of Arkansas, Inc.should be read in conjunction with the consolidated financial statements andthe notes herein.

** **

**           FIRSTFEDERAL BANCSHARES OF ARKANSAS, INC.**

**           (ParentCompany Only)**

** **

**           CONDENSEDSTATEMENTS OF FINANCIAL CONDITION**

**           DECEMBER31, 2007 AND 2006**

**           (Inthousands)**

 
| **ASSETS**                                     | ** ** | **2007** | ** ** | **2006** |
|------------------------------------------------|------------|----------|------------|----------|
| Cash  and cash equivalents (deposits in Bank)  |       | $        | 97         |     | $ | 23 |
| Loan  to Bank subsidiary                       |       | 236      |       | 377      |
| Accrued  interest receivable                   |       | 3        |       | 7        |
| Investment  in Bank                            |       | 73,193   |       | 74,881   |
| Other  assets                                  |       | 286      |       | 593      |
|                                           |       |     |       |     |
| TOTAL                                          |       | $        | 73,815     |     | $ | 75,881 |
|                                           |       |     |       |     |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY** |       |     |       |     |
|                                           |       |     |       |     |
| Accrued  expenses and other liabilities        |       | $        | 152        |     | $ | 308 |
| Stockholders’  equity                     |       | 73,663   |       | 75,573   |
|                                           |       |     |       |     |
| TOTAL                                          |       | $        | 73,815     |     | $ | 75,881 |

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

72

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**FIRSTFEDERAL BANCSHARES OF ARKANSAS, INC.**

**(ParentCompany Only)**

** **

**CONDENSEDSTATEMENTS OF INCOME**

**YEARSENDED DECEMBER 31, 2007, 2006, AND 2005**

**(Inthousands)**

** **

 
| ** **                                                                                      | ** ** | **2007**   | ** ** | **2006**   | ** ** | **2005**   | ** ** |
|-------------------------------------------------------------------------------------------------|------------|------------|------------|------------|------------|------------|------------|
| ** **                                                                                      | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| INCOME:                                                                                         |       |       |       |       |       |       |       |
| Dividends from the Bank                                                                         |       | $          | 5,000      |       | $          | 8,000      |       | $ | 7,000 |   |
| Interest income—loan to  the Bank                                                          |       | 50         |       | 52         |       | 45         |       |
|                                                                                            |       |       |       |       |       |       |       |
| Total income                                                                                    |       | 5,050      |       | 8,052      |       | 7,045      |       |
|                                                                                            |       |       |       |       |       |       |       |
| EXPENSES:                                                                                       |       |       |       |       |       |       |       |
| Management fees                                                                                 |       | 66         |       | 66         |       | 66         |       |
| Other operating expenses                                                                        |       | 290        |       | 259        |       | 230        |       |
|                                                                                            |       |       |       |       |       |       |       |
| Total expenses                                                                                  |       | 356        |       | 325        |       | 296        |       |
|                                                                                            |       |       |       |       |       |       |       |
| INCOME BEFORE INCOME TAXBENEFIT AND EQUITY IN UNDISTRIBUTED EARNINGS  (LOSS) OF BANK SUBSIDIARY |       | 4,694      |       | 7,727      |       | 6,749      |       |
|                                                                                            |       |       |       |       |       |       |       |
| INCOME  TAX BENEFIT                                                                             |       | 118        |       | 105        |       | 96         |       |
|                                                                                            |       |       |       |       |       |       |       |
| INCOME BEFORE EQUITY IN  UNDISTRIBUTED  EARNINGS (LOSS) OF BANK  SUBSIDIARY                |       | 4,812      |       | 7,832      |       | 6,845      |       |
|                                                                                            |       |       |       |       |       |       |       |
| EQUITY IN UNDISTRIBUTED  EARNINGS (LOSS) OF BANK SUBSIDIARY                                |       | (2,169     | )          | (449       | )          | 1,005      |       |
|                                                                                            |       |       |       |       |       |       |       |
| NET  INCOME                                                                                     |       | $          | 2,643      |       | $          | 7,383      |       | $ | 7,850 |   |

 

 

 

73

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**FIRSTFEDERAL BANCSHARES OF ARKANSAS, INC.**

**(ParentCompany Only)**

** **

**CONDENSEDSTATEMENTS OF CASH FLOWS**

**YEARSENDED DECEMBER 31, 2007, 2006, AND 2005**

**(Inthousands)**

** **

 
| ** **                                                                         | ** ** | **2007** | ** ** | **2006** | ** ** | **2005** | ** ** |
|------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
|                                                                               |       |     |       |     |       |     |       |
| OPERATING  ACTIVITIES:                                                             |       |     |       |     |       |     |       |
| Net income                                                                         |       | $        | 2,643      |     | $          | 7,383    |       | $ | 7,850 |   |
| Adjustments to reconcile  net income to net cash provided by operating activities: |       |     |       |     |       |     |       |
| Equity in undistributed  net loss (earnings) of Bank                               |       | 2,169    |       | 449      |       | (1,005   | )          |
| Release of ESOP shares                                                             |       | —   |       | 512      |       | 1,991    |       |
| Stock compensation expense                                                         |       | 39       |       | 81       |       | 26       |       |
| Changes in operating  assets and liabilities:                                      |       |     |       |     |       |     |       |
| Accrued interest  receivable                                                       |       | 4        |       | (2       | )          | (2       | )          |
| Other assets                                                                       |       | 307      |       | (40      | )          | 149      |       |
| Accrued expenses and other  liabilities                                            |       | (156     | )          | 163      |       | 108      |       |
|                                                                               |       |     |       |     |       |     |       |
| Net cash provided by  operating activities                                         |       | 5,006    |       | 8,546    |       | 9,117    |       |
|                                                                               |       |     |       |     |       |     |       |
| INVESTING  ACTIVITIES—                                                        |       |     |       |     |       |     |       |
| Loan to Bank, net of  repayments                                                   |       | 141      |       | 1,669    |       | (1,045   | )          |
|                                                                               |       |     |       |     |       |     |       |
| Net cash provided by (used  in) investing activities                               |       | 141      |       | 1,669    |       | (1,045   | )          |
|                                                                               |       |     |       |     |       |     |       |
| FINANCING  ACTIVITIES:                                                             |       |     |       |     |       |     |       |
| Purchase of treasury stock                                                         |       | (2,312   | )          | (8,574   | )          | (7,630   | )          |
| Dividends paid                                                                     |       | (3,111   | )          | (2,899   | )          | (2,527   | )          |
| Stock options exercised                                                            |       | 350      |       | 954      |       | 2,206    |       |
|                                                                               |       |     |       |     |       |     |       |
| Net cash used in financing  activities                                             |       | (5,073   | )          | (10,519  | )          | (7,951   | )          |
|                                                                               |       |     |       |     |       |     |       |
| NET INCREASE (DECREASE) IN  CASH AND CASHEQUIVALENTS                               |       | 74       |       | (304     | )          | 121      |       |
|                                                                               |       |     |       |     |       |     |       |
| CASH  AND CASH EQUIVALENTS:                                                        |       |     |       |     |       |     |       |
| Beginning of period                                                                |       | 23       |       | 327      |       | 206      |       |
|                                                                               |       |     |       |     |       |     |       |
| End of period                                                                      |       | $        | 97         |     | $          | 23       |       | $ | 327 |   |

 

******

 

74

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**SELECTED QUARTERLY OPERATING RESULTS (UNAUDITED)**

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

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

 
| **YEAR  ENDED DECEMBER 31, 2006**                   | ** ** | **Fourth  Quarter** | ** ** | **Third  Quarter** | ** ** | **Second  Quarter** | ** ** | **First  Quarter** | ** ** |
|-----------------------------------------------------|------------|---------------------|------------|--------------------|------------|---------------------|------------|--------------------|------------|
| Interest income                                     |       | $                   | 13,610     |               | $          | 13,681              |       | $                  | 13,737     |   | $ | 13,091 |   |
| Interest expense                                    |       | 7,377               |       | 7,307              |       | 6,704               |       | 6,188              |       |
| Net interest income                                 |       | 6,233               |       | 6,374              |       | 7,033               |       | 6,903              |       |
| Provision for loan losses                           |       | 354                 |       | 484                |       | 359                 |       | 285                |       |
| Net interest income after provision for loan losses |       | 5,879               |       | 5,890              |       | 6,674               |       | 6,618              |       |
| Noninterest income                                  |       | 1,890               |       | 2,013              |       | 2,033               |       | 2,286              |       |
| Noninterest expense                                 |       | 5,755               |       | 5,449              |       | 5,326               |       | 5,991              |       |
| Income before income taxes                          |       | 2,014               |       | 2,454              |       | 3,381               |       | 2,913              |       |
| Income tax provision                                |       | 591                 |       | 754                |       | 1,106               |       | 928                |       |
| Net income                                          |       | $                   | 1,423      |               | $          | 1,700               |       | $                  | 2,275      |   | $ | 1,985 |   |
|                                                |       |                |       |               |       |                |       |               |       |
| Earnings per share(1):                              |       |                |       |               |       |                |       |               |       |
| Basic                                               |       | $                   | 0.30       |               | $          | 0.34                |       | $                  | 0.45       |   | $ | 0.39 |   |
| Diluted                                             |       | $                   | 0.29       |               | $          | 0.33                |       | $                  | 0.44       |   | $ | 0.38 |   |
|                                                |       |                |       |               |       |                |       |               |       |
| Selected Ratios (Annualized):                       |       |                |       |               |       |                |       |               |       |
| Net interest margin                                 |       | 3.14                | %          | 3.12               | %          | 3.46                | %          | 3.43               | %          |
| Return on average assets                            |       | 0.66                |       | 0.77               |       | 1.04                |       | 0.92               |       |
| Return on average equity                            |       | 7.29                |       | 8.54               |       | 11.57               |       | 10.19              |       |

----

(1)  Basic and diluted shares outstandingare summarized below.

 
| ** **                           | ** ** | **Fourth  Quarter** | ** ** | **Third  Quarter** | ** ** | **Second  Quarter** | ** ** | **First  Quarter** | ** ** |
|--------------------------------------|------------|---------------------|------------|--------------------|------------|---------------------|------------|--------------------|------------|
| YEAR ENDED DECEMBER 31, 2007         |       |                |       |               |       |                |       |               |       |
| Basic weighted—average shares   |       | 4,857,406           |       | 4,865,007          |       | 4,868,377           |       | 4,869,855          |       |
| Effect of dilutive securities        |       | 4,555               |       | 7,700              |       | 16,140              |       | 38,509             |       |
| Diluted weighted—average shares |       | 4,861,961           |       | 4,872,707          |       | 4,884,517           |       | 4,908,364          |       |
|                                 |       |                |       |               |       |                |       |               |       |
| YEAR ENDED DECEMBER 31, 2006         |       |                |       |               |       |                |       |               |       |
| Basic weighted—average shares   |       | 4,910,493           |       | 5,006,730          |       | 5,024,563           |       | 5,032,320          |       |
| Effect of dilutive securities        |       | 102,079             |       | 111,206            |       | 118,702             |       | 143,188            |       |
| Diluted weighted—average shares |       | 5,012,572           |       | 5,117,936          |       | 5,143,265           |       | 5,175,508          |       |

 

 

 

75

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

 

Not Applicable.

 

**Item9A.  Controls and Procedures.**

 

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

 

Management’s annual report on internal control over financial reportingand the attestation report of the Company’s independent registered publicaccounting firm are included in Item 8 under the headings “Management Report onInternal Control” and “Report of Independent Registered Public AccountingFirm,” respectively, and are incorporated herein by reference.

 

No change in the Company’sinternal control over financial reporting (as defined in Rules 13a-15(f) and15d-15(f) under the Exchange Act) occurred during the fiscal quarter endedDecember 31, 2007 that has materially affected, or is reasonably likely tomaterially affect, the Company’s internal control over financialreporting.  However, late in the firstquarter of 2007, the Company migrated its operational software system from oneproduct to another offered by its software vendor.  This migration affected the deposit and loanprocessing functions of the Bank. Extensive data verification processes were performed throughout the Bankleading up to the conversion.  Inaddition, our internal audit department reviewed the financial reportingcontrol activities and narratives for each of the Company’s business cyclesthat had previously been identified for the Company’s testing of internalcontrol over financial reporting.   Eachmajor area of the Company that has a direct impact on the creation of data thatis used in the financial reporting process asserted that the conversion did notcreate material changes in the Company’s system of internal controls overfinancial reporting.

 

The Company continues toevaluate and resolve post-conversion issues. The Company’s internal auditdepartment began detailed analysis to identify any significant changes in thequality of internal control over financial reporting as a result of theconversion in the latter part of the second quarter.  This evaluation was completed in the fourthquarter.

 

**Item9B.  Other Information.**

 

Not Applicable.

 

**PART III.**

 

**Item10.  Directors, Executive Officers andCorporate Governance.**

 

The information regarding directors and executive officers isincorporated herein by reference from the section entitled “Information withRespect to Nominee for Director, Continuing Directors and Executive Officers”in our definitive Proxy Statement (“2008 Proxy Statement”) to be filed pursuantto Regulation 14A of the Securities Exchange Act of 1934, as amended, for ourAnnual Meeting of Stockholders to be held on April 23, 2008. The 2008Proxy Statement will be filed within 120 days after the end of our fiscal yearended December 31, 2007.

 

The information regarding compliance with Section 16(a) ofthe Securities and Exchange Act of 1934 is incorporated herein by referencefrom the section entitled “Section 16(a) Beneficial Ownership ReportingCompliance” of our 2008 Proxy Statement.

 

The information regarding the audit committee and audit committeefinancial experts is incorporated by reference herein from the subsectionentitled “Committees and Meetings of the Board of the Company and the Bank” inthe section entitled “Information with Respect to Nominee for Director,Continuing Directors and Executive Officers” in our 2008 Proxy Statement.

 

 

76

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The information regarding the code of ethics applicableto our principal executive officer, principal financial officer and principalaccounting officer is incorporated herein by reference from the subsectionentitled—“Code of Ethics for Executive Officers and Financial Professionals” inthe section entitled “Information with Respect to Nominee for Director,Continuing Directors and Executive Officers” in our 2008 Proxy Statement.

 

**Item11.  Executive Compensation.**

 

Information regarding executive compensationis incorporated herein by reference from the section entitled “ExecutiveCompensation” in our 2008 Proxy Statement.

 

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

 

Information regarding security ownership of certain beneficial ownersand management is incorporated herein by reference from the section entitled“Beneficial Ownership of Common Stock By Certain Beneficial Owners andManagement and Related Stockholder Matters” and information regardingsecurities authorized for issuance under equity compensation plans isincorporated herein by reference from the subsection entitled “Equity-BasedCompensation Plans” in our 2008 Proxy Statement.

 

**Item13.  Certain Relationships and RelatedTransactions, and Director Independence.**

 

Information regarding certain relationships and related transactions isincorporated herein by reference from the section entitled “Transactions withCertain Related Persons” in our 2008 Proxy Statement.

 

Information regarding director independence is incorporated herein byreference from the subsection entitled “Election of Directors” in the sectionentitled “Information with Respect to Nominee for Director, ContinuingDirectors and Executive Officers” in our 2008 Proxy Statement.

 

**Item14.  Principal Accountant Fees andServices.**

 

The information regarding principal auditor fees and services isincorporated herein by reference from the section entitled “Relationship withIndependent Registered Public Accounting Firm” in our 2008 Proxy Statement.

 

 

77

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**PART IV.**

 

**Item15. Exhibits and Financial Statement Schedules.**

 

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

 

(1) Financialstatements have been included in Item 8.

 

(2) Allschedules for which provision is made in the applicable accounting regulationof the SEC are omitted because of the absence of conditions under which theyare required or because the required information is included in the financialstatements and related notes thereto.

 

**(b) Exhibit Index.**

 
| 2.1*     |   | Plan of Conversion                                                                                                                                                         |
|----------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|     |   |                                                                                                                                                                       |
| 3.1*     |   | Articles of Incorporation of First Federal  Bancshares of Arkansas, Inc.                                                                                              |
|     |   |                                                                                                                                                                       |
| 3.2      |   | Amended and Restated Bylaws of First Federal  Bancshares of Arkansas, Inc.                                                                                            |
|     |   |                                                                                                                                                                       |
| 4.0**    |   | Stock Certificate of First Federal Bancshares of  Arkansas, Inc.                                                                                                      |
|     |   |                                                                                                                                                                       |
| 10.6***  |   | Employment Agreement between the Company, the Bank  and Larry J. Brandt as amended and restated                                                                            |
|     |   |                                                                                                                                                                       |
| 10.7***  |   | Employment Agreement between the Company, the Bank  and Tommy W. Richardson as amended and restated                                                                        |
|     |   |                                                                                                                                                                       |
| 10.8***  |   | Employment Agreement between the Company, the Bank  and Sherri R. Billings as amended and restated                                                                         |
|     |   |                                                                                                                                                                       |
| 10.9***  |   | Change in Control Severance Agreement between the  Company, the Bank and Jeffrey Brandt as amended                                                                         |
|     |   | and restated                                                                                                                                                               |
|     |   |                                                                                                                                                                       |
| 10.10*** |   | Change in Control Severance Agreement between the  Company, the Bank and Allen Ross Mallioux as                                                                            |
|     |   | amended and restated                                                                                                                                                       |
|     |   |                                                                                                                                                                       |
| 21.0     |   | Subsidiaries of the Registrant - Reference is made  to                                                                                                                     |
|     |   | “Item 1 Business - Subsidiaries” for the required  information                                                                                                   |
|     |   |                                                                                                                                                                       |
| 23.0     |   | Consent of Deloitte & Touche LLP                                                                                                                                  |
|     |   |                                                                                                                                                                       |
| 31.1     |   | Certification of Chief Executive Officer pursuant to  Rule 13a-14(a) of Exchange Act, as adopted pursuant to  Section 302 of the Sarbanes-Oxley Act of 2002 |
|     |   |                                                                                                                                                                       |
| 31.2     |   | Certification of Chief Financial Officer pursuant to  Rule 13a-14(a) of Exchange Act, as adopted pursuant to  Section 302 of the Sarbanes-Oxley Act of 2002 |
|     |   |                                                                                                                                                                       |
| 32.1     |   | Section 906 Certification of the CEO                                                                                                                                  |
|     |   |                                                                                                                                                                       |
| 32.2     |   | Section 906 Certification of the CFO                                                                                                                                  |

 

 
|   |   | (*)    |   | Incorporated  herein by reference from the Company’s Registration Statement on Form S-1  (File No. 333-612) filed with the SEC. |
|--------|--------|--------|--------|------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |   |   |                                                                                                                                           |
|   |   | (**)   |   | Incorporated  herein by reference from the Company’s Registration Statement on  Form 8-A filed with the SEC.                         |
|   |   |   |   |                                                                                                                                           |
|   |   | (***)  |   | Incorporated  herein by reference from the Company’s Statement on Form 8-K filed with  the SEC.                                      |

 

 

78

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**SIGNATURES**

 

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

 

FIRST FEDERALBANCSHARES OF ARKANSAS, INC.

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

 

Pursuant to therequirements of the Securities Exchange Act of 1934, this report has beensigned below by the following persons on behalf of the Registrant and in thecapacities and on the dates indicated.

 
|   | /s/ Larry J. Brandt                                                   |   |   | February 26, 2008 |
|--------|-----------------------------------------------------------------------|--------|--------|------------------------|
|   | Larry J. Brandt                                                       |   |   |                   |
|   | President and Chief Executive Officer                                 |   |   |                   |
|   |                                                                  |   |   |                   |
|   |                                                                  |   |   |                   |
|   | /s/ John P. Hammerschmidt                                             |   |   | February 26, 2008 |
|   | John P. Hammerschmidt                                                 |   |   |                   |
|   | Chairman                                                              |   |   |                   |
|   |                                                                  |   |   |                   |
|   |                                                                  |   |   |                   |
|   | /s/ Jeff Brandt                                                       |   |   | February 26, 2008 |
|   | Jeff Brandt                                                           |   |   |                   |
|   | Director                                                              |   |   |                   |
|   |                                                                  |   |   |                   |
|   |                                                                  |   |   |                   |
|   | /s/ Kenneth C. Savells                                                |   |   | February 26, 2008 |
|   | Kenneth C. Savells                                                    |   |   |                   |
|   | Director                                                              |   |   |                   |
|   |                                                                  |   |   |                   |
|   |                                                                  |   |   |                   |
|   | /s/ Frank Conner                                                      |   |   | February 26, 2008 |
|   | Frank Conner                                                          |   |   |                   |
|   | Director                                                              |   |   |                   |
|   |                                                                  |   |   |                   |
|   |                                                                  |   |   |                   |
|   | /s/ Sherri R. Billings                                                |   |   | February 26, 2008 |
|   | Sherri R. Billings                                                    |   |   |                   |
|   | Executive Vice President  and Chief  Financial and Accounting Officer |   |   |                   |