**UNITEDSTATES**

**SECURITIESAND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

**FORM 10-Q**
| **x**  | ** ** | **QUARTERLY REPORT  PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**                                                                                                                                                                                                                                                         |   |
|--------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|
|   |       |                                                                                                                                                                                                                                                                                                                                                 |   |
|   |       | **For the quarterly period ended June 30, 2007**                                                                                                                                                                                                                                                                                                     |   |
|   |       |                                                                                                                                                                                                                                                                                                                                                 |   |
| **OR** |
|   |       |                                                                                                                                                                                                                                                                                                                                                 |   |
| **o**  | ** ** | **TRANSITION REPORT  PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**                                                                                                                                                                                                                                                        |   |
|   |       |                                                                                                                                                                                                                                                                                                                                                 |   |
|   |       | **For the transition period from                             to                         ** |   |

 

**CommissionFile Number 0-28312**

**FIRSTFEDERAL BANCSHARES OF ARKANSAS, INC.**

(Exact name ofregistrant as specified in its charter)

| **Texas**                                      |   | **71-0785261**          |
|------------------------------------------------|--------|-------------------------|
| (State or other  jurisdiction of incorporation |   | (I.R.S. Employer        |
| or organization)                               |   | Identification  Number) |
|                                           |   |                    |
| **1401  Highway 62-65 North**                  |   |                    |
| **Harrison,  Arkansas**                        |   | **72601**               |
| (Address of  principal executive office)       |   | (Zip Code)              |

 

**(870) 741-7641**

(Registrant’stelephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reportsrequired to be filed by Section 13 or 15(d) of the Securities Exchange Act of1934 during the preceding 12 months (or for such shorter period that theregistrant was required to file such reports), and (2) has been subject to suchfiling requirements for the past 90 days.

Yes   x    No   o

Indicate by check mark whether the registrant is a large acceleratedfiler, an accelerated filer or a non-accelerated filer.

Large acceleratedfiler   o   Accelerated filer   x    Non-accelerated filer   o

Indicate by checkmark whether the registrant is a shell company (as defined in Rule 12b-2 of theExchange Act).

Yes   o     No    x

Indicate thenumber of shares outstanding of each of the issuer’s classes of common stock,as of the latest practicable date:  As ofJuly 24, 2007, there were issued and outstanding 4,865,401 shares of theRegistrant’s Common Stock, par value $.01 per share.

 

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**FIRSTFEDERAL BANCSHARES OF ARKANSAS, INC.**

**TABLE OFCONTENTS**
| **Part I.**    | ** ** | **Financial Information**                                                                                                                                   |   |   |
|----------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|--------|
|           |       |                                                                                                                                                        |   |   |
| Item 1.        |       | Consolidated Financial Statements                                                                                                                           |   |   |
|           |       |                                                                                                                                                        |   |   |
|           |       | Consolidated  Statements of Financial Condition as of June 30, 2007 and December 31, 2006  (unaudited)                                                      |   |   |
|           |       |                                                                                                                                                        |   |   |
|           |       | Consolidated  Statements of Income for the three and six months ended June 30, 2007 and  2006 (unaudited)                                                   |   |   |
|           |       |                                                                                                                                                        |   |   |
|           |       | Consolidated  Statement of Stockholders’ Equity for the six months ended June 30, 2007  (unaudited)                                                    |   |   |
|           |       |                                                                                                                                                        |   |   |
|           |       | Consolidated  Statements of Cash Flows for the six months ended June 30, 2007 and 2006  (unaudited)                                                         |   |   |
|           |       |                                                                                                                                                        |   |   |
|           |       | Notes to  Unaudited Consolidated Financial Statements                                                                                                       |   |   |
|           |       |                                                                                                                                                        |   |   |
| Item 2.        |       | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                                                                 |   |   |
|           |       |                                                                                                                                                        |   |   |
| Item 3.        |       | Quantitative  and Qualitative Disclosures About Market Risk                                                                                                 |   |   |
|           |       |                                                                                                                                                        |   |   |
| Item 4.        |       | Controls and Procedures                                                                                                                                     |   |   |
|           |       |                                                                                                                                                        |   |   |
| **Part II.**   | ** ** | **Other  Information**                                                                                                                                      |   |   |
|           |       |                                                                                                                                                        |   |   |
| Item 1.        |       | Legal Proceedings                                                                                                                                           |   |   |
| Item  1A.      |       | Risk  Factors                                                                                                                                               |   |   |
| Item 2.        |       | Unregistered  Sales of Equity Securities and Use of Proceeds                                                                                                |   |   |
| Item 3.        |       | Defaults  Upon Senior Securities                                                                                                                            |   |   |
| Item 4.        |       | Submission  of Matters to a Vote of Security Holders                                                                                                        |   |   |
| Item 5.        |       | Other Information                                                                                                                                           |   |   |
| Item  6.       |       | Exhibits                                                                                                                                                    |   |   |
|           |       |                                                                                                                                                        |   |   |
| **Signatures** |       |                                                                                                                                                        |   |   |
|           |       |                                                                                                                                                        |   |   |
| **Exhibits**   |       |                                                                                                                                                        |   |   |
| 31.1           |       | Certification of Chief Executive Officer pursuant to  Rule 13a-14(a) of Exchange Act, as adopted pursuant to Section 302 of the  Sarbanes-Oxley Act of 2002 |   |   |
| 31.2           |       | Certification of Chief Financial Officer pursuant to  Rule 13a-14(a) of Exchange Act, as adopted pursuant to Section 302 of the  Sarbanes-Oxley Act of 2002 |   |   |
| 32.1           |       | Section 906 Certification of the CEO                                                                                                                        |   |   |
| 32.2           |       | Section 906 Certification of the CFO                                                                                                                        |   |   |
|           |       |                                                                                                                                                        |   |   |

 

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

**CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION**

(In thousands, exceptshare data)

(Unaudited)
| ** **                                                                                                                                                                               | ** ** | **June 30,  2007** | ** ** | **December 31,  2006** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|-----------------------------|------------|
| ASSETS                                                                                                                                                                                   |       |                    |       |                        |       |
|                                                                                                                                                                                     |       |                    |       |                        |       |
| Cash and cash  equivalents                                                                                                                                                               |       | $                       | 38,720     |                        | $          | 35,518 |   |
| Investment securities  held to maturity                                                                                                                                                  |       | 74,217                  |       | 60,746                      |       |
| Federal Home Loan Bank  stock                                                                                                                                                            |       | 4,864                   |       | 7,089                       |       |
| Loans receivable, net                                                                                                                                                                    |       | 642,406                 |       | 693,095                     |       |
| Accrued interest  receivable                                                                                                                                                             |       | 11,054                  |       | 9,999                       |       |
| Real estate owned, net                                                                                                                                                                   |       | 7,350                   |       | 3,858                       |       |
| Office properties and  equipment, net                                                                                                                                                    |       | 20,691                  |       | 20,384                      |       |
| Cash surrender value of  life insurance                                                                                                                                                  |       | 19,769                  |       | 19,396                      |       |
| Prepaid expenses and  other assets                                                                                                                                                       |       | 1,420                   |       | 2,390                       |       |
|                                                                                                                                                                                     |       |                    |       |                        |       |
| TOTAL ASSETS                                                                                                                                                                             |       | $                       | 820,491    |                        | $          | 852,475 |   |
|                                                                                                                                                                                     |       |                    |       |                        |       |
| LIABILITIES AND  STOCKHOLDERS’ EQUITY                                                                                                                                               |       |                    |       |                        |       |
|                                                                                                                                                                                     |       |                    |       |                        |       |
| LIABILITIES:                                                                                                                                                                             |       |                    |       |                        |       |
| Deposits                                                                                                                                                                                 |       | $                       | 648,192    |                        | $          | 652,265 |   |
| Federal Home Loan Bank  advances                                                                                                                                                         |       | 91,816                  |       | 120,305                     |       |
| Advance payments by  borrowers for taxes and insurance                                                                                                                                   |       | 344                     |       | 666                         |       |
| Other liabilities                                                                                                                                                                        |       | 5,608                   |       | 3,666                       |       |
| Total  liabilities                                                                                                                                                                       |       | 745,960                 |       | 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, 4,863,289 and  4,838,962 shares outstanding at June 30, 2007 and December 31, 2006,  respectively |       | 103                     |       | 103                         |       |
| Additional paid-in  capital                                                                                                                                                              |       | 56,640                  |       | 56,617                      |       |
| Employee stock benefit  plans                                                                                                                                                            |       | (53                     | )          | (72                         | )          |
| Retained  earnings-substantially restricted                                                                                                                                              |       | 88,204                  |       | 88,068                      |       |
|                                                                                                                                                                                     |       | 144,894                 |       | 144,716                     |       |
| Treasury stock, at  cost, 5,444,213 and 5,468,540 shares at June 30, 2007 and December 31, 2006,  respectively                                                                           |       | (70,363                 | )          | (69,143                     | )          |
| Total  stockholders’ equity                                                                                                                                                         |       | 74,531                  |       | 75,573                      |       |
|                                                                                                                                                                                     |       |                    |       |                        |       |
| TOTAL  LIABILITIES AND STOCKHOLDERS’ EQUITY                                                                                                                                         |       | $                       | 820,491    |                        | $          | 852,475 |   |

 

See notes to unaudited consolidated financial statements.

1

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**FIRSTFEDERAL BANCSHARES OF ARKANSAS, INC.**

**CONSOLIDATED STATEMENTS OF INCOME**

(In thousands, exceptshare data)

(Unaudited)
| ** **                                           | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|------------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                           | ** ** | **June 30,  2007**          | ** ** | **June 30,  2006**        | ** ** | **June 30,  2007** | ** ** | **June 30,  2006** | ** ** |
| INTEREST INCOME:                                     |       |                             |       |                           |       |   |   |   |   |
| Loans receivable                                     |       | $                                | 12,004     |                           | $          | 12,849 |   | $ | 24,205 |   | $ | 25,075 |   |
| Investment securities:                               |       |                             |       |                           |       |   |   |   |   |
| Taxable                                              |       | 712                              |       | 623                            |       | 1,367 |   | 1,203 |   |
| Nontaxable                                           |       | 178                              |       | 187                            |       | 359 |   | 373 |   |
| Other                                                |       | 302                              |       | 78                             |       | 490 |   | 175 |   |
| Total interest income                                |       | 13,196                           |       | 13,737                         |       | 26,421 |   | 26,826 |   |
|                                                 |       |                             |       |                           |       |   |   |   |   |
| INTEREST  EXPENSE:                                   |       |                             |       |                           |       |   |   |   |   |
| Deposits                                             |       | 6,044                            |       | 4,926                          |       | 11,892 |   | 9,371 |   |
| Other borrowings                                     |       | 1,106                            |       | 1,778                          |       | 2,366 |   | 3,520 |   |
| Total interest expense                               |       | 7,150                            |       | 6,704                          |       | 14,258 |   | 12,891 |   |
|                                                 |       |                             |       |                           |       |   |   |   |   |
| NET INTEREST  INCOME                                 |       | 6,046                            |       | 7,033                          |       | 12,163 |   | 13,935 |   |
|                                                 |       |                             |       |                           |       |   |   |   |   |
| PROVISION FOR  LOAN LOSSES                           |       | 370                              |       | 359                            |       | 2,332 |   | 643 |   |
|                                                 |       |                             |       |                           |       |   |   |   |   |
| NET INTEREST  INCOME AFTER PROVISION FOR LOAN LOSSES |       | 5,676                            |       | 6,674                          |       | 9,831 |   | 13,292 |   |
|                                                 |       |                             |       |                           |       |   |   |   |   |
| NONINTEREST  INCOME:                                 |       |                             |       |                           |       |   |   |   |   |
| Deposit fee income                                   |       | 1,269                            |       | 1,237                          |       | 2,426 |   | 2,315 |   |
| Earnings on life insurance policies                  |       | 184                              |       | 185                            |       | 373 |   | 369 |   |
| Gain on sale of loans                                |       | 179                              |       | 278                            |       | 354 |   | 475 |   |
| Other                                                |       | 343                              |       | 385                            |       | 686 |   | 1,243 |   |
| Total noninterest income                             |       | 1,975                            |       | 2,085                          |       | 3,839 |   | 4,402 |   |
|                                                 |       |                             |       |                           |       |   |   |   |   |
| NONINTEREST  EXPENSES:                               |       |                             |       |                           |       |   |   |   |   |
| Salaries and employee benefits                       |       | 3,287                            |       | 3,259                          |       | 6,729 |   | 6,979 |   |
| Net occupancy expense                                |       | 569                              |       | 582                            |       | 1,193 |   | 1,171 |   |
| Data processing                                      |       | 351                              |       | 317                            |       | 805 |   | 758 |   |
| Professional fees                                    |       | 142                              |       | 90                             |       | 282 |   | 195 |   |
| Advertising and public relations                     |       | 251                              |       | 313                            |       | 610 |   | 630 |   |
| Postage and supplies                                 |       | 184                              |       | 200                            |       | 459 |   | 427 |   |
| Other                                                |       | 691                              |       | 617                            |       | 1,466 |   | 1,240 |   |
| Total noninterest expenses                           |       | 5,475                            |       | 5,378                          |       | 11,544 |   | 11,400 |   |
|                                                 |       |                             |       |                           |       |   |   |   |   |
| INCOME BEFORE  INCOME TAXES                          |       | 2,176                            |       | 3,381                          |       | 2,126 |   | 6,294 |   |
| INCOME TAX  PROVISION                                |       | 642                              |       | 1,106                          |       | 433 |   | 2,034 |   |
| NET INCOME                                           |       | $                                | 1,534      |                           | $          | 2,275 |   | $ | 1,693 |   | $ | 4,260 |   |
|                                                 |       |                             |       |                           |       |   |   |   |   |
| EARNINGS PER  SHARE:                                 |       |                             |       |                           |       |   |   |   |   |
| Basic                                                |       | $                                | 0.32       |                           | $          | 0.45 |   | $ | 0.35 |   | $ | 0.85 |   |
|                                                 |       |                             |       |                           |       |   |   |   |   |
| Diluted                                              |       | $                                | 0.32       |                           | $          | 0.44 |   | $ | 0.35 |   | $ | 0.83 |   |
|                                                 |       |                             |       |                           |       |   |   |   |   |
| Cash Dividends Declared                              |       | $                                | 0.16       |                           | $          | 0.14 |   | $ | 0.32 |   | $ | 0.28 |   |

 

See notes to unaudited consolidated financial statements.

2

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**FIRSTFEDERAL BANCSHARES OF ARKANSAS, INC.**

**CONSOLIDATED STATEMENT OF STOCKHOLDERS’ EQUITY**

**FOR THE SIXMONTHS ENDED JUNE 30, 2007**

(In thousands, exceptshare data)

(Unaudited)
| ** **                                                 | ** ** | ** **            | ** ** | ** **     | ** ** | **Employee** | ** ** | ** **   | ** ** |
|------------------------------------------------------------|------------|-----------------------|------------|----------------|------------|--------------|------------|--------------|------------|
| ** **                                                 | ** ** | **Issued**            | ** ** | **Additional** | ** ** | **Stock**    | ** ** | ** **   | ** ** |
| ** **                                                 | ** ** | **Common Stock** | ** ** | **Paid-In**    | ** ** | **Benefit**  | ** ** | **Retained** | ** ** |
| ** **                                                 | ** ** | **Shares**            | ** ** | **Amount**     | ** ** | **Capital**  | ** ** | **Plans**    | ** ** | **Earnings** | ** ** |
| Balance, January  1, 2007                                  |       | 10,307,502            |       | $              | 103        |         | $          | 56,617       |       | $ | (72 | ) | $ | 88,068 |   |
| Net income                                                 |       |                  |       |           |       |         |       |         |       | 1,693 |   |
| Tax effect of  stock compensation plan                     |       |                  |       |           |       | 472          |       |         |       |   |   |
| Treasury shares  reissued due to exercise of stock options |       |                  |       |           |       | (454         | )          |         |       |   |   |
| Purchase of  treasury stock, at cost                       |       |                  |       |           |       |         |       |         |       |   |   |
| Stock  compensation expense                                |       |                  |       |           |       | 5            |       | 19           |       |   |   |
| Dividends paid                                             |       |                  |       |           |       |         |       |         |       | (1,557 | ) |
|                                                       |       |                  |       |           |       |         |       |         |       |   |   |
| Balance, June 30, 2007                                     |       | 10,307,502            |       | $              | 103        |         | $          | 56,640       |       | $ | (53 | ) | $ | 88,204 |   |

 
|                                                            | ** ** | ** **              | ** ** | ** **             | ** ** | **Total ** | ** ** |
|------------------------------------------------------------|------------|-------------------------|------------|------------------------|------------|-----------------|------------|
| ** **                                                 | ** ** | **Treasury Stock** | ** ** | **Stockholders’** | ** ** |
| ** **                                                 | ** ** | **Shares**              | ** ** | **Amount**             | ** ** | **Equity**      | ** ** |
| Balance, January  1, 2007                                  |       | 5,468,540               |       | $                      | (69,143    | )               | $          | 75,573 |   |
| Net income                                                 |       |                    |       |                   |       | 1,693           |       |
| Tax effect of  stock compensation plan                     |       |                    |       |                   |       | 472             |       |
| Treasury shares  reissued due to exercise of stock options |       | (104,853                | )          | 778                    |       | 324             |       |
| Purchase of  treasury stock, at cost                       |       | 80,526                  |       | (1,998                 | )          | (1,998          | )          |
| Stock  compensation expense                                |       |                    |       |                   |       | 24              |       |
| Dividends paid                                             |       |                    |       |                   |       | (1,557          | )          |
|                                                       |       |                    |       |                   |       |            |       |
| Balance, June 30, 2007                                     |       | 5,444,213               |       | $                      | (70,363    | )               | $          | 74,531 |   |

 

See notes to unauditedconsolidated financial statements.

3

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**FIRST FEDERAL BANCSHARES OFARKANSAS, INC.**

**CONSOLIDATEDSTATEMENTS OF CASH FLOWS**

(In Thousands)

(Unaudited)
| ** **                                                                         | ** ** | **Six Months Ended June 30,** | ** ** |
|------------------------------------------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                                                         | ** ** | **2007**                                          | ** ** | **2006** | ** ** |
| OPERATING  ACTIVITIES:                                                             |       |                                              |       |   |   |
| Net income                                                                         |       | $                                                 | 1,693      |   | $ | 4,260 |   |
| Adjustments to reconcile net income to net cash  provided by operating activities: |       |                                              |       |   |   |
| Provision for loan losses                                                          |       | 2,332                                             |       | 643 |   |
| Provision for real estate losses                                                   |       | 77                                                |       | — |   |
| Deferred tax (benefit) provision                                                   |       | (1,006                                            | )          | 47 |   |
| Accretion of discounts on investment securities, net                               |       | (12                                               | )          | (4 | ) |
| Federal Home Loan Bank stock dividends                                             |       | (179                                              | )          | (193 | ) |
| Gain on disposition of office properties and  equipment                            |       | (5                                                | )          | (235 | ) |
| Loss (gain) on sale of repossessed assets, net                                     |       | 51                                                |       | (81 | ) |
| Originations of loans held for sale                                                |       | (35,468                                           | )          | (35,722 | ) |
| Proceeds from sales of loans held for sale                                         |       | 33,138                                            |       | 33,508 |   |
| Gain on sale of loans originated to sell                                           |       | (354                                              | )          | (475 | ) |
| Depreciation                                                                       |       | 701                                               |       | 637 |   |
| Amortization of deferred loan fees, net                                            |       | 220                                               |       | 105 |   |
| Release of ESOP shares                                                             |       | —                                            |       | 511 |   |
| Stock compensation expense                                                         |       | 24                                                |       | 46 |   |
| Earnings on life insurance policies                                                |       | (373                                              | )          | (369 | ) |
| Changes in operating assets and liabilities:                                       |       |                                              |       |   |   |
| Accrued interest receivable                                                        |       | (1,055                                            | )          | (2,137 | ) |
| Prepaid expenses and other assets                                                  |       | 960                                               |       | 19 |   |
| Other liabilities                                                                  |       | 350                                               |       | (209 | ) |
| Net cash provided by operating activities                                          |       | 1,094                                             |       | 351 |   |
|                                                                               |       |                                              |       |   |   |
| INVESTING  ACTIVITIES:                                                             |       |                                              |       |   |   |
| Purchases of investment securities held to maturity                                |       | (15,439                                           | )          | (3,125 | ) |
| Proceeds from maturities/calls of investment  securities held to maturity          |       | 5,050                                             |       | 290 |   |
| Federal Home Loan Bank stock redeemed                                              |       | 2,404                                             |       | 377 |   |
| Loan participations sold                                                           |       | 7,208                                             |       | 3,419 |   |
| Net loan (originations) repayments                                                 |       | 38,608                                            |       | (22,257 | ) |
| Proceeds from sales of repossessed assets                                          |       | 1,738                                             |       | 1,700 |   |
| Improvements to real estate owned                                                  |       | (343                                              | )          | — |   |
| Proceeds from sales of office properties and  equipment                            |       | 10                                                |       | 251 |   |
| Purchases of office properties and equipment                                       |       | (1,013                                            | )          | (1,303 | ) |
| Net cash provided by (used in) investing activities                                |       | 38,223                                            |       | (20,648 | ) |
|                                                                               |       |                                              |       |   |   |
| FINANCING  ACTIVITIES:                                                             |       |                                              |       |   |   |
| Net increase (decrease) in deposits                                                |       | (4,073                                            | )          | 19,123 |   |
| Advances from FHLB                                                                 |       | 4,000                                             |       | 55,000 |   |
| Repayment of advances from FHLB                                                    |       | (32,489                                           | )          | (44,788 | ) |
| Net decrease in advance payments by borrowers for  taxes and insurance             |       | (322                                              | )          | (397 | ) |
| Purchase of treasury stock                                                         |       | (1,998                                            | )          | (3,267 | ) |
| Reissued treasury stock                                                            |       | 324                                               |       | 743 |   |
| Dividends paid                                                                     |       | (1,557                                            | )          | (1,414 | ) |
| Net cash provided by (used in) financing activities                                |       | (36,115                                           | )          | 25,000 |   |
|                                                                               |       |                                              |       |   |   |
| Net increase in  cash and cash equivalents                                         |       | 3,202                                             |       | 4,703 |   |
|                                                                               |       |                                              |       |   |   |
| CASH AND CASH  EQUIVALENTS:                                                        |       |                                              |       |   |   |
| Beginning of period                                                                |       | $                                                 | 35,518     |   | $ | 21,109 |   |
| End of period                                                                      |       | $                                                 | 38,720     |   | $ | 25,812 |   |
|                                                                               |       |                                              |       |   |   |
| SUPPLEMENTAL  DISCLOSURES OF CASH FLOW INFORMATION:                                |       |                                              |       |   |   |
| Cash paid for:                                                                     |       |                                              |       |   |   |
| Interest                                                                           |       | $                                                 | 14,516     |   | $ | 12,789 |   |
| Income taxes                                                                       |       | $                                                 | 236        |   | $ | 1,371 |   |
|                                                                               |       |                                              |       |   |   |
| SUPPLEMENTAL  SCHEDULE OF NONCASH INVESTING ACTIVITIES:                            |       |                                              |       |   |   |
| Real estate and other assets acquired in settlement  of loans                      |       | $                                                 | 5,005      |   | $ | 1,328 |   |
| Loans to facilitate sales of real estate owned                                     |       | $                                                 | 252        |   | $ | — |   |
| Investment  securities traded, recorded in investments not yet settled in cash     |       | $                                                 | 3,070      |   | $ | 1,000 |   |

 

See notes tounaudited consolidated financial statements.

4

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**FIRSTFEDERAL BANCSHARES OF ARKANSAS, INC.**

**NOTES TO UNAUDITED CONSOLIDATEDFINANCIAL STATEMENTS**

# **Note 1 - Basis of Presentationand Principles of Consolidation**

First FederalBancshares of Arkansas, Inc. (the “Company”) is a unitary holding company whichowns all of the stock of First Federal Bank (the “Bank”).  The Bank provides a broad line of financialproducts to individuals and small- to medium-sized businesses.  The unaudited consolidated financialstatements also include the accounts of the Bank’s wholly-owned subsidiary,First Harrison Service Corporation (“FHSC”), which is inactive.

The accompanyingunaudited consolidated financial statements of the Company have been preparedin accordance with instructions to Form 10-Q. Accordingly, they do not include all of the information and footnotesrequired by generally accepted accounting principles for complete financialstatements.  However, such informationreflects all adjustments which are, in the opinion of management, necessary fora fair statement of results for the interim periods.

The accompanyingunaudited consolidated financial statements include the accounts of the Companyand the Bank.  All material intercompanytransactions have been eliminated in consolidation.

The results of operationsfor the six months ended June 30, 2007, are not necessarily indicative of theresults to be expected for the year ending December 31, 2007.  The unaudited consolidated financialstatements and notes thereto should be read in conjunction with the auditedfinancial statements and notes thereto for the year ended December 31,2006, contained in the Company’s 2006 Annual Report to Stockholders.

Certain amounts inthe June 30, 2006, unaudited consolidated financial statements have beenreclassified to conform to the classifications adopted for reporting in 2007.

# **Note 2 – Recently AdoptedAccounting Standard**

We adopted SFAS No. 155, *Accounting for Certain Hybrid Financial Instruments*,as of January 1, 2007.  The adoption ofthis Statement did not have a material effect on the financial statements ofthe Company.

We adopted SFAS No. 156, *Accounting for Servicing of Financial Assets*,as of January 1, 2007.  The adoption ofthis Statement did not have a material effect on the financial statements ofthe Company.

We adopted FASB FinancialInterpretation No. 48, *Accounting forUncertainty in Income Taxes*, as of January 1, 2007.  The adoption of this Statement did not have amaterial effect on the financial statements of the Company.

**Note 3 - Earnings per Share**

The weighted averagenumber of common shares used to calculate earnings per share for the periodsended June 30, 2007 and 2006 were as follows:
| ** **                         | ** ** | **Three months ended June 30,** | ** ** | **Six months ended June 30,** | ** ** |
|------------------------------------|------------|-----------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                         | ** ** | **2007**                                            | ** ** | **2006**                                          | ** ** | **2007** | ** ** | **2006** | ** ** |
| Basic weighted -  average shares   |       | 4,868,377                                           |       | 5,024,563                                         |       | 4,869,112 |   | 5,028,420 |   |
| Effect of  dilutive securities     |       | 16,140                                              |       | 118,702                                           |       | 27,271 |   | 130,796 |   |
| Diluted weighted -  average shares |       | 4,884,517                                           |       | 5,143,265                                         |       | 4,896,383 |   | 5,159,216 |   |

 

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**Note 4 – Allowances for Loan andReal Estate Losses**

A summary of the activityin the allowances for loan and real estate losses is as follows for the periodsended June 30 (in thousands):
|                                   | ** ** | **Three Months Ended  June 30,  2007** | ** ** | **Three Months Ended  June 30,  2006** | ** ** |
|-----------------------------------|------------|-------------------------------------------------------|------------|-------------------------------------------------------|------------|
| ** **                        | ** ** | **Loans**                                             | ** ** | **Real Estate**                                  | ** ** | **Loans** | ** ** | **Real Estate** | ** ** |
| Balance—beginning  of period |       | $                                                     | 4,294      |                                                  | $          | — |   | $ | 2,251 |   | $ | — |   |
|                              |       |                                                  |       |                                                  |       |   |   |   |   |
| Provisions for estimated losses   |       | 370                                                   |       | 3                                                     |       | 359 |   | — |   |
| Recoveries                        |       | 39                                                    |       | —                                                |       | 37 |   | — |   |
| Losses charged off                |       | (412                                                  | )          | (3                                                    | )          | (199 | ) | — |   |
|                              |       |                                                  |       |                                                  |       |   |   |   |   |
| Balance—end of period        |       | $                                                     | 4,291      |                                                  | $          | — |   | $ | 2,448 |   | $ | — |   |

 
|                                   | ** ** | **Six Months Ended   June 30,   2007** | ** ** | **Six Months Ended   June 30,   2006** | ** ** |
|-----------------------------------|------------|-----------------------------------------------------------------|------------|-----------------------------------------------------------------|------------|
| ** **                        | ** ** | **Loans**                                                       | ** ** | **Real Estate**                                            | ** ** | **Loans** | ** ** | **Real Estate** | ** ** |
| Balance—beginning  of period |       | $                                                               | 2,572      |                                                            | $          | — |   | $ | 2,114 |   | $ | — |   |
|                              |       |                                                            |       |                                                            |       |   |   |   |   |
| Provisions for estimated losses   |       | 2,332                                                           |       | 77                                                              |       | 643 |   | — |   |
| Recoveries                        |       | 88                                                              |       | —                                                          |       | 85 |   | — |   |
| Losses charged off                |       | (701                                                            | )          | (77                                                             | )          | (394 | ) |   |   |
|                              |       |                                                            |       |                                                            |       |   |   |   |   |
| Balance—end of period        |       | $                                                               | 4,291      |                                                            | $          | — |   | $ | 2,448 |   | $ | — |   |

 

The allowance for loanlosses increased between the periods listed above primarily due to a $1.4million specific loan loss allowance on two phases of a subdivision recorded asof June 30, 2007.

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# **MANAGEMENT’SDISCUSSION AND ANALYSIS**

**OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS**

### **CRITICALACCOUNTING POLICIES**

Various elements of our accounting policies, by their nature, are inherentlysubject to estimation techniques, valuation assumptions and other subjectiveassessments.  In particular, themethodology for the determination of our allowance for loan losses, due to thejudgments, estimates and assumptions inherent in that policy, is critical topreparation of our financial statements. This policy and the judgments, estimates and assumptions are describedin greater detail in subsequent sections of Management’s Discussion andAnalysis and in the notes to the unaudited financial statements includedherein.  We believe that the judgments,estimates and assumptions used in the preparation of our financial statementsare appropriate given the factual circumstances at the time.  However, given the sensitivity of ourfinancial statements to this critical accounting policy, the use of otherjudgments, estimates and assumptions could result in material differences inour financial condition or results of operations.

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 future marketconditions and their impact on the loan portfolio.  In the event the local or national economywere to sustain a prolonged downturn, the loss factors applied to ourportfolios may need to be revised, which may significantly impact themeasurement of the allowance for loan losses. For impaired loans that are collateral-dependent, the estimated fairvalue of the collateral may deviate significantly from the proceeds receivedwhen the collateral is sold.

## **CHANGES INFINANCIAL CONDITION**

Changes in financial condition between June 30, 2007 and December 31,2006 are presented in the following table (dollars in thousands).  Material changes between the periods arediscussed in the sections which follow the table.
| ** **                                     | ** ** | **June 30,** | ** ** | **December 31,** | ** ** | **Increase**   | ** ** | **Percentage** | ** ** |
|------------------------------------------------|------------|-------------------|------------|-----------------------|------------|----------------|------------|----------------|------------|
| ** **                                     | ** ** | **2007**          | ** ** | **2006**              | ** ** | **(Decrease)** | ** ** | **Change**     | ** ** |
| **ASSETS**                                     |       |              |       |                  |       |           |       |           |       |
| Cash and cash equivalents                      |       | $                 | 38,720     |                  | $          | 35,518         |       | $              | 3,202      |   | 9.0 | % |
| Investment securities held to maturity         |       | 74,217            |       | 60,746                |       | 13,471         |       | 22.2           |       |
| Federal Home Loan Bank stock                   |       | 4,864             |       | 7,089                 |       | (2,225         | )          | (31.4          | )          |
| Loans receivable, net                          |       | 642,406           |       | 693,095               |       | (50,689        | )          | (7.3           | )          |
| Accrued interest receivable                    |       | 11,054            |       | 9,999                 |       | 1,055          |       | 10.6           |       |
| Real estate owned, net                         |       | 7,350             |       | 3,858                 |       | 3,492          |       | 90.5           |       |
| Other assets                                   |       | 41,880            |       | 42,170                |       | (290           | )          | (0.7           | )          |
|                                           |       |              |       |                  |       |           |       |           |       |
| TOTAL                                          |       | $                 | 820,491    |                  | $          | 852,475        |       | $              | (31,984    | ) | (3.8 | )% |
|                                           |       |              |       |                  |       |           |       |           |       |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY** |       |              |       |                  |       |           |       |           |       |
| LIABILITIES:                                   | ** ** | ** **        | ** ** | ** **            | ** ** | ** **     | ** ** | ** **     | ** ** |
| Deposits                                       |       | $                 | 648,192    |                  | $          | 652,265        |       | $              | (4,073     | ) | (0.6 | )% |
| Federal Home Loan Bank advances                |       | 91,816            |       | 120,305               |       | (28,489        | )          | (23.7          | )          |
| Other liabilities                              |       | 5,952             |       | 4,332                 |       | 1,620          |       | 37.4           |       |
|                                           |       |              |       |                  |       |           |       |           |       |
| Total liabilities                              |       | 745,960           |       | 776,902               |       | (30,942        | )          | (4.0           | )          |
|                                           |       |              |       |                  |       |           |       |           |       |
| STOCKHOLDERS’  EQUITY                     |       | 74,531            |       | 75,573                |       | (1,042         | )          | (1.4           | )          |
|                                           |       |              |       |                  |       |           |       |           |       |
| TOTAL                                          |       | $                 | 820,491    |                  | $          | 852,475        |       | $              | (31,984    | ) | (3.8 | )% |
|                                           |       |              |       |                  |       |           |       |           |       |
| BOOK VALUE PER  SHARE                          |       | $                 | 15.33      |                  | $          | 15.62          |       |           |       |   |   |
|                                           |       |              |       |                  |       |           |       |           |       |
| EQUITY TO ASSETS                               |       | 9.1               | %          | 8.9                   | %          |           |       |           |       |

 

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**Loans Receivable. **Changesin loan compositionbetween June 30, 2007 and December 31, 2006 are presented in the followingtable (dollars in thousands).
| ** **                                       | ** ** | **June 30,** | ** ** | **December 31,** | ** ** | **Increase**   | ** ** | ** **        | ** ** |
|--------------------------------------------------|------------|-------------------|------------|-----------------------|------------|----------------|------------|-------------------|------------|
| ** **                                       | ** ** | **2007**          | ** ** | **2006**              | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
| One- to  four-family residences                  |       | $                 | 244,577    |                  | $          | 257,978        |       | $                 | (13,401    | ) | (5.2 | )% |
| Home equity  lines of credit and second mortgage |       | 35,457            |       | 34,971                |       | 486            |       | 1.4               |       |
| Multi-family                                     |       | 12,261            |       | 12,203                |       | 58             |       | 0.5               |       |
| Commercial real  estate                          |       | 125,714           |       | 133,647               |       | (7,933         | )          | (5.9              | )          |
| Land                                             |       | 46,612            |       | 48,737                |       | (2,125         | )          | (4.4              | )          |
| Construction:                                    |       |              |       |                  |       |           |       |              |       |
| One- to four-family residences                   |       | 25,805            |       | 32,036                |       | (6,231         | )          | (19.4             | )          |
| Speculative one-to four-family residences        |       | 62,927            |       | 80,311                |       | (17,384        | )          | (21.6             | )          |
| Multi-family                                     |       | 12,292            |       | 14,120                |       | (1,828         | )          | (12.9             | )          |
| Commercial real estate                           |       | 23,495            |       | 21,896                |       | 1,599          |       | 7.3               |       |
| Land  development                                |       | 46,853            |       | 47,439                |       | (586           | )          | (1.2              | )          |
| Total mortgage loans                             |       | 635,993           |       | 683,338               |       | (47,345        | )          | (6.9              | )          |
|                                             |       |              |       |                  |       |           |       |              |       |
| Commercial                                       |       | 24,240            |       | 26,355                |       | (2,115         | )          | (8.0              | )          |
|                                             |       |              |       |                  |       |           |       |              |       |
| Automobile                                       |       | 11,199            |       | 12,210                |       | (1,011         | )          | (8.3              | )          |
| Other                                            |       | 13,701            |       | 13,690                |       | 11             |       | 0.1               |       |
| Total consumer                                   |       | 24,900            |       | 25,900                |       | (1,000         | )          | (3.9              | )          |
|                                             |       |              |       |                  |       |           |       |              |       |
| Total loans  receivable                          |       | 685,133           |       | 735,593               |       | (50,460        | )          | (6.9              | )          |
|                                             |       |              |       |                  |       |           |       |              |       |
| Undisbursed loan  funds                          |       | (38,668           | )          | (40,069               | )          | 1,401          |       | 3.5               |       |
| Deferred loan  costs – net                  |       | 232               |       | 143                   |       | 89             |       | 62.2              |       |
| Allowance for  loan losses                       |       | (4,291            | )          | (2,572                | )          | (1,719         | )          | 66.8              |       |
|                                             |       |              |       |                  |       |           |       |              |       |
| Loans receivable, net                            |       | $                 | 642,406    |                  | $          | 693,095        |       | $                 | (50,689    | ) | (7.3 | )% |

 

The decrease inthe Bank’s loan portfolio was primarily due to a softening of the housingmarket in Northwest Arkansas.  Marketdata indicates an overall decrease in home sales in Benton and Washingtoncounties in 2007 and 2006 compared to 2005. The Bank’s loan originations were down 45% for the six months ended June30, 2007, compared to the same period in 2006. Although the economy in the Northwest Arkansas region continues to bestrong as reflected in sustained job and population growth, the supply of newresidential lots and new speculative homes for sale has outpaced demand duringthe last few years.

Several years ago, theBank began to emphasize commercial real estate lending, construction lending,and commercial lending to diversify its loan portfolio, take advantage ofmarket opportunities in these types of loans, and help the Bank transition to amore full-service community bank, as well as to provide opportunities tocross-sell its other banking products. Although the Bank plans to continue this emphasis, the volume of suchlending will continue to be subject to the economic and market conditionsdiscussed above and the availability of prudent lending opportunities.

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**Asset Quality.** The following table sets forththe amounts and categories of the Bank’s nonperforming assets at the datesindicated.
|                                                                                                                              | ** ** | **June 30,   2007**        | ** ** | **December 31,  2006** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------|------------|-----------------------------|------------|
| ** **                                                                                                                   | ** ** | **(Dollars in Thousands)** | ** ** |
| Nonaccrual  loans:                                                                                                           |       |                                 |       |                        |       |
| One- to four-family residential                                                                                              |       | $                                    | 4,371      |                        | $          | 3,689 |   |
| Home equity                                                                                                                  | ** ** | 1,091                                |       | 994                         |       |
| Speculative one- to four-family construction                                                                                 | ** ** | 6,378                                |       | 5,417                       |       |
| Acquisition and development                                                                                                  | ** ** | 5,338                                |       | 5,324                       |       |
| Land                                                                                                                         | ** ** | 761                                  |       | 1,372                       |       |
| Commercial real estate                                                                                                       |       | 3,527                                |       | 738                         |       |
| Commercial loans                                                                                                             |       | 598                                  |       | 1,268                       |       |
| Consumer loans                                                                                                               |       | 185                                  |       | 213                         |       |
| Total nonaccrual loans                                                                                                       |       | 22,249                               |       | 19,015                      |       |
|                                                                                                                         |       |                                 |       |                        |       |
| Accruing loans  90 days or more past due                                                                                     |       | 1,179                                |       | 668                         |       |
| Real estate  owned                                                                                                           |       | 7,350                                |       | 3,858                       |       |
|                                                                                                                         |       |                                 |       |                        |       |
| Total nonperforming assets                                                                                                   |       | $                                    | 30,778     |                        | $          | 23,541 |   |
|                                                                                                                         |       |                                 |       |                        |       |
| Total  nonaccrual, accruing loans 90 days or more past due and restructured loans as  a percentage of total loans receivable |       | 3.42                                 | %          | 2.68                        | %          |
|                                                                                                                         |       |                                 |       |                        |       |
| Total nonperforming  assets as a percentage of total assets                                                                  |       | 3.75                                 | %          | 2.76                        | %          |

 

The increase in nonaccrual loans is primarily related to increases innonaccrual commercial real estate loans and nonaccrual speculative one- tofour-family construction loans, offset by decreases in nonaccrual land loansand nonaccrual commercial loans.  TheNorthwest Arkansas market continues to experience an oversupply of lots andspeculative homes. Certain of the Bank’s homebuilders are experiencing extendedmarketing times for the sale of their homes which has resulted in inadequatecash flow to service the interest carry on their loans.  The specific loan loss allowance related toloans to builders and developers was approximately $1.7 million at June 30,2007.

The level of nonaccrualspeculative construction loans, acquisition and development loans andcommercial real estate loans is attributable primarily to four loanrelationships.  These relationships aredescribed in more detail in the paragraphs that follow.

The first relationshiptotaled $5.9 million at June 30, 2007, and is comprised of two subdivisionloans totaling $5.3 million and the borrower’s primary residence totalingapproximately $520,000.  Foreclosureproceedings have begun on the subdivision and the borrower has filed forbankruptcy protection.  The subdivisionloans represent two phases of the same subdivision located in Lowell, Arkansas,one of which is complete and the other is approximately 10% complete.  At December 31, 2006, we estimated no loss onthe subdivision based on estimated sales prices of the lots and the estimatedcosts to complete the incomplete phase of the subdivision.  Since that time market conditions havedeteriorated and a subdivision across the street from this subdivision has goneinto default.  We are aware that thefinancial institution in that case is trying to liquidate the lots quickly at adiscounted price, which has in turn decreased the value of the lots in oursubdivision.  As a result, we obtainednew appraisals on both phases of our subdivision which used discounted cashflow analysis for the complete phase, given the extended selling period thatwould be necessary to recover our costs, and a land only valuation on theincomplete phase given the decreasing likelihood that we would develop theselots.  The new appraisals resulted in aspecific loan loss allowance totaling $1.4 million on this subdivision whichwas recorded in the first quarter of 2007. Due to the nature of these loans and the possibility of continuedadverse changes in market conditions, we may incur losses in the future inexcess of the amount estimated as of June 30, 2007.

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The second relationshiptotaled $1.7 million at June 30, 2007, and is comprised of $1.1 million inspeculative single-family construction loans, approximately $490,000 of rawland, and approximately $113,000 of commercial loans.  The speculative homes are in various stagesof completion ranging from approximately 85% to 100%.  The commercial loans consist of junior lienson the speculative single-family properties. All of the properties in thisrelationship are in foreclosure and the loans secured by such properties are onnonaccrual status.  The properties inthis relationship are cross-collateralized and we have evaluated our lossexposure on a total relationship basis. Based on estimated sales prices of the properties net of costs to sell,compared to principal balances plus estimated costs to complete, asappropriate, we have estimated losses of approximately $147,000 at June 30,2007.  However, based on factors such asthe complexity of this relationship, difficulty in estimating completion costsand potential adverse changes in market conditions, we may incur losses in thefuture in excess of the amount estimated at June 30, 2007.

The third relationshiptotaled $2.4 million at June 30, 2007, of which $2.1 million was on nonaccrualstatus.  This relationship is comprisedof $830,000 of speculative single-family construction loans on two properties,a $560,000 single-family construction loan, approximately $385,000 of land andlot loans, and approximately $280,000 of commercial loans.  All of the real estate loans are inforeclosure.  The commercial loansconsist of a fully reserved unsecured loan of approximately $75,000, and juniorliens on the lots and speculative homes totaling approximately $205,000, withan estimated loss allowance of $80,000. Additionally, there is an approximate $10,000 loss allowance on the landand lot loans.  The remaining $350,000balance on this relationship that was kept on accrual status consists of theborrower’s primary residence.  Based onfactors such as the complexity of this relationship, the difficulty inestimating completion costs, and potential adverse changes in marketconditions, we may incur losses in the future in excess of the amount estimatedat June 30, 2007.

The fourth relationshiptotaled $5.0 million at June 30, 2007, and is comprised primarily of loans toconstruct a shopping center with a total principal balance of $2.6 million and18 speculative single-family construction loans totaling $2.2 million.  The shopping center construction loan maturedin March and during the second quarter the borrower indicated he would beunable to pay the interest due in order to extend the construction loan.  The Bank obtained an updated appraisal on theshopping center and based on the appraised amount, principal balanceoutstanding, and an estimate of costs to complete the construction of theshopping center, the Bank currently estimates no loss on the shopping centerloans.  However, based on factors such asthe difficulty in estimating completion costs and potential adverse changes inmarket conditions, we may incur losses in the future in excess of the amountestimated at June 30, 2007.  As of June30, 2007, all of the speculative homes were current, complete, and scheduled tomature in July.  However, during July2007, the borrower gave the Bank deeds in lieu of foreclosure on all of thespeculative single-family residences. As of June 30, 2007, we have estimatedthat no reserve is necessary on any of the speculative single-family residencesbased on the estimated fair value of the homes.

The increase in realestate owned was primarily due to the foreclosure on properties related to oneborrower totaling $3.0 million.  Theseproperties were comprised of $1.3 million in single-family rental properties and$1.7 million in speculative single-family homes under construction.  The speculative homes are in various stagesof completion ranging from approximately 60% to 100%.  Construction costs are added to the realestate balance to the extent that the resulting balance does not exceed the estimatedfair value of the property less estimated selling costs.  Since December 31, 2006, approximately $5.2million has been added to real estate owned and $1.7 million has been sold at a$42,000 loss.

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**Allowance for Loan Losses**. A summary of the activity in the allowance for loan losses is asfollows (in thousands):
|                                 | ** ** | **Three Months Ended June 30,** | ** ** | **Six Months Ended June 30,** | ** ** |
|---------------------------------|------------|-----------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                      | ** ** | **2007**                                            | ** ** | **2006**                                          | ** ** | **2007** | ** ** | **2006** | ** ** |
| Balance at  beginning of period |       | $                                                   | 4,294      |                                              | $          | 2,251 |   | $ | 2,572 |   | $ | 2,114 |   |
| Provisions for estimated losses |       | 370                                                 |       | 359                                               |       | 2,332 |   | 643 |   |
| Recoveries                      |       | 39                                                  |       | 37                                                |       | 88 |   | 85 |   |
| Losses charged off              |       | (412                                                | )          | (199                                              | )          | (701 | ) | (394 | ) |
| Balance at end of  period       |       | $                                                   | 4,291      |                                              | $          | 2,448 |   | $ | 4,291 |   | $ | 2,448 |   |

 

Changes in the composition of the allowance for loan losses betweenJune 30, 2007 and December 31, 2006 are presented in the following table (inthousands):
|            | ** ** | **June 30,** | ** ** | **December 31,** | ** ** | ** **   | ** ** |
|------------|------------|-------------------|------------|-----------------------|------------|--------------|------------|
| ** ** | ** ** | **2007**          | ** ** | **2006**              | ** ** | **Increase** | ** ** |
| General    |       | $                 | 2,290      |                  | $          | 1,966        |       | $ | 324 |   |
| Specific   |       | 2,001             |       | 606                   |       | 1,395        |       |
|       |       | $                 | 4,291      |                  | $          | 2,572        |       | $ | 1,719 |   |

 

The general component ofthe allowance for loan losses increased due to the loss factor applied tospeculative single-family construction loans and acquisition and developmentloans.  These loss factors were increaseddue to the recent loss history on these types of loans.  The specific component of the allowance forloan losses increased primarily due to specific allowances on one largesubdivision in Lowell, Arkansas, as discussed in “Asset Quality” above.

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 against the allowance when management believesit is likely that a loan balance is uncollectible.  Subsequent recoveries, if any, are creditedto the allowance.

The allowance for loanlosses represents management’s estimate of incurred credit losses inherent inthe Company’s loan portfolio as of the balance sheet date.  The estimation of the allowance is based on avariety of factors, including past loan loss experience, the current creditprofile of the Company’s borrowers, adverse situations that have occurred thatmay affect the borrowers’ ability to repay, the estimated value of underlyingcollateral, and general economic conditions. Losses are recognized when available information indicates that it isprobable that a loss has been incurred and the amount of the loss can bereasonably estimated. This evaluation is inherently subjective as it requiresestimates that are susceptible to significant revision as more informationbecomes available or conditions change.

In determining theallowance for loan losses, the Company allocates a portion of the allowance toits various loan categories based on an analysis of individual loans and poolsof loans.  However, the entire allowanceis available to absorb credit losses inherent in the total loan portfolio as ofthe balance sheet date.

A loan is consideredimpaired when, based on current information and events, it is probable that theBank will be unable to collect the scheduled payments of principal or interestwhen due according to the contractual terms of the loan agreement. Factorsconsidered by management in determining impairment include payment status,collateral value, and the probability of collecting scheduled principal andinterest payments when due. Loans that experience insignificant payment delaysand payment shortfalls generally are not classified as impaired. Managementdetermines the significance of payment delays and payment shortfalls on acase-by-case basis, taking into consideration all of the circumstancessurrounding the loan and the borrower, including the length of the delay, thereasons for the delay, the borrower’s prior payment record, and the amount ofthe short fall in relation to the principal and interest owed. Impairment ismeasured on a loan by loan basis by either the present value of expected futurecash flows discounted at the loan’s effective interest rate, the loan’sobtainable market price, or the fair value of the collateral if the loan iscollateral dependent.  Multi-familyresidential, commercial real estate,

11

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land and landdevelopment, and commercial loans that are delinquent or where the borrower’stotal loan relationship exceeds $1 million are evaluated on a loan by loanbasis at least annually.

Large groups of smallerbalance homogeneous loans are collectively evaluated for impairment.Accordingly, the Bank does not separately identify individual consumer andresidential loans for impairment disclosures. Homogeneous loans are those that are considered to have commoncharacteristics that provide for evaluation on an aggregate or pool basis. TheBank considers the characteristics of (1) one- to four-family residential firstmortgage loans; (2) unsecured consumer loans; and (3) collateralized consumerloans to permit consideration of the appropriateness of the allowance forlosses of each group of loans on a pool basis. The primary methodology used todetermine the appropriateness of the allowance for losses includes segregatingcertain specific, poorly performing loans based on their performancecharacteristics from the pools of loans as to type, valuing these loans, andthen applying a loss factor to the remaining pool balance based on severalfactors including past loss experience, inherent risks, and economic conditionsin the primary market areas.

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 future marketconditions and their impact on the loan portfolio.  In the event the national or local economywere to sustain a prolonged downturn, the loss factors applied to our portfoliosmay need to be revised, which may significantly impact the measurement of theallowance for loan losses.  For impairedloans that are collateral dependent, the estimated fair value of the collateralmay deviate significantly from the proceeds received when the collateral issold in the event that the Bank has to foreclose or repossess the collateral.

Although we consider the allowance for loan losses of approximately$4.3 million adequate to cover losses inherent in our loan portfolio at June30, 2007, no assurance can be given that we will not sustain loan losses thatare significantly different from the amount recorded, or that subsequentevaluations of the loan portfolio, in light of factors then prevailing, wouldnot result in a significant change in the allowance for loan losses.

**Investment Securities. **Changes in the compositionof investment securities held to maturity between June 30, 2007 andDecember 31, 2006 are presented in the following table (in thousands).
|                                         | ** ** | **June 30,** | ** ** | **December 31,** | ** ** | ** **   | ** ** |
|-----------------------------------------|------------|-------------------|------------|-----------------------|------------|--------------|------------|
| ** **                              | ** ** | **2007**          | ** ** | **2006**              | ** ** | **Increase** | ** ** |
| U.S. Government  and agency obligations |       | $                 | 58,265     |                  | $          | 43,857       |       | $ | 14,408 |   |
| Municipal  securities                   |       | 15,952            |       | 16,889                |       | (937         | )          |
| Total                                   |       | $                 | 74,217     |                  | $          | 60,746       |       | $ | 13,471 |   |

 

During the first six months of 2007, investment securities totaling $18.5million were purchased and $5.1 million matured or were called.

At June 30, 2007, estimated fairvalues of investment securities held to maturity were as follows (inthousands):
|                                        | ** ** | **Amortized  Cost** | ** ** | **Fair  Value** | ** ** |
|----------------------------------------|------------|---------------------|------------|-----------------|------------|
| U.S. Government and agency obligations |       | $                   | 58,265     |            | $          | 56,872 |   |
| Municipal securities                   |       | 15,952              |       | 15,751          |       |
| Total                                  |       | $                   | 74,217     |            | $          | 72,623 |   |

 

**Federal Home Loan Bank Stock. **FHLB stock decreased by $2.2 million due to a lower balancerequirement related to the decrease in FHLB advances.

**Accrued Interest Receivable. ** The increase in accruedinterest receivable was primarily due to an increase in the number of daysaccrued as well as an increase in the loan yield at June 30, 2007 compared toDecember 31, 2006.

12

----

**Real Estate Owned. **Theincrease in real estate owned was primarily due to an increase in foreclosuresrelated to speculative homes.  See “AssetQuality” above.

**Deposits. **Changes in the composition of depositsbetween June 30, 2007 and December 31, 2006 are presented in the followingtable (dollars in thousands).
|                          | ** ** | **June 30,** | ** ** | **December 31,** | ** ** | **Increase ** | ** ** | **Percentage ** | ** ** |
|--------------------------|------------|-------------------|------------|-----------------------|------------|--------------------|------------|----------------------|------------|
| ** **               | ** ** | **2007**          | ** ** | **2006**              | ** ** | **(Decrease)**     | ** ** | **Change**           | ** ** |
| Checking  accounts       |       | $                 | 148,127    |                  | $          | 139,372            |       | $                    | 8,755      |   | 6.3 | % |
| Money Market  accounts   |       | 53,132            |       | 51,827                |       | 1,305              |       | 2.5                  | %          |
| Savings accounts         |       | 27,330            |       | 26,824                |       | 506                |       | 1.9                  | %          |
| Certificates of  deposit |       | 419,603           |       | 434,242               |       | (14,639            | )          | (3.4                 | )%         |
|                     |       |              |       |                  |       |               |       |                 |       |
| Total deposits           |       | $                 | 648,192    |                  | $          | 652,265            |       | $                    | (4,073     | ) | (0.6 | )% |

 

Deposits decreased in thecomparison period, primarily due to a decrease in public unit deposits.

**Federal Home Loan Bank Advances. **The Bank used funds from loan repayments to repay FHLB of Dallasadvances during the quarter.  FHLBadvances decreased by $28.5 million or 23.7% during the six months ended June 30,2007.  The balance of advances at June30, 2007 of $91.8 million consisted of $64.8 million of fixed rate advanceswith an average cost of 4.23% and $27.0 million of floating rate advances withan average cost of 5.34%.

**OtherLiabilities.**  Otherliabilities increased primarily due to a pending investment purchase thatsettled in July, offset by a decrease in federal and state deferred taxliabilities related to the increase in the loan loss provision.

**Stockholders’ Equity. **Stockholders’ equity decreased approximately $1.0 million fromDecember 31, 2006 to June 30, 2007.  The decreasein stockholders’ equity was primarily due to the purchase of treasury stocktotaling $2.0 million during the first six months of 2007.  In addition, during the six months ended June30, 2007, cash dividends of approximately $1.6 million were paid.  Such decreases were partially offset by netincome of $1.7 million during the six months ended June 30, 2007.  See the Unaudited Consolidated Statement ofStockholders’ Equity for the six months ended June 30, 2007 for more detail.

13

----

### **AverageBalance Sheets**

The following table setsforth certain information relating to the Company’s average balance sheets andreflects the average yield on assets and average cost of liabilities for theperiods indicated.  Such yields and costsare derived by dividing income or expense by the average balance of assets orliabilities, respectively, for the periods presented.  Average balances are based on daily balancesduring the period.
| ** **                                                         | ** ** | **Three Months Ended June 30,** | ** ** |
|--------------------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                         | ** ** | **2007**                                            | ** ** | **2006** | ** ** |
| ** **                                                         | ** ** | **Average  Balance**                                | ** ** | **Interest** | ** ** | **Average  Yield/  Cost** | ** ** | **Average  Balance** | ** ** | **Interest** | ** ** | **Average  Yield/  Cost** | ** ** |
| ** **                                                         | ** ** | **(Dollars in Thousands)**                | ** ** |
| Interest-earning assets:                                           |       |                                                |       |   |   |   |   |   |   |   |   |   |   |
|  Loans receivable(1)                                          |       | $                                                   | 665,367    |   | $ | 12,004 |   | 7.22 | % | $ | 740,135 |   | $ | 12,849 |   | 6.94 | % |
|  Investment securities(2)                                     |       | 70,154                                              |       | 890 |   | 5.07 |   | 67,136 |   | 810 |   | 4.82 |   |
|  Other interest-earning  assets                               |       | 23,428                                              |       | 302 |   | 5.16 |   | 6,624 |   | 78 |   | 4.70 |   |
| Total interest-earning assets                                      |       | 758,949                                             |       | 13,196 |   | 6.95 |   | 813,895 |   | 13,737 |   | 6.75 |   |
| Noninterest-earning assets                                         |       | 67,146                                              |       |   |   |   |   | 61,082 |   |   |   |   |   |
| Total assets                                                       |       | 826,095                                             |       |   |   |   |   | 874,977 |   |   |   |   |   |
| Interest-bearing liabilities:                                      |       |                                                |       |   |   |   |   |   |   |   |   |   |   |
|  Deposits                                                     |       | 649,338                                             |       | 6,044 |   | 3.72 |   | 630,727 |   | 4,926 |   | 3.12 |   |
|  FHLB advances                                                |       | 96,945                                              |       | 1,106 |   | 4.57 |   | 159,596 |   | 1,778 |   | 4.46 |   |
| Total interest-bearing liabilities                                 |       | 746,283                                             |       | 7,150 |   | 3.83 |   | 790,323 |   | 6,704 |   | 3.39 |   |
| Noninterest-bearing liabilities                                    |       | 4,930                                               |       |   |   |   |   | 5,989 |   |   |   |   |   |
| Total liabilities                                                  |       | 751,213                                             |       |   |   |   |   | 796,312 |   |   |   |   |   |
| Stockholders’ equity                                          |       | 74,882                                              |       |   |   |   |   | 78,665 |   |   |   |   |   |
| Total liabilities and   stockholders’ equity                  |       | $                                                   | 826,095    |   |   |   |   |   | $ | 874,977 |   |   |   |   |   |
|                                                               |       |                                                |       |   |   |   |   |   |   |   |   |   |   |
| Net interest income                                                |       |                                                |       | $ | 6,046 |   |   |   |   |   | $ | 7,033 |   |   |   |
| Net earning assets                                                 |       | $                                                   | 12,666     |   |   |   |   |   | $ | 23,572 |   |   |   |   |   |
| Interest rate spread                                               |       |                                                |       |   |   | 3.12 | % |   |   |   |   | 3.36 | % |
| Net interest margin                                                |       |                                                |       |   |   | 3.19 | % |   |   |   |   | 3.46 | % |
| Ratio of interest-earning assets to   interest-bearing liabilities |       |                                                |       |   |   | 101.70 | % |   |   |   |   | 102.98 | % |

 
| ** **                                                        | ** ** | **Six Months Ended June 30,** | ** ** |
|-------------------------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                                        | ** ** | **2007**                                          | ** ** | **2006** | ** ** |
| ** **                                                        | ** ** | **Average  Balance**                              | ** ** | **Interest** | ** ** | **Average  Yield/  Cost** | ** ** | **Average  Balance** | ** ** | **Interest** | ** ** | **Average  Yield/  Cost** | ** ** |
| ** **                                                        | ** ** | **(Dollars in Thousands)**              | ** ** |
| Interest-earning assets:                                          |       |                                              |       |   |   |   |   |   |   |   |   |   |   |
|  Loans receivable(1)                                         |       | $                                                 | 675,893    |   | $ | 24,205 |   | 7.16 | % | $ | 735,448 |   | $ | 25,075 |   | 6.82 | % |
|  Investment securities(2)                                    |       | 68,558                                            |       | 1,726 |   | 5.04 |   | 66,128 |   | 1,576 |   | 4.77 |   |
|  Other interest-earning  assets                              |       | 19,039                                            |       | 490 |   | 5.15 |   | 7,667 |   | 175 |   | 4.54 |   |
| Total interest-earning assets                                     |       | 763,490                                           |       | 26,421 |   | 6.92 |   | 809,243 |   | 26,826 |   | 6.63 |   |
| Noninterest-earning assets                                        |       | 66,676                                            |       |   |   |   |   | 60,570 |   |   |   |   |   |
| Total assets                                                      |       | 830,166                                           |       |   |   |   |   | 869,813 |   |   |   |   |   |
| Interest-bearing liabilities:                                     |       |                                              |       |   |   |   |   |   |   |   |   |   |   |
|  Deposits                                                    |       | 645,486                                           |       | 11,892 |   | 3.68 |   | 622,495 |   | 9,371 |   | 3.01 |   |
|  FHLB advances                                               |       | 103,717                                           |       | 2,366 |   | 4.56 |   | 162,846 |   | 3,520 |   | 4.32 |   |
| Total interest-bearing liabilities                                |       | 749,203                                           |       | 14,258 |   | 3.80 |   | 785,341 |   | 12,891 |   | 3.28 |   |
| Noninterest-bearing liabilities                                   |       | 5,567                                             |       |   |   |   |   | 6,183 |   |   |   |   |   |
| Total liabilities                                                 |       | 754,770                                           |       |   |   |   |   | 791,524 |   |   |   |   |   |
| Stockholders’ equity                                         |       | 75,396                                            |       |   |   |   |   | 78,289 |   |   |   |   |   |
| Total liabilities and   stockholders’ equity                 |       | $                                                 | 830,166    |   |   |   |   |   | $ | 869,813 |   |   |   |   |   |
|                                                              |       |                                              |       |   |   |   |   |   |   |   |   |   |   |
| Net interest income                                               |       |                                              |       | $ | 12,163 |   |   |   |   |   | $ | 13,935 |   |   |   |
| Net earning assets                                                |       | $                                                 | 14,287     |   |   |   |   |   | $ | 23,902 |   |   |   |   |   |
| Interest rate spread                                              |       |                                              |       |   |   | 3.12 | % |   |   |   |   | 3.35 | % |
| Net interest margin                                               |       |                                              |       |   |   | 3.19 | % |   |   |   |   | 3.44 | % |
| Ratio of interest-earning assets to interest-bearing  liabilities |       |                                              |       |   |   | 101.91 | % |   |   |   |   | 103.04 | % |

 

----

(1)  Includes nonaccrual loans.

(2)  Includes FHLB of Dallasstock.

14

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**Rate/VolumeAnalysis**

The table belowsets forth certain information regarding changes in interest income andinterest expense of the Company for the periods indicated.  For each category of interest-earning assetsand interest-bearing liabilities, information is provided on changes attributableto (i) changes in volume (changes in average volume multiplied by prior rate);(ii) changes in rate (change in rate multiplied by prior average volume); (iii)changes in rate-volume (changes in rate multiplied by the change in averagevolume); and (iv) the net change.
| ** **                         | ** ** | **Three Months Ended June 30,** | ** ** |
|------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                         | ** ** | **2007 vs. 2006**                         | ** ** |
| ** **                         | ** ** | **Increase (Decrease)  Due to**           | ** ** | ** ** | ** ** |
| ** **                         | ** ** | **Volume**                                          | ** ** | **Rate** | ** ** | **Rate/  Volume** | ** ** | **Total  Increase   (Decrease)** | ** ** |
| ** **                         | ** ** | **(In Thousands)**                             | ** ** |
| Interest income:                   |       |                                                |       |   |   |   |   |   |   |
| Loans receivable                   |       | (1,298                                              | )          | 504 |   | (51 | ) | (845 | ) |
| Investment securities              |       | 36                                                  |       | 42 |   | 2 |   | 80 |   |
| Other interest-earning assets      |       | 198                                                 |       | 8 |   | 18 |   | 224 |   |
| Total interest-earning assets      |       | (1,064                                              | )          | 554 |   | (31 | ) | (541 | ) |
|                               |       |                                                |       |   |   |   |   |   |   |
| Interest expense:                  |       |                                                |       |   |   |   |   |   |   |
| Deposits                           |       | 145                                                 |       | 945 |   | 28 |   | 1,118 |   |
| FHLB advances                      |       | (698                                                | )          | 43 |   | (17 | ) | (672 | ) |
| Total interest-bearing liabilities |       | (553                                                | )          | 988 |   | 11 |   | 446 |   |
| Net change in net interest income  |       | (511                                                | )          | (434 | ) | (42 | ) | (987 | ) |

 
| ** **                         | ** ** | **Six Months Ended June 30,** | ** ** |
|------------------------------------|------------|---------------------------------------------------|------------|
| ** **                         | ** ** | **2007 vs. 2006**                       | ** ** |
| ** **                         | ** ** | **Increase (Decrease)  Due to**         | ** ** | ** ** | ** ** |
| ** **                         | ** ** | **Volume**                                        | ** ** | **Rate** | ** ** | **Rate/  Volume** | ** ** | **Total  Increase   (Decrease)** | ** ** |
| ** **                         | ** ** | **(In Thousands)**                           | ** ** |
| Interest income:                   |       |                                              |       |   |   |   |   |   |   |
| Loans receivable                   |       | (2,030                                            | )          | 1,262 |   | (102 | ) | (870 | ) |
| Investment securities              |       | 58                                                |       | 89 |   | 3 |   | 150 |   |
| Other interest-earning assets      |       | 258                                               |       | 23 |   | 34 |   | 315 |   |
| Total interest-earning assets      |       | (1,714                                            | )          | 1,374 |   | (65 | ) | (405 | ) |
|                               |       |                                              |       |   |   |   |   |   |   |
| Interest expense:                  |       |                                              |       |   |   |   |   |   |   |
| Deposits                           |       | 346                                               |       | 2,097 |   | 78 |   | 2,521 |   |
| FHLB advances                      |       | (1,278                                            | )          | 195 |   | (71 | ) | (1,154 | ) |
| Total interest-bearing liabilities |       | (932                                              | )          | 2,292 |   | 7 |   | 1,367 |   |
| Net change in net interest income  |       | (782                                              | )          | (918 | ) | (72 | ) | (1,772 | ) |

 

15

----

**CHANGES IN RESULTS OF OPERATIONS**

The table below presents a comparison of results of operations forthe three months ended June 30, 2007 and 2006 (dollars inthousands).  Specific changes in captionsare discussed in the sections which follow the table.
| ** **                           | ** ** | **Three Months Ended  June 30,** | ** ** | **Increase  (Decrease)** | ** ** | **Percentage   Change** | ** ** |
|--------------------------------------|------------|-------------------------------------------------|------------|--------------------------|------------|------------------------------|------------|
| ** **                           | ** ** | **2007**                                        | ** ** | **2006**                 | ** ** | **2007 vs 2006**   | ** ** | **2007 vs 2006** | ** ** |
| Interest income:                     |       |                                            |       |                     |       |                         |       |   |   |
|  Loans receivable               |       | $                                               | 12,004     |                     | $          | 12,849                       |       | $ | (845 | ) | (6.6 | )% |
|  Investment securities          |       | 890                                             |       | 810                      |       | 80                           |       | 9.9 |   |
|  Other                          |       | 302                                             |       | 78                       |       | 224                          |       | 287.2 |   |
| Total interest  income               |       | 13,196                                          |       | 13,737                   |       | (541                         | )          | (3.9 | ) |
| Interest expense:                    |       |                                            |       |                     |       |                         |       |   |   |
|  Deposits                       |       | 6,044                                           |       | 4,926                    |       | 1,118                        |       | 22.7 |   |
|  Other borrowings               |       | 1,106                                           |       | 1,778                    |       | (672                         | )          | (37.8 | ) |
| Total interest  expense              |       | 7,150                                           |       | 6,704                    |       | 446                          |       | 6.7 |   |
| Net interest income  before          |       |                                            |       |                     |       |                         |       |   |   |
| provision for  loan losses           |       | 6,046                                           |       | 7,033                    |       | (987                         | )          | (14.0 | ) |
| Provision for loan  losses           |       | 370                                             |       | 359                      |       | 11                           |       | 3.1 |   |
| Net interest income  after           |       |                                            |       |                     |       |                         |       |   |   |
| provision for  loan losses           |       | 5,676                                           |       | 6,674                    |       | (998                         | )          | (15.0 | ) |
| Noninterest income:                  |       |                                            |       |                     |       |                         |       |   |   |
|  Deposit fee income             |       | 1,269                                           |       | 1,237                    |       | 32                           |       | 2.6 |   |
|  Gain on sale of loans          |       | 179                                             |       | 278                      |       | (99                          | )          | (35.6 | ) |
|  Other                          |       | 527                                             |       | 570                      |       | (43                          | )          | (7.5 | ) |
| Total  noninterest income            |       | 1,975                                           |       | 2,085                    |       | (110                         | )          | (5.3 | ) |
| Noninterest expenses:                |       |                                            |       |                     |       |                         |       |   |   |
|  Salaries and employee benefits |       | 3,287                                           |       | 3,259                    |       | 28                           |       | 0.9 |   |
|  Other                          |       | 2,188                                           |       | 2,119                    |       | 69                           |       | 3.3 |   |
| Total  noninterest expenses          |       | 5,475                                           |       | 5,378                    |       | 97                           |       | 1.8 |   |
| Income before income  taxes          |       | 2,176                                           |       | 3,381                    |       | (1,205                       | )          | (35.6 | ) |
| Income tax provision                 |       | 642                                             |       | 1,106                    |       | (464                         | )          | (42.0 | ) |
| Net income                           |       | $                                               | 1,534      |                     | $          | 2,275                        |       | $ | (741 | ) | (32.6 | )% |
|                                 |       |                                            |       |                     |       |                         |       |   |   |
| Basic earnings per  share            |       | $                                               | 0.32       |                     | $          | 0.45                         |       | $ | (0.13 | ) | (28.9 | )% |
| Diluted earnings per  share          |       | $                                               | 0.32       |                     | $          | 0.44                         |       | $ | (0.12 | ) | (27.3 | )% |
|                                 |       |                                            |       |                     |       |                         |       |   |   |
| Interest rate spread                 |       | 3.12                                            | %          | 3.36                     | %          |                         |       |   |   |
| Net interest margin                  |       | 3.19                                            | %          | 3.46                     | %          |                         |       |   |   |
|                                 |       |                                            |       |                     |       |                         |       |   |   |
| Average full-time  equivalents       |       | 306                                             |       | 305                      |       |                         |       |   |   |
|                                 |       |                                            |       |                     |       |                         |       |   |   |
| Full-service offices                 |       | 18                                              |       | 18                       |       |                         |       |   |   |

 

16

----

The table below presents a comparison of results of operations forthe six months ended June 30, 2007 and 2006 (dollars in thousands).  Specific changes in captions are discussed inthe sections which follow the table.
| ** **                           | ** ** | **Six Months Ended  June 30,** | ** ** | **Increase  (Decrease)** | ** ** | **Percentage   Change** | ** ** |
|--------------------------------------|------------|-----------------------------------------------|------------|--------------------------|------------|------------------------------|------------|
| ** **                           | ** ** | **2007**                                      | ** ** | **2006**                 | ** ** | **2007 vs 2006**   | ** ** | **2007 vs 2006** | ** ** |
| Interest income:                     |       |                                          |       |                     |       |                         |       |   |   |
|  Loans receivable               |       | $                                             | 24,205     |                     | $          | 25,075                       |       | $ | (870 | ) | (3.5 | )% |
|  Investment securities          |       | 1,726                                         |       | 1,576                    |       | 150                          |       | 9.5 |   |
|  Other                          |       | 490                                           |       | 175                      |       | 315                          |       | 180.0 |   |
| Total interest  income               |       | 26,421                                        |       | 26,826                   |       | (405                         | )          | (1.5 | ) |
| Interest expense:                    |       |                                          |       |                     |       |                         |       |   |   |
|  Deposits                       |       | 11,892                                        |       | 9,371                    |       | 2,521                        |       | 26.9 |   |
|  Other borrowings               |       | 2,366                                         |       | 3,520                    |       | (1,154                       | )          | (32.8 | ) |
| Total interest  expense              |       | 14,258                                        |       | 12,891                   |       | 1,367                        |       | 10.6 |   |
| Net interest income  before          |       |                                          |       |                     |       |                         |       |   |   |
| provision for  loan losses           |       | 12,163                                        |       | 13,935                   |       | (1,772                       | )          | (12.7 | ) |
| Provision for loan  losses           |       | 2,332                                         |       | 643                      |       | 1,689                        |       | 262.7 |   |
| Net interest income  after           |       |                                          |       |                     |       |                         |       |   |   |
| provision for  loan losses           |       | 9,831                                         |       | 13,292                   |       | (3,461                       | )          | (26.0 | ) |
| Noninterest income:                  |       |                                          |       |                     |       |                         |       |   |   |
|  Deposit fee income             |       | 2,426                                         |       | 2,315                    |       | 111                          |       | 4.8 |   |
|  Gain on sale of loans          |       | 354                                           |       | 475                      |       | (121                         | )          | (25.5 | ) |
|  Other                          |       | 1,059                                         |       | 1,612                    |       | (553                         | )          | (34.3 | ) |
| Total  noninterest income            |       | 3,839                                         |       | 4,402                    |       | (563                         | )          | (12.8 | ) |
| Noninterest expenses:                |       |                                          |       |                     |       |                         |       |   |   |
|  Salaries and employee benefits |       | 6,729                                         |       | 6,979                    |       | (250                         | )          | (3.6 | ) |
|  Other                          |       | 4,815                                         |       | 4,421                    |       | 394                          |       | 8.9 |   |
| Total  noninterest expenses          |       | 11,544                                        |       | 11,400                   |       | 144                          |       | 1.3 |   |
| Income before income  taxes          |       | 2,126                                         |       | 6,294                    |       | (4,168                       | )          | (66.2 | ) |
| Income tax provision                 |       | 433                                           |       | 2,034                    |       | (1,601                       | )          | (78.7 | ) |
| Net income                           |       | $                                             | 1,693      |                     | $          | 4,260                        |       | $ | (2,567 | ) | (60.3 | )% |
|                                 |       |                                          |       |                     |       |                         |       |   |   |
| Basic earnings per  share            |       | $                                             | 0.35       |                     | $          | 0.85                         |       | $ | (0.50 | ) | (58.8 | )% |
| Diluted earnings per  share          |       | $                                             | 0.35       |                     | $          | 0.83                         |       | $ | (0.48 | ) | (57.8 | )% |
|                                 |       |                                          |       |                     |       |                         |       |   |   |
| Interest rate spread                 |       | 3.12                                          | %          | 3.35                     | %          |                         |       |   |   |
| Net interest margin                  |       | 3.19                                          | %          | 3.44                     | %          |                         |       |   |   |
|                                 |       |                                          |       |                     |       |                         |       |   |   |
| Average full-time  equivalents       |       | 306                                           |       | 306                      |       |                         |       |   |   |
|                                 |       |                                          |       |                     |       |                         |       |   |   |
| Full-service offices                 |       | 18                                            |       | 18                       |       |                         |       |   |   |

 

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**NetInterest Income. **Netinterest income is determined by the Company’s interest rate spread (i.e., thedifference between the yields earned on its interest-earning assets and therates paid on its interest-bearing liabilities) and the relative amounts ofinterest-earning assets and interest-bearing liabilities.  The decrease in net interest income wasprimarily due to the Company’s negative gap position and the more rapidincrease in rates paid on deposits compared to the yield on the Company’sinterest earning assets.

### **INTEREST INCOME AND INTEREST EXPENSE**

Dollar changes ininterest income and interest expense for the comparison periods are presentedin the Rate/Volume Analysis table which appears on a previous page.

**InterestIncome. **The decreasein interest income for the three and six month comparative periods wasprimarily due to a decrease in the average balance of loans receivable and anincrease in the nonperforming loans in the loan portfolio, offset by anincrease in the average yield earned on loans receivable and an increase in theaverage balance of other interest-earning assets.  The increase in average yields earned was dueprimarily to increases in market interest rates.  The average balance of loans decreasedprimarily due to a decrease in loan originations.

**InterestExpense.  **The increasein interest expense for the three and six month comparative periods was primarilydue to an increase in the average rates paid on deposits and FHLB advances andan increase in the average balance of deposits, offset by a decrease in theaverage balance of FHLB advances.  Theaverage balance of FHLB advances decreased due to funds generated from loanrepayments being used to pay down maturing advances.  The increase in the average rates paid ondeposit accounts reflects the increase in market interest rates.

**Provisionfor Loan Losses.**  Theprovision for loan losses includes charges to maintain an allowance for loanlosses adequate to cover probable credit losses related to specificallyidentified loans as well as probable credit losses inherent in the remainder ofthe loan portfolio that have been incurred as of the balance sheet date.  Such provision and the adequacy of theallowance for loan losses is evaluated quarterly by management of the Bankbased on the Bank’s past loan loss experience, known and inherent risks in theportfolio, adverse situations that may affect the borrower’s ability to repay,the estimated value of any underlying collateral and current economicconditions.

Factors influencingmanagement’s decision to increase the provision in the 2007 vs. 2006 periodsinclude an increase in nonaccrual loans, conditions in the speculativesingle-family real estate market in Northwest Arkansas, and a specific loanloss allowance of $1.4 million on two phases of a subdivision in Lowell,Arkansas, as discussed in “Asset Quality” above.  The speculative single-family constructionmarket demonstrated weakness in late 2005 and we began reducing our exposure inthis area.  During the six months endedJune 30, 2007, we recorded $249,000 in charge-offs on speculative single-familyconstruction loans.  This compares tocharge-offs of $239,000 for the year ended December 31, 2006, $77,000 for theyear ended December 31, 2005, and none for the year ended December 31,2004.  The losses on these loans in 2006related primarily to extraordinary costs in constructing these residences, someoverfunding to cover these costs, and some substandard construction, ratherthan deterioration of the value of the underlying collateral.  However, the continued oversupply ofavailable housing during the quarter ended June 30, 2007 has impacted the valueof speculative single-family homes and development projects, as discussedabove.  Further deterioration in thismarket segment may impact the value of existing single-family home values aswell as our provision for loan losses in the future.

**NoninterestIncome. **Deposit feeincome increased for the three and six month comparative periods in 2007 as aresult of an increase in debit/credit card usage and insufficient funds feeincome.  This increase resulted from anincrease in the number of checking accounts with overdrawn balances and a 4.2%increase in the per item charge that was effective February 1, 2007.  The Bank plans to continue to aggressivelypromote checking accounts in 2007 through direct mail campaigns and offering “thankyou” gifts to further expand its checking accounts and increase deposit feeincome.

The decrease in gains onsales of loans for the three and six month comparative periods ended June 30,2007 was primarily related to a decrease in the number of loans sold.

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The decrease in other noninterestincome for the six month comparative period ended June 30, 2007 was primarilydue to nonrecurring gains on the sales of two properties totaling approximately$528,000 during the quarter ended March 31, 2006.  These properties represented excess land anda building adjacent to two existing branches.

**NoninterestExpense**

**Salariesand Employee Benefits. **Thechanges in the composition of this line item are presented below (inthousands):
| ****                               | ** ** | **Three Months Ended June 30,** | ** ** | **Increase  (Decrease)** | ** ** | **Six Months Ended June 30,** | ** ** | **Increase  (Decrease)** | ** ** |
|------------------------------------|------------|-----------------------------------------------------|------------|--------------------------|------------|---------------------------------------------------|------------|--------------------------|------------|
| ** **                         | ** ** | **2007**                                            | ** ** | **2006**                 | ** ** | **2007 vs 2006**                        | ** ** | **2007**                 | ** ** | **2006** | ** ** | **2007 vs 2006** | ** ** |
| Salaries                           |       | $                                                   | 2,566      |                     | $          | 2,606                                             |       | $                        | (40        | ) | $ | 5,230 |   | $ | 5,121 |   | $ | 109 |   |
| Payroll taxes                      |       | 215                                                 |       | 211                      |       | 4                                                 |       | 478                      |       | 467 |   | 11 |   |
| Insurance                          |       | 170                                                 |       | 173                      |       | (3                                                | )          | 340                      |       | 344 |   | (4 | ) |
| ESOP (1)                           |       | —                                              |       | —                   |       | —                                            |       | —                   |       | 508 |   | (508 | ) |
| 401(k)                             |       | 76                                                  |       | 22                       |       | 54                                                |       | 156                      |       | 22 |   | 134 |   |
| Stock compensation (2)             |       | 10                                                  |       | 12                       |       | (2                                                | )          | 24                       |       | 46 |   | (22 | ) |
| Defined benefit plan  contribution |       | 210                                                 |       | 196                      |       | 14                                                |       | 420                      |       | 393 |   | 27 |   |
| Other                              |       | 40                                                  |       | 39                       |       | 1                                                 |       | 81                       |       | 78 |   | 3 |   |
| Total                              |       | $                                                   | 3,287      |                     | $          | 3,259                                             |       | $                        | 28         |   | $ | 6,729 |   | $ | 6,979 |   | $ | (250 | ) |

 

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(1)  Employee Stock Ownership Plan

(2)  Includes stock options andManagement Recognition and Retention Plan (“MRP”) expense.

The decrease in salariesand employee benefits for the six months ended June 30, 2007, was due primarilyto the decrease in employee stock ownership plan expense, as the plan sharesbecame fully allocated as of March 31, 2006. The Company implemented a 401(k) Plan on June 1, 2006.  The 401(k) expense above relates to employermatching of employee 401(k) contributions. The increase in salaries and employee benefits in the three monthcomparative period is primarily due to 401(k) expense.

**OtherExpenses.**  Otherexpenses increased in the three and six month comparative periods endedJune 30, 2007 primarily due to increased REO-related expenses and costsassociated with upgrading our computer system during the first quarter of2007.  REO-related expenses increasedprimarily due to losses on sales of REO and provisional writedowns of REO.

**Income Taxes. **The provision for incometaxes decreased in both comparison periods due to a decrease in taxable incomeand certain nontaxable income amounts remaining relatively constant andtherefore representing a larger percentage of taxable income.

# **OFF-BALANCE SHEET ARRANGEMENTS**

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

·                  theorigination, purchase or sale of loans;

·                  thefulfillment of commitments under letters-of-credit, extensions of credit onhome equity lines of credit, construction loans, and predetermined overdraftprotection limits; and

·                  the commitment to fund withdrawals ofcertificates of deposit at maturity.

At June 30, 2007, theBank’s off-balance sheet arrangements principally included lending commitments,which are described below.  At June 30,2007, the Company had no interests in non-consolidated special purposeentities.

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At June 30, 2007,commitments included:

·                  total approved commitments tooriginate or purchase loans amounting to $9.7 million, including $1.1 millionof loans committed to sell;

·                  rate lock agreements with customersof $7.8 million, all of which have been locked with an investor;

·                  funded mortgage loans committed tosell of $3.8 million;

·                  unadvanced portion of constructionloans of $38.7 million;

·                  unused lines of credit of $26.3million;

·                  outstanding standby letters of creditof approximately $530,000;

·                  total predetermined overdraftprotection limits of $12.8 million; and

·                  certificates of deposit scheduled tomature in one year or less totaling $329.7 million.

Total unfundedcommitments to originate loans for sale and the related commitments to sell of $7.8million meet the definition of a derivative financial instrument.  The related asset and liability areconsidered immaterial at June 30, 2007.

Historically, a verysmall percentage of predetermined overdraft limits have been used.  At June 30, 2007, overdrafts of accounts withBounce ProtectionTM represented usage of 3.2% of the limit.  We expect utilization of these overdraftlimits to remain at comparable levels in the future.

Based on historicalexperience, management believes that a significant portion of maturing depositswill remain with the Bank.  We anticipatethat we will continue to have sufficient funds, through repayments, depositsand borrowings, to meet our current commitments.

### **LIQUIDITY AND CAPITAL RESOURCES**

The Bank’s liquidity, represented by cash and cash equivalents andeligible investment securities, is a product of its operating, investing andfinancing activities.  The Bank’s primarysources of funds are deposits, borrowings, collections on outstanding loans,maturities and calls of investment securities and other short-term investmentsand funds provided from operations. While scheduled loan amortization and maturing investment securities andshort-term investments are relatively predictable sources of funds, depositflows and loan prepayments are greatly influenced by general interest rates,economic conditions and competition.  TheBank manages the pricing of its deposits to maintain a steady depositbalance.  In addition, the Bank investsexcess funds in overnight deposits and other short-term interest-earning assetswhich provide liquidity to meet lending requirements.  During the first quarter of 2007, the use ofFHLB advances decreased due to the Bank’s using funds generated from loanrepayments to pay down maturing advances. At June 30, 2007,available borrowing capacity with the FHLB was in excess of $208.8 million.

For the six months ended June 30, 2007 and 2006, the Company paiddividends of $0.32 and $0.28 per share, respectively.  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.

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.

As of June 30, 2007, the Bank’s regulatory capital was in excess of all applicableregulatory requirements.  At June30, 2007, the Bank’s tangible,core and risk-based capital ratios amounted to 8.96%, 8.96% and 12.60%,respectively, compared to regulatory requirements of 1.5%, 4.0% and 8.0%,respectively.

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

The financial statementsand related financial data presented herein have been prepared in accordancewith generally accepted accounting principles, which require the measurement offinancial position and operating results in terms of historical dollars, withoutconsidering changes in relative purchasing power over time due to inflation.

Unlike most industrial companies, virtually all of the Bank’s assetsand liabilities are monetary in nature. As a result, interest rates generally have a more significant impact ona financial institution’s performance than does the effect of inflation.

### **FORWARD-LOOKING STATEMENTS**

The Company’s QuarterlyReport on Form 10-Q contains certain forward-looking statements and informationrelating to the Company that are based on the beliefs of management as well asassumptions made by and information currently available to management.  In addition, in this document, the words “anticipate”,“believe,” “estimate,”****“expect,” “intend,”“should” and similar expressions, or the negative thereof, as they relate tothe Company or the Company’s management, are intended to identifyforward-looking statements.  Suchstatements reflect the current views of the Company with respect to futurelooking events and are subject to certain risks, uncertainties 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.

**QUANTITATIVEAND QUALITATIVE DISCLOSURES****ABOUT MARKET RISK**

There has been nomaterial change in the market value of the Bank’s portfolio equity sinceDecember 31, 2006.  Similarly, whilethere has been no material change in the Company’s asset and liability positionsince such time, the Bank’s negative gap position has adversely impacted netincome as interest expense during the six months ended June 30, 2007 increasedat a greater pace than the comparable increase in interest income.  Correspondingly, the Bank’s net interestmargin decreased from 3.44% for the six months ended June 30, 2006 to 3.19% forthe same period in 2007.   Based on thecurrent market interest rate environment and increased competition, managementanticipates continued pressure on the Bank’s interest rate spread and interestmargin for the third quarter of 2007.

**CONTROLSAND PROCEDURES**

Our management evaluated,with the participation of our Chief Executive Officer and Chief FinancialOfficer, the effectiveness of the design and operation of our disclosurecontrols and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under theSecurities Exchange Act of 1934) as of the end of the period covered by thisreport.  Based on such evaluation, ourChief Executive Officer and Chief Financial Officer have concluded that ourdisclosure controls and procedures are designed to ensure that informationrequired to be disclosed by us in the reports that we file or submit under theSecurities Exchange Act of 1934 is recorded, processed, summarized and reportedwithin the time periods specified in the SEC’s rules and regulations and areoperating in an effective manner.

No change in the Company’sinternal control over financial reporting (as defined in Rules 13a-15(f) and15d-15(f) under the Securities Exchange Act) occurred during the most recentfiscal quarter 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

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reporting processasserted that the conversion did not create material changes in the Company’ssystem of internal controls over financial reporting.

The Companycontinues to evaluate and resolve post-conversion issues. The Company’sinternal audit department began detailed analysis to identify any significantchanges in the quality of internal control over financial reporting as a resultof the conversion in the latter part of the second quarter.  This evaluation will continue into the thirdquarter.

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**FIRSTFEDERAL BANCSHARES OF ARKANSAS, INC.**

**PartII**

Item 1.             Legal Proceedings

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

Item 1A.         Risk Factors

There have been nomaterial changes in the Company’s risk factors from those previously disclosedin the Company’s Form 10-K for the year ended December 31, 2006.

Item 2.             Unregistered Salesof Equity Securities and Use of Proceeds

ISSUER PURCHASES OF EQUITY SECURITIES
| Period                     | ** ** | **(a) Total  Number of  Shares  Purchased** | ** ** | **(b)  Average  Price Paid  per Share** | ** ** | **(c) Total Number of  Shares Purchased as  Part of Publicly  Announced Plans or  Programs** | ** ** | **(d) Maximum Number  of Shares that May  Yet Be Purchased  Under the Plans or  Programs** | ** ** |
|----------------------------|------------|-------------------------------------------------------|------------|---------------------------------------------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------|------------|
| April 1 to April  30, 2007 |       | —                                                |       | —                                            |       | —                                                                                                                                    |       | —                                                                                                                                       |       |
| May 1 to May 31,  2007     |       | 25,000                                                |       | $                                                 | 24.33      |                                                                                                                                      | 25,000     |                                                                                                                                         | 51,626     |   |
| June 1 to June 30, 2007    |       | —                                                |       | —                                            |       | —                                                                                                                                    |       | —                                                                                                                                       |       |
|                            |            |                                                       |            |                                                   |            |                                                                                                                                           |            |                                                                                                                                              |            |  |

 

The Company is in its 19th announced repurchase program, which wasapproved by the board of directors on July 25, 2006, and publicly announced onNovember 8, 2006.  Total shares approvedto be purchased in this program are 245,197 of which 193,571 have beenpurchased as of June 30, 2007.  Alltreasury stock purchases are made under publicly announced repurchase programs.

Item 3.             Defaults UponSenior Securities

Not applicable.

Item 4.             Submission ofMatters to a Vote of Security Holders

On April 25, 2007,the Corporation held an annual meeting of stockholders for the followingpurposes:

(1)                           Toelect two directors for a term of three years; and

(2)                           Toratify the appointment by the Board of Directors of Deloitte and Touche LLP asthe Corporation’s independent auditors for the year ending December 31, 2007.

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The results of thevoting are set forth below:

Proposal One(Election of Directors):
| NAME            | ** ** | **FOR**   | ** ** | **AGAINST/  WITHHELD** | ** ** | **NOT  VOTED** | ** ** |
|-----------------|------------|-----------|------------|------------------------|------------|----------------|------------|
| Larry J. Brandt |       | 4,410,220 |       | 7,561                  |       | 454,459        |       |
| Frank Conner    |       | 4,408,463 |       | 9,318                  |       | 454,459        |       |

 

Proposal Two(Ratification of Auditors):
| FOR       | ** ** | **AGAINST** | ** ** | **ABSTAIN** | ** ** | **NOT  VOTED** | ** ** |
|-----------|------------|-------------|------------|-------------|------------|----------------|------------|
| 4,385,976 |       | 5,470       |       | 2,372       |       | 478,422        |       |

 

Item 5.             Other Information

None.

Item 6.             Exhibits 

|        | Exhibit 31.1 –  Certification of Chief Executive Officer, |                                                                        |
|--------|----------------------------------------------------------------|-----------------------------------------------------------------------------|
|   |                                                           | Pursuant to  Section 302 of the Sarbanes-Oxley Act of 2002 (18 U.S.C. 1350) |
|   | Exhibit 31.2 –  Certification of Chief Financial Officer, |                                                                        |
|   |                                                           | Pursuant to  Section 302 of the Sarbanes-Oxley Act of 2002 (18 U.S.C. 1350) |
|   | Exhibit 32.1 –  Certification of Chief Executive Officer, |                                                                        |
|   |                                                           | Pursuant to  Section 906 of the Sarbanes-Oxley Act of 2002 (18 U.S.C. 1350) |
|   | Exhibit 32.2 –  Certification of Chief Financial Officer, |                                                                        |
|   |                                                           | Pursuant to  Section 906 of the Sarbanes-Oxley Act of 2002 (18 U.S.C. 1350) |
|        |                                                                |                                                                             |  |

 

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**SIGNATURES**

Pursuant to therequirements of the Securities Exchange Act of 1934, the Registrant has dulycaused this report to be signed on its behalf by the undersigned thereunto dulyauthorized.

**FIRST FEDERAL BANCSHARES OF ARKANSAS,INC.**
| Date:   July 26, 2007 | By:    |   /s/ Larry J. Brandt                                   |   |
|--------------------------------------|--------|-------------------------------------------------------------------|--------|
|                                 |   |   Larry J. Brandt                                       |
|                                 |   |   Chief Executive Officer                               |
|                                 |   |                                                              |
|                                 |   |                                                              |
| Date:   July 26, 2007 | By:    |   /s/ Sherri R. Billings                                |   |
|                                 |   |   Sherri R. Billings                                    |
|                                 |   |   Chief Financial Officer and Chief  Accounting Officer |

 

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