Tableof Contents

 

 

 

**UNITED STATES**

**SECURITIES AND EXCHANGECOMMISSION**

**Washington, D.C. 20549**

 

**FORM 10-Q**

 

**x****      QUARTERLY REPORT PURSUANT TO SECTION 13 OR15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**

 

**For the quarterly period ended June 30,2010**

 

**OR**

 

**x****      TRANSITION REPORT PURSUANT TO SECTION 13 OR15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**

 

**For the transition period from****            to           **

 

**Commission File Number 0-28312**

 

**FIRST FEDERAL BANCSHARES OFARKANSAS, INC.**

(Exact name of registrant as specified in itscharter)

 

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

 

**(870) 741-7641**

(Registrant’s telephone number, including areacode)

 

Indicate by check mark whether the registrant (1) hasfiled all reports required to be filed by Section 13 or 15(d) of theSecurities Exchange Act of 1934 during the preceding 12 months (or for suchshorter period that the registrant was required to file such reports), and (2) hasbeen subject to such filing requirements for the past 90 days.  Yes  x  No  o

 

Indicate by check mark whether the registrant hassubmitted electronically and posted on its corporate Web site, if any, everyInteractive Data File required to be submitted and posted pursuant to Rule 405of Regulation S-T during the preceding 12 months (or for such shorter periodthat the registrant was required to submit and post such files).  Yes  o  No  o

 

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

 

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

 

Indicate by check mark whether the registrant isa shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes  o  No  x

 

Indicate the number of shares outstanding of each of theissuer’s classes of common stock, as of the latest practicable date:  As of July 29, 2010, there were issuedand outstanding 4,846,785 shares of the Registrant’s Common Stock, par value$.01 per share.

 

 

 

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Table ofContents

 

**FIRST FEDERAL BANCSHARES OFARKANSAS, INC.**

 

**TABLE OF CONTENTS**

 
| ** **        | ** ** | ** **                                                                                                                                                                 | ** ** | **Page**   |
|-------------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------|
| ** **        | ** ** | ** **                                                                                                                                                                 | ** ** | ** ** |
| **Part I.**  |       | **Financial  Information**                                                                                                                                                 |       |       |
|              |       |                                                                                                                                                                       |       |       |
| Item 1.           |       | Condensed  Consolidated Financial Statements                                                                                                                               |       |       |
|              |       |                                                                                                                                                                       |       |       |
|              |       | Condensed Consolidated Statements of Financial  Condition as ofJune 30, 2010  and December 31, 2009 (unaudited)                                                  |       | 1          |
|              |       |                                                                                                                                                                       |       |       |
|              |       | Condensed Consolidated Statements of Operations for  the three and six months endedJune 30,  2010 and 2009 (unaudited)                                                |       | 2          |
|              |       |                                                                                                                                                                       |       |       |
|              |       | Condensed Consolidated Statement of Stockholders’  Equity for the six months ended June 30, 2010 (unaudited)                                                     |       | 3          |
|              |       |                                                                                                                                                                       |       |       |
|              |       | Condensed Consolidated Statements of Cash Flows for the  six months endedJune 30,  2010 and 2009 (unaudited)                                                          |       | 4          |
|              |       |                                                                                                                                                                       |       |       |
|              |       | Notes to Unaudited Condensed Consolidated Financial  Statements                                                                                                            |       | 6          |
|              |       |                                                                                                                                                                       |       |       |
| Item 2.           |       | Management’s  Discussion and Analysis of Financial Conditionand Results of Operations                                                                                 |       | 18         |
|              |       |                                                                                                                                                                       |       |       |
| Item 3.           |       | Quantitative  and Qualitative Disclosures About Market Risk                                                                                                                |       | 44         |
|              |       |                                                                                                                                                                       |       |       |
| Item 4.           |       | Controls and  Procedures                                                                                                                                                   |       | 44         |
|              |       |                                                                                                                                                                       |       |       |
| **Part II.** | ** ** | **Other Information**                                                                                                                                                      | ** ** | ** ** |
|              |       |                                                                                                                                                                       |       |       |
| Item 1.           |       | Legal Proceedings                                                                                                                                                          |       | 45         |
| Item  1A.         |       | Risk  Factors                                                                                                                                                              |       | 45         |
| Item 2.           |       | Unregistered  Sales of Equity Securities and Use of Proceeds                                                                                                               |       | 52         |
| Item 3.           |       | Defaults  Upon Senior Securities                                                                                                                                           |       | 52         |
| Item 4.           |       | Removed and  Reserved                                                                                                                                                      |       | 52         |
| Item 5.           |       | Other Information                                                                                                                                                          |       | 52         |
| Item  6.          |       | Exhibits                                                                                                                                                                   |       | 52         |
|              |       |                                                                                                                                                                       |       |       |
| **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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Tableof Contents

 

**Part I.    Financial Information**

 

**Item 1.  Financial Statements.**

 

**FIRST FEDERAL BANCSHARES OFARKANSAS, INC.**

**CONDENSED CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION**

(In thousands, except share data)

(Unaudited)

 
| ** **                                                                                                                                                                                                       | ** ** | **June 30,** | ** ** | **December 31,** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                                                                       | ** ** | **2010**          | ** ** | **2009**              | ** ** |
| ASSETS                                                                                                                                                                                                           |       |              |       |                  |       |
|                                                                                                                                                                                                             |       |              |       |                  |       |
| Cash and cash equivalents                                                                                                                                                                                        |       | $                 | 63,796     |                  | $          | 22,149 |   |
| Investment securities held  to maturity                                                                                                                                                                          |       | 88,290            |       | 135,531               |       |
| Federal Home Loan Bank stock                                                                                                                                                                                     |       | 1,573             |       | 3,125                 |       |
| Loans receivable, net of  allowance of $31,553 and $32,908                                                                                                                                                       |       | 437,796           |       | 481,542               |       |
| Loans held for sale                                                                                                                                                                                              |       | 1,628             |       | 1,012                 |       |
| Accrued interest receivable                                                                                                                                                                                      |       | 2,943             |       | 4,229                 |       |
| Real estate owned, net                                                                                                                                                                                           |       | 34,327            |       | 35,155                |       |
| Office properties and  equipment, net                                                                                                                                                                            |       | 22,926            |       | 23,567                |       |
| Cash surrender value of life  insurance                                                                                                                                                                          |       | 21,627            |       | 21,226                |       |
| Prepaid expenses and other  assets                                                                                                                                                                               |       | 3,193             |       | 3,534                 |       |
|                                                                                                                                                                                                             |       |              |       |                  |       |
| TOTAL ASSETS                                                                                                                                                                                                     |       | $                 | 678,099    |                  | $          | 731,070 |   |
|                                                                                                                                                                                                             |       |              |       |                  |       |
| LIABILITIES AND  STOCKHOLDERS’ EQUITY                                                                                                                                                                       |       |              |       |                  |       |
|                                                                                                                                                                                                             |       |              |       |                  |       |
| LIABILITIES:                                                                                                                                                                                                     |       |              |       |                  |       |
| Deposits                                                                                                                                                                                                         |       | $                 | 599,298    |                  | $          | 624,624 |   |
| Other borrowings                                                                                                                                                                                                 |       | 20,921            |       | 59,546                |       |
| Advance payments by  borrowers for taxes and insurance                                                                                                                                                           |       | 346               |       | 695                   |       |
| Other liabilities                                                                                                                                                                                                |       | 13,104            |       | 2,905                 |       |
| Total liabilities                                                                                                                                                                                                |       | 633,669           |       | 687,770               |       |
|                                                                                                                                                                                                             |       |              |       |                  |       |
| STOCKHOLDERS’ EQUITY:                                                                                                                                                                                       |       |              |       |                  |       |
| Preferred stock, no par  value, 5,000,000 shares authorized; Series A fixed rate cumulative  perpetual; liquidation preference of $1,000 per share; 16,500 shares issued  and outstanding                   |       | $                 | 16,228     |                  | $          | 16,195 |   |
| Common stock, $.01 par  value, 30,000,000 shares authorized; 4,846,785 shares issued and outstanding  at June 30, 2010;10,307,502 shares issued and 4,846,785 shares  outstanding at December 31, 2009 |       | 48                |       | 103                   |       |
| Additional paid-in capital                                                                                                                                                                                       |       | 26,796            |       | 56,986                |       |
| Retained  earnings-substantially restricted                                                                                                                                                                      |       | 1,358             |       | 40,634                |       |
|                                                                                                                                                                                                             |       | 44,430            |       | 113,918               |       |
| Treasury stock, at cost,  5,460,717 shares at December 31, 2009                                                                                                                                             |       | —            |       | (70,618               | )          |
| Total stockholders’ equity                                                                                                                                                                                  |       | 44,430            |       | 43,300                |       |
|                                                                                                                                                                                                             |       |              |       |                  |       |
| TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY                                                                                                                                                                  |       | $                 | 678,099    |                  | $          | 731,070 |   |

 

See notes to unaudited condensed consolidatedfinancial statements.

 

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**FIRSTFEDERAL BANCSHARES OF ARKANSAS, INC.**

**CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS**

(In thousands, except share data)

(Unaudited)

 
| ** **                                                             | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|------------------------------------------------------------------------|------------|------------------------|------------|----------------------|------------|
| ** **                                                             | ** ** | **June 30,**      | ** ** | **June 30,**    | ** ** | **June 30,** | ** ** | **June 30,** | ** ** |
| ** **                                                             | ** ** | **2010**               | ** ** | **2009**             | ** ** | **2010** | ** ** | **2009** | ** ** |
|                                                                   |       |                   |       |                 |       |   |   |   |   |
| INTEREST INCOME:                                                       |       |                   |       |                 |       |   |   |   |   |
| Loans receivable                                                       |       | $                      | 6,371      |                 | $          | 7,565 |   | $ | 13,200 |   | $ | 15,120 |   |
| Investment securities:                                                 |       |                   |       |                 |       |   |   |   |   |
| Taxable                                                                |       | 1,051                  |       | 1,373                |       | 2,365 |   | 2,721 |   |
| Nontaxable                                                             |       | 271                    |       | 243                  |       | 543 |   | 459 |   |
| Other                                                                  |       | 16                     |       | 12                   |       | 32 |   | 16 |   |
| Total interest income                                                  |       | 7,709                  |       | 9,193                |       | 16,140 |   | 18,316 |   |
|                                                                   |       |                   |       |                 |       |   |   |   |   |
| INTEREST EXPENSE:                                                      |       |                   |       |                 |       |   |   |   |   |
| Deposits                                                               |       | 2,417                  |       | 3,513                |       | 4,966 |   | 7,293 |   |
| Other borrowings                                                       |       | 161                    |       | 547                  |       | 403 |   | 1,192 |   |
| Total interest expense                                                 |       | 2,578                  |       | 4,060                |       | 5,369 |   | 8,485 |   |
|                                                                   |       |                   |       |                 |       |   |   |   |   |
| NET INTEREST INCOME                                                    |       | 5,131                  |       | 5,133                |       | 10,771 |   | 9,831 |   |
|                                                                   |       |                   |       |                 |       |   |   |   |   |
| PROVISION FOR LOAN LOSSES                                              |       | 63                     |       | 2,445                |       | 116 |   | 5,966 |   |
|                                                                   |       |                   |       |                 |       |   |   |   |   |
| NET INTEREST INCOME AFTER  PROVISION FOR LOAN LOSSES                   |       | 5,068                  |       | 2,688                |       | 10,655 |   | 3,865 |   |
|                                                                   |       |                   |       |                 |       |   |   |   |   |
| NONINTEREST INCOME:                                                    |       |                   |       |                 |       |   |   |   |   |
| Deposit fee income                                                     |       | 1,316                  |       | 1,328                |       | 2,506 |   | 2,520 |   |
| Earnings on life insurance  policies                                   |       | 203                    |       | 200                  |       | 401 |   | 398 |   |
| Gain on sale of loans                                                  |       | 70                     |       | 152                  |       | 206 |   | 300 |   |
| Other                                                                  |       | 267                    |       | 359                  |       | 563 |   | 728 |   |
| Total noninterest income                                               |       | 1,856                  |       | 2,039                |       | 3,676 |   | 3,946 |   |
|                                                                   |       |                   |       |                 |       |   |   |   |   |
| NONINTEREST EXPENSES:                                                  |       |                   |       |                 |       |   |   |   |   |
| Salaries and employee  benefits                                        |       | 2,765                  |       | 2,845                |       | 5,564 |   | 5,813 |   |
| Occupancy expense                                                      |       | 644                    |       | 663                  |       | 1,313 |   | 1,340 |   |
| Real estate owned, net                                                 |       | 913                    |       | 1,085                |       | 1,714 |   | 1,480 |   |
| FDIC insurance premium                                                 |       | 509                    |       | 687                  |       | 1,023 |   | 928 |   |
| Data processing                                                        |       | 368                    |       | 338                  |       | 746 |   | 746 |   |
| Professional fees                                                      |       | 321                    |       | 185                  |       | 727 |   | 476 |   |
| Advertising and public  relations                                      |       | 64                     |       | 91                   |       | 127 |   | 202 |   |
| Postage and supplies                                                   |       | 178                    |       | 144                  |       | 340 |   | 384 |   |
| Other                                                                  |       | 616                    |       | 518                  |       | 1,424 |   | 1,037 |   |
| Total noninterest expenses                                             |       | 6,378                  |       | 6,556                |       | 12,978 |   | 12,406 |   |
|                                                                   |       |                   |       |                 |       |   |   |   |   |
| INCOME (LOSS) BEFORE INCOME  TAXES                                     |       | 546                    |       | (1,829               | )          | 1,353 |   | (4,595 | ) |
| INCOME TAX BENEFIT                                                     |       | (91                    | )          | (892                 | )          | (190 | ) | (2,156 | ) |
| NET INCOME (LOSS)                                                      |       | $                      | 637        |                 | $          | (937 | ) | $ | 1,543 |   | $ | (2,439 | ) |
| PREFERRED STOCK DIVIDENDS  AND ACCRETION OF  PREFERRED  STOCK DISCOUNT |       | 223                    |       | 222                  |       | 446 |   | 284 |   |
| NET INCOME (LOSS) AVAILABLE  TO COMMON SHAREHOLDERS                    |       | $                      | 414        |                 | $          | (1,159 | ) | $ | 1,097 |   | $ | (2,723 | ) |
|                                                                   |       |                   |       |                 |       |   |   |   |   |
| EARNINGS (LOSS) PER COMMON  SHARE:                                     |       |                   |       |                 |       |   |   |   |   |
| Basic                                                                  |       | $                      | 0.09       |                 | $          | (0.24 | ) | $ | 0.23 |   | $ | (0.56 | ) |
|                                                                   |       |                   |       |                 |       |   |   |   |   |
| Diluted                                                                |       | $                      | 0.09       |                 | $          | (0.24 | ) | $ | 0.23 |   | $ | (0.56 | ) |
|                                                                   |       |                   |       |                 |       |   |   |   |   |
| Cash Dividends Declared                                                |       | $                      | —     |                 | $          | (0.01 | ) | $ | — |   | $ | (0.02 | ) |

 

See notes to unaudited condensed consolidatedfinancial statements.

 

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**FIRST FEDERAL BANCSHARES OFARKANSAS, INC.**

**CONDENSED CONSOLIDATED STATEMENTOF STOCKHOLDERS’ EQUITY**

**FOR THE SIX MONTHS ENDED JUNE30, 2010**

(In thousands, except share data)

(Unaudited)

 
| ** **                             | ** ** | **Preferred Stock** | ** ** | **Common Stock** | ** ** | **Additional****Paid-In** | ** ** | **Retained****Earnings  (Substantially** | ** ** | **Treasury Stock** | ** ** | **Total  Stockholders’** | ** ** |
|----------------------------------------|------------|--------------------------|------------|-----------------------|------------|---------------------------|------------|------------------------------------------|------------|-------------------------|------------|-------------------------------|------------|
| ** **                             | ** ** | **Shares**               | ** ** | **Amount**            | ** ** | **Shares**                | ** ** | **Amount**                               | ** ** | **Capital**             | ** ** | **Restricted)**               | ** ** | **Shares** | ** ** | **Amount** | ** ** | **Equity** | ** ** |
| Balance, January 1,  2010         |       | 16,500                   |       | $                     | 16,195     |                      | 10,307,502 |                                     | $          | 103                     |       | $                             | 56,986     |   | $ | 40,634 |   | 5,460,717 |   | $ | (70,618 | ) | $ | 43,300 |   |
| Net income                             |       |                     |       |                  |       |                      |       |                                     |       |                    |       | 1,543                         |       |   |   |   |   | 1,543 |   |
| Preferred stock dividends  accrued     |       |                     |       |                  |       |                      |       |                                     |       |                    |       | (413                          | )          |   |   |   |   | (413 | ) |
| Accretion of preferred stock  discount |       |                     |       | 33                    |       |                      |       |                                     |       |                    |       | (33                           | )          |   |   |   |   | — |   |
| Cancellation of treasury  stock        |       |                     |       |                  |       | (5,460,717                | )          | (55                                      | )          | (30,190                 | )          | (40,373                       | )          | (5,460,717 | ) | 70,618 |   | — |   |
|                                   |       |                     |       |                  |       |                      |       |                                     |       |                    |       |                          |       |   |   |   |   |   |   |
| Balance, June 30, 2010            |       | 16,500                   |       | $                     | 16,228     |                      | 4,846,785  |                                     | $          | 48                      |       | $                             | 26,796     |   | $ | 1,358 |   | — |   | $ | — |   | $ | 44,430 |   |

 

See notes to unaudited condensed consolidated financialstatements.

 

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**FIRST FEDERAL BANCSHARES OFARKANSAS, INC.**

**CONDENSED CONSOLIDATEDSTATEMENTS OF CASH FLOWS**

(In Thousands)

(Unaudited)

 
| ** **                                                                                  | ** ** | **Six Months Ended June 30,** | ** ** |
|---------------------------------------------------------------------------------------------|------------|------------------------------------|------------|
| ** **                                                                                  | ** ** | **2010**                           | ** ** | **2009** | ** ** |
|                                                                                        |       |                               |       |   |   |
| OPERATING ACTIVITIES:                                                                       |       |                               |       |   |   |
| Net income (loss)                                                                           |       | $                                  | 1,543      |   | $ | (2,439 | ) |
| Adjustments to reconcile net  income (loss)  to net cash  provided by operating activities: |       |                               |       |   |   |
| Provision for loan losses                                                                   |       | 116                                |       | 5,966 |   |
| Provision for real estate  losses                                                           |       | 1,141                              |       | 715 |   |
| Deferred tax provision  (benefit)                                                           |       | 206                                |       | (2,982 | ) |
| Deferred tax asset valuation  allowance                                                     |       | (396                               | )          | — |   |
| Accretion of discounts on  investment securities,  net of  premium amortization             |       | (48                                | )          | (58 | ) |
| Federal Home Loan Bank stock  dividends                                                     |       | (6                                 | )          | (8 | ) |
| Gain on sale of property and  equipment                                                     |       | (1                                 | )          | — |   |
| Loss on sale of repossessed  assets                                                         |       | 86                                 |       | 233 |   |
| Originations of loans held  for sale                                                        |       | (11,581                            | )          | (24,680 | ) |
| Proceeds from sales of loans  held for sale                                                 |       | 11,171                             |       | 23,049 |   |
| Gain on sale of loans  originated to sell                                                   |       | (206                               | )          | (300 | ) |
| Depreciation                                                                                |       | 703                                |       | 749 |   |
| Amortization of deferred loan costs                                                         |       | 184                                |       | 197 |   |
| Stock compensation expense                                                                  |       | —                             |       | 1 |   |
| Earnings on life insurance  policies                                                        |       | (401                               | )          | (398 | ) |
| Changes in operating assets  and liabilities:                                               |       |                               |       |   |   |
| Accrued interest receivable                                                                 |       | 1,286                              |       | 1,377 |   |
| Prepaid expenses and other  assets                                                          |       | 426                                |       | 20 |   |
| Other liabilities                                                                           |       | (21                                | )          | 591 |   |
| Net cash provided by  operating activities                                                  |       | 4,202                              |       | 2,033 |   |
|                                                                                        |       |                               |       |   |   |
| INVESTING ACTIVITIES:                                                                       |       |                               |       |   |   |
| Purchases of investment  securities held to maturity                                        |       | (1,999                             | )          | (117,512 | ) |
| Proceeds from  maturities/calls of investment  securities held to maturity                  |       | 59,285                             |       | 106,074 |   |
| Federal Home Loan Bank stock  redeemed                                                      |       | 2,080                              |       | 1,177 |   |
| Federal Home Loan Bank stock  purchased                                                     |       | (522                               | )          | — |   |
| Loan participations  purchased                                                              |       | (1,188                             | )          | (937 | ) |
| Net loan repayments                                                                         |       | 39,878                             |       | 9,582 |   |
| Proceeds from sales of  repossessed assets                                                  |       | 4,563                              |       | 1,429 |   |
| Improvements to real estate  owned                                                          |       | (291                               | )          | (58 | ) |
| Purchases of office  properties and equipment                                               |       | (61                                | )          | (206 | ) |
| Net cash provided by (used in) investing  activities                                        |       | 101,745                            |       | (451 | ) |
|                                                                                        |       |                               |       |   |   |
| FINANCING ACTIVITIES:                                                                       |       |                               |       |   |   |
| Net increase (decrease) in  deposits                                                        |       | (25,326                            | )          | 2,177 |   |
| Repayment of advances from  FHLB                                                            |       | (14,625                            | )          | (8,934 | ) |
| Short-term FHLB advances, net                                                               |       | (24,000                            | )          | — |   |
| Net decrease in Federal Reserve Bank advances                                               |       | —                             |       | (9,495 | ) |
| Net decrease in advance payments by borrowers for taxes and insurance                       |       | (349                               | )          | (400 | ) |
| Proceeds from issuance of  preferred stock and related  common  stock warrant               |       | —                             |       | 16,500 |   |
| Preferred dividends paid                                                                    |       | —                             |       | (159 | ) |
| Common dividends paid                                                                       |       | —                             |       | (97 | ) |
| Net cash used in financing  activities                                                      |       | (64,300                            | )          | (408 | ) |
|                                                                                        |       |                               |       |   |   |
|                                                                                        |       |                               |       | (continued) |   |
|                                                                                             |            |                                    |            |  |  |  |  |

 

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**FIRST FEDERAL BANCSHARES OFARKANSAS, INC.**

**CONDENSED CONSOLIDATEDSTATEMENTS OF CASH FLOWS**

(In Thousands)

(Unaudited)

 
|                                                                                     |   | **Six Months Ended June 30,** |       |
|------------------------------------------------------------------------------------------|--------|------------------------------------|------------|
|                                                                                     |   | **2010**                           | ** ** | **2009** |   |
| Net increase in cash and  cash equivalents                                               |   | $                                  | 41,647     |   | $ | 1,174 |   |
|                                                                                     |   |                               |       |   |   |
| CASH AND CASH EQUIVALENTS:                                                               |   |                               |       |   |   |
| Beginning of period                                                                      |   | 22,149                             |       | 9,367 |   |
| End of period                                                                            |   | $                                  | 63,796     |   | $ | 10,541 |   |
|                                                                                     |   |                               |       |   |   |
| SUPPLEMENTAL DISCLOSURES OF  CASH FLOW INFORMATION:                                      |   |                               |       |   |   |
| Cash paid for:                                                                           |   |                               |       |   |   |
| Interest                                                                                 |   | $                                  | 5,515      |   | $ | 8,793 |   |
| Income taxes                                                                             |   | $                                  | 38         |   | $ | 864 |   |
|                                                                                     |   |                               |       |   |   |
| SUPPLEMENTAL SCHEDULE OF  NONCASH INVESTING  AND FINANCING  ACTIVITIES:                  |   |                               |       |   |   |
| Real estate and other assets  acquired in settlement of  loans                           |   | $                                  | 12,563     |   | $ | 8,860 |   |
| Loans to facilitate sales of  real estate owned and other noncash  loan and REO activity |   | $                                  | 7,807      |   | $ | 5,460 |   |
| Investment securities  purchased — not settled                                      |   | $                                  | 9,997      |   | $ | 2,775 |   |
| Preferred stock dividends accrued, not paid                                              |   | $                                  | 413        |   | $ | 105 |   |

 
|   |   |   |   | (Concluded) |   |
|--------|--------|--------|--------|-------------|--------|

 

See notes to unaudited condensed consolidated financial statements.

 

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**FIRST FEDERAL BANCSHARES OFARKANSAS, INC.**

**NOTES TO UNAUDITED CONDENSEDCONSOLIDATED FINANCIAL STATEMENTS**

 

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

 

First Federal Bancshares of Arkansas, Inc.(the “Company”) is a unitary holding company which owns all of the stock ofFirst Federal Bank (the “Bank”).  TheBank provides a broad line of financial products to individuals and small- tomedium-sized businesses.  The unauditedcondensed consolidated financial statements also include the accounts of theBank’s wholly-owned subsidiary, First Harrison Service Corporation (“FHSC”),which is inactive.

 

The accompanying unaudited condensed consolidatedfinancial statements of the Company have been prepared in accordance withinstructions 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 accompanying unaudited condensed consolidatedfinancial statements include the accounts of the Company and the Bank.  All material intercompany transactions havebeen eliminated in consolidation.

 

The results of operations for the six monthsended June 30, 2010, are not necessarily indicative of the results to beexpected for the year ending December 31, 2010.  The unaudited condensed consolidated financialstatements and notes thereto should be read in conjunction with the auditedfinancial statements and notes thereto for the year ended December 31,2009, contained in the Company’s 2009 Annual Report to Stockholders.

 

**Note 2 - Going Concern**

 

The consolidated financial statements have been preparedon a going concern basis, which contemplates the realization of assets and thesatisfaction of liabilities in the normal course of business for theforeseeable future. However, the events and circumstances described belowcreate an uncertainty about the Company’s ability to continue as a goingconcern.  The unaudited condensedconsolidated financial statements do not include any adjustment that mightresult from the outcome of this uncertainty.

 

The Company recorded a net loss of $45.5 million in2009, primarily due to the level of nonperforming assets, the provision forloan losses of $44.4 million, real estate owned expenses of $8.4 million, andFDIC insurance premiums of $1.7 million. Our losses were largely a result of nonperforming loans and real estateowned. Our net loss also included the establishment of a valuation allowanceagainst the realization of our deferred tax asset of $18.1 million.

 

At June 30, 2010, the Company was above theregulatory minimums for tangible, core, total risk-based and tier 1 risk-basedcapital.  On April 12, 2010, theCompany and the Bank each consented to the terms of Cease and Desist Ordersissued by the Office of Thrift Supervision (“OTS”) (the “Bank Order” and the “CompanyOrder” and, together, the “Orders”).  TheOrders impose certain operations restrictions on the Company and, to a greaterextent, the Bank, including lending and dividend restrictions.  The Orders also require the Company and theBank to take certain actions, including the submission to the OTS of capitalplans and business plans to, among other things, preserve and enhance thecapital of the Company and the Bank and strengthen and improve the consolidatedCompany’s operations, earnings and profitability.  The Bank Order specifically requires the Bankto achieve and maintain, by December 31, 2010, a tier 1 (core) capitalratio of at least 8% and a total risk-based capital ratio of at least 12.0% andmaintain these higher ratios for as long as the Bank Order is in effect.  At June 30, 2010, the Bank’s core andtotal risk-based capital ratios were 6.46% and 11.40%.  Had the Bank been required to meet thesecapital requirements at June 30, 2010, it would have needed additionalcapital of approximately $10.5 million.

 

Management has developed and will continue to refinecapital and strategic plans which take into consideration available informationin the development of future financial projections, which includes, but is notlimited to, twelve months from the balance sheet date of December 31,2009. The expected results of these plans, forecasts and strategic initiatives,which are based on multiple scenarios and stress tested cases, provide for theenhancement and preservation of capital. Management’s plans to preserve andenhance the Company’s capital levels depend on various factors, some of whichare outside the control of management. These factors include improvement in theeconomy, the ability to raise capital, the ability to reduce nonperformingassets, and the ability to maintain the Company’s liquidity.

 

The Company is continuing to aggressively pursue variousavailable alternatives to improve its capital ratios, including operatingstrategies designed to improve operating results, through, among others, areduction of nonperforming assets and reduction of operating costs, shrinkingthe balance sheet, and raising capital. There can be no assurance that the economic conditions that caused thedeterioration in the Company’s loan quality, operating 

 

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results and capital will improve, and should theBank’s capital and related ratios continue to deteriorate, the OTS could imposemore severe directives on the Bank. The projected results of operations in 2010and balance sheet shrinkage will not be sufficient to comply with theOrders.  Currently, the Company intendsto raise capital in the third or fourth quarter of 2010 to comply with therequirements of the Orders.

 

The Company’s ability to raise additional capital willdepend on conditions in the capital markets at that time, which are outside theCompany’s control. Accordingly, the Company cannot be certain of its ability toraise additional capital on acceptable terms. The Company’s potential inabilityto raise capital and comply with the terms of the Order raises substantialdoubt about its ability to continue as a going concern.

 

**Note 3 —Recent Accounting Standards Issued or Adopted**

 

In June 2009,the Financial Accounting Standards Board (“FASB”) issued Accounting StandardsCodification (“ASC”) 860, formerly Statement of Financial Accounting Standards(“SFAS”) 166, *Accounting for Transfers ofFinancial Assets,*which**is a revision to ASC 860, formerlySFAS 140, *Accounting for Transfers andServicing of Financial Assets and Extinguishments of Liabilities*,and requires more information about transfers of financial assets, includingsecuritization transactions, and where companies have continuing exposure tothe risks related to transferred financial assets. The statement alsoeliminates the concept of a “qualifying special-purpose entity”, changes therequirements for derecognizing financial assets and requires additionaldisclosures. It was effective for financial statements issued for interim andannual periods beginning after November 15, 2009.  The recognition and measurement provisionsshall be applied to transfers that occur on or after the effective date. TheBank adopted this statement on January 1, 2010, as required.  The adoption of this statement did not have amaterial effect on the consolidated financial statements.

 

In June 2009,the FASB issued ASC 860, formerly SFAS 167, *Amendmentsto FASB Interpretation No. 46(R),*which changed the way entities account for securitizations andspecial-purpose entities. The statement is a revision to ASC 810, formerly FASBInterpretation No. 46(R), *Consolidationof Variable Interest Entities*, and changes how a company determineswhen an entity that is insufficiently capitalized or is not controlled throughvoting (or similar rights) should be consolidated. The determination of whethera company is required to consolidate an entity is based on, among other things,an entity’s purpose and design and a company’s ability to direct the activitiesof the entity that most significantly impact the entity’s economic performance.It was effective for financial statements issued for interim and annual periodsbeginning after November 15, 2009. The Bank adopted this statement on January 1, 2010, asrequired.  The adoption of this statementdid not have a material effect on the consolidated financial statements.

 

In January 2010,the FASB issued Accounting Standards Update (“ASU”) No. 2010-06, *Fair Value Measurements and Disclosures (Topic 820): ImprovingDisclosures about Fair Value Measurements*. ASU 2010-06 revises twodisclosure requirements concerning fair value measurements and clarifies twoothers. It requires separate presentation of significant transfers into and outof Levels 1 and 2 of the fair value hierarchy and disclosure of the reasons forsuch transfers. It will also require the presentation of purchases, sales,issuances, and settlements within Level 3 on a gross basis rather than a netbasis. The amendments also clarify that disclosures should be disaggregated byclass of asset or liability and that disclosures about inputs and valuationtechniques should be provided for both recurring and non-recurring fair valuemeasurements. The Company’s disclosures about fair value measurements arepresented in Note 10. These new disclosure requirements were effectivebeginning with the period ended March 31, 2010, except for the requirementconcerning gross presentation of Level 3 activity, which is effective forfiscal years beginning after December 15, 2010. There was no significanteffect on the Company’s financial statement disclosure upon adoption of thisASU.

 

In February 2010,the FASB issued ASU No. 2010-09, *Subsequent Events (Topic855): Amendments to Certain Recognition and Disclosure Requirements*.The amendments remove the requirement for an SEC registrant to disclose thedate through which subsequent events were evaluated as this requirement wouldhave potentially conflicted with SEC reporting requirements. Removal of thedisclosure requirement did not have an effect on the nature or timing ofsubsequent events evaluations performed by the Company. ASU 2010-09 becameeffective upon issuance.

 

In July 2010,the FASB issued ASU No. 2010-20, *Receivables (Topic 310): Disclosures about the Credit Quality ofFinancing Receivables and the Allowance for Credit Losses,*whichwill require the Company to provide a greater level of disaggregatedinformation about the credit quality of the Company’s loans and the allowancefor loan losses (the “allowance”). This ASU will also require the Company todisclose additional information related to credit quality indicators, past dueinformation, and information related to loans modified in a troubled debtrestructuring. The provisions of this ASU are effective beginning with theCompany’s reporting period ending December 31, 2010. As this ASU amendsonly the disclosure requirements for loans and leases and the Allowance, theadoption will have no impact on the Company’s financial condition or results ofoperations.

 

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**Note 4 — Preferred Stock**

 

On March 6,2009, as part of the Troubled Asset Relief Program (“TARP”) Capital PurchaseProgram, the Company entered into a Securities Purchase Agreement (the “PurchaseAgreement”) with the United States Department of the Treasury (“Treasury”),pursuant to which the Company, for a purchase price of $16.5 million in cash, (i) sold16,500 shares of the Company’s Fixed Rate Cumulative Perpetual Preferred Stock,Series A (the “Series A Preferred Stock”) and (ii) issued awarrant (the “Warrant”) to purchase 321,847 shares of the Company’s commonstock, par value $1.00 per share (the “Common Stock”), at an exercise price of$7.69 per share.  The Series APreferred Stock qualifies as Tier 1 capital and is entitled to cumulativedividends. The preferred stock dividend reduces earnings available to commonshareholders and is computed at an annual rate of 5% per annum for the firstfive years, and 9% per annum thereafter. The Series A Preferred Stock isnon-voting, other than class voting rights on certain matters that couldadversely affect the Series A Preferred Stock. The Series A PreferredStock may be redeemed by the Company with regulatory approval and when suchpreferred shares are redeemed, the Treasury shall liquidate the Warrantassociated with such preferred shares. The Warrant has a 10-year term and was immediately exercisable upon itsissuance, with an exercise price, subject to anti-dilution adjustments, equalto $7.69 per share of the Common Stock.  Treasury has agreed not to exercise voting power with respect to anyshares of Common Stock issued upon exercise of the Warrant that it holds.

 

Uponreceipt of the aggregate consideration from the Treasury on March 6, 2009,the Company allocated the $16.5 million proceeds on a pro rata basis to the Series APreferred Stock and the Warrant based on relative fair values. In estimatingthe fair value of the Warrant, the Company utilized an option pricing modelwhich includes assumptions regarding the Company’s common stock prices, stockprice volatility, dividend yield, the risk free interest rate and the estimatedlife of the Warrant. The fair value of the Series A Preferred Stock wasdetermined using a discounted cash flow methodology and a discount rate of 12%.As a result, the Company assigned $358,000 of the aggregate proceeds to theWarrant and $16.1 million to the Series A Preferred Stock. The valueassigned to the Series A Preferred Stock will be accreted up to the $16.5million liquidation value of such preferred stock, with the cost of suchaccretion being reported as additional preferred stock dividends. This resultsin a total dividend with a constant effective yield of 5.50% over a five-yearperiod, which is the expected life of the Series A Preferred Stock. Inaddition, the Purchase Agreement (i) grants the holders of the Series APreferred Stock, the Warrant and the Warrant Common Stock certain registrationrights, (ii) subjects the Company to certain of the executive compensationlimitations included in the EESA (which are discussed below) and (iii) allowsthe Treasury to unilaterally amend any of the terms of the Purchase Agreementto the extent required to comply with any changes after March 6, 2009 inapplicable federal statutes. On April 2, 2009, the Company filed a “shelf”registration statement on Form S-3 with the Securities and ExchangeCommission (the “Commission”) for the purpose of registering the Warrant andthe Warrant Common Stock in order to permit the sale of such securities by theU.S. Treasury at any time after effectiveness of the registration statement. OnApril 28, 2009, the Company was notified by the Commission that the “shelf”registration statement was deemed effective.

 

Immediatelyprior to the execution of the Purchase Agreement, the Company amended itscompensation, bonus, incentive and other benefit plans, arrangements andagreements to the extent necessary to comply with the executive compensationand corporate governance requirements of Section 111(b) of the EESAand applicable guidance or regulations issued by the Treasury on or prior to March 6,2009. The applicable executive compensation requirements apply to thecompensation of the Company’s chief executive officer, chief financial officerand three other most highly compensated executive officers (collectively, the “seniorexecutive officers”). In addition, in connection with the closing of theTreasury’s purchase of the Series A Preferred Stock each of the seniorexecutive officers was required to execute a waiver of any claim against theUnited States or the Company for any changes to his or her compensation orbenefits that are required in order to comply with the regulation issued by theTreasury as published in the Federal Register on October 20, 2008.

 

TheCompany’s ability to repurchase its shares is restricted. Consent of theTreasury generally is required for the Company to make any stock repurchaseuntil the third anniversary of the investment by Treasury unless all of the Series APreferred Stock has been redeemed or transferred to a third party. Further,common, junior preferred or *pari passu* preferredshares may not be repurchased if the Company is in arrears on the Series APreferred Stock dividends. Under the terms of the Purchase Agreement, theCompany’s ability to declare or pay dividends on any of its shares isrestricted.  Specifically, the Companymay not declare dividend payments on common, junior preferred or *pari passu* preferred shares if it is in arrears on thedividends on the Series A Preferred Stock. In addition, the Company may not increase the dividends on its CommonStock above the amount of the last quarter cash dividend per share declaredprior to October 14, 2008, which was $0.16 per share, without the Treasury’sapproval until the third anniversary of the investment unless all of the Series APreferred Stock has been redeemed or transferred to a third party.

 

TheCompany and the Bank are subject to a regulatory order which prohibits theCompany and the Bank from paying dividends on any of its stock, including the Series APreferred Stock, without prior written non-objection of the OTS.  As a result, the Company elected to deferpayment of its Series A Preferred Stock dividends beginning with the 

 

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dividendpayment that was due February 15, 2010. However, the Company has continued to accrue these dividends and at June 30,2010 dividends of approximately $518,000 were accrued in other liabilities onthe consolidated statement of financial condition related to these dividendpayments.

 

**Note 5 - Earnings per CommonShare**

 

The weighted average number of common shares usedto calculate earnings per share for the periods ended June 30, 2010 and2009 were as follows:

 
| ** **                                | ** ** | **Three months ended****June 30,** | ** ** | **Six months ended****June 30,** | ** ** |
|-------------------------------------------|------------|-----------------------------------------|------------|---------------------------------------|------------|
| ** **                                | ** ** | **2010**                                | ** ** | **2009**                              | ** ** | **2010** | ** ** | **2009** | ** ** |
| Basic weighted - average  common shares   |       | 4,846,785                               |       | 4,846,785                             |       | 4,846,785 |   | 4,846,785 |   |
| Effect of dilutive  securities            |       | —                                  |       | —                                |       | — |   | — |   |
| Diluted weighted - average  common shares |       | 4,846,785                               |       | 4,846,785                             |       | 4,846,785 |   | 4,846,785 |   |

 

The calculation of diluted earnings per share excludes 14,282 optionsoutstanding for the three and six months ended June 30, 2010 and 17,242 options outstanding for the threeand six months ended June 30, 2009, which were antidilutive. In addition,the calculation excludes the Warrant to purchase 321,847 shares of common stockoutstanding for the three and six month periods ended June 30, 2010 and 2009, which was antidilutive.

 

**Note 6 — Investment Securities**

 

Investment securities consisted of the following (inthousands):

 
| ** **                              | ** ** | **June 30, 2010** | ** ** |
|-----------------------------------------|------------|------------------------|------------|
| ** **                              | ** ** | ** **             | ** ** | **Gross** | ** ** | **Gross** | ** ** | ** ** | ** ** |
| ** **                              | ** ** | **Amortized**          | ** ** | **Unrealized** | ** ** | **Unrealized** | ** ** | **Fair** | ** ** |
| **Held To Maturity**                    | ** ** | **Cost**               | ** ** | **Gains** | ** ** | **Losses** | ** ** | **Value** | ** ** |
|                                    |       |                   |       |   |   |   |   |   |   |
| Municipal securities                    |       | $                      | 24,678     |   | $ | 331 |   | $ | (131 | ) | $ | 24,878 |   |
| U.S. Government and Agency  obligations |       | 63,612                 |       | 956 |   | (1 | ) | 64,567 |   |
|                                    |       |                   |       |   |   |   |   |   |   |
| Total                                   |       | $                      | 88,290     |   | $ | 1,287 |   | $ | (132 | ) | $ | 89,445 |   |

 
| ** **                              | ** ** | **December 31, 2009** | ** ** |
|-----------------------------------------|------------|----------------------------|------------|
| ** **                              | ** ** | ** **                 | ** ** | **Gross** | ** ** | **Gross** | ** ** | ** ** | ** ** |
| ** **                              | ** ** | **Amortized**              | ** ** | **Unrealized** | ** ** | **Unrealized** | ** ** | **Fair** | ** ** |
| **Held To Maturity**                    | ** ** | **Cost**                   | ** ** | **Gains** | ** ** | **Losses** | ** ** | **Value** | ** ** |
|                                    |       |                       |       |   |   |   |   |   |   |
| Municipal securities                    |       | $                          | 25,480     |   | $ | 247 |   | $ | (269 | ) | $ | 25,458 |   |
| U.S. Government and Agency  obligations |       | 110,051                    |       | 21 |   | (3,021 | ) | 107,051 |   |
|                                    |       |                       |       |   |   |   |   |   |   |
| Total                                   |       | $                          | 135,531    |   | $ | 268 |   | $ | (3,290 | ) | $ | 132,509 |   |

 

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The following tables summarize the gross unrealizedlosses and fair value of the Company’s investments with unrealized losses thatare not deemed to be other-than-temporarily impaired (“OTTI”) (in thousands),aggregated by investment category and length of time that individual securitieshave been in a continuous unrealized loss position:

 
| ** **                              | ** ** | **June 30, 2010**  | ** ** |
|-----------------------------------------|------------|-------------------------|------------|
| ** **                              | ** ** | **Less than 12 Months** | ** ** | **12 Months or More** | ** ** | **Total** | ** ** |
| ** **                              | ** ** | **Fair**                | ** ** | **Unrealized** | ** ** | **Fair** | ** ** | **Unrealized** | ** ** | **Fair** | ** ** | **Unrealized** | ** ** |
| ** **                              | ** ** | **Value**               | ** ** | **Losses** | ** ** | **Value** | ** ** | **Losses** | ** ** | **Value** | ** ** | **Losses** | ** ** |
|                                    |       |                    |       |   |   |   |   |   |   |   |   |   |   |
| Municipal securities                    |       | $                       | 1,291      |   | $ | 15 |   | $ | 2,715 |   | $ | 116 |   | $ | 4,006 |   | $ | 131 |   |
| U.S. Government and Agency  obligations |       | —                  |       | — |   | 1,314 |   | 1 |   | 1,314 |   | 1 |   |
|                                    |       |                    |       |   |   |   |   |   |   |   |   |   |   |
|                                    |       | $                       | 1,291      |   | $ | 15 |   | $ | 4,029 |   | $ | 117 |   | $ | 5,320 |   | $ | 132 |   |

 
| ** **                              | ** ** | **December 31, 2009** | ** ** |
|-----------------------------------------|------------|----------------------------|------------|
| ** **                              | ** ** | **Less than 12 Months**    | ** ** | **12 Months or More** | ** ** | **Total** | ** ** |
| ** **                              | ** ** | **Fair**                   | ** ** | **Unrealized** | ** ** | **Fair** | ** ** | **Unrealized** | ** ** | **Fair** | ** ** | **Unrealized** | ** ** |
| ** **                              | ** ** | **Value**                  | ** ** | **Losses** | ** ** | **Value** | ** ** | **Losses** | ** ** | **Value** | ** ** | **Losses** | ** ** |
|                                    |       |                       |       |   |   |   |   |   |   |   |   |   |   |
| Municipal securities                    |       | $                          | 5,156      |   | $ | 92 |   | $ | 2,453 |   | $ | 177 |   | $ | 7,609 |   | $ | 269 |   |
| U.S. Government and Agency  obligations |       | 100,142                    |       | 2,908 |   | 2,888 |   | 113 |   | 103,030 |   | 3,021 |   |
|                                    |       |                       |       |   |   |   |   |   |   |   |   |   |   |
|                                    |       | $                          | 105,298    |   | $ | 3,000 |   | $ | 5,341 |   | $ | 290 |   | $ | 110,639 |   | $ | 3,290 |   |

 

On a quarterly basis, management conducts a formalreview of securities for the presence of OTTI.  Management assesseswhether an OTTI is present when the fair value of a security is less than itsamortized cost basis at the balance sheet date.  For such securities,OTTI is considered to have occurred if the Company intends to sell thesecurity, if it is more likely than not the Company will be required to sellthe security before recovery of its amortized cost basis or if the presentvalues of expected cash flows is not sufficient to recover the entire amortizedcost.

 

The unrealized losses are primarily a result ofincreases in market yields from the time of purchase.  In general, asmarket yields rise, the fair value of securities will decrease; as marketyields fall, the fair value of securities will increase. Management generallyviews changes in fair value caused by changes in interest rates as temporary;therefore, these securities have not been classified as other-than-temporarilyimpaired.  Additionally, the unrealized losses are also consideredtemporary because scheduled coupon payments have been made, it is anticipatedthat the entire principal balance will be collected as scheduled, andmanagement neither intends to sell the securities nor is it more likely thannot that the Company will be required to sell the securities before therecovery of the remaining amortized cost amount.

 

The Company has pledged investment securities held tomaturity with carrying values of approximately $38.0 million at June 30, 2010, and $59.5 millionat December 31, 2009 as collateral for certain deposits in excess of$250,000.

 

The scheduled maturities of debt securities at June 30, 2010, by contractualmaturity are shown below (in thousands). Expected maturities may differ fromcontractual maturities because borrowers may have the right to call or prepayobligations with or without call or prepayment penalties.

 
| ** **                        | ** ** | **June 30, 2010** | ** ** |
|-----------------------------------|------------|------------------------|------------|
| ** **                        | ** ** | **Amortized**          | ** ** | **Fair** | ** ** |
| ** **                        | ** ** | **Cost**               | ** ** | **Value** | ** ** |
|                              |       |                   |       |   |   |
| Within one year                   |       | $                      | 200        |   | $ | 202 |   |
| Due from one year to five  years  |       | 3,200                  |       | 3,209 |   |
| Due from five years to ten  years |       | 8,190                  |       | 8,196 |   |
| Due after ten years               |       | 76,700                 |       | 77,838 |   |
|                              |       |                   |       |   |   |
| Total                             |       | $                      | 88,290     |   | $ | 89,445 |   |

 

As of June 30,2010 and December 31, 2009, investments with carrying values ofapproximately $81.4 million and $127.6 million, respectively, have call optionsheld by the issuer, of which approximately $62.7 million and $99.2 million,respectively, are or were callable within one year.

 

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**Note 7 — Impaired Loans**

 

Impaired loans consisted of the following as of thedates indicated (in thousands):

 
| ** **                                     | ** ** | **June 30****, 2010** | ** ** | **December 31, 2009 (1)** | ** ** |
|------------------------------------------------|------------|----------------------------|------------|--------------------------------|------------|
| ** **                                     | ** ** | **Recorded  Investment**   | ** ** | **Valuation  Allowance**       | ** ** | **Carrying  Value** | ** ** | **Recorded  Investment** | ** ** | **Valuation  Allowance** | ** ** | **Carrying  Value** | ** ** |
| Nonaccrual loans with a valuation allowance    |       | $                          | 34,090     |                           | $          | 9,870 |   | $ | 24,220 |   | $ | 24,095 |   | $ | 7,476 |   | $ | 16,619 |   |
| Nonaccrual loans without a valuation allowance |       | 23,167                     |       | —                         |       | 23,167 |   | 26,248 |   | — |   | 26,248 |   |
| Total nonaccrual loans                         |       | 57,257                     |       | 9,870                          |       | 47,387 |   | 50,343 |   | 7,476 |   | 42,867 |   |
| Performing restructured loans (2)              |       | 2,070                      |       | —                         |       | 2,070 |   | 4,609 |   | — |   | 4,609 |   |
| Other impaired loans (3)                       |       | 3,380                      |       | —                         |       | 3,380 |   | 6,334 |   | — |   | 6,334 |   |
| Total impaired loans                           |       | $                          | 62,707     |                           | $          | 9,870 |   | $ | 52,837 |   | $ | 61,286 |   | $ | 7,476 |   | $ | 53,810 |   |

 
| ** **                                                    | ** ** | ** ** | ** ** | **Six Months Ended  June 30, 2010** | ** ** | ** ** | ** ** | **Year Ended  December 31, 2009** | ** ** |
|---------------------------------------------------------------|------------|------------|------------|---------------------------------------------------------|------------|------------|------------|--------------------------------------------------|------------|
| Average investment in impaired loans                          |       |       |       | $                                                       | 56,178     |       |       |                                             | $          | 48,609 |   |
|                                                          |       |       |       |                                                    |       |       |       |                                             |       |
| Interest income recognized on impaired loans                  |       |       |       | $                                                       | 539        |       |       |                                             | $          | 1,747 |   |
|                                                          |       |       |       |                                                    |       |       |       |                                             |       |
| Interest based on original terms                              |       |       |       | $                                                       | 2,082      |       |       |                                             | $          | 4,355 |   |
|                                                          |       |       |       |                                                    |       |       |       |                                             |       |
| Interest income recognized on a cash basis on  impaired loans |       |       |       | $                                                       | 153        |       |       |                                             | $          | 128 |   |

 

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(1)          Subsequent to the issuance of the Company’s 2009 consolidated financialstatements included in its Annual Report on Form 10-K, filed on April 15,2010, management identified an immaterial error in the disclosure of impairedloans in the table above.  Impaired loans of $20.5 million were omittedfrom the previously presented disclosure as of December 31, 2009. This amount primarily represents impaired non-homogeneous loans less than$500,000 and borrower relationships less than $1.0 million.  Thedisclosed amounts of impaired loans without valuation allowance and impairedloans with a valuation allowance previously presented have been restated toinclude these impaired loans and restated to conform with the currentpresentation.  The previously omitted loans did not impact theconsolidated statements of financial condition, operations or cash flows forthe year ended December 31, 2009.

(2)          Performing restructured loans represent (A) loans thatwere not already on nonaccrual status before the restructuring that have beenrestructured so as to be reasonably assured of repayment and of performanceaccording to prudent modified terms or (B) loans that have had sustainedhistorical repayment performance for a reasonable period of time after therestructuring, generally a minimum of six months.  After a restructuredloan has performed satisfactorily for a period of at least 12 months, it isgenerally no longer reported as a restructured loan for financial reportingpurposes.

(3)          Other impaired loans generally include loans for which there may be doubtabout the ultimate timing of collection of principal and interest compared tothe original terms of the note but where the payment history has beensatisfactory and collateral coverage is estimated to be adequate to payprincipal and interest in full.  Totalaccrued interest for these loans was $25,000 at June 30, 2010, and $52,000at December 31, 2009.

 

**Note 8 — Allowances for Loan andReal Estate Losses**

 

A summary of the activity in the allowances for loan andreal estate losses is as follows for the three and six months ended June 30 (in thousands):

 
| ** **                       | ** ** | **Three Months Ended****June 30****, 2010** | ** ** | **Three Months Ended****June 30****, 2009** | ** ** |
|----------------------------------|------------|---------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                       | ** ** | **Loans**                                   | ** ** | **Real Estate**                                  | ** ** | **Loans** | ** ** | **Real Estate** | ** ** |
|                             |       |                                        |       |                                             |       |   |   |   |   |
| Balance—beginning of period |       | $                                           | 32,652     |                                             | $          | 5,923 |   | $ | 9,558 |   | $ | — |   |
|                             |       |                                        |       |                                             |       |   |   |   |   |
| Provisions for estimated  losses |       | 63                                          |       | 561                                              |       | 2,445 |   | 552 |   |
| Recoveries                       |       | 62                                          |       | —                                           |       | 693 |   | — |   |
| Losses charged off               |       | (1,224                                      | )          | (786                                             | )          | (772 | ) | (552 | ) |
|                             |       |                                        |       |                                             |       |   |   |   |   |
| Balance—end of period       |       | $                                           | 31,553     |                                             | $          | 5,698 |   | $ | 11,924 |   | $ | — |   |

 

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| ** **                       | ** ** | **Six Months Ended********June 30****, 2010** | ** ** | **Six Months Ended********June 30****, 2009** | ** ** |
|----------------------------------|------------|----------------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                       | ** ** | **Loans**                                          | ** ** | **Real Estate**                                    | ** ** | **Loans** | ** ** | **Real Estate** | ** ** |
|                             |       |                                               |       |                                               |       |   |   |   |   |
| Balance—beginning of period |       | $                                                  | 32,908     |                                               | $          | 5,543 |   | $ | 6,441 |   | $ | — |   |
|                             |       |                                               |       |                                               |       |   |   |   |   |
| Provisions for estimated  losses |       | 116                                                |       | 1,141                                              |       | 5,966 |   | 715 |   |
| Recoveries                       |       | 131                                                |       | —                                             |       | 754 |   | — |   |
| Losses charged off               |       | (1,602                                             | )          | (986                                               | )          | (1,237 | ) | (715 | ) |
|                             |       |                                               |       |                                               |       |   |   |   |   |
| Balance—end of period       |       | $                                                  | 31,553     |                                               | $          | 5,698 |   | $ | 11,924 |   | $ | — |   |

 

The allowance for loan losses as of June 30, 2010 and 2009 includesgeneral valuation allowances of $21.7 million and $6.0 million, respectively,and specific valuation allowances of $9.9 million and $5.9 million,respectively.  The provision for loanlosses decreased between the periods listed above primarily due to decreases inloan balances offset by increases in total nonaccrual loans and in the lossfactors used in certain allowance categories, as well as an increase inspecific loan loss allowances, in each respect due to deteriorating economic conditions.

 

**Note 9 — Income Taxes**

 

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

 
| ** **                       | ** ** | **Six Months Ended**   | ** ** |
|----------------------------------|------------|------------------------|------------|
| ** **                       | ** ** | **June 30, 2010** | ** ** | **June 30, 2009** | ** ** |
|                             |       |                   |       |   |   |
| Income tax provision  (benefit): |       |                   |       |   |   |
| Current:                         |       |                   |       |   |   |
| Federal                          |       | $                      | —     |   | $ | 816 |   |
| State                            |       | —                 |       | 10 |   |
| Total current                    |       | —                 |       | 826 |   |
|                             |       |                   |       |   |   |
| Deferred:                        |       |                   |       |   |   |
| Federal                          |       | 117                    |       | (2,490 | ) |
| State                            |       | 89                     |       | (492 | ) |
| Valuation allowance              |       | (396                   | )          | — |   |
| Total deferred                   |       | (190                   | )          | (2,982 | ) |
|                             |       |                   |       |   |   |
| Total                            |       | $                      | (190       | ) | $ | (2,156 | ) |

 

The reasons for the differences between the statutoryfederal income tax rates and the effective tax rates are summarized as follows(in thousands):

 
| ** **                           | ** ** | **Six Months Ended June 30,** | ** ** |
|--------------------------------------|------------|------------------------------------|------------|
| ** **                           | ** ** | **2010**                           | ** ** | **2009** | ** ** |
|                                 |       |                               |       |   |   |   |   |   |   |
| Taxes at statutory rate              |       | $                                  | 460        |   | 34.0 | % | $ | (1,563 | ) | 34.0 | % |
| Increase (decrease)  resulting from: |       |                               |       |   |   |   |   |   |   |
| State income tax—net            |       | 58                                 |       | 4.3 |   | (292 | ) | 6.4 |   |
| Valuation allowance                  |       | (396                               | )          | (29.3 | ) | — |   | — |   |
| Earnings on life insurance  policies |       | (136                               | )          | (10.1 | ) | (135 | ) | 2.9 |   |
| Nontaxable investments               |       | (176                               | )          | (13.0 | ) | (147 | ) | 3.2 |   |
| Other—net                       |       | —                             |       | — |   | (19 | ) | 0.4 |   |
|                                 |       |                               |       |   |   |   |   |   |   |
| Total                                |       | $                                  | (190       | ) | (14.1 | )% | $ | (2,156 | ) | 46.9 | % |

 

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The Company’s net deferred tax liability account wascomprised of the following (in thousands):

 
| ** **                                      | ** ** | **June 30****, 2010** | ** ** | **December 31, 2009** | ** ** |
|-------------------------------------------------|------------|----------------------------|------------|----------------------------|------------|
|                                            |       |                       |       |                       |       |
| Deferred tax assets:                            |       |                       |       |                       |       |
| Allowance for loan losses                       |       | $                          | 9,611      |                       | $          | 11,054 |   |
| Real estate owned                               |       | 3,534                      |       | 3,426                      |       |
| NOL carryovers                                  |       | 5,272                      |       | 4,432                      |       |
| Other                                           |       | 192                        |       | 190                        |       |
| Total deferred tax assets                       |       | 18,609                     |       | 19,102                     |       |
| Valuation allowance                             |       | (17,729                    | )          | (18,124                    | )          |
| Deferred tax asset, net of  valuation allowance |       | 880                        |       | 978                        |       |
|                                            |       |                       |       |                       |       |
| Deferred tax liabilities:                       |       |                       |       |                       |       |
| Office properties                               |       | (898                       | )          | (928                       | )          |
| Federal Home Loan Bank stock                    |       | (130                       | )          | (300                       | )          |
| Pension plan contribution                       |       | —                     |       | (94                        | )          |
| Prepaid expenses                                |       | (136                       | )          | (130                       | )          |
| Total deferred tax  liabilities                 |       | (1,164                     | )          | (1,452                     | )          |
|                                            |       |                       |       |                       |       |
| Deferred tax liability, net                     |       | $                          | (284       | )                          | $          | (474 | ) |

 

A deferred tax asset or liability is recognized for thetax consequences of temporary differences in the recognition of revenue andexpense, and unrealized gains and losses, for financial and tax reportingpurposes. Deferred tax assets are reduced by a valuation allowance when, in theopinion of management, it is more likely than not that some or all of the deferredtax assets will not be realized. The Company conducted an analysis toassess the need for a valuation allowance at June 30, 2010. As part of this assessment, all availableevidence, including both positive and negative, was considered to determinewhether, based on the weight of such evidence, a valuation allowance on theCompany’s deferred tax assets was needed. In accordance with ASC Topic 740-10, *Income Taxes* (ASC 740), a valuation allowance is deemed tobe needed when, based on the weight of the available evidence, it is morelikely than not (a likelihood of more than 50%) that some portion or all of adeferred tax asset will not be realized. The future realization of the deferredtax asset depends on the existence of sufficient taxable income within thecarryback and carryforward periods.  Thecarryback and carryforward periods for federal tax are two years and twentyyears, respectively.  The state taxcarryforward period is five years with no carryback period allowed.

 

As part of its analysis, the Company considered thefollowing positive evidence:

 

·                  TheCompany has a long history of earnings profitability.

·                  TheCompany is projecting future taxable income sufficient to utilize all netoperating loss carryforwards prior to expiration.

·                  Futurereversals of certain deferred tax liabilities.

 

As part of its analysis, the Company considered thefollowing negative evidence:

 

·                  TheCompany recorded a large net loss in 2009.

·                  TheCompany did not meet its financial goals in 2009.

·                  TheCompany may not meet its projections concerning future taxable income.

 

At June 30,2010, we determined that a valuation allowance relating to both the federal andstate portion of our deferred tax asset was necessary. This determination forthe state deferred tax asset was based largely on the negative evidencerepresented by the level of state tax exempt interest income which reducesstate taxable income to a level that makes it unlikely the Company will realizeits state deferred tax asset. Therefore, valuation allowances of $14.4 millionand $3.3 million at June 30,2010 were recorded for a portion of the federal deferred tax asset and all ofthe state deferred tax asset, respectively.

 

Specifically exempted from deferred tax recognitionrequirements are bad debt reserves for tax purposes of U.S. savings and loansin the institution’s base year, as defined. Base year reserves totaledapproximately $4.2 million. Consequently, a deferred tax liability ofapproximately $1.6 million related to such reserves was not provided for in theconsolidated statements of financial condition at June 30, 2010 and December 31,2009. Payment of dividends to shareholders out of retained earnings deemed tohave been made out of earnings previously set aside as bad debt reserves maycreate taxable income to the Bank. No provision has been made for income tax onsuch a distribution as the Bank does not anticipate making such distributions.

 

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The Company files income tax returns in the U.S. federaljurisdiction and the state of Arkansas. The Company is subject to U.S. federaland state income tax examinations by tax authorities for tax years ended December 31,2007 and forward.  The Company’s 2007federal income tax return was subject to a limited scope examination by theInternal Revenue Service during the first quarter of 2009.  As a result of the examination, the Companywas assessed approximately $45,000, including interest, for the 2007 taxyear.  The Company recognizes interestand penalties on income taxes as a component of income tax expense.

 

**Note 10 — Fair Value Measurement**

 

ASC 820, formerly SFAS 157, *Fair ValueMeasurement*, provides a framework for measuring fair value anddefines fair value as the exchange price that would be received for an asset orpaid to transfer a liability (an exit price) in the principal or mostadvantageous market for the asset or liability in an orderly transaction betweenmarket participants on the measurement date. ASC 820 also establishes a fairvalue hierarchy which requires an entity to maximize the use of observableinputs and minimize the use of unobservable inputs when measuring fair value.ASC 820 describes three levels of inputs that may be used to measure fairvalue:

 

Level 1                    Unadjusted, quoted prices in active markets for identical assets orliabilities at the measurement date.

 

Level 2                    Observable inputs other than Level 1 prices, such as quoted prices for similarassets or liabilities; quoted prices in markets that are not active; or otherinputs that are observable or can be corroborated by observable market data atthe measurement date for substantially the full term of the assets orliabilities.

 

Level 3                    Unobservable inputs that reflect management’s best estimate of whatmarket participants would use in pricing the asset or liability at themeasurement date.

 

The following is a description of valuationmethodologies used for significant assets measured at fair value on anon-recurring basis.

 

*Loans Receivable*

Loans which meet certain criteria are evaluatedindividually for impairment. A loan is considered impaired when, based uponcurrent information and events, it is probable the Bank will be unable to collectall amounts due, including principal and interest, according to the contractualterms of the loan agreement.  Substantially all of the Bank’simpaired loans at June 30,2010 are secured by real estate.  These impaired loans areindividually assessed to determine that the carrying value of the loan is notin excess of the fair value of the collateral, less estimated selling costs.Fair value is estimated through current appraisals, real estate brokers orlisting prices.  Fair values may be adjusted by management to reflectcurrent economic and market conditions and, as such, are classified asLevel 3.  Impaired loans recorded at fair value with partialcharge-offs and specific valuation allowances were $28.3 million net ofspecific valuation allowances of $9.9 million at June 30, 2010.

 

*Real Estate Owned, net (“REO”)*

REO represents real estate acquired as a result offoreclosure or by deed in lieu of foreclosure and is carried at the lower ofcost or fair value less estimated selling costs.  Fair value isestimated through current appraisals, real estate brokers or listingprices.  As these properties are actively marketed, estimated fairvalues may be adjusted by management to reflect current economic and marketconditions and, as such, are classified as Level 3.  REO at June 30, 2010 was $34.3 million.During the six months ended June 30,2010, charge-offs to the allowance for loan losses related to loans that weretransferred to REO were $999,000 on transfers to REO of $13.3million.  Write downs related to REO thatwere charged to expense were $1.1 million for the six months ended June 30, 2010.

 

The following table provides the level of valuationassumption used to determine the carrying value of the Company’s assetsmeasured at fair value on a non-recurring basis at June 30, 2010:

 
| ** **      | ** ** | **Fair Value** | ** ** | **Quoted Prices in  Active Markets for  Identical Assets  (Level 1)** | ** ** | **Significant****Other Observable  Inputs  (Level 2)** | ** ** | **Significant****Unobservable  Inputs  (Level 3)** | ** ** |
|-----------------|------------|----------------|------------|-----------------------------------------------------------------------|------------|--------------------------------------------------------|------------|----------------------------------------------------|------------|
| Impaired  loans |       | $              | 28,284     |                                                                  | $          | —                                                 |       | $                                                  | —     |   | $ | 28,284 |   |
| REO,  net (1)   |       | 35,747         |       | —                                                                |       | —                                                 |       | 35,747                                             |       |
|            |       | $              | 64,031     |                                                                  | $          | —                                                 |       | $                                                  | —     |   | $ | 64,031 |   |

 

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(1)          The amounts listed reflect fair value measurements of the propertiesbefore deducting estimated costs to sell.

 

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FAIRVALUE OF FINANCIAL INSTRUMENTS

 

The estimated fair value amounts have been determined bythe Company using available market information and appropriate valuationmethodologies. However, considerable judgment is required to interpret marketdata to develop the estimates of fair value. Accordingly, the estimatespresented herein are not necessarily indicative of the amounts the Companycould realize in a current market exchange. The use of different marketassumptions and/or estimation methodologies may have a material effect on theestimated fair value amounts. The estimated fair values of financialinstruments are as follows (in thousands):

 
| ** **                                             | ** ** | **June 30, 2010** | ** ** | **December 31, 2009** | ** ** |
|--------------------------------------------------------|------------|------------------------|------------|----------------------------|------------|
| ** **                                             | ** ** | ** **             | ** ** | **Estimated**              | ** ** | ** ** | ** ** | **Estimated** | ** ** |
| ** **                                             | ** ** | **Carrying**           | ** ** | **Fair**                   | ** ** | **Carrying** | ** ** | **Fair** | ** ** |
| ** **                                             | ** ** | **Value**              | ** ** | **Value**                  | ** ** | **Value** | ** ** | **Value** | ** ** |
| ASSETS:                                                |       |                   |       |                       |       |   |   |   |   |
| Cash and cash equivalents                              |       | $                      | 63,796     |                       | $          | 63,796 |   | $ | 22,149 |   | $ | 22,149 |   |
| Investment securities—held  to maturity           |       | 88,290                 |       | 89,445                     |       | 135,531 |   | 132,509 |   |
| Federal Home Loan Bank stock                           |       | 1,573                  |       | 1,573                      |       | 3,125 |   | 3,125 |   |
| Loans receivable—net                              |       | 437,796                |       | 440,468                    |       | 481,542 |   | 483,127 |   |
| Loans held for sale                                    |       | 1,628                  |       | 1,628                      |       | 1,012 |   | 1,012 |   |
| Cash surrender value of life  insurance                |       | 21,627                 |       | 21,627                     |       | 21,226 |   | 21,226 |   |
| Accrued interest receivable                            |       | 2,943                  |       | 2,943                      |       | 4,229 |   | 4,229 |   |
|                                                   |       |                   |       |                       |       |   |   |   |   |
| LIABILITIES:                                           |       |                   |       |                       |       |   |   |   |   |
| Deposits:                                              |       |                   |       |                       |       |   |   |   |   |
| Checking, money market and  savings accounts           |       | 211,929                |       | 211,929                    |       | 245,287 |   | 245,287 |   |
| Certificates of deposit                                |       | 387,369                |       | 390,649                    |       | 379,337 |   | 383,187 |   |
| Other borrowings                                       |       | 20,921                 |       | 21,515                     |       | 59,546 |   | 60,203 |   |
| Accrued interest payable                               |       | 328                    |       | 328                        |       | 474 |   | 474 |   |
| Advance payments by  borrowers for taxes and insurance |       | 346                    |       | 346                        |       | 695 |   | 695 |   |
|                                                        |            |                        |            |                            |            |  |  |  |  |  |  |  |  |

 

For cash and cash equivalents, Federal Home Loan Bankstock, cash surrender value of life insurance and accrued interest receivable,the carrying value is a reasonable estimate of fair value, primarily because ofthe short-term nature of the instruments or, as to Federal Home Loan Bankstock, the ability to sell the stock back to the Federal Home Loan Bank atcost. The fair value of investment securities is based on quoted market prices,dealer quotes and prices obtained from independent pricing services. The fairvalue of variable rate loans is based on repricing dates. Fixed rate loans werevalued using discounted cash flows. The discount rates used to determine thepresent value of these loans were based on interest rates currently beingcharged by the Bank on comparable loans as to credit risk and term.

 

The fair value of checking accounts, savings accountsand money market deposits is the amount payable on demand at the reportingdate. The fair value of fixed-maturity certificates of deposit and Federal HomeLoan Bank advances is estimated using the rates currently offered for depositsof similar terms and advances of similar remaining maturities at the reportingdate. For advance payments by borrowers, for taxes and insurance, accruedinterest payable and Federal Reserve Bank advances, the carrying value is areasonable estimate of fair value, primarily because of the short-term natureof the instruments.

 

The fair value estimates presented herein are based onpertinent information available to management as of June 30, 2010 and December 31, 2009. Although managementis not aware of any factors that would significantly affect the estimated fairvalue amounts, such amounts have not been comprehensively revalued for purposesof these financial statements since the reporting date and, therefore, currentestimates of fair value may differ significantly from the amounts presentedherein.

 

**Note 11 — Regulatory Matters**

 

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

 

Quantitative measures established by regulation toensure capital adequacy require the Bank to maintain minimum amounts and ratios(set forth in the following table) of tangible capital (as defined) to tangibleassets (as defined) and core capital (as defined) to adjusted tangible assets(as defined), and of total risk-based capital (as defined) to risk-

 

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weighted assets (as defined).   Tier 1 (core) capital includes commonstockholders’ equity and qualifying preferred stock less certain otherdeductions.  Total capital includes tier1 capital plus the allowance for loan losses, subject to limitations.

 

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

 
| ** **                                | ** ** | **Actual** | ** ** | **For Capital  Adequacy Purposes** | ** ** | **To be Categorized  as Adequately  Capitalized Under  Prompt Corrective  Action Provisions** | ** ** |
|-------------------------------------------|------------|------------|------------|------------------------------------|------------|-----------------------------------------------------------------------------------------------|------------|
| ** **                                | ** ** | **Amount** | ** ** | **Ratio**                          | ** ** | **Amount**                                                                                    | ** ** | **Ratio** | ** ** | **Amount** | ** ** | **Ratio** | ** ** |
|                                      |       |       |       |                               |       |                                                                                          |       |   |   |   |   |   |   |
| As of June 30, 2010:                 |       |       |       |                               |       |                                                                                          |       |   |   |   |   |   |   |
|                                      |       |       |       |                               |       |                                                                                          |       |   |   |   |   |   |   |
| Tangible Capital to Tangible  Assets      |       | $          | 43,777     |                               | 6.46       | %                                                                                             | $          | 10,168 |   | 1.50 | % | N/A |   | N/A |   |
|                                      |       |       |       |                               |       |                                                                                          |       |   |   |   |   |   |   |
| Core Capital to Adjusted  Tangible Assets |       | 43,777     |       | 6.46                               | %          | 54,232                                                                                        | (1)        | 8.00 | %(1) | $ | 54,232 | (1) | 8.00 | %(1) |
|                                      |       |       |       |                               |       |                                                                                          |       |   |   |   |   |   |   |
| Total Capital to  Risk-Weighted Assets    |       | 49,391     |       | 11.40                              | %          | 51,971                                                                                        | (1)        | 12.00 | %(1) | 51,971 | (1) | 12.00 | %(1) |
|                                      |       |       |       |                               |       |                                                                                          |       |   |   |   |   |   |   |
| Tier I Capital to Risk-Weighted  Assets   |       | 43,777     |       | 10.11                              | %          | N/A                                                                                           |       | N/A |   | 17,324 |   | 4.00 | % |
|                                      |       |       |       |                               |       |                                                                                          |       |   |   |   |   |   |   |
| As of December 31,  2009:            |       |       |       |                               |       |                                                                                          |       |   |   |   |   |   |   |
|                                      |       |       |       |                               |       |                                                                                          |       |   |   |   |   |   |   |
| Tangible Capital to Tangible  Assets      |       | $          | 42,042     |                               | 5.75       | %                                                                                             | $          | 10,965 |   | 1.50 | % | N/A |   | N/A |   |
|                                      |       |       |       |                               |       |                                                                                          |       |   |   |   |   |   |   |
| Core Capital to Adjusted  Tangible Assets |       | 42,042     |       | 5.75                               | %          | 36,550                                                                                        |       | 5.00 | % | $ | 36,550 |   | 5.00 | % |
|                                      |       |       |       |                               |       |                                                                                          |       |   |   |   |   |   |   |
| Total Capital to  Risk-Weighted Assets    |       | 48,344     |       | 9.97                               | %          | 48,512                                                                                        |       | 10.00 | % | 48,512 |   | 10.00 | % |
|                                      |       |       |       |                               |       |                                                                                          |       |   |   |   |   |   |   |
| Tier I Capital to  Risk-Weighted Assets   |       | 42,042     |       | 8.67                               | %          | N/A                                                                                           |       | N/A |   | 19,405 |   | 4.00 | % |

 

----

(1) The Bank Order states that no later than December31, 2010, the Bank shall achieve and maintain a Tier 1 (Core) capital ratio ofat least 8% and a total risk-based capital ratio of at least 12%.  The required amounts presented reflect theseratios.

 

As discussed further in Part I, Item 2 underthe section “Executive Summary — Regulatory Enforcement Actions”, on April 12,2010, the Company and the Bank each consented to the terms of Cease and DesistOrders issued by the OTS. The Orders became effective on April 14, 2010.The Bank Order states that no later than December 31, 2010, the Bank shallachieve and maintain a Tier 1 (Core) capital ratio of at least 8% and a totalrisk-based capital ratio of at least 12%.  The requirement to meet and maintain a specificcapital level means that the Bank may not be deemed to be well-capitalized forthe purposes of prompt corrective action. The Bank had historically beencategorized as well-capitalized in periods prior to December 31, 2009.

 

The Bank Order also states that by June 30, 2010,the Bank shall submit to the OTS a written capital plan to achieve and maintainthe foregoing capital levels.  At a minimum, the plan shall: (i) addressthe amount of additional capital that will be necessary to meet the foregoing capitallevels under different, progressively stressed economic environments; (ii) addressthe requirements and restrictions imposed by the Order and the Bank’s mostrecent examination; (iii) address the Bank’s level of classified assets,allowance for loan and lease losses, earnings, asset concentrations, liquidityneeds, and trends in this area;  (iv) addresscurrent and projected trends in real estate market conditions; (v) addressthe Bank’s capital preservation and enhancement strategies; and (vi) identifyspecific sources of additional capital and the timeframes and methods by whichadditional capital will be raised.  TheBank submitted its written capital plan to the OTS by the June 30, 2010deadline.

 

Under the regulatory framework for prompt correctiveaction, the Bank’s capital status may preclude the Bank from access toborrowings from the Federal Reserve System through the discount window. Also,as required by the framework, the Bank must submit to the OTS a written capitalplan as described above.  The Bankbelieves it can attain these ratios by December 31, 2010 through improvedoperating results, shrinkage in asset size, potential branch sales, and raisingcapital in the third or fourth quarter of 2010. Management’s plan is subject to economic conditions and assumes nosignificant further deterioration of the Bank’s loan portfolio.

 

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**Dividend Restrictions.**  The principal source of the Company’srevenues is dividends from the Bank.  TheCompany’s ability to pay dividends to our shareholders depends to a largeextent upon the dividends we receive from the Bank.  On November 19, 2009, the OTS issuedwritten directives to the Company and the Bank which require the Company andthe Bank to obtain prior written non-objection of the OTS in order to make ordeclare any dividends or payments on their outstanding securities.

 

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**Item 2.  MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIALCONDITION AND RESULTS OF OPERATIONS**

 

**EXECUTIVESUMMARY**

 

Management’s discussionand analysis of financial condition and results of operations is intended toassist a reader inunderstanding the consolidated financial condition and resultsof operations of the Company for the periods presented.  The information contained in thissection should be read in conjunction with the unaudited condensed consolidatedfinancial statements and the notes to such financial statements found in thisreport under “Part I, Item 1, Consolidated Financial Statements”.

 

The Bank is a federallychartered stock savings and loan association that was formed in 1934.  First Federal conducts business from its mainoffice and nineteen full-service branch offices, all of which are located in asix county area in Northcentral and Northwest Arkansas comprised of Benton,Marion, Washington, Carroll, Baxter and Boone counties. The Bank’s focus willcontinue in this six county area.  TheBank is a community-oriented financial institution offering a wide range ofretail and commercial deposit accounts, including noninterest bearing andinterest bearing checking, savings and money market accounts, certificates ofdeposit, and individual retirement accounts. Loan products offered by the Bank include residential real estate,consumer, construction, lines of credit, commercial real estate and commercialbusiness loans. However, the Bank is currently subject to comprehensive lendingrestrictions as a result of the provisions of the Bank Order.  See “Regulatory Enforcement Actions” on thefollowing page for further information. Other financial services includeinvestment products offered through First Federal Investment Services, Inc.;automated teller machines; 24-hour telephone banking; internet banking,including account access, e-statements, bill payment and online loanapplications; Bounce ProtectionTM overdraft service; debit cards; and safedeposit boxes.

 

First Federal’s lendingfocus has traditionally been on permanent residential real estate.  However, between 2003 and 2005, an increasedemphasis was placed on commercial real estate lending and construction lendingbased on opportunities in Washington and Benton counties.  Beginning in late 2005, we reduced our focuson construction lending due to an oversupply of homes and lots in NorthwestArkansas.  While oversupply continues tobe a significant issue, the market in Northwest Arkansas continues tooutperform the national and state economies with lower unemployment andcontinued population growth. Washington and Benton County are the headquartersof the state’s two largest employers, Wal-Mart and Tyson Foods.  These employers attract suppliers whoestablish offices in the area and create jobs, fostering demand for housing andoffice space.  As of June 2010,unemployment in the Fayetteville/Springdale/Rogers metro area was 6.2% (notseasonally adjusted), compared to the Arkansas rate of 7.5% and the U.S. rateof 9.5%, both seasonally adjusted.

 

Certificates of depositcontinue to comprise the majority of our deposit accounts.  However, in recent years, increased emphasishas been placed on growth in checking accounts. The Bank focused its marketing efforts toincrease checking accounts by offering a checking product which has a higherinterest rate than the Bank’s other checking account products. To earn themaximum rate under the new product, customers must qualify based on usage ofelectronic banking services such as debit card transactions, e-statements, anddirect deposits or automatic payments. The Bank will continue to promote checking accounts asthey are an attractive source of funds for the Bank as they offer overalllow-interest deposits, fee income potential, and the opportunity to cross-sellother financial services.

 

The Company’s resultsof operations depend primarily on its net interest income, which is thedifference between interest income on interest earning assets, such as loansand investments, and interest expense on interest bearing liabilities, such asdeposits and borrowings.  Net interestincome is affected by the level of nonperforming assets as they provide nointerest earnings to the Bank.  TheCompany’s results of operations are also affected by the provision for loanlosses, the level of its noninterest income and expenses, and income taxexpense.

 

Noninterest income isgenerated primarily through deposit account fee income, profit on sale ofloans, loan fee income, and earnings on life insurance policies.

 

Noninterest expenseconsists primarily of employee compensation and benefits, office occupancyexpense, data processing expense, real estate owned expense, and otheroperating expense.

 

Like many banks, FirstFederal Bank’s greatest challenge in this economic environment is reducing thelevel of nonperforming assets and managing both interest rate risk and assetquality.  We strive to maintain the assetquality of our loan portfolio at acceptable levels through sound underwritingprocedures, including the use of credit scoring; a thorough loan reviewfunction; active collection procedures for delinquent loans; and, in the eventof repossession, prompt and efficient liquidation of real estate, automobilesand other forms of collateral.  We haveexperienced a significant increase in nonperforming assets, primarily due tothe housing market oversupply in Northwest Arkansas as well as the downturn inthe general economy.  We attempt to workwith troubled borrowers to return their loans to 

 

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performing status wherepossible. However, given current market conditions, the trend of increasingnonperforming assets may continue for the foreseeable future.  Both the board of directors and seniormanagement place a high priority on reducing our nonperforming assets andmanaging asset quality.

 

Management is alsochallenged with managing interest rate risk. The Bank’s current interest rate risk position as measured by ourregulator, the OTS, is at a minimal level as defined by Thrift Bulletin13a.  The movement of interest ratesimpacts the level of interest rate risk and the timing and magnitude of assetsrepricing compared to liabilities repricing. The Bank attempts to reduce the impact of changes in interest rates onits net interest income by managing the repricing gap.

 

In addition, the Bank’s regulatory burden continues toincrease.  The U.S. Congress recentlypassed the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-FrankAct”), which will change our primary regulator and may, among other things,restrict or increase the regulation of certain of our business activities andincrease the cost of doing business. At this time we cannot determine theultimate effect that potential legislation, or subsequent implementingregulations, if enacted, would have upon our earnings and financialposition.  Key provisions of thelegislation include (1) establishment of a Financial Stability OversightCouncil to identify, monitor and address systemic risks posed by large, complexfinancial firms as well as products and activities that spread risk acrossfirms; (2) a new orderly liquidation mechanism; (3) changes in bankregulatory structure, including merging our primary regulator, the OTS, withthe Office of Comptroller of Currency within 12 months of enactment (subject toa six month extension); (4) regulation of investment advisers to privatefunds; (5) regulation of the insurance industry; (6) prohibitions onproprietary trading and certain relationships with hedge funds and privateequity funds; (7) regulation of over-the-counter derivatives markets; (8) apossible new fiduciary standard for investment advisers to retail customers; (9) regulationof credit rating agencies; (10) establishment of an independent ConsumerFinancial Protection Bureau; (11) changes to the Federal Reserve System; (12)mortgage reform; (13) creation of a Financial Crisis Assessment Fund; and (14)establishment of new rules regarding executive compensation.

 

**CorporateOverview and Strategic Initiatives**

 

**Overview.**  As a community-oriented financial institutionserving the borrowing and deposit needs of its primary market area ofNorthcentral and Northwest Arkansas, the Bank’s loan portfolio grew as areflection of the economic strength and expansion of its primary marketarea.  Between December 31, 2002 andDecember 31, 2005, the Bank’s loan portfolio grew from $507.0 million to$790.6 million, primarily as a result of increased construction, commercialreal estate, and land lending. However, beginning in late 2005, the Bank beganto note an oversupply of homes and lots in the Northwest Arkansas market andlimited its construction loan activity. Construction loan originations dropped from $195.8 million in 2005 to$93.6 million in 2006, $39.0 million in 2007, $15.1 million in 2008, and $12.5million in 2009.  This oversupply and,beginning in 2007, the current recession, resulted in an increase in nonperformingassets, which amounted to $82.4 million or 12.15% of total assets at June 30, 2010 compared to $78.0million or 10.67% of total assets at December 31, 2009.  As discussed further below, management hastaken various actions to address its operational issues and will continue todevote substantial resources toward the resolution of all delinquent andnonperforming assets.

 

**RegulatoryEnforcement Actions.**

The OTS is the primary federalregulator of the Bank.  As a result ofthe loss in 2009 and the increase in nonperforming assets and based on aregulatory examination of the Company and the Bank in the fall of 2009, on April 12,2010, the Company and the Bank each consented to the terms of Cease and DesistOrders issued by the OTS.  The Ordersbecame effective on April 14, 2010.

 

The Company Order, among other things, provides that:

 

·                  By June 30,2010, the Company shall submit to the OTS a written capital plan to preserveand enhance the capital of the Company and the Bank to ensure that the Bankcomplies with the capital requirements imposed by the Bank Order.  Ata minimum, the plan shall: (i) address the requirements and restrictionsimposed by the Orders; (ii) detail the Company’s capital preservation andenhancement strategies; (iii) identify specific sources of additionalcapital and the timeframes and methods by which additional capital will beraised; (iv) establish an alternative strategy, which includes, but is notlimited to, seeking a merger or acquisition partner for the Company and/or theBank to be implemented if the primary strategy to raise additional capital isunsuccessful; and (v) require management to submit monthly reports to theBoard regarding the Company and the Bank’s compliance with their respectivecapital plans.  This plan has beensubmitted as required.

 

·                  By June 30,2010, the Company shall submit to the OTS a business plan for the remainder ofthe calendar year 2010 and calendar years 2011 and 2012 that is acceptable tothe OTS Regional Director.  At a minimum,the plan shall include: (i) actions to address the requirements containedin the Order issued to the Company and the comments contained within theCompany’s most recent examination by the OTS; (ii) 

 

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strategies for capital enhancement with the capitalmaintenance requirements of the foregoing capital plan; (iii) plans andstrategies to strengthen and improve the consolidated Company’s operations,earnings and profitability; (iv) a detailed discussion of the Company’scurrent financial position and resources; (v) quarterly pro formafinancial projections; (vi) identification of all relevant assumptions anddocumentation; (v) a contingency plan that addresses, under different,progressively stressed economic environments: projected short and long-termsources of liquidity and cash flow; the payment of the Company’s operatingexpenses; and the payment of dividends on preferred stock without reliance oncapital distributions or any other payments from the Bank.  This plan has been submitted as required.

 

·                  Effectiveimmediately, the Company shall not declare or pay any cash dividends or capitaldistributions on the Company’s stock or repurchase such shares without theprior written non-objection of the OTS.

 

·                  Effectiveimmediately, the Company shall not issue a new class of stock or change theterms of any existing classes of stock, or convert any class of stock intoanother class of stock without the prior written non-objection of the OTS.

 

·                  Effectiveimmediately, the Company shall not incur, renew or increase any debt withoutthe prior written non-objection of the OTS.

 

·                  Effectiveimmediately, the Company shall not enter into, renew, extend or revise anycontractual arrangements related to compensation or benefits with any directoror senior executive officer of the Company without first providing OTS priorwritten notice.

 

·                  Effectiveimmediately, the Company shall not make any “golden parachute payment” or anyprohibited indemnification payment unless the Company complies with 12 C.F.R. Part 359.

 

·                  Effectiveimmediately, the Company shall comply with the OTS prior notificationrequirements for changes in directors and senior executive officers set forthin 12 C.F.R. Part 563, Subpart H.

 

·                  Effectiveimmediately, the Company shall not engage in any new transactions with the Bankexcept exempt transactions under 12 C.F.R. 223 and intercompany cost-sharingtransactions and tax sharing transactions without the prior writtennon-objection of the OTS.

 

The Company Order will remain in effect untilterminated, modified or suspended by the OTS.

 

Among other things, the Bank Order provides that:

 

·                  Nolater than December 31, 2010, the Bank shall achieve and maintain a Tier 1(Core) Capital Ratio of at least 8.0% and a Total Risk-Based Capital Ratio ofat least 12.0%.

 

·                  By June 30,2010, the Bank shall submit to the OTS a written capital plan to achieve andmaintain the foregoing capital levels.  At a minimum, the plan shalladdress: (i) the amount of additional capital that will be necessary tomeet the foregoing capital levels under different, progressively stressedeconomic environments; (ii) the requirements and restrictions imposed bythe Order and the Bank’s most recent examination; (iii) the Bank’s levelof classified assets, allowance for loan and lease losses (“ALLL”), earnings,asset concentrations, liquidity needs, and trends in these areas;  (iv) current and projected trends inreal estate market conditions; (v) the Bank’s capital preservation andenhancement strategies; and (vi) identify specific sources of additionalcapital and the timeframes and methods by which additional capital will beraised.  This plan has been submitted asrequired.

 

·                  In theevent the Bank fails to meet the capital requirements of the Order, fails tocomply with the capital plan or at the request of the OTS, the Bank shallprepare and submit a contingency plan to the OTS within 30 days of such event.The contingency plan shall detail actions to be taken to achieve either amerger or acquisition of the Bank by another depository institution or avoluntary liquidation of the Bank.

 

·                  Effectiveimmediately, the Bank shall not, without the prior written non-objection of theOTS, increase its total assets during any quarter in excess of an amount equalto net interest credited on deposit liabilities during the prior quarter.

 

·                  By June 30,2010, the Bank shall submit to the OTS a new business plan and budget for theremainder of the calendar year 2010 and calendar years 2011 and 2012 that isacceptable to the OTS Regional Director. At a minimum, the plan shall include: (i) plans and strategies torestructure the Bank’s operations, improve earnings, reduce expenses and achievepositive core income; (ii) strategies for ensuring the Bank has thefinancial and personnel resources necessary to implement and adhere to theplan; (iii) quarterly pro forma financial projections; and (iv) identificationof all relevant assumptions made in formulating the plan.  This 

 

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plan has been submitted as required.

 

·                  Effectiveimmediately, the Bank shall not accept, renew or roll over any brokered depositwithout a specific waiver from the OTS and the FDIC.

 

·                  Effectiveimmediately, the Bank shall develop an internal system to monitor the interestrates offered on all interest bearing accounts to ensure compliance with 12C.F.R. 337.6(b).

 

·                  Effectiveimmediately, the Bank shall review its liquidity position and prepare a dailyliquidity report setting forth the uses and sources of funds for the Bank’soperations and cash flow projections for a 180 day period.  The liquidity report is required to besubmitted daily to the OTS Regional Director and the Bank’s Asset/LiabilityCommittee.

 

·                  Effectiveimmediately, the Bank shall not declare or pay dividends or make any othercapital distributions without the prior written approval of the OTS.

 

·                  Effectiveimmediately, the Bank shall not make, purchase, or commit to make or purchase acommercial real estate (CRE) loan or an extension of credit for the purpose ofland acquisition, development, and/or construction without the prior writtennon-objection of the OTS, except for construction of an owner occupiedone-to-four family dwelling with at least a 20 percent down payment or that issubject to a binding pre-sold commitment.

 

·                  Effectiveimmediately, the Bank shall not make, purchase, or refinance or commit to make,purchase, or refinance an extension of credit if any of the proceeds of theloan will be used for the payment of interest on any loan or will be used forthe establishment of an interest carry reserve on a loan without the priorwritten non-objection of the OTS.

 

·                  Effectiveimmediately, the Bank shall not make or purchase, or commit to make or purchasean extension of credit that is in excess of the supervisory loan-to-valuelimits set forth in the Appendix to 12 C.F.R. 560.101 without the prior writtennon-objection of the OTS.

 

·                  Withintwenty-five (25) days after the end of each quarter, beginning with the quarterended March 31, 2010, the Bank shall submit a written report to the Bank’sBoard of Directors setting forth the ALLL analysis for the Bank’s assets andall assumptions used to determine the adequacy of the ALLL, given currenteconomic conditions and the Bank’s risk profile.  The written report is required to besubmitted to the OTS Regional Director within thirty (30) days after the end ofeach quarter. These reports have been submitted as required.

 

·                  Effectiveimmediately, the Bank shall evaluate and classify its assets and establish ALLLand specific valuation allowances in accordance with applicable laws,regulations, and regulatory guidance.

 

·                  Effectiveimmediately, the Bank shall implement and maintain an internal asset reviewprogram independent of the loan underwriting and approval functions to identifyand grade loans with potential credit weaknesses in accordance with applicableregulations and regulatory guidance regarding internal asset reviews.

 

·                  By April 1,2010, the Bank shall engage a qualified independent consultant to perform anon-site internal asset review and analyses of the assets on the Bank’s books asof December 31, 2009, including: (i) all non-owner occupied mortgageloans exceeding two hundred fifty thousand dollars ($250,000); (ii) allother nonhomogeneous loans exceeding five hundred thousand dollars ($500,000);and (iii) all homogeneous loans designated as special mention or watchexceeding five hundred thousand dollars ($500,000). The review shall becompleted by May 31, 2010 and the Bank shall submit the consultant’sreport to the OTS by June 30, 2010. The Bank has already engaged a qualified independent consultant to meetthis requirement and the report has been submitted to the OTS as required.

 

·                  By June 30,2010, the Bank shall submit a comprehensive classified asset reduction plan toreduce classified assets that is acceptable to the OTS Regional Director. At aminimum, such plan shall include: (i) targets for the level of classifiedassets as a percentage of Tier 1 (Core) capital and ALLL and the timeframe foreach such target; (ii) a description of the manner of, and methods for,reducing the Bank’s level of classified assets to the targets set forththerein; and (iii) all relevant assumptions and projections based ondifferent scenarios, and documentation supporting such assumptions andprojections.  This plan has beensubmitted as required.

 

·                  By June 30,2010, the Bank shall submit a Loan-to-Value Plan to reduce the aggregate amountof all loans in excess of the supervisory loan-to-value limits set forth in theAppendix to 12 C.F.R. 560.101.  At aminimum, the plan shall include: (i) targets for the aggregate amount ofall loans in excess of such supervisory loan-to-value limits; (ii) targetsfor the aggregate amount of all commercial loans, agricultural 

 

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loans, multifamily loans, or loans secured by propertiesother than owner occupied one-to-four family residential properties in excessof such supervisory loan-to-value limits; (iii) a description of themanner of, and methods for, reducing the Bank’s level of loans in excess ofsuch supervisory loan-to-value limits to the targets set forth therein; and (iv) allrelevant assumptions and projections based on a best-case scenario, aworst-case scenario, and a most probable case scenario, and documentationsupporting such assumptions and projections. This plan has been submitted as required.

 

·                  By May 31,2010, the Bank will submit to the OTS a certified written report regarding thetransactions that do not comply with the requirements of 12 U.S.C. 1464 and 12C.F.R. 560.30, specifically related to all real estate transactions and realestate transfer transactions conducted from January 1, 2008 throughJanuary 31, 2010.  This report hasbeen submitted as required.

 

·                  By June 30,2010, the Bank shall submit a plan to divest of any impermissible asset that isacceptable to the OTS Regional Director. This plan has been submitted as required.

 

·                  By June 30,2010, the Bank shall submit a commercial real estate concentration plan to theOTS, subject to OTS Regional Director acceptance, that, at a minimum,addresses: (i) the reduction of the amount of the Bank’s existing CREloans to two hundred percent (200%) or less of Tier 1 (Core) capital and ALLL; (ii) thereduction of each category of assets within the CRE portfolio to one hundredpercent (100%) or less of Tier 1 (Core) capital and ALLL; (iii) the timeframes for reaching each such target; and (iv) the assessment, monitoring,and control of the risks associated with the Bank’s CRE portfolio in accordancewith applicable regulatory guidance. This plan has been submitted as required.

 

·                  Effectiveimmediately, the Bank shall not engage in any new transaction with an affiliateunless the Bank has complied with certain regulatory requirements.

 

·                  Effectiveimmediately, the Bank shall not enter into any arrangement or contract with athird party service provider that is significant to the overall operation orfinancial condition of the Bank or outside the Bank’s normal course of businesswithout obtaining written non-objection from the OTS.

 

·                  Effectiveimmediately, the Bank shall not enter into, renew, extend or revise anycontractual arrangement relating to compensation or benefits for any seniorexecutive officer or director unless prior written notice is provided to theOTS.

 

·                  Effectiveimmediately, the Bank shall not increase any salaries, bonuses or director’sfees or make any other similar payments to directors or senior executiveofficers without prior written non-objection from the OTS.

 

·                  Effectiveimmediately, the Bank shall not make any “golden parachute payments” orprohibited indemnification payment unless the Bank has complied with 12 C.F.R. Part 359and 12 C.F.R. Section 545.121.

 

·                  Effectiveimmediately, the Bank shall comply with the prior notification requirements forchanges in directors and senior executive officers set forth in 12 C.F.R. Part 563,Subpart H.

 

·                  By April 30,2010, the Bank shall retain an independent third party consultant acceptable tothe OTS Regional Director to conduct a review of supervision of the Bank’slending operations by the Board and management. At a minimum, the ManagementStudy shall include: (i) the identification of present and future staffingrequirements for the Bank’s lending operations; (ii) an evaluation of theperformance of management with respect to the Bank’s lending operations, includingan assessment of whether compensation is commensurate with job performance andresponsibilities in compliance with 12 C.F.R. § 563.161(b); (iii) theestablishment of standards by which management’s effectiveness in the Bank’slending operations will be measured; (iv) an assessment of the adequacy ofcommunication regarding the Bank’s lending operations between management andthe Board and the quality and timeliness of reporting to the Board; and (v) recommendationson whether to expand the scope, frequency, and sufficiency of informationregarding the Bank’s lending operations provided to the Board by management. ByJuly 30, 2010, the Board shall adopt a written plan to address anyidentified weaknesses or deficiencies noted in such study. The Bank shallprovide such plan to the OTS within fifteen (15) days after the boardmeeting.  The Bank retained theindependent third party consulting firm and the firm has completed its reviewand issued its report.  Management haswritten a plan in response to the report and both the review report andmanagement’s plan have been reviewed by the board and submitted to the OTS asrequired.

 

The Bank Order will remain in effect until terminated,modified or suspended by the OTS.  Copiesof the stipulations and the Orders are included as Exhibits 10.7 to 10.10 tothe Company’s 2009 Annual Report on Form 10-K filed with the SEC on April 15,2010.  The descriptions of the Orders setforth herein do not purport to be complete, and are qualified by reference tothe full text of the Orders.

 

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The Company and the Bank have taken such actions asnecessary to comply with the provisions of the Orders which are currentlyeffective and are continuing to work toward compliance with the provisions ofthe Orders with future compliance dates. Any material failure by the Company and the Bank to comply with theprovisions of the Orders could result in further enforcement actions by theOTS. While the Company and the Bank intend to take such actions as may benecessary to comply with the requirements of the Orders, there can be noassurance that the Company or the Bank will be able to comply fully with theOrders, or that efforts to comply with the Orders will not have adverse effectson the operations and financial condition of the Company or the Bank.  See “Risk Factors.”

 

**Report of Independent Registered Public Accounting Firm.**The report of the Company’s independent registered public accounting firmfor the year ended December 31, 2009 contained an explanatory paragraph asto the Company’s ability to continue as a going concern primarily due to theCompany’s loss of $45.5 million in 2009, the Bank’s significant level ofcriticized assets and the decline in the Bank’s capital position.  See Note 2 of the Notes to the UnauditedCondensed Consolidated Financial Statements included in Part I, Item1 herein.

 

**Strategic Initiatives. **In response to the operational issues which have arisen as a result ofthe level of the Bank’s nonperforming assets and the difficult economic andbanking environment, management has taken a number of cost saving actions,implemented various strategic initiatives and aggressively addressed the natureand level of its nonperforming assets.

 

During 2009, the Company reviewed all aspects of itscost structure and implemented the following cost saving measures whichcontinue in 2010:

 

·                  Reductions in compensation and benefits through

 

·                  decreased executive and senior management salaries,

·                  reduced director fees,

·                  reduced staffing levels,

·                  eliminated Company’s 401(k) match,

·                  suspended pay increases and bonuses;

 

·                  Reductions in discretionary expenses such as travel and entertainment,professional education and contributions;

·                  Reductions in advertising and public relations costs; and

·                  Reductions in third-party contract provider costs.

 

In order to complement the cost saving of the actionsdescribed above and to provide the Company with greater operationalflexibility, the Company has taken the following actions:

 

·                  Significantly reduced lending, particularly construction and land loans;

·                  Increased liquidity;

·                  Suspended cash dividends on common and preferred stock; and

·                  Maintained the level of its interest rate spread and net interest margin.

 

The Company continues to work through the creditproblems presented by the oversupply of homes and lots in the Company’sNorthwest Arkansas market area, the housing market downturn and current marketconditions.  In order to address theCompany’s nonperforming assets, the Company has taken the following steps in2010:

 

·                  Hired an independent third party contractor to conduct a thorough reviewand analysis of its loan portfolio, including a review of collateralvaluations;

·                  Hired an experienced former bank regulator as the Bank’s Credit Risk andLoan Review Manager; and

·                  Hired an Appraisal Review Officer.

 

During 2010, the Company intends to continue toproactively address the challenges presented by the economy.  The Company will focus on the followingprimary objectives during 2010:

 

·                  Addressing and resolving problem assets;

·                  Further reducing costs to achieve greater efficiency;

·                  Addressing and complying with all terms and conditions of the Orders; and

·                  Raising capital.

 

The Orders require the Company and the Bank to, amongother things, submit a capital plan to the OTS to preserve and enhance thecapital of the Company and the Bank.  Inaddition, the Bank Order requires the Bank to achieve and maintain a tier onecore capital ratio and a total risk-based capital ratio of at least 8% and 12%,respectively, by December 31, 2010. While the Company will consider all strategic alternatives available toit, including the reduction of assets, the Company currently intends to raisecapital in the third or fourth quarter of 2010.

 

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**CRITICALACCOUNTING POLICIES**

 

Various elements of ouraccounting policies, by their nature, are inherently subject to estimationtechniques, valuation assumptions and other subjective assessments.  In particular, the following estimates, dueto the judgments, estimates and assumptions inherent in those policies, arecritical to preparation of our financial statements.

 

·            Determination of our allowance for loan losses

·            Valuation of real estate owned

·            Valuation of our deferred tax assets

 

These policies and thejudgments, estimates and assumptions are described in greater detail insubsequent sections of Management’s Discussion and Analysis and in the notes tothe unaudited condensed consolidated financial statements included herein. Webelieve that the judgments, estimates and assumptions used in the preparationof our consolidated financial statements are appropriate given the factualcircumstances at the time.  However,given the sensitivity of our consolidated financial statements to thesecritical accounting policies, the use of other judgments, estimates andassumptions could result in material differences in our results of operationsor financial condition.

 

In estimating theamount of credit losses inherent in our loan portfolio, various judgments andassumptions are made.  For example, whenassessing the condition of the overall economic environment, assumptions aremade regarding market conditions and their impact on the loan portfolio.  In the event the economy were to sustain aprolonged downturn, the loss factors applied to our portfolios may need to berevised, which may significantly impact the measurement of the allowance forloan losses.  For impaired loans that arecollateral dependent and for real estate owned, the estimated fair value of thecollateral may deviate significantly from the proceeds received when the collateralis sold.

 

We recognize deferred tax assets and liabilitiesfor the future tax consequences related to differences between the financialstatement carrying amounts of existing assets and liabilities and theirrespective tax bases, and for tax credits. We evaluate our deferred tax assetsfor recoverability using a consistent approach that considers the relativeimpact of negative and positive evidence, including our historicalprofitability and projections of future taxable income. We are required toestablish a valuation allowance for deferred tax assets if we determine, basedon available evidence at the time the determination is made, that it is morelikely than not that some portion or all of the deferred tax assets will not berealized. In evaluating the need for a valuation allowance, we estimate futuretaxable income based on management-approved business plans and ongoing taxplanning strategies. This process involves significant management judgmentabout assumptions that are subject to change from period to period based onchanges in tax laws or variances between our projected operating performance,our actual results and other factors.

 

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**CHANGES IN FINANCIAL CONDITION**

 

Changes infinancial condition between June 30, 2010 and December 31, 2009 arepresented 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** | ** ** |
|------------------------------------------------|------------|-----------------------|------------|-----------------------|------------|----------------|------------|----------------|------------|
| ** **                                     | ** ** | **2010**              | ** ** | **2009**              | ** ** | **(Decrease)** | ** ** | **Change**     | ** ** |
| **ASSETS**                                     |       |                  |       |                  |       |           |       |           |       |
| Cash and cash equivalents                      |       | $                     | 63,796     |                  | $          | 22,149         |       | $              | 41,647     |   | 188.0 | % |
| Investment securities held  to maturity        |       | 88,290                |       | 135,531               |       | (47,241        | )          | (34.9          | )          |
| Federal Home Loan Bank stock                   |       | 1,573                 |       | 3,125                 |       | (1,552         | )          | (49.7          | )          |
| Loans receivable, net                          |       | 437,796               |       | 481,542               |       | (43,746        | )          | (9.1           | )          |
| Loans held for sale                            |       | 1,628                 |       | 1,012                 |       | 616            |       | 60.9           |       |
| Accrued interest receivable                    |       | 2,943                 |       | 4,229                 |       | (1,286         | )          | (30.4          | )          |
| Real estate owned, net                         |       | 34,327                |       | 35,155                |       | (828           | )          | (2.4           | )          |
| Office properties and  equipment, net          |       | 22,926                |       | 23,567                |       | (641           | )          | (2.7           | )          |
| Prepaid expenses and other  assets             |       | 24,820                |       | 24,760                |       | 60             |       | 0.2            |       |
|                                           |       |                  |       |                  |       |           |       |           |       |
| TOTAL                                          |       | $                     | 678,099    |                  | $          | 731,070        |       | $              | (52,971    | ) | (7.3 | )% |
|                                           |       |                  |       |                  |       |           |       |           |       |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY** |       |                  |       |                  |       |           |       |           |       |
| LIABILITIES:                                   |       |                  |       |                  |       |           |       |           |       |
| Deposits                                       |       | $                     | 599,298    |                  | $          | 624,624        |       | $              | (25,326    | ) | (4.1 | )% |
| Other borrowings                               |       | 20,921                |       | 59,546                |       | (38,625        | )          | (64.9          | )          |
| Other liabilities                              |       | 13,450                |       | 3,600                 |       | 9,850          |       | 273.6          |       |
|                                           |       |                  |       |                  |       |           |       |           |       |
| Total liabilities                              |       | 633,669               |       | 687,770               |       | (54,101        | )          | (7.9           | )          |
|                                           |       |                  |       |                  |       |           |       |           |       |
| STOCKHOLDERS’ EQUITY                      |       | 44,430                |       | 43,300                |       | 1,130          |       | 2.6            |       |
|                                           |       |                  |       |                  |       |           |       |           |       |
| TOTAL                                          |       | $                     | 678,099    |                  | $          | 731,070        |       | $              | (52,971    | ) | (7.3 | )% |
|                                           |       |                  |       |                  |       |           |       |           |       |
| BOOK VALUE PER COMMON SHARE                    |       | $                     | 5.82       |                  | $          | 5.59           |       |           |       |   |   |
|                                           |       |                  |       |                  |       |           |       |           |       |
| COMMON EQUITY TO ASSETS                        |       | 4.2                   | %          | 3.7                   | %          |           |       |           |       |
|                                           |       |                  |       |                  |       |           |       |           |       |
| TOTAL EQUITY TO ASSETS                         |       | 6.6                   | %          | 5.9                   | %          |           |       |           |       |

 

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**LoansReceivable. **Changes in loan composition between June 30, 2010 and December 31, 2009 are presented in thefollowing table (dollars in thousands).

 
| ** **                                       | ** ** | **June 30****,** | ** ** | **December 31,** | ** ** | **Increase**   | ** ** | ** **   | ** ** |
|--------------------------------------------------|------------|-----------------------|------------|-----------------------|------------|----------------|------------|--------------|------------|
| ** **                                       | ** ** | **2010**              | ** ** | **2009**              | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
|                                             |       |                  |       |                  |       |           |       |         |       |
| One- to four-family  residences                  |       | $                     | 234,023    |                  | $          | 235,990        |       | $            | (1,967     | ) | (0.8 | )% |
| Home equity lines of credit  and second mortgage |       | 21,633                |       | 27,022                |       | (5,389         | )          | (19.9        | )          |
| Multifamily                                      |       | 27,553                |       | 25,368                |       | 2,185          |       | 8.6          |       |
| Commercial real estate                           |       | 104,402               |       | 107,237               |       | (2,835         | )          | (2.6         | )          |
| Land                                             |       | 34,055                |       | 41,405                |       | (7,350         | )          | (17.8        | )          |
| Construction:                                    |       |                  |       |                  |       |           |       |         |       |
| One- to four-family  residences                  |       | 1,825                 |       | 7,102                 |       | (5,277         | )          | (74.3        | )          |
| Speculative one-to  four-family residences       |       | 1,716                 |       | 8,849                 |       | (7,133         | )          | (80.6        | )          |
| Multifamily                                      |       | 10,439                |       | 14,178                |       | (3,739         | )          | (26.4        | )          |
| Commercial real estate                           |       | 1,740                 |       | 9,717                 |       | (7,977         | )          | (82.1        | )          |
| Land development                                 |       | 7,562                 |       | 9,449                 |       | (1,887         | )          | (20.0        | )          |
| Total construction loans                         |       | 23,282                |       | 49,295                |       | (26,013        | )          | (52.8        | )          |
| Total mortgage loans                             |       | 444,948               |       | 486,317               |       | (41,369        | )          | (8.5         | )          |
|                                             |       |                  |       |                  |       |           |       |         |       |
| Commercial                                       |       | 12,141                |       | 14,575                |       | (2,434         | )          | (16.7        | )          |
|                                             |       |                  |       |                  |       |           |       |         |       |
| Automobile                                       |       | 5,025                 |       | 6,810                 |       | (1,785         | )          | (26.2        | )          |
| Other                                            |       | 8,861                 |       | 11,052                |       | (2,191         | )          | (19.8        | )          |
| Total consumer                                   |       | 13,886                |       | 17,862                |       | (3,976         | )          | (22.3        | )          |
|                                             |       |                  |       |                  |       |           |       |         |       |
| Total loans receivable                           |       | 470,975               |       | 518,754               |       | (47,779        | )          | (9.2         | )          |
|                                             |       |                  |       |                  |       |           |       |         |       |
| Undisbursed loan funds                           |       | (1,463                | )          | (4,327                | )          | 2,864          |       | (66.2        | )          |
| Deferred loan costs (fees) —  net           |       | (163                  | )          | 23                    |       | (186           | )          | (808.7       | )          |
| Allowance for loan losses  (1)                   |       | (31,553               | )          | (32,908               | )          | 1,355          |       | (4.1         | )          |
|                                             |       |                  |       |                  |       |           |       |         |       |
| Loans receivable, net                            |       | $                     | 437,796    |                  | $          | 481,542        |       | $            | (43,746    | ) | (9.1 | )% |

 

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(1)          Theallowance for loan losses at June 30,2010 and December 31, 2009, is comprised of specific valuation allowancesof $9.9 million and $7.5 million, respectively, and general valuationallowances of $21.7 million and $25.4 million, respectively.

 

The decrease inthe Bank’s loan portfolio was primarily due to repayments and a decrease inloan originations as a result of continued softening of the housing market inthe Bank’s market area and transfers of nonperforming loans to REO, net ofloans to facilitate sales of REO. Market data indicates an overall decrease inhome sales in Benton and Washington counties in 2009, 2008 and 2007.  Although the Northwest Arkansas region’seconomy continues to experience population growth and a relatively good jobmarket, the supply of new residential lots and new speculative homes for salecontinues to outpace demand.  We expectthis trend to continue for the foreseeable future given the level of oversupplyin the market.

 

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**Asset Quality. **Thefollowing table sets forth the amounts, net of specific valuation allowances,and categories of the Bank’s nonperforming assets at the dates indicated (dollars in thousands**)**.

 
| ** **                                                          | ** ** | **June 30, 2010** | ** ** | **December 31, 2009** | ** ** | **Increase** | ** ** |
|---------------------------------------------------------------------|------------|------------------------|------------|----------------------------|------------|--------------|------------|
| ** **                                                          | ** ** | **Net**                | ** ** | **% Assets**               | ** ** | **Net**      | ** ** | **% Assets** | ** ** | **(Decrease)** | ** ** |
| Nonaccrual  Loans:                                                  |       |                   |       |                       |       |         |       |   |   |   |   |
| One- to four-family  residential                                    |       | $                      | 14,989     |                       | 2.21       | %            | $          | 11,941 |   | 1.63 | % | $ | 3,048 |   |
| Home equity and second mortgage                                     |       | 1,080                  |       | 0.16                       |       | 1,174        |       | 0.16 |   | (94 | ) |
| Speculative one- to  four-family construction                       |       | 432                    |       | 0.06                       |       | 1,081        |       | 0.15 |   | (649 | ) |
| Multifamily residential                                             |       | 3,690                  |       | 0.54                       |       | 1,431        |       | 0.20 |   | 2,259 |   |
| Land development                                                    |       | 5,211                  |       | 0.77                       |       | 6,144        |       | 0.84 |   | (933 | ) |
| Land                                                                |       | 10,233                 |       | 1.51                       |       | 13,709       |       | 1.88 |   | (3,476 | ) |
| Commercial real estate                                              |       | 11,114                 |       | 1.64                       |       | 6,795        |       | 0.93 |   | 4,319 |   |
| Commercial loans                                                    |       | 453                    |       | 0.07                       |       | 463          |       | 0.06 |   | (10 | ) |
| Consumer loans                                                      |       | 186                    |       | 0.03                       |       | 129          |       | 0.01 |   | 57 |   |
|                                                                |       |                   |       |                       |       |         |       |   |   |   |   |
| Total nonaccrual loans                                              |       | 47,388                 |       | 6.99                       | %          | 42,867       |       | 5.86 | % | 4,521 |   |
| Accruing loans 90 days or more past due                             |       | 660                    |       | 0.10                       |       | —       |       | — |   | 660 |   |
| Real estate owned                                                   |       | 34,327                 |       | 5.06                       |       | 35,155       |       | 4.81 |   | (828 | ) |
|                                                                |       |                   |       |                       |       |         |       |   |   |   |   |
| Total nonperforming assets                                          |       | 82,375                 |       | 12.15                      |       | 78,022       |       | 10.67 |   | 4,353 |   |
| Performing restructured  loans                                      |       | 2,070                  |       | 0.30                       |       | 4,609        |       | 0.63 |   | (2,539 | ) |
|                                                                |       |                   |       |                       |       |         |       |   |   |   |   |
| Total nonperforming assets  and performing  restructured  loans (1) |       | $                      | 84,445     |                       | 12.45      | %            | $          | 82,631 |   | 11.30 | % | $ | 1,814 |   |

 

----

(1) The table above does not include substandardimpaired loans of $3.4 million and $6.3 million as of June 30, 2010 and December 31, 2009, respectively.  These impaired loans generally include loansfor which there may be doubt about the ultimate timing of collection ofprincipal and interest compared to the original terms of the note but where thepayment history has been satisfactory and collateral coverage is estimated tobe adequate to pay principal and interest in full.  See Note 7 to the unaudited condensedconsolidated financial statements.  Thetable also does not include substandard loans which were judged not to beimpaired totaling $30.0 million and $37.3 million at June 30, 2010 and December 31,2009, respectively.

 

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The increase in netnonaccrual loans from $42.9 million at December 31, 2009 to $47.4 millionat June 30, 2010 was primarily related to increases innonaccrual single family residential loans, nonaccrual multifamily residentialloans and nonaccrual commercial real estate loans, offset by a decrease innonaccrual land loans. The increase in nonaccrual single family loans was dueto a $3.1 million increase in nonaccrual nonowner-occupied single familyloans.  At December 31, 2009, therewere 32 such loans totaling $4.9 million compared to 51 such loans totaling$8.0 million at June 30, 2010.  Theincrease in nonaccrual multifamily loans was primarily due to a $3.0 millionconstruction loan on a 56 unit apartment complex in Rogers, Arkansas thatmatured April 1, 2010.  Based onestimated costs to complete the project and a May 2010 appraisal, aspecific loan loss allowance of approximately $680,000 was recorded for thisloan as of June 30, 2010. The increase in nonaccrual commercial real estate loans was primarilyrelated to two borrowers.  The firstrelationship totaled $2.8 million and is collateralized by retail storebuildings in the Mountain Home area.  Thesecond totaled $1.3 million and is collateralized by an office building inNorthwest Arkansas.  Nonaccrual multifamily,land development, land and commercial real estate loans comprise over 60% ofnonaccrual loans at June 30, 2010. Loans in these categories with balancesin excess of $1.0 million at June 30, 2010 are listed in the table below (in thousands).

 
| ** **                                             | ** ** | **Location**      | ** ** | **Date to  Nonaccrual** | ** ** | **Comments** | ** ** | **Loan  Balance** | ** ** | **Specific  Valuation  Allowance** | ** ** | **Net of SVA** | ** ** | **Valuation  Date** | ** ** | **Source** | ** **      |
|--------------------------------------------------------|------------|-------------------|------------|-------------------------|------------|--------------|------------|-------------------|------------|------------------------------------|------------|----------------|------------|---------------------|------------|------------|-----------------|
|                                                   |       |              |       |                    |       |         |       |              |       |                               |       |           |       |                |       |       |            |
| **Multifamily**                                        |       |              |       |                    |       |         |       |              |       |                               |       |           |       |                |       |       |            |
| 56-unit apartment complex,  under construction         |       | Rogers,  AR       |       | 1Q2010                  |       | (A)          |       | $                 | 2,982      |                               | $          | 682            |       | $                   | 2,300      |       | May 2010   |   | (L) |   |
| 24-unit apartment complex,  under construction         |       | Fayetteville,  AR |       | 4Q2009                  |       | (B)          |       | 1,629             |       | 469                                |       | 1,160          |       | May 2010       |       | (L)        |            |
| Other - 2 loans under  $500,000 each                   |       |              |       |                    |       |         |       | 479               |       | 249                                |       | 230            |       |                |       |       |            |
| ** **                                             |       |              |       |                    |       |         |       | $                 | 5,090      |                               | $          | 1,400          |       | $                   | 3,690      |       |            |   |   |   |
|                                                   |       |              |       |                    |       |         |       |              |       |                               |       |           |       |                |       |       |            |
| **Land Development**                                   |       |              |       |                    |       |         |       |              |       |                               |       |           |       |                |       |       |            |
| 52 single family lots and 25 acres of undeveloped land |       | Fayetteville,  AR |       | 1Q2009                  |       | (C)          |       | $                 | 3,649      |                               | $          | —         |       | $                   | 3,649      |       | April 2010 |   | (K) |   |
| 40 acres, proposed residential subdivision             |       | Farmington,  AR   |       | 3Q2009                  |       | (D)          |       | 1,060             |       | 148                                |       | 912            |       | June 2010      |       | (K)        |            |
| Other — 3 loans under $500,000 each               |       |              |       |                    |       |         |       | 750               |       | 100                                |       | 650            |       |                |       |       |            |
|                                                   |       |              |       |                    |       |         |       | $                 | 5,459      |                               | $          | 248            |       | $                   | 5,211      |       |            |   |   |   |
| **Land**                                               |       |              |       |                    |       |         |       |              |       |                               |       |           |       |                |       |       |            |
| 29 acres for future commercial development             |       | Springdale,  AR   |       | 1Q2009                  |       | (E)          |       | $                 | 2,039      |                               | $          | 10             |       | $                   | 2,029      |       | March 2010 |   | (L) |   |
| 96 developed single family lots                        |       | Fayetteville,  AR |       | 1Q2009                  |       | (F)          |       | 2,735             |       | 370                                |       | 2,365          |       | March 2010     |       | (K)        |            |
| 60 acres, residential zoned                            |       | Fayetteville,  AR |       | 1Q2009                  |       | (C)          |       | 2,005             |       | 777                                |       | 1,228          |       | February 2010  |       | (L)        |            |
| 35 acres, proposed residential subdivision             |       | Fayetteville,  AR |       | 3Q2009                  |       | (D)          |       | 3,447             |       | 2,308                              |       | 1,139          |       | January 2010   |       | (L)        |            |
| Other - 26 loans under $1 million each                 |       |              |       |                    |       |         |       | 3,903             |       | 431                                |       | 3,472          |       |                |       |       |            |
|                                                   |       |              |       |                    |       |         |       | $                 | 14,129     |                               | $          | 3,896          |       | $                   | 10,233     |       |            |   |   |   |
|                                                   |       |              |       |                    |       |         |       |              |       |                               |       |           |       |                |       |       |            |
| **Commercial Real Estate**                             |       |              |       |                    |       |         |       |              |       |                               |       |           |       |                |       |       |            |
| 5,980-square foot retail property                      |       | Fayetteville,  AR |       | 4Q2009                  |       | (G)          |       | $                 | 2,723      |                               | $          | 423            |       | $                   | 2,300      |       | April 2010 |   | (L) |   |
| 15-unit strip mall development, under construction     |       | Farmington,  AR   |       | 3Q2009                  |       | (H)          |       | 1,752             |       | 706                                |       | 1,046          |       | April 2010     |       | (M)        |            |
| 42,267-square feet retail/office space                 |       | Mtn  Home, AR     |       | 2Q2010                  |       | (I)          |       | 2,777             |       | —                             |       | 2,777          |       | April 2010     |       | (L)        |            |
| 9,551-square foot office building                      |       | Bentonville,  AR  |       | 2Q2010                  |       | (J)          |       | 1,323             |       | —                             |       | 1,323          |       | May 2010            |       | (L)        |            |
| Other - 16 loans under $1 million each                 |       |              |       |                    |       |         |       | 4,352             |       | 684                                |       | $              | 3,668      |                |       |       |            |   |
|                                                   |       |              |       |                    |       |         |       | $                 | 12,927     |                               | $          | 1,813          |       | $                   | 11,114     |       |            |   |   |   |

 

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| (A) |  - | The  borrower is working to complete the construction and begin leasing the units.  The loan matured April 1, 2010. Additional funds will be needed to  complete construction and the Bank is evaluating the loan for renewal. The  loan was valued based on an “as is” appraisal. |
|-----|---------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| (B) |  - | The borrower is working to complete the construction  and begin leasing the units. The loan matures November 30, 2010. The  loan was placed on nonaccrual status due to the borrower’s debt service  coverage ratio.                                                                    |
| (C) |  - | These two loans are related to the same borrower. The  loans matured in January 2010 and are now in foreclosure.                                                                                                                                                                             |
| (D) |  - | These two loans are related to the same borrower.  These loans have matured and have been sent to legal counsel for  collection/foreclosure.                                                                                                                                                      |
| (E) |  - | This loan is in foreclosure.                                                                                                                                                                                                                                                                      |
| (F) |  - | This loan is in foreclosure. This property is also the  subject of litigation related to bonds that were sold without satisfying the  first mortgage with the Bank.                                                                                                                               |
| (G) |  - | This loan was placed on nonaccrual status due to  borrower’s global cash flow. The borrower is continuing to make payments and  at June 30, 2010 was sixty days past due.                                                                                                               |
| (H) |  - | This loan was placed on nonaccrual status due to  borrower’s global cash flow. The loan matured in March 2010. The borrower  is attempting to sell the property.                                                                                                                        |
| (I) |  - | This loan was placed on nonaccrual status due to the  borrower’s debt service coverage ratio. The loan was not past due at  June 30, 2010, but has experienced past due payments in the past.                                                                                           |
| (J) |  - | This loan was placed on nonaccrual status due to the  borrower’s debt service coverage ratio. The loan was less than 30 days past  due at June 30, 2010.                                                                                                                                |
| (K) |  - | This valuation is based on discounted cash flow  analysis.                                                                                                                                                                                                                                        |
| (L) |  - | This valuation is based on an appraisal.                                                                                                                                                                                                                                                          |
| (M) |  - | This valuation is based on the contract sales price.                                                                                                                                                                                                                                              |

 

We expect a significantamount of the nonaccrual real estate loans to eventually migrate to real estateowned as $23.8 million of the nonaccrual real estate loans, net of specificvaluation allowances of $5.5 million, are in bankruptcy or some stage of theforeclosure process as of June 30, 2010.  Therefore, we expect realestate owned and associated expenses to continue to remain at elevated levelsin future periods as such loans migrate from loans to real estate owned.

 

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The following table sets forth the amounts andcategories of the Bank’s real estate owned at the dates indicated.

 
| ** **                                        | ** ** | **June 30,********2010** | ** ** | **December 31,  2009** | ** ** | **Increase********(Decrease)** | ** ** | **Percentage Change** | ** ** |
|---------------------------------------------------|------------|-------------------------------|------------|-----------------------------|------------|--------------------------------|------------|-----------------------|------------|
| ** **                                        | ** ** | **(Dollars in Thousands)**    | ** ** | ** **                  | ** ** | ** **                     | ** ** |
| Real estate owned                                 |       |                          |       |                        |       |                           |       |                  |       |
| One- to four-family residential                   |       | $                             | 7,463      |                        | $          | 10,216                         |       | $                     | (2,753     | ) | (26.9 | )% |
| Speculative one- to  four-family  construction(1) |       | 1,001                         |       | 3,186                       |       | (2,185                         | )          | (68.6                 | )          |
| Multifamily                                       |       | 377                           |       | 545                         |       | (168                           | )          | (30.8                 | )          |
| Land(2)                                           |       | 19,085                        |       | 13,952                      |       | 5,133                          |       | 36.8                  |       |
| Commercial real estate                            |       | 6,401                         |       | 7,256                       |       | (855                           | )          | (11.8                 | )          |
| Total real estate owned                           |       | $                             | 34,327     |                        | $          | 35,155                         |       | $                     | (828       | ) | (2.4 | )% |

 

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(1)          At June 30, 2010, $762,000 of these properties were 100%complete.  The remaining property was 98%complete.

(2)          At June 30, 2010, $9.6 million of the land balance represented 351developed subdivision lots and $2.5 million represented four unimprovedcommercial lots. The remaining $6.9 million consisted of raw land.

 

The land component ofreal estate owned is made up of the following at June 30, 2010 (in thousands):

 
| ** **                                     | ** ** | **Location**     | ** ** | **Date to real  estate owned** | ** ** | **Balance** | ** ** | **Valuation Date** | ** ** | **Source** | ** ** |
|------------------------------------------------|------------|------------------|------------|--------------------------------|------------|-------------|------------|--------------------|------------|------------|------------|
|                                           |       |             |       |                           |       |        |       |               |       |       |       |
| **Land**                                       |       |             |       |                           |       |        |       |               |       |       |       |
| 35 developed single family  lots               |       | Pea Ridge, AR    |       | 12/30/2008                     |       | $           | 385        |               | 1/14/2010  |       | (1)        |   |
| 48 developed single family  lots               |       | Elm Springs, AR  |       | 10/21/2008                     |       | 1,230       |       | 1/27/2010          |       | (1)        |       |
| 110 developed single family  lots              |       | Springdale, AR   |       | 4/17/2008                      |       | 3,534       |       | 1/14/2010          |       | (1)        |       |
| 60 developed single family  lots               |       | Lowell, AR       |       | 5/30/2008                      |       | 1,662       |       | 1/15/2010          |       | (1)        |       |
| 42 developed single family  lots               |       | Cave Springs, AR |       | 6/21/2010                      |       | 900         |       | 1/5/2010           |       | (1)        |       |
| 79.7 acres for future  residential development |       | Fayetteville, AR |       | 4/7/2010                       |       | 2,223       |       | 2/2/2010           |       | (2)        |       |
| 24.0 acres for future  residential development |       | Lowell, AR       |       | 4/19/2010                      |       | 1,947       |       | 3/29/2010          |       | (2)        |       |
| 30.7 acres for future  residential development |       | Lowell, AR       |       | 5/30/2008                      |       | 1,222       |       | 3/29/2010          |       | (2)        |       |
| 63.3 acres for future  residential development |       | Elm Springs, AR  |       | 10/21/2008                     |       | 883         |       | 1/27/2010          |       | (2)        |       |
| 15 developed residential  lots                 |       | Fayetteville, AR |       | 5/25/2010                      |       | 417         |       | 7/14/2009          |       | (2)        |       |
| 10 developed single family  lots               |       | Farmington, AR   |       | 7/2/2009                       |       | 477         |       | 5/27/2010          |       | (2)        |       |
| 1 unimproved commercial lot                    |       | Rogers, AR       |       | 10/29/2009                     |       | 1,879       |       | 1/27/2010          |       | (2)        |       |
| 3 unimproved commercial lots                   |       | Springdale, AR   |       | 11/19/2009                     |       | 663         |       | 1/25/2010          |       | (1)        |       |
| Other - 36 properties                          |       |             |       |                           |       | 1,663       |       |               |       |       |       |
|                                           |       |             |       |                           |       | $           | 19,085     |               |       |       |       |   |

 

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(1) — This valuation is based on discounted cashflow.

(2) — This valuation is based on comparablesales.

 

The Bank is diligentlyworking to dispose of its REO and has several team members dedicated to thiseffort, including an experienced special assets officer who is workingfull-time to liquidate the Bank’s properties in the Northwest Arkansas market.Each property is evaluated on a case-by-case basis to determine the best courseof action with respect to liquidation.  Properties are marketed directlyby the Bank or listed with local real estate agents utilizing appraisals,market information from realtors, market research reports, and our own marketevaluations to make pricing and selling decisions.  The Bank’s ChiefLending Officer, loan officers, credit manager, special assets officer, andteam members in the collections department all work together in thisendeavor.  The Bank’s goal is to liquidate these properties in an orderlyand efficient manner without incurring extraordinary losses due to quick salepricing.  During the six months ended June 30, 2010, the Bank’s net sales proceeds from REO saleswere $12.2 million, which included $4.6 million of loans to facilitate thesales of REO.

 

**Classified Assets. **Federalregulations require that each insured savings association classify its assetson a regular basis.  In addition, inconnection with examinations of insured institutions, federal examiners haveauthority to identify problem assets and, if appropriate, classify them.  There are three classifications for problemassets: “substandard,” “doubtful” and “loss.” Substandard assets have one or more defined weaknesses and arecharacterized by the distinct possibility that the insured institution willsustain some loss if the deficiencies are not corrected.  Doubtful assets have the weaknesses ofsubstandard assets with the additional characteristic that the weaknesses makecollection or liquidation in full on the basis of currently existing facts,conditions and values questionable, and there is a high possibility ofloss.  An asset classified loss isconsidered uncollectible and of such little value that continuance as an assetof the institution is not warranted.  At June 30, 2010, the Bank had$113.1 million of classified assets, all of which were classified assubstandard, including $47.4 million of nonaccrual loans and $34.3 million ofreal estate owned.  Substandard loansinclude $30.0 million of loans with accrued interest of $196,000 not includedin the 

 

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nonperforming assets table.  Such loans have been reviewed and determinednot to be impaired or if impaired, were estimated to have no loss.  As a result, such loans remained on accrualstatus at June 30, 2010.

 

**PotentialProblem Loans.**  At June 30, 2010, theBank had $43.8 million of assets with accrued interest of $396,000 designatedas special mention. Special mention assets have potential weaknesses thatdeserve management’s close attention.  Ifleft uncorrected, these potential weaknesses may result in deterioration of therepayment prospects for the asset or the institution’s credit position at somefuture date.  There are sevenrelationships exceeding $1 million designated as special mention totaling $30.0million with accrued interest of $333,000

 

**DelinquentLoans.**  The following table representsloans past due 30 — 89 days not on nonaccrual status as of June 30, 2010 and December 31,2009 (in thousands).  The amountspresented represent the total outstanding principal balances of the relatedloans, rather than the actual payment amounts that are past due.

 
| ** **                       | ** ** | **June 30****, 2010** | ** ** | **December 31, 2009** | ** ** |
|----------------------------------|------------|----------------------------|------------|----------------------------|------------|
| One- to four-family  residential |       | $                          | 2,711      |                       | $          | 2,759 |   |
| Home equity and second  mortgage |       | 182                        |       | 201                        |       |
| Multifamily residential          |       | 22                         |       | —                     |       |
| Land                             |       | 750                        |       | 1,156                      |       |
| Commercial real estate           |       | 4,051                      |       | 974                        |       |
| Commercial loans                 |       | 132                        |       | 1,668                      |       |
| Consumer loans                   |       | 148                        |       | 118                        |       |
|                             |       | $                          | 7,996      |                       | $          | 6,876 |   |
|                             |       |                       |       |                       |       |
| Percentage of Portfolio          |       | 1.70                       | %          | 1.33                       | %          |

 

Past due loans not on nonaccrual status are up since December 31,2009 primarily due to two commercial real estate loans totaling $3.1 million toa single borrower.  The Bank does notexpect any problems with these loans.

 

**Allowancefor Loan Losses**.  Asummary of the activity in the allowance for loan losses is as follows (in thousands):

 
| ** **                       | ** ** | **Three Months Ended********June 30****,** | ** ** | **Six Months Ended********June 30****,** | ** ** |
|----------------------------------|------------|-------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                       | ** ** | **2010**                                        | ** ** | **2009**                                      | ** ** | **2010** | ** ** | **2009** | ** ** |
| Balance at beginning of  period  |       | $                                               | 32,652     |                                          | $          | 9,558 |   | $ | 32,908 |   | $ | 6,441 |   |
| Provisions for estimated  losses |       | 63                                              |       | 2,445                                         |       | 116 |   | 5,966 |   |
| Recoveries                       |       | 62                                              |       | 693                                           |       | 131 |   | 754 |   |
| Losses charged off               |       | (1,224                                          | )          | (772                                          | )          | (1,602 | ) | (1,237 | ) |
| Balance at end of period         |       | $                                               | 31,553     |                                          | $          | 11,924 |   | $ | 31,553 |   | $ | 11,924 |   |

 

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A summary of theactivity in the allowance for losses by category for the six months ended June30, 2010 is presented below (in thousands):

 
| ** **                                   | ** ** | **December 31,  2009** | ** ** | **Charge-offs (1)** | ** ** | **Recoveries** | ** ** | **Provisions** | ** ** | **Change in SVA** | ** ** | **Change in GVA  Allocation** | ** ** | **June 30, 2010** | ** ** |
|----------------------------------------------|------------|------------------------|------------|---------------------|------------|----------------|------------|----------------|------------|-------------------|------------|-------------------------------|------------|-------------------|------------|
| One- to four-family residential              |       | $                      | 4,436      |                | $          | 656            |       | $              | 30         |              | $          | —                        |       | $                 | 662        |   | $ | 2,366 |   | $ | 3,810 |   |
| Home equity and second mortgage              |       | 1,688                  |       | 215                 |       | 2              |       | —         |       | 86                |       | (71                           | )          | 1,475             |       |
| Speculative one- to four-family construction |       | 884                    |       | —              |       | —         |       | —         |       | (32               | )          | (636                          | )          | 884               |       |
| Multifamily residential                      |       | 3,915                  |       | 80                  |       | —         |       | —         |       | 853               |       | (577                          | )          | 3,835             |       |
| Land development                             |       | 1,181                  |       | 140                 |       | —         |       | —         |       | 178               |       | (206                          | )          | 1,041             |       |
| Land                                         |       | 8,589                  |       | 70                  |       | 15             |       | —         |       | (28               | )          | (1,147                        | )          | 8,534             |       |
| Commercial real estate                       |       | 9,077                  |       | 57                  |       | 1              |       | —         |       | 104               |       | (2,195                        | )          | 9,021             |       |
| Commercial loans                             |       | 2,578                  |       | 157                 |       | 13             |       | —         |       | 543               |       | 114                           |       | 2,434             |       |
| Consumer loans                               |       | 560                    |       | 227                 |       | 70             |       | 116            |       | 28                |       | (42                           | )          | 519               |       |
|                                         |       | $                      | 32,908     |                | $          | 1,602          |       | $              | 131        |              | $          | 116                           |       | $                 | 2,394      |   | $ | (2,394 | ) | $ | 31,553 |   |

 

----

(1)          As noted in the table above, charge-offs for the six months ended June 30,2010, were $1.6 million.  At June 30,2010, specific valuation allowances were $9.9 million.  Due to the level of specific valuationallowances, we expect charge-offs to increase in future periods.

 

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The compositionof the allowance for loan losses by component and category as of June 30,2010 and December 31, 2009 is presented below (in thousands):

 
| ** **                                   | ** ** | **June 30****, 2010**         | ** ** | **December 31, 2009**        | ** ** |
|----------------------------------------------|------------|------------------------------------|------------|-----------------------------------|------------|
| ** **                                   | ** ** | **Specific  Valuation  Allowance** | ** ** | **General  Valuation  Allowance** | ** ** | **GVA % of  Portfolio** | ** ** | **Specific  Valuation  Allowance** | ** ** | **General  Valuation  Allowance** | ** ** | **GVA % of  Portfolio** | ** ** |
| One- to four-family residential              |       | $                                  | 1,068      |                              | $          | 5,770 |   | 2.46 | % | $ | 405 |   | $ | 4,031 |   | 1.66 | % |
| Home equity and second mortgage              |       | 391                                |       | 1,099                             |       | 5.17 |   | 305 |   | 1,384 |   | 5.18 |   |
| Speculative one- to four-family construction |       | 88                                 |       | 128                               |       | 7.86 |   | 120 |   | 764 |   | 8.75 |   |
| Multifamily residential                      |       | 1,400                              |       | 2,711                             |       | 7.41 |   | 547 |   | 3,368 |   | 8.09 |   |
| Land development                             |       | 248                                |       | 765                               |       | 10.46 |   | 70 |   | 1,110 |   | 11.83 |   |
| Land                                         |       | 3,895                              |       | 3,464                             |       | 11.49 |   | 3,923 |   | 4,665 |   | 12.45 |   |
| Commercial real estate                       |       | 1,813                              |       | 5,117                             |       | 4.90 |   | 1,708 |   | 7,368 |   | 6.54 |   |
| Commercial loans                             |       | 834                                |       | 2,257                             |       | 19.96 |   | 291 |   | 2,286 |   | 16.00 |   |
| Consumer loans                               |       | 133                                |       | 372                               |       | 2.70 |   | 107 |   | 456 |   | 2.57 |   |
|                                         |       | $                                  | 9,870      |                              | $          | 21,683 |   | 4.70 | % | $ | 7,476 |   | $ | 25,432 |   | 4.97 | % |
| GVA as % of nonperforming loans              |       |                               |       |                              |       | 45.13 | % |   |   |   |   | 59.33 | % |

 

Changes in thecomposition of the allowance for loan losses between June 30, 2010 and December 31,2009 are presented in the following table (in thousands):

 
| ** ** | ** ** | **June 30,** | ** ** | **December 31,** | ** ** | **Increase**   | ** ** |
|------------|------------|-------------------|------------|-----------------------|------------|----------------|------------|
| ** ** | ** ** | **2010**          | ** ** | **2009**              | ** ** | **(Decrease)** | ** ** |
| General    |       | $                 | 21,683     |                  | $          | 25,432         |       | $ | (3,749 | ) |
| Specific   |       | 9,870             |       | 7,476                 |       | 2,394          |       |
|       |       | $                 | 31,553     |                  | $          | 32,908         |       | $ | (1,355 | ) |

 

The general component of the allowance for loan lossesdecreased primarily due to decreases in certain of the related loan balancesand a decrease in certain loss rates. The specific component of the allowance for loan losses increasedprimarily due to allowances established since December 31, 2009 onmultifamily loans and commercial loans. See “Asset Quality.”

 

Management maintains an allowance for loan losses forknown and inherent losses in the loan portfolio based on ongoing quarterlyassessments of the loan portfolio.  Ourallowance for loan losses consists of general valuation allowances (“GVAs”)calculated based on a formula analysis and specific valuation allowances (“SVAs”)for identified impaired loans.  Theestimated appropriate level of the allowance for loan losses is maintainedthrough a provision for loan losses charged to earnings.  Charge-offs are recorded against theallowance when management believes the estimated loss has been confirmed.  Generally, this is at the time of transfer toreal estate owned, but may be earlier in certain circumstances.  Subsequent recoveries, if any, are creditedto the allowance.

 

The allowance for loan losses represents management’sestimate of incurred credit losses inherent in the Company’s loan portfolio asof the balance sheet date.  Theestimation of the allowance is based on a variety of factors, including pastloan loss experience, the current credit profile of the Company’s borrowers,adverse situations that have occurred that may affect the borrowers’ ability torepay, the estimated value of underlying collateral, and general economicconditions, including unemployment, bankruptcy trends, vacancy rates and homesales.  Losses are recognized whenavailable information indicates that it is probable that a loss has beenincurred and the amount of the loss can be reasonably estimated. Thisevaluation is inherently subjective as it requires estimates that aresusceptible to significant revision as more information becomes available orconditions change.

 

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

 

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

 

In estimating theamount of credit losses inherent in our loan portfolio, various judgments andassumptions are made.  For example, whenassessing the condition of the overall economic environment, assumptions aremade regarding market conditions and their impact on the loan portfolio.  For impaired loans that are collateraldependent, the estimated fair value of the collateral may deviate significantlyfrom the proceeds received when the collateral is sold in the event that theBank has to foreclose or repossess the collateral.

 

Although we considerthe allowance for loan losses of approximately $31.6 million, which consists ofa general valuation allowance of $21.7 million and a specific valuationallowance of $9.9 million, adequate to cover losses inherent in our loanportfolio at June 30, 2010, no assurance can be given that we will notsustain loan losses that are significantly different from the amount recorded,or that subsequent evaluations of the loan portfolio, in light of factors thenprevailing, would not result in a significant change in the allowance for loanlosses.  Either of these occurrencescould materially and adversely affect our financial condition and results ofoperations.

 

**InvestmentSecurities. **Changes in the composition of investment securities held to maturitybetween June 30,2010 and December 31, 2009 are presented in thefollowing table (in thousands).

 
| ** **                              | ** ** | **June 30****,** | ** ** | **December 31,** | ** ** | ** **   | ** ** |
|-----------------------------------------|------------|-----------------------|------------|-----------------------|------------|--------------|------------|
| ** **                              | ** ** | **2010**              | ** ** | **2009**              | ** ** | **Decrease** | ** ** |
| U.S. Government and agency  obligations |       | $                     | 63,612     |                  | $          | 110,051      |       | $ | (46,439) |   |
| Municipal securities                    |       | 24,678                |       | 25,480                |       | (802         | )          |
| Total                                   |       | $                     | 88,290     |                  | $          | 135,531      |       | $ | (47,241 | ) |

 

During the first sixmonths of 2010, investment securities totaling $59.3 million with an averagetax equivalent yield of 5.07% matured or were called and $12.0 million with anaverage tax equivalent yield of 3.87% were purchased.

 

At June 30, 2010, estimated fair values ofinvestment securities held to maturity were as follows (in thousands):

** **
| ** **                             | ** ** | **Amortized  Cost** | ** ** | **Fair****Value** | ** ** |
|----------------------------------------|------------|---------------------|------------|-------------------|------------|
|                                   |       |                |       |              |       |
| U.S. Government and agency obligations |       | $                   | 63,612     |              | $          | 64,567 |   |
| Municipal securities                   |       | 24,678              |       | 24,878            |       |
| Total                                  |       | $                   | 88,290     |              | $          | 89,445 |   |

 

**AccruedInterest Receivable. ** The decrease in accrued interest receivable was primarily due to adecrease in the loans receivable balance and a decrease in the loan yield at June 30, 2010compared to December 31, 2009.

 

**Real Estate Owned, net.**  Changes in the composition of real estate owned between June 30,2010and December 31, 2009 are presented in thefollowing table (dollars in thousands).

 
| ** **                      | ** ** | **December 31,  2009** | ** ** | **Additions** | ** ** | **Fair  Value  Adjustments** | ** ** | **Net  Sales  Proceeds(1)** | ** ** | **Loss** | ** ** | **June 30,****2010** | ** ** |
|---------------------------------|------------|-----------------------------|------------|---------------|------------|------------------------------|------------|-----------------------------|------------|----------|------------|---------------------------|------------|
| One- to four-family residential |       | $                           | 10,216     |          | $          | 6,197                        |       | $                           | (551       | )        | $          | (8,399                    | )          | $ | — |   | $ | 7,463 |   |
| Speculative one- to four-family |       | 3,186                       |       | 311           |       | (138                         | )          | (2,326                      | )          | (32      | )          | 1,001                     |       |
| Multifamily                     |       | 545                         |       | —        |       | (2                           | )          | (125                        | )          | (41      | )          | 377                       |       |
| Land                            |       | 13,952                      |       | 5,752         |       | (305                         | )          | (309                        | )          | (5       | )          | 19,085                    |       |
| Commercial real estate          |       | 7,256                       |       | 376           |       | (145                         | )          | (1,085                      | )          | (1       | )          | 6,401                     |       |
|                            |       | $                           | 35,155     |          | $          | 12,636                       |       | $                           | (1,141     | )        | $          | (12,244                   | )          | $ | (79 | ) | $ | 34,327 |   |

 

----

(1)         Net sales proceeds include $4.6 million ofloans made by the Bank to facilitate the sale of real estate owned.

 

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**Deposits. **Changes in the composition of deposits between June 30,2010 and December 31, 2009 are presented in the following table (dollars inthousands).

 
| ** **              | ** ** | **June 30,****2010** | ** ** | **December 31,  2009** | ** ** | **Increase  (Decrease)** | ** ** | **Percentage  Change** | ** ** |
|-------------------------|------------|---------------------------|------------|-----------------------------|------------|--------------------------|------------|------------------------|------------|
|                    |       |                      |       |                        |       |                     |       |                   |       |
| Checking accounts       |       | $                         | 134,744    |                        | $          | 166,707                  |       | $                      | (31,963    | ) | (19.2 | )% |
| Money Market accounts   |       | 50,296                    |       | 53,597                      |       | (3,301                   | )          | (6.2                   | )          |
| Savings accounts        |       | 26,889                    |       | 24,983                      |       | 1,906                    |       | 7.6                    |       |
| Certificates of deposit |       | 387,369                   |       | 379,337                     |       | 8,032                    |       | 2.1                    |       |
|                    |       |                      |       |                        |       |                     |       |                   |       |
| Total deposits          |       | $                         | 599,298    |                        | $          | 624,624                  |       | $                      | (25,326    | ) | (4.1 | )% |

 

Deposits decreased in the comparison period, primarilydue to a decrease in public school checking accounts, offset by an increase incertificates of deposit. The Bank views checking accounts as an attractive source of funds andwill continue to promote such accounts as they offer overall low-interestdeposits, fee income potential, and the opportunity to cross-sell otherfinancial services.

 

**Other Borrowings.**  The Bank experienced a $38.6million or 64.9% decrease in FHLB of Dallas borrowings during the quarter.  The FHLB of Dallas advances at June 30, 2010of $20.9 million consisted of $10.9 million of fixed rate advances with anaverage cost of 4.57% and $10.0 million of floating rate advances with anaverage cost of 0.37%.

 

**Other Liabilities.**  The Bank experienced a $9.9million increase in other liabilities as of June 30, 2010 compared to December 31,2009 primarily due to a $10.0 million liability recorded as of June 30,2010 for investment securities traded as of that date but not yet settled.

 

**Stockholders’Equity. **Stockholders’ equity increased approximately $1.1million from December 31, 2009 to June 30, 2010.  The increase in stockholders’ equity wasprimarily due to net income of $1.5 million during the first six months of2010.  In addition, during the six monthsended June 30, 2010, preferred dividends of approximately $412,500 wereaccrued.  See the Unaudited CondensedConsolidated Statement of Stockholders’ Equity for the six months ended June 30,2010 for more detail.

 

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**Average Balance Sheets**

 

The following table sets forth certain informationrelating to the Company’s average balance sheets and reflects the average yieldon assets and average cost of liabilities for the periods indicated.  Such yields and costs are derived by dividingincome or expense by the average balance of assets or liabilities,respectively, for the periods presented. Average balances are based on daily balances during the period.

** **
| ** **                                                        | ** ** | **Three  Months Ended June 30,** | ** ** |
|-------------------------------------------------------------------|------------|---------------------------------------|------------|
| ** **                                                        | ** ** | **2010**                              | ** ** | **2009** | ** ** |
| ** **                                                        | ** ** | **Average  Balance**                  | ** ** | **Interest** | ** ** | **Average  Yield/  Cost** | ** ** | **Average  Balance** | ** ** | **Interest** | ** ** | **Average  Yield/  Cost** | ** ** |
| ** **                                                        | ** ** | **(Dollars  in Thousands)**           | ** ** |
| Interest-earning assets:                                          |       |                                  |       |   |   |   |   |   |   |   |   |   |   |
| Loans receivable(1)                                               |       | $                                     | 473,602    |   | $ | 6,371 |   | 5.38 | % | $ | 563,088 |   | $ | 7,565 |   | 5.37 | % |
| Investment securities(2)                                          |       | 110,862                               |       | 1,322 |   | 4.77 |   | 139,734 |   | 1,616 |   | 4.63 |   |
| Other interest-earning assets                                     |       | 34,227                                |       | 16 |   | 0.19 |   | 16,109 |   | 12 |   | 0.30 |   |
| Total interest-earning assets                                     |       | 618,691                               |       | 7,709 |   | 4.98 |   | 718,931 |   | 9,193 |   | 5.12 |   |
| Noninterest-earning assets                                        |       | 70,856                                |       |   |   |   |   | 77,128 |   |   |   |   |   |
| Total assets                                                      |       | $                                     | 689,547    |   |   |   |   |   | $ | 796,059 |   |   |   |   |   |
| Interest-bearing liabilities:                                     |       |                                  |       |   |   |   |   |   |   |   |   |   |   |
| Deposits                                                          |       | $                                     | 608,985    |   | 2,417 |   | 1.59 |   | $ | 630,382 |   | 3,513 |   | 2.23 |   |
| Other borrowings                                                  |       | 31,611                                |       | 161 |   | 2.04 |   | 67,231 |   | 547 |   | 3.26 |   |
| Total interest-bearing liabilities                                |       | 640,596                               |       | 2,578 |   | 1.61 |   | 697,613 |   | 4,060 |   | 2.33 |   |
| Noninterest-bearing liabilities                                   |       | 4,422                                 |       |   |   |   |   | 10,191 |   |   |   |   |   |
| Total liabilities                                                 |       | 645,018                               |       |   |   |   |   | 707,804 |   |   |   |   |   |
| Stockholders’ equity                                         |       | 44,529                                |       |   |   |   |   | 88,255 |   |   |   |   |   |
| Total liabilities and  stockholders’ equity                  |       | $                                     | 689,547    |   |   |   |   |   | $ | 796,059 |   |   |   |   |   |
|                                                              |       |                                  |       |   |   |   |   |   |   |   |   |   |   |
| Net interest income                                               |       |                                  |       | $ | 5,131 |   |   |   |   |   | $ | 5,133 |   |   |   |
| Net earning assets (interest-bearing  liabilities)                |       | $                                     | (21,905    | ) |   |   |   |   | $ | 21,318 |   |   |   |   |   |
| Interest rate spread                                              |       |                                  |       |   |   | 3.37 | % |   |   |   |   | 2.79 | % |
| Net interest margin                                               |       |                                  |       |   |   | 3.32 | % |   |   |   |   | 2.86 | % |
| Ratio of interest-earning assets to  interest-bearing liabilities |       |                                  |       |   |   | 96.58 | % |   |   |   |   | 103.06 | % |

** **
| ** **                                                        | ** ** | **Six  Months Ended June 30,** | ** ** |
|-------------------------------------------------------------------|------------|-------------------------------------|------------|
| ** **                                                        | ** ** | **2010**                            | ** ** | **2009** | ** ** |
| ** **                                                        | ** ** | **Average****Balance**              | ** ** | **Interest** | ** ** | **Average****Yield/  Cost** | ** ** | **Average****Balance** | ** ** | **Interest** | ** ** | **Average****Yield/  Cost** | ** ** |
| ** **                                                        | ** ** | **(Dollars  in Thousands)**         | ** ** |
| Interest-earning assets:                                          |       |                                |       |   |   |   |   |   |   |   |   |   |   |
| Loans receivable(1)                                               |       | $                                   | 486,468    |   | $ | 13,200 |   | 5.43 | % | $ | 565,417 |   | $ | 15,120 |   | 5.35 | % |
| Investment securities(2)                                          |       | 122,186                             |       | 2,908 |   | 4.76 |   | 132,987 |   | 3,180 |   | 4.78 |   |
| Other interest-earning assets                                     |       | 30,491                              |       | 32 |   | 0.21 |   | 15,424 |   | 16 |   | 0.20 |   |
| Total interest-earning assets                                     |       | 639,145                             |       | 16,140 |   | 5.05 |   | 713,828 |   | 18,316 |   | 5.13 |   |
| Noninterest-earning assets                                        |       | 70,582                              |       |   |   |   |   | 80,767 |   |   |   |   |   |
| Total assets                                                      |       | $                                   | 709,727    |   |   |   |   |   | $ | 794,595 |   |   |   |   |   |
| Interest-bearing liabilities:                                     |       |                                |       |   |   |   |   |   |   |   |   |   |   |
| Deposits                                                          |       | $                                   | 613,130    |   | 4,966 |   | 1.62 |   | $ | 629,606 |   | 7,293 |   | 2.32 |   |
| Other borrowings                                                  |       | 47,814                              |       | 403 |   | 1.68 |   | 72,806 |   | 1,192 |   | 3.28 |   |
| Total interest-bearing liabilities                                |       | 660,944                             |       | 5,369 |   | 1.62 |   | 702,412 |   | 8,485 |   | 2.42 |   |
| Noninterest-bearing liabilities                                   |       | 4,585                               |       |   |   |   |   | 9,006 |   |   |   |   |   |
| Total liabilities                                                 |       | 665,529                             |       |   |   |   |   | 711,418 |   |   |   |   |   |
| Stockholders’ equity                                         |       | 44,198                              |       |   |   |   |   | 83,177 |   |   |   |   |   |
| Total liabilities and  stockholders’ equity                  |       | $                                   | 709,727    |   |   |   |   |   | $ | 794,595 |   |   |   |   |   |
|                                                              |       |                                |       |   |   |   |   |   |   |   |   |   |   |
| Net interest income                                               |       |                                |       | $ | 10,771 |   |   |   |   |   | $ | 9,831 |   |   |   |
| Net earning assets (interest-bearing  liabilities)                |       | $                                   | (21,799    | ) |   |   |   |   | $ | 11,416 |   |   |   |   |   |
| Interest rate spread                                              |       |                                |       |   |   | 3.43 | % |   |   |   |   | 2.71 | % |
| Net interest margin                                               |       |                                |       |   |   | 3.37 | % |   |   |   |   | 2.75 | % |
| Ratio of interest-earning assets to  interest-bearing liabilities |       |                                |       |   |   | 96.70 | % |   |   |   |   | 101.63 | % |

 

----

(1) Includes nonaccrual loans.

(2) Includes FHLB of Dallas stock.

 

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**Rate/Volume Analysis**

 

The table below sets forth certain informationregarding changes in interest income and interest expense of the Company forthe periods indicated.  For each categoryof interest-earning assets and interest-bearing liabilities, information isprovided on changes attributable to (i) changes in volume (changes inaverage volume multiplied by prior rate); (ii) changes in rate (change inrate multiplied by prior average volume); (iii) changes in rate-volume(changes in rate multiplied by the change in average volume); and (iv) thenet change.

 
| ** **                         | ** ** | **Three  Months Ended June 30,** | ** ** |
|------------------------------------|------------|---------------------------------------|------------|
| ** **                         | ** ** | **2010  vs. 2009**                    | ** ** |
| ** **                         | ** ** | **Increase  (Decrease)****Due to**    | ** ** | **Total** | ** ** |
| ** **                         | ** ** | **Volume**                            | ** ** | **Rate** | ** ** | **Rate/****Volume** | ** ** | **Increase  (Decrease)** | ** ** |
| ** **                         | ** ** | **(In  Thousands)**                   | ** ** |
| Interest income:                   |       |                                  |       |   |   |   |   |   |   |
| Loans receivable                   |       | $                                     | (1,202     | ) | $ | 10 |   | $ | (2 | ) | $ | (1,194 | ) |
| Investment  securities             |       | (334                                  | )          | 50 |   | (10 | ) | (294 | ) |
| Other interest-earning assets      |       | 14                                    |       | (5 | ) | (5 | ) | 4 |   |
| Total  interest-earning assets     |       | (1,522                                | )          | 55 |   | (17 | ) | (1,484 | ) |
|                               |       |                                  |       |   |   |   |   |   |   |
| Interest expense:                  |       |                                  |       |   |   |   |   |   |   |
| Deposits                           |       | (119                                  | )          | (1,011 | ) | 34 |   | (1,096 | ) |
| Other borrowings                   |       | (290                                  | )          | (204 | ) | 108 |   | (386 | ) |
| Total interest-bearing liabilities |       | (409                                  | )          | (1,215 | ) | 142 |   | (1,482 | ) |
| Net change in net interest income  |       | $                                     | (1,113     | ) | $ | 1,270 |   | $ | (159 | ) | $ | (2 | ) |

** **
| ** **                         | ** ** | **Six  Months Ended June 30,  2010 vs. 2009** | ** ** |
|------------------------------------|------------|----------------------------------------------------|------------|
| ** **                         | ** ** | **Increase  (Decrease)****Due to**                 | ** ** | **Total** | ** ** |
| ** **                         | ** ** | **Volume**                                         | ** ** | **Rate** | ** ** | **Rate/****Volume** | ** ** | **Increase  (Decrease)** | ** ** |
| ** **                         | ** ** | **(In  Thousands)**                                | ** ** |
| Interest income:                   |       |                                               |       |   |   |   |   |   |   |
| Loans receivable                   |       | $                                                  | (2,111     | ) | $ | 222 |   | $ | (31 | ) | $ | (1,920 | ) |
| Investment  securities             |       | (258                                               | )          | (15 | ) | 1 |   | (272 | ) |
| Other interest-earning assets      |       | 15                                                 |       | — |   | 1 |   | 16 |   |
| Total  interest-earning assets     |       | (2,354                                             | )          | 207 |   | (29 | ) | (2,176 | ) |
|                               |       |                                               |       |   |   |   |   |   |   |
| Interest expense:                  |       |                                               |       |   |   |   |   |   |   |
| Deposits                           |       | (191                                               | )          | (2,193 | ) | 57 |   | (2,327 | ) |
| Other borrowings                   |       | (409                                               | )          | (579 | ) | 199 |   | (789 | ) |
| Total interest-bearing liabilities |       | (600                                               | )          | (2,772 | ) | 256 |   | (3,116 | ) |
| Net change in net interest income  |       | $                                                  | (1,754     | ) | $ | 2,979 |   | $ | (285 | ) | $ | 940 |   |

 

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**CHANGESIN RESULTS OF OPERATIONS**

 

The table belowpresents a comparison of results of operations for the three months ended June 30,2010 and 2009 (dollars in thousands).  Specific changes in captions are discussed inthe sections which follow the table.

 
| ** **                                                             | ** ** | **Three Months Ended****June 30,** | ** ** | **Increase****(Decrease)** | ** ** | **Percentage  Change** | ** ** |
|------------------------------------------------------------------------|------------|-----------------------------------------|------------|----------------------------|------------|------------------------|------------|
| ** **                                                             | ** ** | **2010**                                | ** ** | **2009**                   | ** ** | **2010 vs 2009**       | ** ** | **2010 vs 2009** | ** ** |
| Interest income:                                                       |       |                                    |       |                       |       |                   |       |   |   |
| Loans receivable                                                       |       | $                                       | 6,371      |                       | $          | 7,565                  |       | $ | (1,194 | ) | (15.8 | )% |
| Investment securities                                                  |       | 1,322                                   |       | 1,616                      |       | (294                   | )          | (18.2 | ) |
| Other                                                                  |       | 16                                      |       | 12                         |       | 4                      |       | 33.3 |   |
| Total interest income                                                  |       | 7,709                                   |       | 9,193                      |       | (1,484                 | )          | (16.1 | ) |
| Interest expense:                                                      |       |                                    |       |                       |       |                   |       |   |   |
| Deposits                                                               |       | 2,417                                   |       | 3,513                      |       | (1,096                 | )          | (31.2 | ) |
| Other borrowings                                                       |       | 161                                     |       | 547                        |       | (386                   | )          | (70.6 | ) |
| Total interest expense                                                 |       | 2,578                                   |       | 4,060                      |       | (1,482                 | )          | (36.5 | ) |
| Net  interest income before provision for loan losses                  |       | 5,131                                   |       | 5,133                      |       | (2                     | )          | (0.0 | ) |
| Provision for loan losses                                              |       | 63                                      |       | 2,445                      |       | (2,382                 | )          | (97.4 | ) |
| Net  interest income after provision for loan losses                   |       | 5,068                                   |       | 2,688                      |       | 2,380                  |       | 88.5 |   |
| Noninterest income:                                                    |       |                                    |       |                       |       |                   |       |   |   |
| Deposit fee income                                                     |       | 1,316                                   |       | 1,328                      |       | (12                    | )          | (0.9 | ) |
| Earnings on life insurance  policies                                   |       | 203                                     |       | 200                        |       | 3                      |       | 1.5 |   |
| Gain on sale of loans                                                  |       | 70                                      |       | 152                        |       | (82                    | )          | (54.0 | ) |
| Other                                                                  |       | 267                                     |       | 359                        |       | (92                    | )          | (25.6 | ) |
| Total noninterest income                                               |       | 1,856                                   |       | 2,039                      |       | (183                   | )          | (9.0 | ) |
| Noninterest expenses:                                                  |       |                                    |       |                       |       |                   |       |   |   |
| Salaries and employee  benefits                                        |       | 2,765                                   |       | 2,845                      |       | (80                    | )          | (2.8 | ) |
| Real estate owned, net                                                 |       | 913                                     |       | 1,085                      |       | (172                   | )          | (15.9 | ) |
| FDIC insurance premium                                                 |       | 509                                     |       | 687                        |       | (178                   | )          | (25.9 | ) |
| Professional fees                                                      |       | 321                                     |       | 185                        |       | 136                    |       | 73.5 |   |
| Advertising and public  relations                                      |       | 64                                      |       | 91                         |       | (27                    | )          | (29.7 | ) |
| Other                                                                  |       | 1,806                                   |       | 1,663                      |       | 143                    |       | 8.6 |   |
| Total noninterest expenses                                             |       | 6,378                                   |       | 6,556                      |       | (178                   | )          | (2.7 | ) |
| Income (loss) before income  taxes                                     |       | 546                                     |       | (1,829                     | )          | 2,375                  |       | 129.8 |   |
| Income tax provision  (benefit)                                        |       | (91                                     | )          | (892                       | )          | 801                    |       | 89.8 |   |
| Net income (loss)                                                      |       | 637                                     |       | (937                       | )          | 1,574                  |       | 168.0 |   |
| Preferred stock dividends and  accretion of  preferred stock  discount |       | 223                                     |       | 222                        |       | 1                      |       | 0.5 |   |
| Net income (loss) available to common  shareholders                    |       | $                                       | 414        |                       | $          | (1,159                 | )          | $ | 1,573 |   | 135.7 | % |
|                                                                   |       |                                    |       |                       |       |                   |       |   |   |
| Basic earnings (loss) per  common share                                |       | $                                       | 0.09       |                       | $          | (0.24                  | )          | $ | 0.33 |   | 135.9 | % |
| Diluted earnings (loss) per  common share                              |       | $                                       | 0.09       |                       | $          | (0.24                  | )          | $ | 0.33 |   | 135.9 | % |
|                                                                   |       |                                    |       |                       |       |                   |       |   |   |
| Interest rate spread                                                   |       | 3.37                                    | %          | 2.79                       | %          |                   |       |   |   |
| Net interest margin                                                    |       | 3.32                                    | %          | 2.86                       | %          |                   |       |   |   |
|                                                                   |       |                                    |       |                       |       |                   |       |   |   |
| Average full-time  equivalents                                         |       | 245                                     |       | 280                        |       |                   |       |   |   |
|                                                                   |       |                                    |       |                       |       |                   |       |   |   |
| Full-service offices                                                   |       | 20                                      |       | 20                         |       |                   |       |   |   |

 

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The table below presents acomparison of results of operations for the six months ended June 30, 2010and 2009 (dollars in thousands). Specific changes in captions are discussed inthe sections which follow the table.

 
| ** **                                                             | ** ** | **Six Months Ended****June 30,** | ** ** | **Increase****(Decrease)** | ** ** | **Percentage  Change** | ** ** |
|------------------------------------------------------------------------|------------|---------------------------------------|------------|----------------------------|------------|------------------------|------------|
| ** **                                                             | ** ** | **2010**                              | ** ** | **2009**                   | ** ** | **2010 vs 2009**       | ** ** | **2010 vs 2009** | ** ** |
| Interest income:                                                       |       |                                  |       |                       |       |                   |       |   |   |
| Loans receivable                                                       |       | $                                     | 13,200     |                       | $          | 15,120                 |       | $ | (1,920 | ) | (12.7 | )% |
| Investment securities                                                  |       | 2,908                                 |       | 3,180                      |       | (272                   | )          | (8.6 | ) |
| Other                                                                  |       | 32                                    |       | 16                         |       | 16                     |       | 100.0 |   |
| Total interest income                                                  |       | 16,140                                |       | 18,316                     |       | (2,176                 | )          | (11.9 | ) |
| Interest expense:                                                      |       |                                  |       |                       |       |                   |       |   |   |
| Deposits                                                               |       | 4,966                                 |       | 7,293                      |       | (2,327                 | )          | (31.9 | ) |
| Other borrowings                                                       |       | 403                                   |       | 1,192                      |       | (789                   | )          | (66.2 | ) |
| Total interest expense                                                 |       | 5,369                                 |       | 8,485                      |       | (3,116                 | )          | (36.7 | ) |
| Net  interest income before provision for loan losses                  |       | 10,771                                |       | 9,831                      |       | 940                    |       | 9.6 |   |
| Provision for loan losses                                              |       | 116                                   |       | 5,966                      |       | (5,850                 | )          | (98.1 | ) |
| Net  interest income after provision for loan losses                   |       | 10,655                                |       | 3,865                      |       | 6,790                  |       | 175.7 |   |
| Noninterest income:                                                    |       |                                  |       |                       |       |                   |       |   |   |
| Deposit fee income                                                     |       | 2,506                                 |       | 2,520                      |       | (14                    | )          | (0.6 | ) |
| Earnings on life insurance  policies                                   |       | 401                                   |       | 398                        |       | 3                      |       | 0.5 |   |
| Gain on sale of loans                                                  |       | 206                                   |       | 300                        |       | (94                    | )          | (31.3 | ) |
| Other                                                                  |       | 563                                   |       | 728                        |       | (165                   | )          | (22.5 | ) |
| Total noninterest income                                               |       | 3,676                                 |       | 3,946                      |       | (270                   | )          | (6.8 | ) |
| Noninterest expenses:                                                  |       |                                  |       |                       |       |                   |       |   |   |
| Salaries and employee  benefits                                        |       | 5,564                                 |       | 5,813                      |       | (249                   | )          | (4.3 | ) |
| Real estate owned, net                                                 |       | 1,714                                 |       | 1,480                      |       | 234                    |       | 15.8 |   |
| FDIC insurance premium                                                 |       | 1,023                                 |       | 928                        |       | 95                     |       | 10.2 |   |
| Professional fees                                                      |       | 727                                   |       | 476                        |       | 251                    |       | 52.7 |   |
| Advertising and public  relations                                      |       | 127                                   |       | 202                        |       | (75                    | )          | (37.1 | ) |
| Other                                                                  |       | 3,823                                 |       | 3,507                      |       | 316                    |       | 9.0 |   |
| Total noninterest expenses                                             |       | 12,978                                |       | 12,406                     |       | 572                    |       | 4.6 |   |
| Income before income taxes                                             |       | 1,353                                 |       | (4,595                     | )          | 5,948                  |       | 129.5 |   |
| Income tax provision  (benefit)                                        |       | (190                                  | )          | (2,156                     | )          | 1,966                  |       | 91.2 |   |
| Net income (loss)                                                      |       | 1,543                                 |       | (2,439                     | )          | 3,982                  |       | 163.3 |   |
| Preferred stock dividends and  accretion of  preferred stock  discount |       | 446                                   |       | 284                        |       | 162                    |       | 57.0 |   |
| Net income (loss) available to common  shareholders                    |       | $                                     | 1,097      |                       | $          | (2,723                 | )          | $ | 3,820 |   | 140.3 | % |
|                                                                   |       |                                  |       |                       |       |                   |       |   |   |
| Basic earnings (loss) per share                                        |       | $                                     | 0.23       |                       | $          | (0.56                  | )          | $ | 0.79 |   | 140.4 | % |
| Diluted earnings (loss) per share                                      |       | $                                     | 0.23       |                       | $          | (0.56                  | )          | $ | 0.79 |   | 140.4 | % |
|                                                                   |       |                                  |       |                       |       |                   |       |   |   |
| Interest rate spread                                                   |       | 3.43                                  | %          | 2.71                       | %          |                   |       |   |   |
| Net interest margin                                                    |       | 3.37                                  | %          | 2.75                       | %          |                   |       |   |   |
|                                                                   |       |                                  |       |                       |       |                   |       |   |   |
| Average full-time  equivalents                                         |       | 249                                   |       | 285                        |       |                   |       |   |   |
|                                                                   |       |                                  |       |                       |       |                   |       |   |   |
| Full-service offices                                                   |       | 20                                    |       | 20                         |       |                   |       |   |   |

 

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**Net Interest 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.

 

**INTEREST INCOME AND INTERESTEXPENSE**

 

Dollar changes in interest income and interest expensefor the comparison periods are presented in the Rate/Volume Analysis tablewhich appears on a previous page.

 

**Interest Income. **Thedecrease in interest income for the three and six month comparative periods wasprimarily due to decreases in the average balances of loans receivable andinvestment securities.  The averagebalance of loans receivable decreased due to repayments as well as a decreasein loan originations.  The averagebalance of investment securities decreased due to calls of investmentsecurities.

 

**Interest Expense. **Thedecrease in interest expense for the three and six month comparative periodswas primarily due to a decrease in the average rates paid on deposits and otherborrowings as well as a decrease in the related average balances.  The decrease in the average rates paid ondeposit accounts and other borrowings reflects decreases in market interestrates.

 

**Provision for Loan Losses.**  The provision for loan lossesincludes charges to maintain an allowance for loan losses adequate to coverprobable credit losses related to specifically identified loans as well asprobable credit losses inherent in the remainder of the loan portfolio thathave 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.

 

The provision for loan losses decreased $2.4 million to$63,000 for the quarter ended June 30, 2010 compared to $2.4 million forthe quarter ended June 30, 2009 and decreased $5.9 million to $116,000 forthe six months ended June 30, 2010 compared to $6.0 million for the sixmonths ended June 30, 2009.  Duringthe first two quarters of 2010, the loan portfolio held for investment shrankfrom $518.7 million to $471.0 million. The $47.7 million decrease in the loan portfolio was primarilyresponsible for the $3.7 million decline in the general valuation allowancebetween December 31, 2009 and June 30, 2010.  This was offset somewhat by a $2.4 millionincrease in specific valuation allowances, $680,000 of which was due to amultifamily residential construction loan. See “Asset Quality.”

 

**NONINTEREST EXPENSE**

 

**Noninterest expense. **Noninterest expenses were down overall for thequarter ended June 30, 2010 compared to the same period in 2009 primarilydue to a decrease in REO expenses and FDIC insurance premiums as explained onthe following pages.** **Noninterest expenses were upoverall for the six months ended June 30, 2010, compared to the sameperiod in 2009, primarily due to the effects of the level of nonperformingloans and related collection costs, the level of real estate owned and relatedcosts, and costs incurred as a result of the Company Order and the Bank Order,as illustrated below.

 
| ** **                | ** ** | **Three  Months Ended****June 30,** | ** ** | **Increase****(Decrease)** | ** ** | **Six  Months Ended****June 30,** | ** ** | **Increase** | ** ** |
|---------------------------|------------|------------------------------------------|------------|----------------------------|------------|----------------------------------------|------------|--------------|------------|
| ** **                | ** ** | **2010**                                 | ** ** | **2009**                   | ** ** | **2010 vs 2009**                       | ** ** | **2010**     | ** ** | **2009** | ** ** | **2010 vs 2009** | ** ** |
| Real  estate owned, net   |       | $                                        | 913        |                       | $          | 1,085                                  |       | $            | (172       | ) | $ | 1,714 |   | $ | 1,480 |   | $ | 234 |   |
| FDIC  insurance           |       | 509                                      |       | 687                        |       | (178                                   | )          | 1,023        |       | 928 |   | 95 |   |
| Supervisory  assessments  |       | 106                                      |       | 48                         |       | 58                                     |       | 212          |       | 97 |   | 115 |   |
| Professional  fees        |       | 321                                      |       | 185                        |       | 140                                    |       | 727          |       | 476 |   | 251 |   |
| Consultant  fees          |       | 63                                       |       | 52                         |       | 11                                     |       | 244          |       | 109 |   | 135 |   |
| Loan  collection expenses |       | 58                                       |       | —                     |       | 58                                     |       | 214          |       | — |   | 214 |   |
| Total                     |       | $                                        | 1,970      |                       | $          | 2,057                                  |       | $            | (83        | ) | $ | 4,134 |   | $ | 3,090 |   | $ | 1,048 |   |

 

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In order to offset theeffects of the increased costs, the Company has worked to control other costswhere possible, as illustrated below.

 
| ** **                        | ** ** | **Three Months Ended****June 30,** | ** ** | **Increase****(Decrease)** | ** ** | **Six Months Ended****June 30,** | ** ** | **Decrease** | ** ** |
|-----------------------------------|------------|-----------------------------------------|------------|----------------------------|------------|---------------------------------------|------------|--------------|------------|
| ** **                        | ** ** | **2010**                                | ** ** | **2009**                   | ** ** | **2010 vs 2009**                      | ** ** | **2010**     | ** ** | **2009** | ** ** | **2010 vs 2009** | ** ** |
| Salaries  and employee benefits   |       | $                                       | 2,765      |                       | $          | 2,845                                 |       | $            | (80        | ) | $ | 5,564 |   | $ | 5,813 |   | $ | (249 | ) |
| Occupancy  expense                |       | 644                                     |       | 663                        |       | (19                                   | )          | 1,313        |       | 1,340 |   | (27 | ) |
| Data  processing                  |       | 368                                     |       | 338                        |       | 30                                    |       | 746          |       | 746 |   | — |   |
| Advertising  and public relations |       | 64                                      |       | 91                         |       | (27                                   | )          | 127          |       | 202 |   | (75 | ) |
| Postage  and supplies             |       | 178                                     |       | 144                        |       | 34                                    |       | 340          |       | 384 |   | (44 | ) |
| Other                             |       | 389                                     |       | 418                        |       | (29                                   | )          | 754          |       | 831 |   | (77 | ) |
| Total                             |       | $                                       | 4,408      |                       | $          | 4,499                                 |       | $            | (91        | ) | $ | 8,844 |   | $ | 9,316 |   | $ | (472 | ) |

 

**Salaries and EmployeeBenefits. **The changes 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)** | ** ** |
|------------------------------------|------------|-----------------------------------------|------------|----------------------------|------------|---------------------------------------|------------|----------------------------|------------|
| ** **                         | ** ** | **2010**                                | ** ** | **2009**                   | ** ** | **2010 vs 2009**                      | ** ** | **2010**                   | ** ** | **2009** | ** ** | **2010 vs 2009** | ** ** |
| Salaries                           |       | $                                       | 2,275      |                       | $          | 2,404                                 |       | $                          | (129       | ) | $ | 4,568 |   | $ | 4,871 |   | $ | (303 | ) |
| Payroll taxes                      |       | 194                                     |       | 210                        |       | (16                                   | )          | 399                        |       | 439 |   | (40 | ) |
| Insurance                          |       | 138                                     |       | 156                        |       | (18                                   | )          | 280                        |       | 314 |   | (34 | ) |
| 401(k)(1)                          |       | —                                  |       | —                     |       | —                                |       | —-                    |       | 38 |   | (38 | ) |
| Defined benefit plan  contribution |       | 123                                     |       | 39                         |       | 84                                    |       | 246                        |       | 77 |   | 169 |   |
| Other                              |       | 35                                      |       | 36                         |       | (1                                    | )          | 71                         |       | 74 |   | (3 | ) |
| Total                              |       | $                                       | 2,765      |                       | $          | 2,845                                 |       | $                          | (80        | ) | $ | 5,564 |   | $ | 5,813 |   | $ | (249 | ) |

 

----

(1)          RepresentsCompany matching contributions on the 401(k) plan.  Effective February 16, 2009, the Companydiscontinued its matching contributions to the 401(k) plan.

 

The decrease insalaries and benefits was primarily due to a reduction in full time equivalentemployees.

 

The Bank is a participant in the multiemployer PentegraDefined Benefit Plan (the “Plan”).  ThePlan is non-contributory and covers all qualified employees. Since the Plan isa multiemployer plan, contributions of participating employers are commingledand invested on a pooled basis without allocation to specific employers oremployees.  On April 30, 2010, theBoard of Directors of the Bank elected to freeze the Plan effective July 1,2010, eliminating all future benefit accruals for participants in the Plan andclosing the Plan to new participants as of that date. The Bank currentlyanticipates annual cost savings from freezing the Plan of approximately$140,000. Actual cost savings will depend on a number of factors, including,but not limited to, administrative and other costs, the level of interest ratesin the future and the performance of Plan assets.  After July 1,2010, the Bank will continue to incur costs consisting of administration andPension Benefit Guaranty Corporation insurance expenses as well as amortizationcharges based on the funding level of the Plan.  The level of amortizationcharges is determined by the Plan’s funding shortfall, which is determined bycomparing Plan liabilities to Plan assets.  Based on current interestrates and Plan assets, the Bank anticipates that the funding shortfall mayincrease, resulting in increased amortization charges effective July 1,2010.  Increased amortization charges will decrease cost savingsassociated with freezing the Plan.

 

**Real Estate Owned, net. **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)** | ** ** |
|---------------------|------------|-----------------------------------------|------------|----------------------------|------------|---------------------------------------|------------|----------------------------|------------|
| ** **          | ** ** | **2010**                                | ** ** | **2009**                   | ** ** | **2010 vs 2009**                      | ** ** | **2010**                   | ** ** | **2009** | ** ** | **2010 vs 2009** | ** ** |
| Loss provisions     |       | $                                       | 561        |                       | $          | 552                                   |       | $                          | 9          |   | $ | 1,141 |   | $ | 715 |   | $ | 426 |   |
| Net loss on sales   |       | 27                                      |       | 254                        |       | (227                                  | )          | 79                         |       | 233 |   | (154 | ) |
| Taxes and insurance |       | 187                                     |       | 138                        |       | 49                                    |       | 283                        |       | 322 |   | (39 | ) |
| Other               |       | 138                                     |       | 141                        |       | (3                                    | )          | 211                        |       | 210 |   | 1 |   |
| Total               |       | $                                       | 913        |                       | $          | 1,085                                 |       | $                          | (172       | ) | $ | 1,714 |   | $ | 1,480 |   | $ | 234 |   |

 

Real estate owned is expected to increase in theforeseeable future and real estate owned expenses associated with maintainingthe properties are expected to increase accordingly.  Future levels of loss provisions and netgains or losses on sales of real estate owned will be dependent on marketconditions.

 

**FDIC Insurance Premium.**  FDIC insurance increased during the six monthcomparison periods due to an increase in the premium rate for 2010.  The FDIC premium decreased during the threemonth comparison periods due to the five basis point special assessment on allinsured depository institutions based on assets minus Tier 1 capital as of June 30,2009.  The Bank recorded a charge ofapproximately $350,000 for the special assessment during the 

 

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quarter ended June 30, 2009.  There was no such special assessment duringthe quarter ended June 30, 2010; however, the Bank’s FDIC insurancepremium has gone up compared to the quarter ended June 30, 2009, whichpartially offset the decrease due to the special assessment.  The increase in the Bank’s FDIC insurancepremium will continue to impact the Corporation’s noninterest expense in futureperiods. See “Part II, Item 1A Risk Factors — Future FDIC insurancepremiums or special assessments may impact our earnings.”

 

**Professional Fees. **Professionalfees increased primarily due to an increase in audit fees and to a lesserdegree an increase in legal fees related to nonaccrual loans.  We expect professional fees to remain at anelevated level due to the amount of nonaccrual loans and the increased legal,accounting, and other fees associated with reporting and compliancerequirements.

 

**Advertising and Public Relations.**  The decrease in 2010 is primarilyrelated to a decrease in direct mail, print media and broadcast mediaadvertising.

 

**Income Taxes. **Theincome tax benefit decreased primarily due to the increase in income as well asthe fact that there is a valuation allowance on the deferred tax asset as of June 30,2010 and there was no such valuation allowance as of June 30, 2009.  See also Note 9 to the unaudited condensedconsolidated financial statements included in Part I, Item 1 hereinfor further information regarding income taxes.

 

**OFF-BALANCE SHEET ARRANGEMENTS**

 

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

 

·                  the origination, purchase or sale of loans;

·                  the fulfillment of commitments under letters-of-credit, extensions ofcredit on home equity lines of credit, construction loans, and predeterminedoverdraft protection limits; and

·                  the commitment to fund withdrawals of certificates of deposit atmaturity.

 

At June 30, 2010, the Bank’s off-balancesheet arrangements principally included lending commitments, which aredescribed below.  At June 30, 2010,the Company had no interests in non-consolidated special purpose entities.

 

At June 30, 2010, commitments included:

 

·                  total approved commitments to originate or purchase loans amounting to$1.3 million;

·                  rate lock agreements with customers of $2.9  million, all of which have been locked withan investor;

·                  funded mortgage loans committed to sell of $1.6 million;

·                  unadvanced portion of construction loans of $1.5 million;

·                  unused lines of credit of $11.5 million;

·                  outstanding standby letters of credit of approximately $3.4 million;

·                  total predetermined overdraft protection limits of $11.9 million; and

·                  certificates of deposit scheduled to mature in one year or less totaling$252.4 million.

 

Total unfunded commitments to originate loans for saleand the related commitments to sell of $2.9 million meet the definition of aderivative financial instrument.  Therelated asset and liability are considered immaterial at June 30, 2010.

 

Historically, a very small percentage of predeterminedoverdraft limits have been used.  At June 30,2010, overdrafts of accounts with Bounce ProtectionTM represented usage of 4.33% of thelimit.  We expect utilization of theseoverdraft limits to remain at comparable levels in the future.

 

In light of the Company’s efforts to coordinate acontrolled decrease in assets and liabilities and as a result of the currentinterest rate environment, management cannot estimate the portion of maturingdeposits that will remain with the Bank. We anticipate that we will continue to have sufficient funds, throughrepayments, deposits and borrowings, to meet our current commitments.

 

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**LIQUIDITY AND CAPITAL RESOURCES**

 

Liquidity management isboth a daily and long-term function of business management. The Bank’sliquidity, represented by cash and cash equivalents and eligible investmentsecurities, is a product of its operating, investing and financingactivities.  The Bank’s primary sourcesof funds are deposits, borrowings, payments on outstanding loans, maturitiesand calls of investment securities and other short-term investments and fundsprovided from operations.  Whilescheduled loan amortization and maturing investment securities and short-terminvestments are relatively predictable sources of funds, deposit flows and loanprepayments are greatly influenced by general interest rates, economicconditions and competition. Calls of investment securities are determined bythe issuer and are generally influenced by the level of market interest ratesat the bond’s call date compared to the coupon rate of the bond.  The Bank manages the pricing of its depositsto maintain deposit balances at levels commensurate with the operating,investing and financing activities of the Bank. In addition, the Bank invests excess funds in overnight deposits andother short-term interest-earning assets that provide liquidity to meet lendingrequirements and pay deposit withdrawals. When funds from the retail depositmarket are inadequate for the liquidity needs of the Bank or the pricing ofdeposits is not as favorable as other sources, the Bank has borrowed from theFHLB of Dallas.  Borrowings from the FRBdiscount window may currently be used only when other sources of liquidity arenot available to the Bank.

 

In April 2008, based on the FHLB rating criteria,the Bank was notified of the replacement of its FHLB blanket lien with arestricted custody collateral arrangement, whereby the FHLB has custody andendorsement of the loans that collateralize the Bank’s outstanding borrowingswith the FHLB.  Qualifying loans (i) must not be 90 days or more pastdue; (ii) must not have been in default within the most recenttwelve-month period, unless such default has been cured in a manner acceptableto the FHLB; (iii) must relate to real property that is covered by fireand hazard insurance in an amount at least sufficient to discharge the mortgageloan in case of loss and as to which all real estate taxes are current; (iv) mustnot have been classified as substandard, doubtful, or loss by the Bank’sregulatory authority or the Bank; and (v) must not secure the indebtednessto any director, officer, employee, attorney, or agent of the Bank or of anyFHLB.  The FHLB currently allows an aggregate collateral or lendable valueon the qualifying loans of approximately 75% of the outstanding balance of theloans pledged to the FHLB.

 

During the first sixmonths of 2010, the use of FHLB borrowings decreased by $38.6 million or 64.9%.At June 30, 2010, the Bank’s borrowingcapacity with the FHLB was $84.1 million, comprised of qualifying loanscollateralized by first-lien one- to four-family mortgages with a collateralvalue of $87.0 million and qualifying investment securities with a collateralvalue of $18.0 million less outstanding advances at June 30, 2010 of $20.9million.  The Bank may transfer additional eligible collateral tothe FHLB to provide additional borrowing capacity if needed.  Due to the Bank’s restricted status at theFHLB, the Bank may only borrow short-term FHLB advances with maturities up tothirty days.

 

The Bank was notifiedin December 2009 by the FRB of various restrictions and collateralrequirements.  The Bank is required topledge collateral with a value of $16.0 million to secure account transactionsettlements.  This collateral may also beavailable to access the secondary discount window if unencumbered fortransaction settlement and when other sources of funding are not available tothe Bank. In addition, the Bank is required to maintain an account balance atthe FRB to cover charges to the Bank’s transaction account to avoid any daylightoverdrafts.

 

The Bank uses qualifying investment securities andqualifying commercial real estate loans as collateral for the discount windowand to secure transactions settlements. In September 2008, a subordinationagreement was secured with the FHLB based on its blanket lien of commercialreal estate loans.  This agreementprovides the Bank the ability to pledge commercial real estate loans to the FRBdiscount window and to secure transaction settlements.  The loan collateral was held by the Bankthrough the FRB’s Borrower in Custody of Collateral Program until December 2009,when the FRB notified the Bank that custody must be transferred to the FRB.

 

TheFRB will not accept loans that: (i) are 30 days or more past due; (ii) areclassified as substandard, doubtful, or loss by the Bank’s regulating authorityor the Bank; (iii) are illegal investments for the Bank; (iv) securethe indebtedness to any director, officer, employee, attorney, affiliate oragent of the Bank; or that (v) exhibit collateral and credit documentationdeficiencies.  The lendable value of commercial real estate ofapproximately $12.6 million at June 30,2010 was 41% of the fair market value of the loans as determined by the FRBtaking into consideration the rate and duration of the loans pledged.  Inaddition, at June 30, 2010, theBank pledged qualifying investment securities with a collateral value ofapproximately $4.4 million for the discount window and to secure transactionsettlements.

 

AtJune 30, 2010, the Bank hadshort-term funds availability of approximately $175.8 million or 25.9% ofassets consisting of borrowing capacity at the FHLB and the FRB, unpledgedinvestment securities, and overnight funds including the balances maintained atthe FRB.  The Bank anticipates it will continue to rely primarily ondeposits, calls of investment securities, loan repayments, and funds providedfrom operations to provide liquidity.  As necessary, the sources ofborrowed funds described above will be used to augment the Bank’s other fundingsources.

 

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The Bank uses itssources of funds primarily to meet its ongoing commitments, to pay maturingsavings certificates and savings withdrawals, to repay maturing borrowings, tofund loan commitments, and to purchase investment securities. As of June 30, 2010, the Bank had outstanding commitments to originate loans of $1.3million, including $197,000 of loans committed to sell; unadvanced portion ofconstruction loans of $1.5 million; and commitments to extend funds to, or onbehalf of, customers pursuant to lines and letters of credit of $15.0million.  Scheduled maturities ofcertificates of deposit for the Bank during the twelve months following June 30, 2010 amounted to $252.4 million. In light of the Company’s efforts to coordinate acontrolled decrease in assets and liabilities and as a result of the currentinterest rate environment, management cannot estimate the portion of maturingdeposits that will remain with the Bank. Managementanticipates the Bank will continue to have sufficient funds, through loanrepayments, deposits, and borrowings, to meet our current commitments.  This expectation assumes that the FHLB willcontinue to extend credit based on our borrowing capacity and that coredeposits do not experience a substantial decline.

 

The Bank emphasizesdeposit growth and retention throughout our retail branch network to enhanceour liquidity position. Effective with the Bank Order in April 2010, theBank must comply with federal restrictions on the interest rates we may offerto our depositors.  Under theserestrictions, we may pay up to 75 basis points over the national average ratesset by the FDIC for each deposit product. Although we do not believe these rate restrictions will have asignificant impact on the level of new and existing deposits, we cannot predictthe impact on our liquidity.  We havehistorically paid rates the middle of the market for regular term certificatesof deposit and paid above average rates locally for certificates of depositwith special terms.

 

The Bank isparticipating in the FDIC’s Transaction Account Guarantee Program (“TAGP”)which fully insures noninterest bearing transaction deposit accounts, NOWaccounts paying less than 0.5% per annum through June 30, 2010, when thethreshold rate lowered to 0.25%, and Interest on Lawyers Trust Accounts,regardless of dollar amount. This program,originally set to expire on December 31, 2009 was extended to December 31,2010.  An annualized 15 to 25 basis pointassessment on balances in qualifying accounts that exceed the existing depositinsurance limit of $250,000 will be assessed on a quarterly basis.  The assessment rate will depend on theinstitution’s risk category.  At June 30, 2010, the Bank had approximately $4.9 millionin transaction deposit accounts included in the TAGP with $2.6 million inexcess of $250,000 normal insurance coverage. The recently enacted Dodd-Frank Wall Street Reform and ConsumerProtection Act (the “Dodd-Frank Act”) provides unlimited FDIC insurancecoverage for noninterest-bearing transaction accounts in all banks effective December 31,2010 and continuing through December 31, 2012.  The TAGP, which continues through December 31,2010, is not changed by the Dodd-Frank Act. The Dodd-Frank Act also permanently increases deposit insurance coverageto $250,000 per depositor.

 

As of November 19,2009 and in accordance with the directive from the OTS, the Bank may no longeraccept, renew or roll over brokered deposits without the written non-objectionof the regional director of the OTS. The Bank has not relied on brokereddeposits as a primary source of funding. As of June 30, 2010 the Bank had $9.8 million or 2% ofdeposits in brokered deposits. Approximately $4.3 million of the brokered accounts mature in 2010.  Based on the current minimal level ofbrokered deposits, management does not anticipate that the restrictions imposedby the OTS on brokered deposits will have a significant impact on the Bank’sliquidity position.

 

In the first six months of 2010, management tookadditional steps to strengthen the Bank’s liquidity position including thetransfer of additional collateral in the form of qualifying one- to four-familyloans to the FHLB of Dallas, a decrease in the Bank’s loan portfolio,establishment of a repurchase agreement to utilize our investment portfolio forliquidity, and membership in an internet service in order to bid fornon-brokered certificates of deposit as another source of liquidity.

 

The Bank’s liquidityrisk management program assesses our current and projected funding needs toensure that sufficient funds or access to funds exist to meet those needs.  The program also includes effective methodsto achieve and maintain sufficient liquidity and to measure and monitorliquidity risk, including the preparation and submission of liquidity reportson a regular basis to the board of directors and to the OTS.  The program also contains a ContingencyFunding Plan that forecasts funding needs and funding sources under differentstress scenarios.  The ContingencyFunding Plan approved by the board of directors is designed to respond to anoverall decline in the economic environment, the banking industry or a problemspecific to our Bank.  A number ofdifferent contingency funding conditions may arise which may result in strainsor expectation of strains in the Bank’s normal funding activities includingcustomer reaction to negative news of the banking industry, in general, or us,specifically.  As a result of negativenews, some depositors may reduce the amount of depositsheld at the Bank if concerns persist, which could affect the level andcomposition of the Bank’s deposit portfolio and thereby directly impact theBank’s liquidity, funding costs and net interest margin. The Bank’s fundingcosts may also be adversely affected in the event that activities of theFederal Reserve Board and the U.S. Department of the Treasury to provideliquidity for the banking system and improvement in capital markets arecurtailed or are unsuccessful. Such events could reduce liquidity in themarkets, thereby increasing funding costs to the Bank or reducing theavailability of funds to the Bank to finance its existing operations andthereby adversely affect the Company’s results of operations, financialcondition, future prospects, profitability, and stock price.

 

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For 2009, the Companydeclared dividends of $0.01 per share in each of the first, second, and thirdquarters.  No dividend was declared forthe first and second quarter of 2010. Future dividend payments are subject to restrictions.  See Part 1. Item 2 “RegulatoryEnforcement Actions” for further information regarding dividend restrictions.

 

Since the Company is aholding company and does not conduct operations, its primary source ofliquidity is dividends from the Bank. The Company has no borrowings fromoutside sources.  The Company and theBank are currently not allowed to declare or pay dividends or make any othercapital distributions without the prior written approval of the OTS.  The Company suspended its common stockdividend in the fourth quarter of 2009 and deferred the payment of the dividendfor the quarters ended March 31, 2010 and June 30,2010 on its FixedRate Cumulative Perpetual Preferred Stock, Series A issued to the Treasuryon March 6, 2009 as part of the Capital Purchase Program.  The Company funds its expenses from cashdeposits maintained in the Bank and from repayments on the loan to the Banksubsidiary. The deposits in the Bank and the loan to the Bank amounted to$935,000 at June 30, 2010.  Management believes the Company has sufficient resources to fundexpenses throughout 2010.

 

At June 30, 2010, the Bank’s tangible, core and risk-based capital ratios amounted to 6.46%,6.46% and 11.40%, respectively, compared to OTS capital requirements of 1.5%, 8%and 12%.  The Bank Order requires theBank to achieve and maintain a tier 1 core capital ratio and total risk-basedcapital ratio of 8% and 12%, respectively, by December 31, 2010.  TheBank did not meet the core and risk-based capital requirements as of June 30,2010 and would have needed approximately $10.5 million in additional capitalbased on assets at such date to meet these requirements.

 

**FORWARD-LOOKINGSTATEMENTS**

 

The Company’s Quarterly Report on Form 10-Qcontains certain forward-looking statements and information relating to theCompany that are based on the beliefs of management as well as assumptions madeby 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.

 

**Item 3.  QUANTITATIVE AND QUALITATIVE DISCLOSURESABOUT MARKET RISK**

 

Therehas been no material change in the market value of the Bank’s portfolio equitysince December 31, 2009.  Similarly, while there has been no materialchange in the Company’s asset and liability position since such time, the Bank’slevel of nonperforming assets continued to impact the level of net interestincome during the three and six months ended June 30, 2010.  The Bank’s net interest margin decreasedslightly from 3.49% for the three months ended December 31, 2009 to 3.42%for the three months ended March 31, 2010 and to 3.32% for the threemonths ended June 30, 2010.  Based on the level of nonperformingassets, competitive pressures on loan and deposit rates, and a recent increasedlevel of calls of investment securities resulting in a higher level of lowyielding cash balances, management anticipates continued pressure on the Bank’sinterest rate spread and net interest margin for the third quarter of 2010,although maturing certificates of deposit repricing to lower rates willsomewhat offset the pressure on the interest rate spread and margin.

 

The ability to maximizenet interest income is largely dependent upon the achievement of a positiveinterest rate spread that can be sustained during fluctuations in prevailinginterest rates.  Interest rate sensitivityis a measure of the difference between amounts of interest earning assets andinterest bearing liabilities that either reprice or mature within a givenperiod of time.  The difference, or theinterest rate repricing “gap”, provides an indication of the extent to which aninstitution’s interest rate spread will be affected by changes in interestrates.  A gap is considered positive whenthe amount of interest rate-sensitive assets exceeds the amount of interestrate-sensitive liabilities, and is considered negative when the amount ofinterest rate-sensitive liabilities exceeds the amount of interestrate-sensitive assets.  Generally, duringa period of rising interest rates, a negative gap within shorter maturitieswould adversely affect net interest income, while a positive gap within shortermaturities would result in an increase in net interest income, and during aperiod of falling interest rates, a negative gap within shorter maturitieswould result in an increase in net interest income while a positive gap withinshorter maturities would have the opposite effect.  Based on the Bank’s negativegap position, a rising rate environment will negatively affect our interestrate spread and net interest margin.

 

**Item 4.  CONTROLS AND PROCEDURES**

 

Our management evaluated, with the participationof our Chief Executive Officer and Chief Financial Officer, the effectivenessof the design and operation of our disclosure controls and procedures (asdefined in Rules 13a-15(e)

 

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and 15d-15(e) under the Securities ExchangeAct of 1934) as of the end of the period covered by this report.  Based on such evaluation, our Chief ExecutiveOfficer and Chief Financial Officer have concluded that our disclosure controlsand procedures are operating effectively.

 

No change in the Company’s internal control overfinancial reporting (as defined in Rules 13a-15(f) and 15d-15(f) underthe Securities Exchange Act) occurred during the most recent fiscal quarterthat has materially affected, or is reasonably likely to materially affect, theCompany’s internal control over financial reporting.

 

**Part II**

 

Item1.           Legal Proceedings

 

Neither the Company nor the Bank is involved inany other pending legal proceedings other than non-material legal proceedingsoccurring in the ordinary course of business.

 

Item1A.        Risk Factors

 

*You should carefully consider thefollowing risk factors, as well as other information in this Form 10-Q andthe information contained in our other filings with the SEC.  You should carefully consider the followingrisks in light of our current operating environment and regulatory status. Theoccurrence of any of the events described below could materially adverselyaffect our liquidity, results of operations and financial condition and ourability to continue as a going concern. Additional risks not presently known byus or that we currently deem immaterial may also have a material adverse impact.*

 

**The current economic environmentposes significant challenges for the Company and could continue to adverselyaffect its financial condition and results of operations.**

 

The Company is operating in a challenging and uncertaineconomic environment, including generally uncertain national and localconditions.  Financial institutionscontinue to be affected by sharp declines in the real estate market andconstrained financial markets.  Dramaticdeclines in the housing market over the past year, with falling home prices andincreasing foreclosures and unemployment, have resulted in significantwrite-downs of asset values by the Bank and other financial institutions.  Continued declines in real estate values,home sales volumes, and financial stress on borrowers as a result of theuncertain economic environment could continue to have an adverse effect on theBank’s borrowers or their customers, which could adversely affect the Company’sfinancial condition and results of operations. A worsening of these conditions would likely exacerbate the adverseeffects on the Company and others in the financial services industry.  For example, further deterioration in localeconomic conditions in the Company’s markets could drive losses beyond thatwhich is provided for in its allowance for loan losses.  The Company may also face the following risksin connection with these events:

 

·                  Economicconditions that negatively affect housing prices and the job market haveresulted, and may continue to result, in deterioration in credit quality of theBank’s loan portfolio, and such deterioration in credit quality has had, andcould continue to have, a negative impact on the Company’s business andfinancial condition.

·                  Marketdevelopments may affect consumer confidence levels and may cause adversechanges in payment patterns, causing increases in delinquencies and defaultrates on loans and other credit facilities.

·                  Theprocesses the Company uses to estimate the allowance for loan losses may nolonger be reliable because they rely on complex judgments, including forecastsof economic conditions, which may no longer be capable of accurate estimation.

·                  TheBank’s ability to assess the creditworthiness of its customers may be impairedif the processes and approaches it uses to select, manage, and underwrite itscustomers become less predictive of future charge-offs.

·                  TheCompany expects to face increased regulation of its industry, and compliancewith such regulation may increase its costs, limit its ability to pursuebusiness opportunities, and increase compliance challenges.

 

As these conditions or similar ones continue to exist orworsen, the Company could experience continuing or increased adverse effects onits financial condition and results of operations.

 

**Our failure to comply withapplicable regulatory requirements and regulatory enforcement actions couldresult in further restrictions and enforcement actions.**

 

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The Bank is subject to supervision and regulation by theOTS.  As a federally chartered stock savings and loan association, theBank’s good standing with its regulators is of fundamental importance to thecontinuation of its business.  As more fully described in Part I, Item2, “Regulatory Enforcement Actions”, on April 12, 2010, the Company andthe Bank both consented to the Orders issued by the OTS.  The Ordersrequire the Company and the Bank to, among other things, file with the OTS anupdated business plan and capital plan and submit to the OTS, on a quarterlybasis with respect to the business plan and monthly with respect to the capitalplan, variance reports related to the plans.  The Order issued to the Bankalso substantially restricts the Bank’s lending activities.  We have incurred and expect to continue toincur significant additional regulatory compliance expense in connection withthe Orders, and we will incur ongoing expenses attributable to compliance withthe terms of the Orders.  In addition,the OTS must approve any deviation from our business plan, which could limit ourability to make any changes to our business, which could negatively impact thescope and flexibility of our business activities.  We cannot predict thefurther impact of the Orders upon our business, financial condition or resultsof operations.

 

Any material failure by the Company and the Bank tocomply with the provisions of the Orders could result in further enforcementactions by the OTS. While the Company and the Bank intend to take such actionsas may be necessary to comply with the requirements of the Orders, there can beno assurance that the Company or the Bank will be able to comply fully with theOrders, or that efforts to comply with the Orders will not have adverse effectson the operations and financial condition of the Company or the Bank.

 

**Our capital levels currently arenot sufficient to achieve compliance with the higher capital requirements wemust meet by December 31, 2010.**

 

The Bank Order directs the Bank to raise its tier 1 corecapital and total risk-based capital ratios to 8% and 12%, respectively, by December 31,2010.  At June 30, 2010, we did notmeet these requirements and would have needed approximately $10.5 million inadditional capital based on assets at such date to meet theserequirements.  The Company currently doesnot have any capital available to invest in the Bank.  We are considering various strategies to helpus achieve these capital levels by December 31, 2010, but there is noassurance that any capital raising strategy can be completed successfully bythat date.  Moreover, any furtherincreases to our allowance for loan losses or further operating losses****would negatively impact our capital levels and make it moredifficult to achieve the capital levels directed by the OTS.  If we fail to meet the required capital levelsby December 31, 2010, the OTS could take additional enforcement actionagainst us, including the imposition of further operating restrictions.  The OTS also could direct us to seek a mergerpartner or to liquidate the Bank.

 

The decline in the Bank’s capital in 2009 as aresult of the Company’s loss and the significant level of the Bank’s criticizedassets were noted by the Company’s independent registered public accountingfirm as primary factors in including an explanatory paragraph in their auditopinion for the year ended December 31, 2009, which expressed uncertaintyabout the Company’s ability to continue as a going concern.

 

**We have a high percentage ofnonperforming loans and classified assets relative to our total assets.  If our allowance for loan losses is notsufficient to cover our actual loan losses, our results of operations will beadversely affected.**

 

At June 30, 2010, our nonperforming loans totaled$47.4 million, representing 10.2% of total loans and 7.1% of total assets.  Further, assets classified by management assubstandard, including nonperforming loans, totaled $113.1 million,representing 24.5% of total loans and 16.7% of total assets.  At June 30, 2010, our allowance for loanlosses was $31.6 million, consisting of $21.7 million of general loan lossallowances and $9.9 million of specific valuation allowances.  The general valuation allowance represents45.1% of nonperforming loans.  In theevent our loan customers do not repay their loans according to their terms andthe collateral securing the payment of these loans is insufficient to pay anyremaining loan balance, we may experience significant loan losses, which couldhave a material adverse effect on our operating results.

 

Management maintains an allowance for loan losses basedupon, among other things:

 

·historical experience;

·repayment capacity of borrowers;

· anevaluation of local, regional and national economic conditions;

·regular reviews of delinquencies and loan portfolio quality;

·collateral evaluations;

·current trends regarding the volume and severity of problem loans;

 

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· theexistence and effect of concentrations of credit; and

·results of regulatory examinations.

 

Based on those factors, management makes variousassumptions and judgments about the ultimate collectibility of the respectiveloan portfolios.  The determination ofthe appropriate level of the allowance for loan losses inherently involves ahigh degree of subjectivity and requires management to make significantestimates of current credit risks and future trends, all of which may undergomaterial changes. In addition, our board of directors and the OTS periodicallyreview our allowance for loan losses and may require an increase in theprovision for possible loan losses or the recognition of further loancharge-offs. The OTS’ judgments may differ from those of our management. Theamount of future loan losses is susceptible to changes in economic, operatingand other conditions, which may be beyond our control, including changes ininterest rates, and these losses may exceed current estimates. Federalregulatory agencies, as an integral part of their examination process, reviewour loans and allowance for loan losses. The most recent OTS examination wascompleted in December 2009. While we believe that the allowance for loanlosses is adequate to cover current losses, we cannot provide assurances thatwe will not need to increase our allowance for loan losses or that regulatorswill not require an increase in our allowance. Either of these occurrencescould materially and adversely affect our financial condition and results ofoperations.

 

**Liquidityneeds could adversely affect our results of operations and financial condition.**

 

The Bank’s primary sources of funds are deposits,maturing or called securities, and loan repayments. While scheduled loanrepayments are a relatively stable source of funds, they are subject to theability of borrowers to repay the loans. The ability of borrowers to repayloans can be adversely affected by a number of factors outside of our control,including changes in economic conditions, adverse trends or events affectingbusiness industry groups, reductions in real estate values or markets, businessclosings or lay-offs, inclement weather, natural disasters and internationalinstability. Additionally, deposit levels may be affected by a number offactors, including rates paid by competitors, general interest rate levels,returns available to customers on alternative investments, financial conditionor regulatory status of the Bank, actions by the OTS and general economicconditions. Accordingly, we may be required from time to time to rely onsecondary sources of liquidity to meet withdrawal demands or otherwise fundoperations. Those sources may include Federal Home Loan Bank advances,repurchase agreements and the Federal Reserve discount window.  Currently, however, the Bank may only borrowfrom the Federal Home Loan Bank on a short-term basis.

 

Our financial flexibility will be constrained if wecontinue to incur losses and are unable to maintain our access to funding or ifadequate financing is not available at acceptable interest rates. We may seekadditional debt in the future. Additional borrowings, if sought, may not beavailable to us or, if available, may not be available on reasonable terms. Ifadditional financing sources are unavailable, or are not available onreasonable terms, our financial condition, results of operations and futureprospects could be materially adversely affected. Finally, if we are requiredto rely more heavily on more expensive funding sources to support futuregrowth, our revenues may not increase proportionately to cover our costs. Inaddition, we may be required to slow or discontinue capital expenditures ormake other investments or liquidate assets should those sources not beadequate.

 

**There are increased risksinvolved with commercial real estate, construction, commercial business andconsumer lending activities.**

 

Our loan portfolio includes loans secured by existingcommercial real estate.  In addition, ourportfolio includes loans for the construction of single-family residential realestate and land development loans.  Commercialreal estate and construction lending generally is considered to involve ahigher degree of risk than single-family residential lending due to a varietyof factors, including generally larger loan balances, the dependency onsuccessful completion or operation of the project for repayment, thedifficulties in estimating construction costs and loan terms which often do notrequire full amortization of the loan over its term and, instead, provide for aballoon payment at stated maturity.  Ourloan portfolio also includes commercial business loans to small- tomedium-sized businesses, which generally are secured by various equipment,machinery and other corporate assets, and a variety of consumer loans,including automobile loans, deposit account secured loans and unsecuredloans.  Although commercial businessloans and consumer loans generally have shorter terms and higher interest ratesthan mortgage loans, they generally involve more risk than mortgage loansbecause of the nature of, or in certain cases the absence of, the collateralwhich secures such loans.  The Bank’slending activities are currently restricted as a result of the Orders.  For a further discussion of the Orders, see Part I, Item2, “Regulatory Enforcement Actions.”

 

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**We may experience an ownershipchange which would result in a limitation of the use of our net operatinglosses.**

 

In general, under Section 382 of the Code, acorporation that undergoes an “ownership change” is subject to limitations onits ability to utilize its pre-change net operating losses (“NOLs”) to offsetfuture taxable income.  If we undergo anownership change in the future as a result of issuances of our common stock orotherwise, our ability to utilize NOLs could be further limited by Section 382of the Code.  In the event of anownership change, Section 382 imposes an annual limitation on the amountof post-ownership change taxable income a corporation may offset withpre-ownership change NOL carryforwards and certain recognized built-in losses.

 

**We may issue additional shares ofour common stock in the future, which would dilute existing stockholder’sownership if they did not, or were not permitted to, invest in the additionalissuances.**

 

The Bank has been directed by the OTS to raise its tier1 core capital and total risk-based capital ratios to 8% and 12%, respectively,by December 31, 2010.  Had the Bankbeen required to meet these capital requirements at June 30, 2010, itwould have needed additional capital of approximately $10.5 million.  To meet these capital requirements and forother purposes, we expect to seek to raise capital during the third or fourthquarter of 2010.  Our ability to raiseadditional capital, if needed, will depend on conditions in the capital marketsat that time, which are outside our control, and on our financial condition andperformance.  Accordingly, we cannot makeassurances that we will be able to raise additional capital if needed on termsthat are acceptable to us, or at all.  Ifwe cannot raise additional capital when needed, the OTS could take additionalenforcement action against us, including the imposition of further operatingrestrictions.  The OTS also could directus to seek a merger partner or to liquidate the Bank.  Our certificate of incorporation makesavailable additional authorized shares of common stock and preferred stock forissuance from time to time at the discretion of our board of directors, withoutfurther action by the shareholders, except where shareholder approval isrequired by law or the Nasdaq Capital Market requirements.  The issuance of any additional shares ofcommon stock, preferred stock, or convertible securities could be substantiallydilutive to shareholders of our common stock. Holders of our shares of common stock have no preemptive rights thatentitle them to purchase their *pro rata* shareof any offering of shares of any class or series and, therefore, ourshareholders may not be permitted to invest in future issuances of our commonstock and as a result will be diluted.

 

**Future FDIC insurance premiumsor special assessments may adversely impact our earnings.**

 

On May 22, 2009, the FDIC adopted a final rule levying a five basis point specialassessment on each insured depository institution’s assets minus Tier 1 capitalas of June 30, 2009. We recorded an expense of approximately $350,000during the quarter ended June 30, 2009, to reflect the special assessment.The final rule permitted the FDICto levy up to two additional special assessments of up to five basis pointseach during 2009 if the FDICestimated that the Deposit Insurance Fund reserve ratio will fall to a levelthat the FDIC believes would adverselyaffect public confidence or to a level that will be close to or below zero. Noadditional levies were assessed in 2009. In addition, the FDICincreased the general assessment rate and, therefore, our FDIC general insurance premium expensewill increase compared to prior periods.

 

On November 12, 2009, the FDIC adopted a final rule pursuant to which insureddepository institutions will be required to prepay their estimated assessmentsfor the fourth quarter of 2009, and for all of 2010, 2011 and 2012. Thispre-payment was due on December 30, 2009. Under the rule, the assessmentrate for the fourth quarter of 2009 and for 2010 is based on each institution’stotal base assessment rate for the third quarter of 2009, modified to assumethat the assessment rate in effect on September 30, 2009 had been ineffect for the entire third quarter, and the assessment rate for 2011 and 2012would be equal to the modified third quarter assessment rate plus an additional3 basis points. In addition, each institution’s base assessment rate for eachperiod is calculated using its third quarter assessment base, adjustedquarterly for an estimated 5% annual growth rate in the assessment base throughthe end of 2012.  The Bank received anexemption from this prepayment requirement but will pay each quarterlyassessment as it becomes due.  The Bankreceived an exemption from this prepayment requirement due to its potentialimpact on the Bank’s liquidity position.

 

Recent insured institution failures, as well asdeterioration in banking and economic conditions, have significantly increasedthe loss provisions of the FDIC, resulting in a decline in the designatedreserve ratio to historical lows. The FDIC expects a higher rate of insuredinstitution failures in the next few years compared to recent years. Therefore,the reserve ratio may continue to decline. These 

 

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developments have caused the premiums assessed on us bythe FDIC to increase and materially increase FDIC insurance expense. We areunable to predict the effect in future periods if the economic crisiscontinues.

 

**We areheavily regulated, and that regulation could limit or restrict our activitiesand adversely affect our earnings.**

 

We operate in a highly regulated industry and aresubject to examination, supervision, and comprehensive regulation by variousfederal and state agencies, including the OTS and the FDIC.  Our compliance with these regulations iscostly and may restrict some of our activities, including payment of dividends,mergers and acquisitions, investments, loans and interest rates and locationsof offices.

 

In light of current conditions in the global financialmarkets and the global economy, regulators have increased their focus on theregulation of the financial services industry. Over the past year and a half,the U.S. financial regulators responding to directives of the ObamaAdministration and Congress have intervened on an unprecedented scale. Newlegislative proposals continue to be introduced in the U.S. Congress that couldfurther substantially increase regulation of the financial services industryand impose restrictions on the operations and general ability of firms withinthe industry to conduct business consistent with historical practices,including with respect to compensation, interest rates and the effect ofbankruptcy proceedings on consumer real property mortgages. Further, federaland state regulatory agencies may adopt changes to their regulations and/orchange the manner in which existing regulations are applied. We cannot predictthe substance or effect of pending or future legislation or regulation or theapplication of laws and regulation to us. Compliance with current and potentialregulation and scrutiny may significantly increase our costs, impede theefficiency of our internal business processes, require us to increase ourregulatory capital and limit our ability to pursue business opportunities in anefficient manner by requiring us to expend significant time, effort andresources to ensure compliance. Additionally, evolving regulations concerningexecutive compensation may impose limitations on us that affect our ability tocompete successfully for executive and management talent.

 

In addition, given the current economic and financialenvironment, our regulators may elect to alter standards or the interpretationof the standards used to measure regulatory compliance or to determine the adequacyof liquidity, certain risk management or other operational practices forfinancial services companies in a manner that impacts our ability to implementour strategy and could affect us in substantial and unpredictable ways andcould have an adverse effect on our business, financial condition and resultsof operations. Furthermore, the regulatory agencies have extremely broaddiscretion in their interpretation of the regulations and laws and theirinterpretation of the quality of our loan portfolio, securities portfolio andother assets. If any regulatory agency’s assessment of the quality of ourassets differs from our assessment, we may be required to take additionalcharges that would have the effect of materially reducing our earnings, capitalratios and stock price.

 

Changes in regulatory requirements effective in thethird quarter of 2010 could impact the volume of fee revenue related to debitcard and automated teller machine transactions.  In November 2009, the Federal ReserveBoard issued a final rule that, effective July 1, 2010, prohibitsfinancial institutions from charging consumers fees for paying overdrafts onautomated teller machine and one-time debit card transactions on new accounts,unless a consumer consents, or opts in, to the overdraft service for thosetypes of transactions.  For accounts opened prior to July 1, 2010, the financial institutionmust not assess any fees or charges on a consumer’s account on or after August 15,2010 for paying an ATM or one-time debit card transaction pursuant to theoverdraft service, unless the institution has obtained the consumer’saffirmative consent.  Consumers must be provided a notice thatexplains the financial institution’s overdraft services, including the feesassociated with the service, and the consumer’s choices.  Because the Company’s customers must provideadvance consent to the overdraft service for automated teller machine andone-time debit card transactions, the Company cannot provide any assurance asto the ultimate impact of this rule on the amount ofoverdraft/insufficient funds charges reported in future periods.

 

The U.S. Congress recently passed the Dodd-Frank WallStreet Reform and Consumer Protection Act (the “Dodd-Frank Act”), whichincludes sweeping changes in the banking regulatory environment.  The Act will change our primary regulator andmay, among other things, restrict or increase the regulation of certain of ourbusiness activities and increase the cost of doing business. We cannotdetermine the ultimate effect that potential legislation, or subsequentimplementing regulations, if enacted, would have upon our earnings andfinancial position.  Key provisions ofthe legislation include (1) establishment of a Financial StabilityOversight Council to identify, monitor and address systemic risks posed bylarge, complex financial firms as well as products and activities that spreadrisk across firms; (2) a new orderly liquidation mechanism; (3) changesin bank regulatory structure, including merging our primary regulator, the OTS,with the Office of Comptroller of Currency within 12 months of enactment(subject to 

 

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a six month extension); (4) regulation ofinvestment advisers to private funds; (5) regulation of the insuranceindustry; (6) prohibitions on proprietary trading and certainrelationships with hedge funds and private equity funds; (7) regulation ofover-the-counter derivatives markets; (8) a possible new fiduciarystandard for investment advisers to retail customers; (9) regulation ofcredit rating agencies; (10) establishment of an independent ConsumerFinancial Protection Bureau; (11) changes to the Federal Reserve System; (12)mortgage reform; (13) creation of a Financial Crisis Assessment Fund; and (14)establishment of new rules regarding executive compensation.  The Dodd-Frank Act also amended theElectronic Funds Transfer Act to authorize the Federal Reserve Bank to issueregulations regarding any interchange transaction fee that an issuer mayreceive or charge for an electronic debit transaction (a transaction in which aperson uses a debit card). The amount of any interchange transaction fee thatan issuer may receive or charge with respect to an electronic debit transactionmust be reasonable and proportional to the cost incurred by the issuer withrespect to the transaction.

** **

**Changes in interest rates couldhave a material adverse effect on our operations.**

 

The operations of financial institutions such as theBank are dependent to a large extent on net interest income, which is thedifference between the interest income earned on interest earning assets suchas loans and investment securities and the interest expense paid on interestbearing liabilities such as deposits and borrowings.  Changes in the general level of interestrates can affect our net interest income by affecting the difference betweenthe weighted average yield earned on our interest earning assets and theweighted average rate paid on our interest bearing liabilities, or interestrate spread, and the average life of our interest earning assets and interestbearing liabilities.  Changes in interestrates also can affect our ability to originate loans; the value of our interestearning assets; our ability to obtain and retain deposits in competition withother available investment alternatives; and the ability of our borrowers torepay adjustable or variable rate loans. Interest rates are highly sensitive to many factors, includinggovernmental monetary policies, domestic and international economic andpolitical conditions and other factors beyond our control.  There can be no assurance that our results ofoperations would not be adversely affected during any period of changes ininterest rates due to a number of factors which can have a material impact onthe Bank’s interest rate risk position. Such factors include among other items, call features and interest ratecaps and floors on various assets and liabilities, prepayments, the currentinterest rates on assets and liabilities to be repriced in each period, and therelative changes in interest rates on different types of assets andliabilities.

 

**The Company is subject torestrictions on its ability to declare or pay dividends and repurchase itsshares as a result of its participation in the Treasury’s Troubled Asset ReliefProgram Capital Purchase Program.  TheCompany and the Bank are prohibited from paying dividends or repurchasingcommon stock.**

 

On March 6, 2009, the Company issued to theTreasury for aggregate consideration of $16.5 million (i) 16,500 shares ofSeries A Preferred Stock and (ii) a Warrant to purchase 321,847shares of the Company’s Common Stock pursuant to the terms of the Purchase Agreement.  Under the terms of the Purchase Agreement,the Company’s ability to declare or pay dividends on any of its shares isrestricted.  Specifically, the Companymay not declare dividend payments on common, junior preferred or *pari passu* preferred shares if it is in arrears on thedividends on the Series A Preferred Stock. In addition, the Company may not increase the dividends on its CommonStock above the amount of the last quarter cash dividend per share declaredprior to October 14, 2008, which was $0.16 per share, without the Treasury’sapproval until the third anniversary of the investment unless all of the Series APreferred Stock has been redeemed or transferred.  The Company is currently restricted frommaking or declaring any payments on its outstanding securities, including thedividends payable on the Series A Preferred Stock, without prior writtennon-objection from the OTS.  The Companydeferred payment of the dividend on the Series A Preferred Stock in thefirst and second quarters of 2010.

 

The Company’s ability to repurchase its shares is alsorestricted under the terms of the Purchase Agreement.  The Treasury’s consent generally is requiredfor the Company to make any stock repurchases until the third anniversary ofthe investment by the Treasury unless all of the Series A Preferred Stockhas been redeemed or transferred. Further, common, junior preferred or *pari passu*preferred shares may not be repurchased if the Company is in arrears on the Series APreferred Stock dividends.  Under theCompany Order, the Company may not repurchase shares of its common stockwithout the prior written non-objection of the OTS.

 

**We aresubject to restrictions on executive compensation as a result of ourparticipation in the CPP.**

 

Under the terms of the CPP, the U.S. Treasury hasimposed specified standards for executive compensation and corporate governancefor the period during which the U.S. Treasury holds any equity 

 

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or warrants issued pursuant to the CPP. These standardsgenerally apply to our chief executive officer, chief financial officer, chiefoperating officer, and the two next most highly compensated senior executiveofficers. The standards include:

 

·                  ensuringthat incentive compensation for senior executives does not encourageunnecessary and excessive risks that threaten our value;

·                  requiredclawback of any bonus or incentive compensation paid to a senior executivebased on statements of earnings, gains or other criteria that are later provento be materially inaccurate;

·                  prohibitionon making golden parachute payments to senior executives; and

·                  agreementnot to deduct for tax purposes executive compensation in excess of $500,000 foreach senior executive.

 

Under the American Recovery and Reinvestment Act of 2009(the “ARRA”), further compensation restrictions, including significantlimitations on incentive compensation, have been imposed on our seniorexecutive officers and most highly compensated employees. Those restrictions,and any future restrictions on executive compensation that may be adopted,could adversely affect our ability to hire and retain senior executiveofficers.

 

**We may incur increased employeebenefit costs.**

 

The Bank is a participant in a non-contributorymultiemployer defined benefit pension plan covering all qualifiedemployees.  On April 30, 2010, theBoard of Directors of the Bank elected to freeze the plan effective July 1,2010.  Freezing the plan eliminates allfuture benefit accruals for participants in the plan and closes the plan to newparticipants as of that date.  After July 1,2010, the Bank will continue to incur costs consisting of administration andPension Benefit Guaranty Corporation insurance expenses as well as amortizationcharges based on the funding level of the plan. The level of amortization charges is determined by the plan’s fundingshortfall, which is determined by comparing plan liabilities to planassets.  Based on current interest rates and plan assets, the Bankanticipates that the funding shortfall may increase, resulting in increasedamortization charges effective July 1, 2010.  Future pensionfunding requirements, and the timing of funding payments, may be subject tochanges in legislation.

 

**We face strong competition thatmay adversely affect our profitability.**

 

We are subject to vigorous competition in all aspectsand areas of our business from banks and other financial institutions,including savings and loan associations, savings banks, finance companies,credit unions and other providers of financial services, such as money marketmutual funds, brokerage firms, consumer finance companies and insurancecompanies.  We also compete withnon-financial institutions, including retail stores that maintain their owncredit programs and governmental agencies that make available low cost orguaranteed loans to certain borrowers. Certain of our competitors are larger financial institutions withsubstantially greater resources, lending limits, larger branch systems and awider array of banking services. Competition from both bank and non-bank organizations will continue.

 

**Our ability to successfullycompete may be reduced if we are unable to make technological advances.**

 

The banking industry is experiencing rapid changes intechnology.  In addition to improvingcustomer services, effective use of technology increases efficiency and enablesfinancial institutions to reduce costs. As a result, our future success will depend in part on our ability toaddress our customers’ needs by using technology.  We cannot assure that we will be able toeffectively develop new technology-driven products and services or besuccessful in marketing these products to our customers.  Many of our competitors have greater resourcesthan we have to invest in technology.

 

**Weare subject to security and operational risks relating to our use of technologythat could damage our reputation and our business.**

 

Security breaches in our internet banking activitiescould expose us to possible liability and damage our reputation. Any compromiseof our security also could deter customers from using our internet bankingservices that involve the transmission of confidential information. We rely onstandard internet security systems to provide the security and authenticationnecessary to effect secure transmission of data. These precautions may notprotect our systems from compromises or breaches of our security measures thatcould result in damage to our reputation and our business. Additionally, weoutsource our data processing to a third party. If our third party providerencounters difficulties or if we have 

 

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difficulty in communicating with such third party, itcould significantly affect our ability to adequately process and account forcustomer transactions, which could significantly affect our businessoperations.  The Bank has never incurreda material security breach nor encountered any significant down time with ouroutsourced partners.

 

Item 2.           Unregistered Sales of Equity Securities and Use of Proceeds

 

The Company did not repurchase any securitiesduring the second quarter of 2010.  TheCompany is in its 19th announced repurchase program, which was approved by theboard of directors on July 25, 2006, and publicly announced on November 8,2006.  Total shares approved to bepurchased in this program are 245,197 of which 214,587 have been purchased asof June 30, 2010.  All treasurystock purchases are made under publicly announced repurchase programs.  The repurchase program is currentlysuspended.  The Company Order prohibitsthe Company from repurchasing shares of its common stock without the priorwritten non-objection of the OTS.

 

Item 3.           Defaults Upon Senior Securities

 

Not applicable.

 

Item 4.           Removed and reserved.

 

Item 5.           Other Information

 

None.

 

Item 6.           Exhibits

Exhibit 31.1 — Certification of ChiefExecutive Officer,

Pursuant to Section 302 of theSarbanes-Oxley Act of 2002 (18 U.S.C. 1350)

Exhibit 31.2 — Certification of ChiefFinancial Officer,

Pursuant to Section 302 of theSarbanes-Oxley Act of 2002 (18 U.S.C. 1350)

Exhibit 32.1 — Certification of ChiefExecutive Officer,

Pursuant to Section 906 of theSarbanes-Oxley Act of 2002 (18 U.S.C. 1350)

Exhibit 32.2 — Certification of ChiefFinancial Officer,

Pursuant to Section 906 of theSarbanes-Oxley Act of 2002 (18 U.S.C. 1350)

 

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**SIGNATURES**

 

Pursuant to the requirements of the SecuritiesExchange Act of 1934, the Registrant has duly caused this report to be signedon its behalf by the undersigned thereunto duly authorized.

 

 
|   |   |                 | **FIRST FEDERAL BANCSHARES OF ARKANSAS, INC.** |
|--------|--------|----------------------|-----------------------------------------------------|
|   |   |                 |                                                |   |
|   |   |                 |                                                |   |
|   | Date:  | August 12, 2010 |                                                | By: | /s/ Larry J. Brandt |
|   |   |                 |                                                |   | Larry J. Brandt |
|   |   |                 |                                                |   | Chief Executive Officer |
|   |   |                 |                                                |   |   |
|   |   |                 |                                                |   |   |
|   | Date:  | August 12, 2010 |                                                | By: | /s/ Sherri R. Billings |
|   |   |                 |                                                | Sherri R. Billings |
|   |   |                 |                                                | Chief Financial Officer and Chief Accounting Officer |

 

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