**UNITEDSTATES**

**SECURITIES AND EXCHANGECOMMISSION**

**Washington, D.C. 20549**

 

**FORM 10-Q**

 

**ý****                                  ****QUARTERLY REPORT PURSUANT TOSECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934For the quarterly period ended September 30, 2005**

** **

**OR**

** **

**o****                                  ****TRANSITION REPORT PURSUANT TOSECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934For the transition period from                           to                         **

** **

**Commission File Number 0-28312**

** **

**FIRST FEDERAL BANCSHARES OFARKANSAS, INC.**

(Exact name of registrant as specified in its charter)

 
| **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 area code)

 

 

Indicate by check mark whether the registrant(1) has filed 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)has been subject to such filing requirements for the past 90 days.

Yes ý    No o

 

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

Yes ý    No o

 

Indicate by check mark whetherthe registrant is a shell company (as defined in Rule 12b-2 of the ExchangeAct).

Yes o    No ý

 

Indicate the number of shares outstanding ofeach of the issuer’s classes of common stock, as of the latest practicabledate:  As of October 24, 2005, there wereissued and outstanding 5,062,563 shares of the Registrant’s Common Stock, parvalue $.01 per share.

 

 

 

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

 

**TABLE OF CONTENTS**

 

| **Part I.**    | ** **                                                                                                                                                  | **Financial Information** | ** ** | ** ** |
|----------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------|---------------------------|------------|------------|
|           |                                                                                                                                                        |                      |
| Item 1.        | Consolidated  Financial Statements                                                                                                                          |                      |
|           |                                                                                                                                                        |                      |
|           | Consolidated Statements of Financial  Condition as of September 30, 2005 and December 31, 2004 (unaudited)                                                  |                      |
|           |                                                                                                                                                        |                      |
|           | Consolidated Statements of Income for the  three and nine months ended September 30, 2005 and 2004 (unaudited)                                              |                      |
|           |                                                                                                                                                        |                      |
|           | Consolidated Statement of Stockholders’  Equity for the nine months ended September 30, 2005 (unaudited)                                               |                      |
|           |                                                                                                                                                        |                      |
|           | Consolidated Statements of Cash Flows for  the nine months ended September 30, 2005 and 2004 (unaudited)                                                    |                      |
|           |                                                                                                                                                        |                      |
|           | Notes to Unaudited Consolidated Financial  Statements                                                                                                       |                      |
|           |                                                                                                                                                        |                      |
| Item 2.        | Management’s Discussion and Analysis of  Financial Condition and Results of Operations                                                                 |                      |
|           |                                                                                                                                                        |                      |
| Item 3.        | Quantitative and Qualitative Disclosures  About Market Risk                                                                                                 |                      |
|           |                                                                                                                                                        |                      |
| Item 4.        | Controls and Procedures                                                                                                                                     |                      |
|           |                                                                                                                                                        |                      |
| **Part II.**   | **Other  Information**                                                                                                                                      | ** **                |
|           |                                                                                                                                                        |                      |
| Item 1.        | Legal Proceedings                                                                                                                                           |                      |
| Item 2.        | Unregistered Sales of Equity Securities and  Use of Proceeds                                                                                                |                      |
| Item 3.        | Defaults Upon Senior Securities                                                                                                                             |                      |
| Item 4.        | Submission of Matters to a Vote of Security  Holders                                                                                                        |                      |
| Item 5.        | Other Information                                                                                                                                           |                      |
| Item 6.        | Exhibits                                                                                                                                                    |                      |
|           |                                                                                                                                                        |                      |
| **Signatures** | ** **                                                                                                                                                  | ** **                |
|           |                                                                                                                                                        |                      |
| **Exhibits**   | ** **                                                                                                                                                  | ** **                |
| 31.1           | Certification  of Chief Executive Officer pursuant to Rule 13a-14(a) of Exchange Act, as  adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 |                      |
| 31.2           | Certification  of Chief Financial Officer pursuant to Rule 13a-14(a) of Exchange Act, as  adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 |                      |
| 32.1           | Section 906  Certification of the CEO                                                                                                                       |                      |
| 32.2           | Section 906  Certification of the CFO                                                                                                                       |                      |
|           |                                                                                                                                                        |                      |

 

 

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

**CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION**

(In thousands, except share data)

(Unaudited)

 
| ** **                                                                                                                                                                                   | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------|------------|------------------|------------|
| ** **                                                                                                                                                                                   | ** ** | **2005**          | ** ** | **2004**         | ** ** |
| ASSETS:                                                                                                                                                                                      |       |              |       |             |       |
|                                                                                                                                                                                         |       |              |       |             |       |
| Cash and cash equivalents                                                                                                                                                                    |       | $                 | 18,376     |             | $          | 16,003 |   |
| Investment securities held to maturity                                                                                                                                                       |       | 56,184            |       | 56,660           |       |
| Federal Home Loan Bank stock                                                                                                                                                                 |       | 8,329             |       | 4,876            |       |
| Loans receivable, net                                                                                                                                                                        |       | 713,576           |       | 634,217          |       |
| Accrued interest receivable                                                                                                                                                                  |       | 6,469             |       | 4,427            |       |
| Real estate acquired in settlement of  loans, net                                                                                                                                            |       | 348               |       | 563              |       |
| Office properties and equipment, net                                                                                                                                                         |       | 17,742            |       | 15,295           |       |
| Cash surrender value of life insurance                                                                                                                                                       |       | 18,476            |       | 17,897           |       |
| Prepaid expenses and other assets                                                                                                                                                            |       | 1,404             |       | 1,727            |       |
|                                                                                                                                                                                         |       |              |       |             |       |
| TOTAL ASSETS                                                                                                                                                                                 |       | $                 | 840,904    |             | $          | 751,665 |   |
|                                                                                                                                                                                         |       |              |       |             |       |
| LIABILITIES AND STOCKHOLDERS’ EQUITY                                                                                                                                                    |       |              |       |             |       |
|                                                                                                                                                                                         |       |              |       |             |       |
| LIABILITIES:                                                                                                                                                                                 |       |              |       |             |       |
| Deposits                                                                                                                                                                                     |       | $                 | 589,298    |             | $          | 582,424 |   |
| Federal Home Loan Bank advances                                                                                                                                                              |       | 169,491           |       | 89,756           |       |
| Advance payments by borrowers for taxes and  insurance                                                                                                                                       |       | 595               |       | 757              |       |
| Other liabilities                                                                                                                                                                            |       | 3,911             |       | 3,427            |       |
| Total liabilities                                                                                                                                                                            |       | 763,295           |       | 676,364          |       |
|                                                                                                                                                                                         |       |              |       |             |       |
| STOCKHOLDERS’ EQUITY:                                                                                                                                                                   |       |              |       |             |       |
| Preferred stock, no par value, 5,000,000  shares authorized, none issued                                                                                                                     |       |              |       |             |       |
| Common stock, $.01 par value, 20,000,000  shares authorized, 10,307,502 shares issued, 5,062,563 and 5,094,020 shares  outstanding at September 30, 2005 and December 31, 2004, respectively |       | 103               |       | 103              |       |
| Additional paid-in capital                                                                                                                                                                   |       | 55,791            |       | 54,427           |       |
| Employee stock benefit plans                                                                                                                                                                 |       | (250              | )          | (582             | )          |
| Retained earnings-substantially restricted                                                                                                                                                   |       | 82,339            |       | 78,261           |       |
|                                                                                                                                                                                         |       | 137,983           |       | 132,209          |       |
| Treasury stock, at cost, 5,244,939 and  5,213,482 shares at September 30, 2005 and December 31, 2004, respectively                                                                           |       | (60,374           | )          | (56,908          | )          |
| Total stockholders’ equity                                                                                                                                                              |       | 77,609            |       | 75,301           |       |
|                                                                                                                                                                                         |       |              |       |             |       |
| TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY                                                                                                                                              |       | $                 | 840,904    |             | $          | 751,665 |   |

 

See notes to unauditedconsolidated financial statements.

 

1

----

 

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

**CONSOLIDATED STATEMENTS OF INCOME**

(In thousands, except share data)

(Unaudited)

 
| ** **                                           | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|------------------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                                           | ** ** | **September 30,**      | ** ** | **September 30,**     | ** ** | **September 30,** | ** ** | **September 30,** | ** ** |
| ** **                                           | ** ** | **2005**               | ** ** | **2004**              | ** ** | **2005** | ** ** | **2004** | ** ** |
| INTEREST INCOME:                                     |       |                   |       |                  |       |   |   |   |   |
| Loans receivable                                     |       | $                      | 11,150     |                  | $          | 9,160 |   | $ | 31,300 |   | $ | 26,234 |   |
| Investment securities:                               |       |                   |       |                  |       |   |   |   |   |
| Taxable                                              |       | 561                    |       | 727                   |       | 1,610 |   | 2,299 |   |
| Nontaxable                                           |       | 180                    |       | 178                   |       | 538 |   | 515 |   |
| Other                                                |       | 25                     |       | 18                    |       | 64 |   | 128 |   |
| Total interest income                                |       | 11,916                 |       | 10,083                |       | 33,512 |   | 29,176 |   |
|                                                 |       |                   |       |                  |       |   |   |   |   |
| INTEREST EXPENSE:                                    |       |                   |       |                  |       |   |   |   |   |
| Deposits                                             |       | 3,742                  |       | 3,178                 |       | 10,505 |   | 9,472 |   |
| Other borrowings                                     |       | 1,393                  |       | 442                   |       | 3,345 |   | 1,087 |   |
| Total interest expense                               |       | 5,135                  |       | 3,620                 |       | 13,850 |   | 10,559 |   |
|                                                 |       |                   |       |                  |       |   |   |   |   |
| NET INTEREST INCOME                                  |       | 6,781                  |       | 6,463                 |       | 19,662 |   | 18,617 |   |
|                                                 |       |                   |       |                  |       |   |   |   |   |
| PROVISION FOR LOAN LOSSES                            |       | 285                    |       | 202                   |       | 820 |   | 663 |   |
|                                                 |       |                   |       |                  |       |   |   |   |   |
| NET INTEREST INCOME AFTER PROVISION FOR  LOAN LOSSES |       | 6,496                  |       | 6,261                 |       | 18,842 |   | 17,954 |   |
|                                                 |       |                   |       |                  |       |   |   |   |   |
| NONINTEREST INCOME:                                  |       |                   |       |                  |       |   |   |   |   |
| Deposit fee income                                   |       | 1,193                  |       | 994                   |       | 3,307 |   | 2,661 |   |
| Earnings on life insurance policies                  |       | 191                    |       | 190                   |       | 579 |   | 597 |   |
| Gain on sale of loans                                |       | 195                    |       | 141                   |       | 511 |   | 463 |   |
| Other                                                |       | 239                    |       | 248                   |       | 714 |   | 867 |   |
| Total noninterest income                             |       | 1,818                  |       | 1,573                 |       | 5,111 |   | 4,588 |   |
|                                                 |       |                   |       |                  |       |   |   |   |   |
| NONINTEREST EXPENSES:                                |       |                   |       |                  |       |   |   |   |   |
| Salaries and employee benefits                       |       | 3,256                  |       | 2,830                 |       | 9,272 |   | 8,266 |   |
| Net occupancy expense                                |       | 532                    |       | 493                   |       | 1,537 |   | 1,494 |   |
| Data processing                                      |       | 392                    |       | 399                   |       | 1,145 |   | 1,194 |   |
| Professional fees                                    |       | 101                    |       | 117                   |       | 321 |   | 346 |   |
| Advertising and public relations                     |       | 318                    |       | 294                   |       | 801 |   | 726 |   |
| Postage and supplies                                 |       | 186                    |       | 151                   |       | 566 |   | 503 |   |
| Other                                                |       | 528                    |       | 450                   |       | 1,546 |   | 1,502 |   |
| Total noninterest expenses                           |       | 5,313                  |       | 4,734                 |       | 15,188 |   | 14,031 |   |
|                                                 |       |                   |       |                  |       |   |   |   |   |
| INCOME BEFORE INCOME TAXES                           |       | 3,001                  |       | 3,100                 |       | 8,765 |   | 8,511 |   |
| INCOME TAX PROVISION                                 |       | 965                    |       | 1,002                 |       | 2,815 |   | 2,723 |   |
| NET INCOME                                           |       | $                      | 2,036      |                  | $          | 2,098 |   | $ | 5,950 |   | $ | 5,788 |   |
|                                                 |       |                   |       |                  |       |   |   |   |   |
| EARNINGS PER SHARE:                                  |       |                   |       |                  |       |   |   |   |   |
| Basic                                                |       | $                      | 0.41       |                  | $          | 0.42 |   | $ | 1.19 |   | $ | 1.14 |   |
|                                                 |       |                   |       |                  |       |   |   |   |   |
| Diluted                                              |       | $                      | 0.39       |                  | $          | 0.39 |   | $ | 1.14 |   | $ | 1.07 |   |
|                                                 |       |                   |       |                  |       |   |   |   |   |
| Cash Dividends Declared                              |       | $                      | 0.13       |                  | $          | 0.11 |   | $ | 0.37 |   | $ | 0.31 |   |

 

See notes to unauditedconsolidated financial statements.

 

2

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

**CONSOLIDATED STATEMENT OF STOCKHOLDERS’EQUITY**

**FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2005**

(In thousands, except share data)

(Unaudited)

 
| ** **                                                 | ** ** | **Issued Common Stock** | ** ** | **Additional Paid-In**        | ** ** | **Employee Stock** | ** ** | **Retained**      | ** ** |
|------------------------------------------------------------|------------|-------------------------|------------|-------------------------------|------------|--------------------|------------|-------------------|------------|
| ** **                                                 | ** ** | **Shares**              | ** ** | **Amount**                    | ** ** | **Capital**        | ** ** | **Benefit Plans** | ** ** | **Earnings** | ** ** |
| Balance, January 1, 2005                                   |       | 10,307,502              |       | $                             | 103        |               | $          | 54,427            |       | $ | (582 | ) | $ | 78,261 |   |
| Net income                                                 |       |                    |       |                          |       |               |       |              |       | 5,950 |   |
| Release of ESOP shares                                     |       |                    |       |                          |       | 1,191              |       | 312               |       |   |   |
| Tax effect of stock compensation plan                      |       |                    |       |                          |       | 477                |       |              |       |   |   |
| Treasury shares reissued due to exercise of  stock options |       |                    |       |                          |       | (304               | )          |              |       |   |   |
| Purchase of treasury stock, at cost                        |       |                    |       |                          |       |               |       |              |       |   |   |
| Vesting of MRP shares                                      |       |                    |       |                          |       |               |       | 20                |       |   |   |
| Dividends paid                                             |       |                    |       |                          |       |               |       |              |       | (1,872 | ) |
|                                                       |       |                    |       |                          |       |               |       |              |       |   |   |
| Balance, September 30, 2005                                |       | 10,307,502              |       | $                             | 103        |               | $          | 55,791            |       | $ | (250 | ) | $ | 82,339 |   |
|                                                       |       |                    |       |                          |       |               |       |              |       |   |   |
| ** **                                                 | ** ** | **Treasury  Stock**     | ** ** | **Total  Stockholders’** | ** ** | ** **         | ** ** | ** **        | ** ** |
| ** **                                                 | ** ** | **Shares**              | ** ** | **Amount**                    | ** ** | **Equity**         | ** ** | ** **        | ** ** | ** ** | ** ** |
|                                                       |       |                    |       |                          |       |               |       |              |       |   |   |
| Balance, January 1, 2005                                   |       | 5,213,482               |       | $                             | (56,908    | )                  | $          | 75,301            |       |   |   |   |   |
| Net income                                                 |       |                    |       |                          |       | 5,950              |       |              |       |   |   |
| Release of ESOP shares                                     |       |                    |       |                          |       | 1,503              |       |              |       |   |   |
| Tax effect of stock compensation plan                      |       |                    |       |                          |       | 477                |       |              |       |   |   |
| Treasury shares reissued due to exercise of  stock options |       | (201,543                | )          | 2,256                         |       | 1,952              |       |              |       |   |   |
| Purchase of treasury stock, at cost                        |       | 233,000                 |       | (5,722                        | )          | (5,722             | )          |              |       |   |   |
| Vesting of MRP shares                                      |       |                    |       |                          |       | 20                 |       |              |       |   |   |
| Dividends paid                                             |       |                    |       |                          |       | (1,872             | )          |              |       |   |   |
|                                                       |       |                    |       |                          |       |               |       |              |       |   |   |
| Balance, September 30, 2005                                |       | 5,244,939               |       | $                             | (60,374    | )                  | $          | 77,609            |       |   |   |   |   |

 

 

See notes to unauditedconsolidated financial statements.

 

3

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

**CONSOLIDATED STATEMENTS OF CASH FLOWS**

(In Thousands)

(Unaudited)

 
| ** **                                                                         | ** ** | **Nine Months Ended September 30,** | ** ** |
|------------------------------------------------------------------------------------|------------|-------------------------------------|------------|
| ** **                                                                         | ** ** | **2005**                            | ** ** | **2004** | ** ** |
| OPERATING ACTIVITIES:                                                              |       |                                |       |   |   |
| Net income                                                                         |       | $                                   | 5,950      |   | $ | 5,788 |   |
| Adjustments to reconcile net income to net  cash provided by operating activities: |       |                                |       |   |   |
| Provision for loan losses                                                          |       | 820                                 |       | 663 |   |
| Provision for real estate losses                                                   |       | 30                                  |       | 32 |   |
| Deferred tax benefit                                                               |       | (95                                 | )          | (140 | ) |
| Accretion of discounts on investment  securities, net                              |       | (1                                  | )          | (34 | ) |
| Federal Home Loan Bank stock dividends                                             |       | (168                                | )          | (44 | ) |
| Gain (loss) on disposition of office  properties and equipment                     |       | 4                                   |       | (38 | ) |
| Loss on sale of repossessed assets, net                                            |       | (14                                 | )          | (1 | ) |
| Originations of loans held for sale                                                |       | (37,565                             | )          | (35,354 | ) |
| Proceeds from sales of loans held for sale                                         |       | 36,901                              |       | 36,213 |   |
| Gain on sale of loans originated to sell                                           |       | (511                                | )          | (463 | ) |
| Depreciation                                                                       |       | 885                                 |       | 887 |   |
| Amortization of deferred loan fees, net                                            |       | 115                                 |       | 49 |   |
| Release of ESOP shares                                                             |       | 1,503                               |       | 1,261 |   |
| MRP compensation expense                                                           |       | 20                                  |       | 20 |   |
| Earnings on life insurance policies                                                |       | (579                                | )          | (597 | ) |
| Changes in operating assets and  liabilities:                                      |       |                                |       |   |   |
| Accrued interest receivable                                                        |       | (2,042                              | )          | (287 | ) |
| Prepaid expenses and other assets                                                  |       | 323                                 |       | 700 |   |
| Other liabilities                                                                  |       | 1,056                               |       | 541 |   |
| Net cash provided by operating activities                                          |       | 6,632                               |       | 9,196 |   |
|                                                                               |       |                                |       |   |   |
| INVESTING ACTIVITIES:                                                              |       |                                |       |   |   |
| Purchases of investment securities held to  maturity                               |       | (3,939                              | )          | (84,744 | ) |
| Proceeds from maturities/calls of investment  securities held to maturity          |       | 4,416                               |       | 97,810 |   |
| Purchases of FHLB stock                                                            |       | (3,285                              | )          | (711 | ) |
| Redemptions of FHLB stock                                                          |       | —                              |       | 679 |   |
| Loan participations sold                                                           |       | 1,787                               |       | 3,970 |   |
| Loan originations, net of repayments                                               |       | (81,199                             | )          | (96,045 | ) |
| Proceeds from sales of repossessed assets                                          |       | 492                                 |       | 582 |   |
| Proceeds from sales of office properties  and equipment                            |       | 4                                   |       | 581 |   |
| Purchases of office properties and  equipment                                      |       | (3,340                              | )          | (1,369 | ) |
| Net cash used in investing activities                                              |       | (85,064                             | )          | (79,247 | ) |
|                                                                               |       |                                |       |   |   |
| FINANCING ACTIVITIES:                                                              |       |                                |       |   |   |
| Net increase in deposits                                                           |       | 6,874                               |       | 8,814 |   |
| Advances from FHLB                                                                 |       | 131,243                             |       | 41,733 |   |
| Repayment of advances from FHLB                                                    |       | (51,508                             | )          | (16,076 | ) |
| Net decrease in advance payments by  borrowers for taxes and insurance             |       | (162                                | )          | (91 | ) |
| Purchase of treasury stock                                                         |       | (5,722                              | )          | (7,373 | ) |
| Reissued treasury stock                                                            |       | 1,952                               |       | 1,476 |   |
| Dividends paid                                                                     |       | (1,872                              | )          | (1,618 | ) |
| Net cash provided by financing activities                                          |       | 80,805                              |       | 26,865 |   |
|                                                                               |       |                                |       |   |   |
| Net increase (decrease) in cash and cash  equivalents                              |       | 2,373                               |       | (43,186 | ) |
|                                                                               |       |                                |       |   |   |
| CASH AND CASH EQUIVALENTS:                                                         |       |                                |       |   |   |
| Beginning of period                                                                |       | $                                   | 16,003     |   | $ | 56,201 |   |
| End of period                                                                      |       | $                                   | 18,376     |   | $ | 13,015 |   |
|                                                                               |       |                                |       |   |   |
| SUPPLEMENTAL DISCLOSURES OF CASH FLOW  INFORMATION:                                |       |                                |       |   |   |
| Cash paid for:                                                                     |       |                                |       |   |   |
| Interest                                                                           |       | $                                   | 13,443     |   | $ | 10,517 |   |
| Income taxes                                                                       |       | $                                   | 2,053      |   | $ | 2,294 |   |
|                                                                               |       |                                |       |   |   |
| SUPPLEMENTAL SCHEDULE OF NONCASH INVESTING  ACTIVITIES:                            |       |                                |       |   |   |
| Real estate and other assets acquired in  settlement of loans                      |       | $                                   | 293        |   | $ | 307 |   |
| Loans to facilitate sales of real estate  owned                                    |       | $                                   | —     |   | $ | 197 |   |
| Investment securities traded, recorded in  investments not yet settled in cash     |       | $                                   | —     |   | $ | 1,000 |   |

 

See notes to unauditedconsolidated financial statements.

 

4

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

 

**NOTES TO UNAUDITED CONSOLIDATED FINANCIALSTATEMENTS**

 

 

# **Note 1 - Basis of Presentation and Principlesof Consolidation**

 

First Federal Bancshares ofArkansas, Inc. (the “Company”) is a unitary holding company which owns all ofthe stock of First Federal Bank of Arkansas, FA (the “Bank”).  The Bank provides a broad line of financialproducts to individuals and small- to medium-sized businesses in Northwest andNorthcentral Arkansas.  The unauditedconsolidated financial statements also include the accounts of the Bank’swholly-owned subsidiary, First Harrison Service Corporation (“FHSC”), which isinactive.

 

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

 

The accompanying unauditedconsolidated financial statements include the accounts of the Company and theBank.  All material intercompanytransactions have been eliminated in consolidation.

 

The results of operations for the nine monthsended September 30, 2005, are not necessarily indicative of the results to beexpected for the year ending December 31, 2005. The unaudited consolidated financial statements and notes thereto shouldbe read in conjunction with the audited financial statements and notes theretofor the year ended December 31, 2004, contained in the Company’s 2004Annual Report to Stockholders.

 

Certain amounts in theSeptember 30, 2004, unaudited consolidated financial statements have beenreclassified to conform to the classifications adopted for reporting in 2005.

 

**Note 2 - Earnings per Share**

 

The weighted average number ofcommon shares used to calculate earnings per share for the periods endedSeptember 30, 2005 and 2004 were as follows:

 
| ** **                         | ** ** | **Three months ended September 30,** | ** ** | **Nine months ended September 30,** | ** ** |
|------------------------------------|------------|--------------------------------------|------------|-------------------------------------|------------|
| ** **                         | ** ** | **2005**                             | ** ** | **2004**                            | ** ** | **2005** | ** ** | **2004** | ** ** |
| Basic  weighted - average shares   |       | 4,990,081                            |       | 5,022,009                           |       | 4,984,411 |   | 5,093,719 |   |
| Effect of  dilutive securities     |       | 222,985                              |       | 299,808                             |       | 251,165 |   | 319,389 |   |
| Diluted  weighted - average shares |       | 5,213,066                            |       | 5,321,817                           |       | 5,235,576 |   | 5,413,108 |   |

 

5

----

 

### **MANAGEMENT’S DISCUSSION AND ANALYSIS**

### **OF FINANCIAL CONDITION AND RESULTS OFOPERATIONS**

 

### **CRITICAL ACCOUNTING POLICIES**

 

Various elements of ouraccounting policies, by their nature, are inherently subject to estimationtechniques, valuation assumptions and other subjective assessments.  In particular, the methodology for thedetermination of our allowance for loan losses, due to the judgments, estimatesand assumptions inherent in that policy, is critical to preparation of ourfinancial statements.  This policy andthe judgments, estimates and assumptions are described in greater detail insubsequent sections of Management’s Discussion and Analysis and in the notes tothe unaudited financial statements included herein.  We believe that the judgments, estimates andassumptions used in the preparation of our financial statements are appropriategiven the factual circumstances at the time. However, given the sensitivity of our financial statements to thiscritical accounting policy, the use of other judgments, estimates andassumptions could result in material differences in our financial condition orresults of operations.

 

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

##  

## **CHANGES IN FINANCIAL CONDITION**

 

Changes in financialcondition between September 30, 2005 and December 31, 2004 are presented in thefollowing table (dollars in thousands). Material changes between the periods are discussed in the sections whichfollow the table.

 
| ** **                                    | ** ** | **September  30,** | ** ** | **December 31,** | ** ** | **Increase**   | ** ** | **Percentage** | ** ** |
|-----------------------------------------------|------------|--------------------|------------|------------------|------------|----------------|------------|----------------|------------|
| ** **                                    | ** ** | **2005**           | ** ** | **2004**         | ** ** | **(Decrease)** | ** ** | **Change**     | ** ** |
| **ASSETS**                                    |       |               |       |             |       |           |       |           |       |
| Cash and cash equivalents                     |       | $                  | 18,376     |             | $          | 16,003         |       | $              | 2,373      |   | 14.8 | % |
| Investment securities held to maturity        |       | 56,184             |       | 56,660           |       | (476           | )          | (0.8           | )%         |
| Loans receivable, net                         |       | 713,576            |       | 634,217          |       | 79,359         |       | 12.5           | %          |
| Federal Home Loan Bank stock                  |       | 8,329              |       | 4,876            |       | 3,453          |       | 70.8           | %          |
| Office properties and equipment, net          |       | 17,742             |       | 15,295           |       | 2,447          |       | 16.0           | %          |
| Prepaid expenses and other assets             |       | 26,697             |       | 24,614           |       | 2,083          |       | 8.5            | %          |
|                                          |       |               |       |             |       |           |       |           |       |
| TOTAL                                         |       | $                  | 840,904    |             | $          | 751,665        |       | $              | 89,239     |   | 11.9 | % |
|                                          |       |               |       |             |       |           |       |           |       |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY** |       |               |       |             |       |           |       |           |       |
| LIABILITIES:                                  |       |               |       |             |       |           |       |           |       |
| Deposits                                      |       | $                  | 589,298    |             | $          | 582,424        |       | $              | 6,874      |   | 1.2 | % |
| Federal Home Loan Bank advances               |       | 169,491            |       | 89,756           |       | 79,735         |       | 88.8           | %          |
| Other liabilities                             |       | 4,506              |       | 4,184            |       | 322            |       | 7.7            | %          |
|                                          |       |               |       |             |       |           |       |           |       |
| Total liabilities                             |       | 763,295            |       | 676,364          |       | 86,931         |       | 12.9           | %          |
|                                          |       |               |       |             |       |           |       |           |       |
| STOCKHOLDERS’ EQUITY                     |       | 77,609             |       | 75,301           |       | 2,308          |       | 3.1            | %          |
|                                          |       |               |       |             |       |           |       |           |       |
| TOTAL                                         |       | $                  | 840,904    |             | $          | 751,665        |       | $              | 89,239     |   | 11.9 | % |
|                                          |       |               |       |             |       |           |       |           |       |
| BOOK VALUE PER SHARE                          |       | $                  | 15.33      |             | $          | 14.78          |       |           |       |   |   |
|                                          |       |               |       |             |       |           |       |           |       |
| EQUITY TO ASSETS                              |       | 9.2                | %          | 10.0             | %          |           |       |           |       |

 

6

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**LoansReceivable. **Changes in loan composition between September 30,2005 and December 31, 2004 are presented in the following table (dollars inthousands).

 
| ** **                                     | ** ** | **September 30,** | ** ** | **December 31,** | ** ** | **Increase**   | ** ** | **Percentage** | ** ** |
|------------------------------------------------|------------|-------------------|------------|------------------|------------|----------------|------------|----------------|------------|
| ** **                                     | ** ** | **2005**          | ** ** | **2004**         | ** ** | **(Decrease)** | ** ** | **Change**     | ** ** |
| One- to  four- family residential              |       | $                 | 275,204    |             | $          | 282,144        |       | $              | (6,940     | ) |   |   |
| Multi-family  residential                      |       | 13,061            |       | 9,454            |       | 3,607          |       |           |       |
| Commercial  real estate(1)                     |       | 152,526           |       | 145,909          |       | 6,617          |       |           |       |
| Construction(2)                                |       | 248,065           |       | 159,111          |       | 88,954         |       |           |       |
| Total first mortgage loans                     |       | 688,856           |       | 596,618          |       | 92,238         |       | 15.5           | %          |
|                                           |       |              |       |             |       |           |       |           |       |
| Commercial                                     |       | 33,310            |       | 27,545           |       | 5,765          |       | 20.9           | %          |
|                                           |       |              |       |             |       |           |       |           |       |
| Home equity  and second mortgage               |       | 48,412            |       | 45,256           |       | 3,156          |       |           |       |
| Automobile                                     |       | 16,596            |       | 19,101           |       | (2,505         | )          |           |       |
| Other                                          |       | 12,390            |       | 10,685           |       | 1,705          |       |           |       |
| Total consumer                                 |       | 77,398            |       | 75,042           |       | 2,356          |       | 3.1            | %          |
|                                           |       |              |       |             |       |           |       |           |       |
| Total loans  receivable                        |       | 799,564           |       | 699,205          |       | 100,359        |       | 14.4           | %          |
| Less:                                          |       |              |       |             |       |           |       |           |       |
| Undisbursed  loan funds                        |       | (83,696           | )          | (62,661          | )          | (21,035        | )          |           |       |
| Unearned  discounts and net deferred loan fees |       | (216              | )          | (481             | )          | 265            |       |           |       |
| Allowance  for loan losses                     |       | (2,076            | )          | (1,846           | )          | (230           | )          |           |       |
|                                           |       |              |       |             |       |           |       |           |       |
| Total loans  receivable, net                   |       | $                 | 713,576    |             | $          | 634,217        |       | $              | 79,359     |   | 12.5 | % |

 

----

(1)          At September 30, 2005and December 31, 2004, commercial real estate loans included land loans of$35.2 million and $31.1 million, respectively.

(2)          At September 30, 2005,construction loans included loans to construct one- to four- family residentialproperties of $166.4 million, multi-family residential properties of $21.3million, commercial real estate properties of $20.6 million, and loans todevelop land of $39.8 million.  AtDecember 31, 2004, construction loans included loans to construct one- to four-family residential properties of $111.7 million, multi-family residentialproperties of $21.9 million, commercial real estate properties of $11.5million, and loans to develop land of $14.0 million.

 

The Bank continued to experience demand formulti-family loans, commercial real estate loans, construction loans,commercial loans, and consumer loans. The interest rate environment and robust economy of our market areaprovided continued demand and opportunity for our other loan products aswell.  In recent years, the Bank hasplaced an increased emphasis on commercial real estate lending, constructionlending, and commercial lending to diversify its loan portfolio, take advantageof market opportunities in these types of loans, and help the Bank transitionto a more full-service community bank, as well as to provide opportunities tocross-sell its other banking products. Construction lending has continued to increase, with $54.7 million ofthe increase due to one- to four- family residential construction, $9.2 milliondue to commercial real estate construction, and $25.8 million due to landdevelopment loans.  The increase in landdevelopment loans was primarily due to loans for development of residentialbuilding lots. The growth in the consumer loan category was primarily withinhome equity loans.

 

7

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** **

**Asset Quality. **The following table sets forth the amounts andcategories of the Bank’s nonperforming assets at the dates indicated.

 
| ** **                                                                         | ** ** | **September 30, 2005**     | ** ** | **December 31, 2004** | ** ** |
|------------------------------------------------------------------------------------|------------|----------------------------|------------|-----------------------|------------|
| ** **                                                                         | ** ** | **(Dollars in Thousands)** | ** ** |
| Nonaccrual loans:                                                                  |       |                       |       |                  |       |
| One- to four-family residential                                                    |       | $                          | 2,740      |                  | $          | 2,619 |   |
| Construction loans                                                                 |       | 945                        |       | 634                   |       |
| Commercial real estate                                                             |       | 963                        |       | —                |       |
| Commercial loans                                                                   |       | 323                        |       | 186                   |       |
| Consumer loans                                                                     |       | 561                        |       | 723                   |       |
| Total nonaccrual loans                                                             |       | 5,532                      |       | 4,162                 |       |
|                                                                               |       |                       |       |                  |       |
| Accruing loans 90 days or more past due                                            |       | 4,018                      |       | —                |       |
| Restructured loans                                                                 |       | 3,869                      |       | 3,790                 |       |
| Real estate owned                                                                  |       | 348                        |       | 563                   |       |
|                                                                               |       |                       |       |                  |       |
| Nonperforming assets                                                               |       | $                          | 13,767     |                  | $          | 8,515 |   |
|                                                                               |       |                       |       |                  |       |
| Total nonaccrual and restructured loans as  a percentage of total loans receivable |       | 1.68                       | %          | 1.14                  | %          |
|                                                                               |       |                       |       |                  |       |
| Total nonperforming assets as a percentage  of total assets                        |       | 1.64                       | %          | 1.13                  | %          |

 

The increase in nonaccrual commercialreal estate loans between December 31, 2004 and September 30, 2005 wasprimarily due to a single commercial real estate loan of approximately$700,000.  This loan is included in alending relationship offive loans totaling $1.54 million, consisting of $700,000 of one- to four-family residential first mortgage loans secured by two residential propertiesand $138,000 of commercial loans secured by junior liens on an office buildingand residential property.  The Bank hasinitiated foreclosure proceedings on all three properties as of September 30,2005.  At September 30, 2005, eachof the loans in this relationship was reviewed and the value of underlyingcollateral was estimated, primarily based on appraisals.  The Bank estimates, based on currentinformation, that it will incur no loss.

 

The increase in accruing loans 90 days or more past due was due toa relationship including 24 loans totaling $4.0 million, all classified assubstandard.  These loans consisted of$786,000 of one- to four-family residential loans, $890,000 of commercial realestate loans, $2.3 million of commercial loans, and $40,000 of consumerloans.  These loans include approximately$130,000 in unsecured loans and a collateral shortfall of approximately $45,000on one of the properties when loan balances were compared to appraised amounts. The Bank has received correspondencefrom the borrower’s attorney that the borrower intends to refinance $1.8million with other institutions and pay interest current for the remaining $2.2million held at the Bank.  The Bankreceived the interest payments on the $2.2 million as promised.  Based on the payment history of the borrower,the underlying value of the collateral, and correspondence with the borrower,the interest on $4.0 million of this borrower’s loans was returned to accrualstatus as of September 30, 2005.

 

At September 30, 2005 and December 31, 2004,restructured loans consisted of a group of commercial loans and commercial realestate loans to a single borrower. Although the loans were not past due more than 90 days at either date,the borrower has used overdraft privileges with the Bank to maintain paymentson the loans.  At December 31, 2004, theborrower was overdrawn $151,000.   Duringthe third quarter of 2005, the Bank suspended the borrower’s unsecuredoverdraft privileges and transferred the outstanding balance of the overdraftto a three-month line of credit secured by real estate.  The line of credit has a maximum amount of$250,000.  At September 30, 2005, theoutstanding balance of the line of credit was $215,000.  The Bank estimates that it will incur no losson this relationship based on the value of the underlying collateral.

 

 

8

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** **

**Allowancefor Loan Losses**.  A summary of theactivity in the allowance for loan losses is as follows (in thousands):

 
| ** **                      | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|---------------------------------|------------|---------------------------------------|------------|--------------------------------------|------------|
| ** **                      | ** ** | **2005**                              | ** ** | **2004**                             | ** ** | **2005** | ** ** | **2004** | ** ** |
| Balance at  beginning of period |       | $                                     | 2,022      |                                 | $          | 1,690 |   | $ | 1,846 |   | $ | 1,621 |   |
| Provisions for estimated losses |       | 285                                   |       | 202                                  |       | 820 |   | 663 |   |
| Recoveries                      |       | 31                                    |       | 30                                   |       | 82 |   | 79 |   |
| Losses charged off              |       | (262                                  | )          | (186                                 | )          | (672 | ) | (627 | ) |
| Balance at  end of period       |       | $                                     | 2,076      |                                 | $          | 1,736 |   | $ | 2,076 |   | $ | 1,736 |   |

 

Changes in the composition ofthe allowance for loan losses between September 30, 2005 and December 31, 2004are presented in the following table (in thousands):

 
| ** **  | ** ** | **September 30,** | ** ** | **December 31,** | ** ** | **Increase**   | ** ** | ** ** | ** ** |
|-------------|------------|-------------------|------------|------------------|------------|----------------|------------|------------|------------|
| ** **  | ** ** | **2005**          | ** ** | **2004**         | ** ** | **(Decrease)** | ** ** | ** ** | ** ** |
| General     |       | $                 | 1,826      |             | $          | 1,476          |       | $          | 350        |   |   |   |
| Specific    |       | 150               |       | 318              |       | (168           | )          |       |       |
| Unallocated |       | 100               |       | 52               |       | 48             |       |       |       |
|        |       | $                 | 2,076      |             | $          | 1,846          |       | $          | 230        |   |   |   |

 

The general component of the allowance forloan losses increased due to loan growth and due to an increase in theestimated loss rate applied to speculative one- to four- family residentialconstruction loans.  The loss rate wasincreased due to the increase in these loan balances and the inherently riskiernature of this category of loans.  Thespecific component of the allowance for loan losses decreased primarily as aresult of removing specific allowances on the loans of the second borrowerdiscussed in the Asset Quality section.

 

The allowance for loan losses isevaluated on a regular basis by management and is based upon management’s periodicreview of the collectibility of the loans in light of historical experience,the nature and volume of the loan portfolio, adverse situations that may affectthe borrower’s ability to repay, the estimated value of any underlyingcollateral and prevailing economic conditions. This evaluation is inherently subjective as it requires estimates thatare susceptible to significant revision as conditions change and moreinformation becomes available.

 

The allowance consists of specific, general and unallocated components.The specific component relates to loans that are classified as loss, doubtful,substandard or special mention. For such loans that are also classified asimpaired, an allowance is established when the discounted cash flows (orcollateral value or observable market price) of the impaired loan is lower thanthe carrying value of that loan. The general component covers non-classifiedloans and is based primarily on historical loss experience. An unallocatedcomponent is maintained to cover uncertainties that could affect management’sestimate of probable losses. The unallocated component of the allowance reflectsthe margin of imprecision inherent in the underlying assumptions used in themethodologies for estimating specific and general losses in the portfolio.

 

The Bank reviews its non-homogeneousloans for impairment on a quarterly basis. The Bank considers commercial real estate, construction, multi-family,and commercial loans to be non-homogeneous loans.  A loan is considered impaired when, based oncurrent information and events, it is probable that the Bank will be unable tocollect the scheduled payments of principal or interest when due according tothe contractual terms of the loan agreement. Factors considered by management in determining impairment includepayment status, collateral value, and the probability of collecting scheduledprincipal and interest payments when due. Loans that experience insignificant payment delays and paymentshortfalls generally are not classified as impaired.  Management determines the significance ofpayment delays and payment shortfalls on a case-by-case basis, taking intoconsideration all of the circumstances surrounding the loan and the borrower,including the length of the delay, the reasons for the delay, the borrower’sprior payment record, and the amount of the shortfall in relation to theprincipal and interest owed.  Impairmentis measured on a loanby loan basis by either the present value of expected future cash flowsdiscounted at the loan’s effective interest rate, the loan’s obtainable marketprice, or the fair value of the collateral if the loan is collateral dependent.

 

9

----

 

Large groupsof smaller balance homogeneous loans are collectively evaluated forimpairment.  Accordingly, the Bank doesnot separately identify individual consumer and residential loans forimpairment disclosures.  Homogeneousloans are those that are considered to have common characteristics that providefor evaluation on an aggregate or pool basis. The Bank considers the characteristics of (1) one- to- four familyresidential first mortgage loans; (2) unsecured consumer loans; and (3)collateralized consumer loans to permit consideration of the appropriateness ofthe allowance for losses of each group of loans on a pool basis.  The primary methodology used to determine theappropriateness of the allowance for losses includes segregating certainspecific, poorly performing loans based on their performance characteristicsfrom the pools of loans as to type, valuing these loans, and then applying aloss factor to the remaining pool balance based on several factors, includingpast loss experience, inherent risks, and economic conditions in the primarymarket areas.

 

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

 

Although we considerthe allowance for loan losses of approximately $2.1 million appropriate andadequate to cover losses inherent in our loan portfolio at September 30, 2005,no assurance can be given that we will not sustain loan losses that aresignificantly different from the amount provided, or that subsequentevaluations of the loan portfolio, in light of factors then prevailing, wouldnot result in a significant change in the allowance for loan losses.

 

**Investment Securities. **Changes in the composition ofinvestment securities held to maturity between September 30, 2005 andDecember 31, 2004 are presented in the following table (in thousands).

 
| ** **                              | ** ** | **September 30,** | ** ** | **December 31,** | ** ** | **Increase**   | ** ** | ** ** | ** ** |
|-----------------------------------------|------------|-------------------|------------|------------------|------------|----------------|------------|------------|------------|
| ** **                              | ** ** | **2005**          | ** ** | **2004**         | ** ** | **(Decrease)** | ** ** | ** ** | ** ** |
| Certificates  of deposit                |       | $                 | —-    |             | $          | 3,000          |       | $          | (3,000     | ) |   |   |
| U.S.  Government and agency obligations |       | 40,033            |       | 37,821           |       | 2,212          |       |       |       |
| Municipal  securities                   |       | 16,151            |       | 15,839           |       | 312            |       |       |       |
| Total                                   |       | $                 | 56,184     |             | $          | 56,660         |       | $          | (476       | ) |   |   |

 

During the first nine monthsof 2005, investment securities totaling $3.9 million were purchased and $4.4 millionmatured or were called.   The increase inU.S. Government and agency obligations was due to purchases in excess of callsand maturities.

 

At September 30, 2005, estimated fair valuesof investment securities held to maturity were as follows (in thousands):

 
| ** **                             | ** ** | **Amortized Cost** | ** ** | **Fair Value** | ** ** | ** ** | ** ** | ** ** | ** ** |
|----------------------------------------|------------|--------------------|------------|----------------|------------|------------|------------|------------|------------|
| U.S. Government and agency obligations |       | $                  | 40,033     |           | $          | 39,231     |       |       |       |   |   |
| Municipal securities                   |       | 16,151             |       | 16,281         |       |       |       |       |       |
| Total                                  |       | $                  | 56,184     |           | $          | 55,512     |       |       |       |   |   |

 

**Federal HomeLoan Bank Stock. ** Federal Home Loan Bank (“FHLB”) stockincreased by approximately $3.5 million due to required purchases related tothe increase in FHLB advances.

 

**OfficeProperties and Equipment. **The increase in office properties andequipment is due to land purchased for branch expansion, construction costs fornew branches in Mountain Home and Springdale, and remodeling of existing branchlocations.

 

10

----

 

**Deposits. **Changes in the composition of depositsbetween September 30, 2005 and December 31, 2004 are presented in the followingtable (dollars in thousands).

 
| ** **               | ** ** | **September 30,** | ** ** | **December 31,** | ** ** | **Increase**   | ** ** | **Percentage** | ** ** |
|--------------------------|------------|-------------------|------------|------------------|------------|----------------|------------|----------------|------------|
| ** **               | ** ** | **2005**          | ** ** | **2004**         | ** ** | **(Decrease)** | ** ** | **Change**     | ** ** |
| DDA and NOW  accounts    |       | $                 | 118,441    |             | $          | 109,772        |       | $              | 8,669      |   | 7.9 | % |
| Money Market  accounts   |       | 70,185            |       | 106,063          |       | (35,878        | )          | (33.8          | )%         |
| Savings  accounts        |       | 29,993            |       | 31,611           |       | (1,618         | )          | (5.1           | )%         |
| Certificates  of deposit |       | 370,679           |       | 334,978          |       | 35,701         |       | 10.7           | %          |
|                     |       |              |       |             |       |           |       |           |       |
| Total  deposits          |       | $                 | 589,298    |             | $          | 582,424        |       | $              | 6,874      |   | 1.2 | % |

 

Deposits increased in thecomparison period, primarily due to focused marketing efforts to increasechecking accounts.  During the period,DDA and NOW account balances increased by $8.7 million and the number of suchaccounts increased by 6.4%.  The Bank will continue to aggressivelypromote checking accounts and expand its promotion of checking accounts bytargeting small- and medium-sized business accounts with its direct mailcampaign and “thank you” gifts which began in the second quarter of 2005.   Checkingaccounts are an attractive source of funds for the Bank as they offerlow-interest deposits, fee income potential, and the opportunity to cross-sellother financial services.

 

The Bank also experienced ashift in the mix of deposits from money market and savings accounts tocertificates of deposit during the nine month period ended September 30,2005.  Certificates of deposit increasedas interest rates began to rise. Further, the Bank has advertised several CD products with special ratesand terms ranging from 7 to 40 months. The cost of deposit funds increased from 2.26% at December 31, 2004 to2.61% at September 30, 2005.

 

**Federal HomeLoan Bank Advances. ** The Bank experienced growth of $79.7million or 88.8% in FHLB of Dallas advances during the first nine months of2005.  The advances were used to fundloan growth during the year.  The balanceof advances at September 30, 2005 of $169.5 million consisted of $107.5 millionof fixed rate advances with an average cost of 3.87% and $62.0 million offloating rate advances with an average cost of 3.82%.

 

**Other Liabilities.**  Other liabilities increased primarily due toan increase in accrued interest payable on FHLB advances related to an increasein the balance of FHLB advances.

 

**Stockholders’Equity. **Stockholders’ equity increased $2.3million from December 31, 2004 to September 30, 2005.  The increase in stockholders’ equity wasprimarily due to net income of $6.0 million and the issuance of treasury stockdue to proceeds received from the exercise of stock options of $2.0 million offsetby the purchase of treasury stock totaling $5.7 million during the first ninemonths of 2005.  In addition, during the ninemonths ended September 30, 2005, cash dividends of $1.9 million were paid.  See the Unaudited Consolidated Statement ofStockholders’ Equity for the nine months ended September 30, 2005 for moredetail.

 

11

----

 

### **Average Balance Sheets**

 

The following table sets forth certaininformation relating to the Company’s average balance sheets and reflects theaverage yield on assets and average cost of liabilities for the periodsindicated and the yields earned and rates paid at September 30, 2005.  Such yields and costs are derived by dividingincome or expense by the average balance of assets or liabilities,respectively, for the periods presented and outstanding balances at September30, 2005.  Average balances are based ondaily balances during the period.

 
| ** **                                                        | ** ** | **September 30, 2005** | ** ** | **Three Months Ended September 30,** | ** ** |
|-------------------------------------------------------------------|------------|-----------------------------|------------|--------------------------------------|------------|
| ** **                                                        | ** ** | ** **                  | **2005**   | ** **                           | **2004**   | ** ** |
| ** **                                                        | ** ** | **Yield/Cost**              | ** ** | **Average  Balance**                 | ** ** | **Interest** | ** ** | **Average  Yield/Cost** | ** ** | **Average  Balance** | ** ** | **Interest** | ** ** | **Average  Yield/Cost** | ** ** |
| ** **                                                        | ** ** | **(Dollars in Thousands)**  | ** ** |
| Interest-earning assets:                                          |       |                        |       |                                 |       |   |   |   |   |   |   |   |   |   |   |
| Loans receivable(1)                                               |       | 6.43                        | %          | $                                    | 697,983    |   | $ | 11,150 |   | 6.39 | % | $ | 594,460 |   | $ | 9,160 |   | 6.16 | % |
| Investment securities(2)                                          |       | 4.66                        |       | 63,272                               |       | 741 |   | 4.68 |   | 75,072 |   | 905 |   | 4.82 |   |
| Other interest-earning  assets                                    |       | 3.76                        |       | 3,079                                |       | 25 |   | 3.29 |   | 5,483 |   | 18 |   | 1.31 |   |
| Total interest-earning  assets                                    |       | 6.28                        |       | 764,334                              |       | 11,916 |   | 6.24 |   | 675,015 |   | 10,083 |   | 5.98 |   |
| Noninterest-earning assets                                        |       |                        |       | 51,215                               |       |   |   |   |   | 48,247 |   |   |   |   |   |
| Total assets                                                      |       |                        |       | $                                    | 815,549    |   |   |   |   |   | $ | 723,262 |   |   |   |   |   |
| Interest-bearing  liabilities:                                    |       |                        |       |                                 |       |   |   |   |   |   |   |   |   |   |   |
| Deposits                                                          |       | 2.61                        |       | 588,858                              |       | 3,742 |   | 2.54 |   | 582,552 |   | 3,178 |   | 2.18 |   |
| FHLB advances                                                     |       | 3.85                        |       | 148,273                              |       | 1,393 |   | 3.76 |   | 61,195 |   | 442 |   | 2.89 |   |
| Total interest-bearing liabilities                                |       | 2.89                        |       | 737,131                              |       | 5,135 |   | 2.79 |   | 643,747 |   | 3,620 |   | 2.25 |   |
| Noninterest-bearing  liabilities                                  |       |                        |       | 5,354                                |       |   |   |   |   | 4,617 |   |   |   |   |   |
| Total liabilities                                                 |       |                        |       | 742,485                              |       |   |   |   |   | 648,364 |   |   |   |   |   |
| Stockholders’ equity                                         |       |                        |       | 73,064                               |       |   |   |   |   | 74,898 |   |   |   |   |   |
| Total liabilities and stockholders’  equity                  |       |                        |       | $                                    | 815,549    |   |   |   |   |   | $ | 723,262 |   |   |   |   |   |
|                                                              |       |                        |       |                                 |       |   |   |   |   |   |   |   |   |   |   |
| Net interest income                                               |       |                        |       |                                 |       | $ | 6,781 |   |   |   |   |   | $ | 6,463 |   |   |   |
| Net earning assets                                                |       |                        |       | $                                    | 27,203     |   |   |   |   |   | $ | 31,268 |   |   |   |   |   |
| Interest rate spread                                              |       | 3.39                        | %          |                                 |       |   |   | 3.45 | % |   |   |   |   | 3.73 | % |
| Net interest margin                                               |       |                        |       |                                 |       |   |   | 3.55 | % |   |   |   |   | 3.83 | % |
| Ratio of interest-earning  assets to interest-bearing liabilities |       |                        |       |                                 |       |   |   | 103.69 | % |   |   |   |   | 104.86 | % |
| ** **                                                        | ** ** | ** **                  | ** ** | ** **                           | ** ** |
| ** **                                                        | ** ** | ** **                  | ** ** | **Nine Months Ended September 30,**  | ** ** |
| ** **                                                        | ** ** | ** **                  | ** ** | **2005**                             | ** ** | **2004** | ** ** |
| ** **                                                        | ** ** | ** **                  | ** ** | **Average Balance**                  | ** ** | **Interest** | ** ** | **Average Yield/Cost** | ** ** | **Average Balance** | ** ** | **Interest** | ** ** | **Average Yield/Cost** | ** ** |
| ** **                                                        | ** ** | **(Dollars in Thousands)**  | ** ** |
| Interest-earning assets:                                          |       |                        |       |                                 |       |   |   |   |   |   |   |   |   |   |   |
| Loans receivable(1)                                               |       |                        |       | $                                    | 676,037    |   | $ | 31,300 |   | 6.17 | % | $ | 557,909 |   | $ | 26,234 |   | 6.27 | % |
| Investment securities(2)                                          |       |                        |       | 62,097                               |       | 2,148 |   | 4.61 |   | 83,700 |   | 2,814 |   | 4.48 |   |
| Other interest-earning  assets                                    |       |                        |       | 2,986                                |       | 64 |   | 2.86 |   | 18,278 |   | 128 |   | 0.93 |   |
| Total interest-earning  assets                                    |       |                        |       | 741,120                              |       | 33,512 |   | 6.03 |   | 659,887 |   | 29,176 |   | 5.89 |   |
| Noninterest-earning assets                                        |       |                        |       | 51,709                               |       |   |   |   |   | 47,772 |   |   |   |   |   |
| Total assets                                                      |       |                        |       | $                                    | 792,829    |   |   |   |   |   | $ | 707,659 |   |   |   |   |   |
| Interest-bearing  liabilities:                                    |       |                        |       |                                 |       |   |   |   |   |   |   |   |   |   |   |
| Deposits                                                          |       |                        |       | 586,762                              |       | 10,505 |   | 2.39 |   | 580,284 |   | 9,472 |   | 2.18 |   |
| FHLB advances                                                     |       |                        |       | 126,015                              |       | 3,345 |   | 3.54 |   | 47,138 |   | 1,087 |   | 3.07 |   |
| Total interest-bearing  liabilities                               |       |                        |       | 712,777                              |       | 13,850 |   | 2.59 |   | 627,422 |   | 10,559 |   | 2.24 |   |
| Noninterest-bearing liabilities                                   |       |                        |       | 5,227                                |       |   |   |   |   | 4,892 |   |   |   |   |   |
| Total liabilities                                                 |       |                        |       | 718,004                              |       |   |   |   |   | 632,314 |   |   |   |   |   |
| Stockholders’ equity                                         |       |                        |       | 74,825                               |       |   |   |   |   | 75,345 |   |   |   |   |   |
| Total liabilities and stockholders’  equity                  |       |                        |       | $                                    | 792,829    |   |   |   |   |   | $ | 707,659 |   |   |   |   |   |
|                                                              |       |                        |       |                                 |       |   |   |   |   |   |   |   |   |   |   |
| Net interest income                                               |       |                        |       |                                 |       | $ | 19,662 |   |   |   |   |   | $ | 18,617 |   |   |   |
| Net earning assets                                                |       |                        |       | $                                    | 28,343     |   |   |   |   |   | $ | 32,465 |   |   |   |   |   |
| Interest rate spread                                              |       |                        |       |                                 |       |   |   | 3.44 | % |   |   |   |   | 3.65 | % |
| Net interest margin                                               |       |                        |       |                                 |       |   |   | 3.54 | % |   |   |   |   | 3.76 | % |
| Ratio of interest-earning  assets to Interest-bearing liabilities |       |                        |       |                                 |       |   |   | 103.98 | % |   |   |   |   | 105.17 | % |
|                                                                   |            |                             |            |                                      |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

----

(1)  Includes nonaccrual loans.

(2)  Includes FHLB of Dallas stock.

 

12

----

 

## **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 in averagevolume multiplied by prior rate); (ii) changes in rate (change in ratemultiplied by prior average volume); (iii) changes in rate-volume (changes inrate multiplied by the change in average volume); and (iv) the net change.

 
| ** **                          | ** ** | **Three Months Ended September 30,** | ** ** |
|-------------------------------------|------------|--------------------------------------|------------|
| ** **                          | ** ** | **2005 vs. 2004**                    | ** ** |
| ** **                          | ** ** | **Increase (Decrease)  Due to**      | ** ** | **Total  Increase** | ** ** |
| ** **                          | ** ** | **Volume**                           | ** ** | **Rate** | ** ** | **Rate/Volume** | ** ** | **(Decrease)** | ** ** |
| ** **                          | ** ** | **(In Thousands)**                   | ** ** |
| Interest income:                    |       |                                 |       |   |   |   |   |   |   |
| Loans receivable                    |       | $                                    | 1,595      |   | $ | 336 |   | $ | 59 |   | $ | 1,990 |   |
| Investment securities               |       | (142                                 | )          | (26 | ) | 4 |   | (164 | ) |
| Other interest-earning  assets      |       | (8                                   | )          | 27 |   | (12 | ) | 7 |   |
| Total interest-earning  assets      |       | 1,445                                |       | 337 |   | 51 |   | 1,833 |   |
|                                |       |                                 |       |   |   |   |   |   |   |
| Interest expense:                   |       |                                 |       |   |   |   |   |   |   |
| Deposits                            |       | 34                                   |       | 524 |   | 6 |   | 564 |   |
| FHLB advances                       |       | 629                                  |       | 133 |   | 189 |   | 951 |   |
| Total interest-bearing  liabilities |       | 663                                  |       | 657 |   | 195 |   | 1,515 |   |
| Net change in net interest income   |       | $                                    | 782        |   | $ | (320 | ) | $ | (144 | ) | $ | 318 |   |
|                                |       |                                 |       |   |   |   |   |   |   |
|                                |       |                                 |       |   |   |   |   |   |   |
| ** **                          | ** ** | **Nine Months Ended September 30,**  | ** ** |
| ** **                          | ** ** | **2005 vs. 2004**                    | ** ** |
| ** **                          | ** ** | **Increase (Decrease)  Due to**      | ** ** | **Total  Increase** | ** ** |
| ** **                          | ** ** | **Volume**                           | ** ** | **Rate** | ** ** | **Rate/Volume** | ** ** | **(Decrease)** | ** ** |
| ** **                          | ** ** | **(In Thousands)**                   | ** ** |
| Interest income:                    |       |                                 |       |   |   |   |   |   |   |
| Loans receivable                    |       | $                                    | 5,555      |   | $ | (404 | ) | $ | (85 | ) | $ | 5,066 |   |
| Investment securities               |       | (727                                 | )          | 82 |   | (21 | ) | (666 | ) |
| Other interest-earning  assets      |       | (107                                 | )          | 264 |   | (221 | ) | (64 | ) |
| Total interest-earning  assets      |       | 4,721                                |       | (58 | ) | (327 | ) | 4,336 |   |
|                                |       |                                 |       |   |   |   |   |   |   |
| Interest expense:                   |       |                                 |       |   |   |   |   |   |   |
| Deposits                            |       | 106                                  |       | 917 |   | 10 |   | 1,033 |   |
| FHLB advances                       |       | 1,819                                |       | 164 |   | 275 |   | 2,258 |   |
| Total interest-bearing  liabilities |       | 1,925                                |       | 1,081 |   | 285 |   | 3,291 |   |
| Net change in net interest income   |       | $                                    | 2,796      |   | $ | (1,139 | ) | $ | (612 | ) | $ | 1,045 |   |

 

13

----

 

**CHANGES IN RESULTS OFOPERATIONS**

 

The table below presents acomparison of results of operations for the three months ended September30, 2005 and 2004 (dollars in thousands). Specific changes in captions are discussed in the sections which followthe table.

 
| ** **                                                 | ** ** | **Three Months Ended  September 30,** | ** ** | **Increase  (Decrease)** | ** ** | **Percentage  Change** | ** ** |
|------------------------------------------------------------|------------|---------------------------------------|------------|--------------------------|------------|------------------------|------------|
| ** **                                                 | ** ** | **2005**                              | ** ** | **2004**                 | ** ** | **2005 vs 2004**       | ** ** | **2005 vs 2004** | ** ** |
| Interest income:                                           |       |                                  |       |                     |       |                   |       |   |   |
| Loans receivable                                           |       | $                                     | 11,150     |                     | $          | 9,160                  |       | $ | 1,990 |   |   |   |
| Investment securities                                      |       | 741                                   |       | 905                      |       | (164                   | )          |   |   |
| Other                                                      |       | 25                                    |       | 18                       |       | 7                      |       |   |   |
| Total interest income                                      |       | 11,916                                |       | 10,083                   |       | 1,833                  |       | 18.2 | % |
| Interest expense:                                          |       |                                  |       |                     |       |                   |       |   |   |
| Deposits                                                   |       | 3,742                                 |       | 3,178                    |       | 564                    |       |   |   |
| Other borrowings                                           |       | 1,393                                 |       | 442                      |       | 951                    |       |   |   |
| Total interest expense                                     |       | 5,135                                 |       | 3,620                    |       | 1,515                  |       | 41.9 | % |
| Net interest income before provision for loan  losses |       | 6,781                                 |       | 6,463                    |       | 318                    |       |   |   |
| Provision for loan losses                                  |       | 285                                   |       | 202                      |       | 83                     |       | 41.1 | % |
| Net interest income after provision for loan  losses  |       | 6,496                                 |       | 6,261                    |       | 235                    |       | 3.8 | % |
| Noninterest income:                                        |       |                                  |       |                     |       |                   |       |   |   |
| Deposit fee income                                         |       | 1,193                                 |       | 994                      |       | 199                    |       |   |   |
| Gain on sale of loans                                      |       | 195                                   |       | 141                      |       | 54                     |       |   |   |
| Other                                                      |       | 430                                   |       | 438                      |       | (8                     | )          |   |   |
| Total noninterest income                                   |       | 1,818                                 |       | 1,573                    |       | 245                    |       | 15.6 | % |
| Noninterest expenses:                                      |       |                                  |       |                     |       |                   |       |   |   |
| Salaries and employee benefits                             |       | 3,256                                 |       | 2,830                    |       | 426                    |       |   |   |
| Net occupancy expense                                      |       | 532                                   |       | 493                      |       | 39                     |       |   |   |
| Advertising and public relations                           |       | 318                                   |       | 294                      |       | 24                     |       |   |   |
| Other                                                      |       | 1,207                                 |       | 1,117                    |       | 90                     |       |   |   |
| Total noninterest expenses                                 |       | 5,313                                 |       | 4,734                    |       | 579                    |       | 12.2 | % |
| Income before income taxes                                 |       | 3,001                                 |       | 3,100                    |       | (99                    | )          |   |   |
| Provision for income taxes                                 |       | 965                                   |       | 1,002                    |       | (37                    | )          |   |   |
| Net income                                                 |       | $                                     | 2,036      |                     | $          | 2,098                  |       | $ | (62 | ) | (3.0) | % |
|                                                       |       |                                  |       |                     |       |                   |       |   |   |
| Basic earnings per share                                   |       | $                                     | 0.41       |                     | $          | 0.42                   |       | $ | (0.01 | ) | (2.8) | % |
| Diluted earnings per share                                 |       | $                                     | 0.39       |                     | $          | 0.39                   |       | $ | 0.00 |   |   |   |
|                                                       |       |                                  |       |                     |       |                   |       |   |   |
| Interest rate spread                                       |       | 3.45                                  | %          | 3.73                     | %          |                   |       |   |   |
| Net interest margin                                        |       | 3.55                                  | %          | 3.83                     | %          |                   |       |   |   |
|                                                       |       |                                  |       |                     |       |                   |       |   |   |
| Average full-time equivalents                              |       | 276                                   |       | 244                      |       |                   |       |   |   |
|                                                       |       |                                  |       |                     |       |                   |       |   |   |
| Full-service offices                                       |       | 16                                    |       | 15                       |       |                   |       |   |   |

 

 

14

----

 

The table below presents acomparison of results of operations for the nine months ended September30, 2005 and 2004 (dollars in thousands). Specific changes in captions are discussed in the sections which followthe table.

 
| ** **                                                  | ** ** | **Nine Months Ended  September 30,** | ** ** | **Increase  (Decrease)** | ** ** | **Percentage  Change** | ** ** |
|-------------------------------------------------------------|------------|--------------------------------------|------------|--------------------------|------------|------------------------|------------|
| ** **                                                  | ** ** | **2005**                             | ** ** | **2004**                 | ** ** | **2005 vs 2004**       | ** ** | **2005 vs 2004** | ** ** |
| Interest  income:                                           |       |                                 |       |                     |       |                   |       |   |   |
| Loans receivable                                            |       | $                                    | 31,300     |                     | $          | 26,234                 |       | $ | 5,066 |   |   |   |
| Investment securities                                       |       | 2,148                                |       | 2,814                    |       | (666                   | )          |   |   |
| Other                                                       |       | 64                                   |       | 128                      |       | (64                    | )          |   |   |
| Total interest income                                       |       | 33,512                               |       | 29,176                   |       | 4,336                  |       | 14.9 | % |
| Interest  expense:                                          |       |                                 |       |                     |       |                   |       |   |   |
| Deposits                                                    |       | 10,505                               |       | 9,472                    |       | 1,033                  |       |   |   |
| Other borrowings                                            |       | 3,345                                |       | 1,087                    |       | 2,258                  |       |   |   |
| Total interest expense                                      |       | 13,850                               |       | 10,559                   |       | 3,291                  |       | 31.2 | % |
| Net interest  income before provision  for loan losses |       | 19,662                               |       | 18,617                   |       | 1,045                  |       |   |   |
| Provision  for loan losses                                  |       | 820                                  |       | 663                      |       | 157                    |       | 23.7 | % |
| Net interest  income after provision  for loan losses  |       | 18,842                               |       | 17,954                   |       | 888                    |       | 5.0 | % |
| Noninterest  income:                                        |       |                                 |       |                     |       |                   |       |   |   |
| Deposit fee income                                          |       | 3,307                                |       | 2,661                    |       | 646                    |       |   |   |
| Gain on sale of loans                                       |       | 511                                  |       | 463                      |       | 48                     |       |   |   |
| Other                                                       |       | 1,293                                |       | 1,464                    |       | (171                   | )          |   |   |
| Total noninterest income                                    |       | 5,111                                |       | 4,588                    |       | 523                    |       | 11.4 | % |
| Noninterest  expenses:                                      |       |                                 |       |                     |       |                   |       |   |   |
| Salaries and employee benefits                              |       | 9,272                                |       | 8,266                    |       | 1,006                  |       |   |   |
| Net occupancy expense                                       |       | 1,537                                |       | 1,494                    |       | 43                     |       |   |   |
| Advertising and public relations                            |       | 801                                  |       | 726                      |       | 75                     |       |   |   |
| Other                                                       |       | 3,578                                |       | 3,545                    |       | 33                     |       |   |   |
| Total noninterest expenses                                  |       | 15,188                               |       | 14,031                   |       | 1,157                  |       | 8.3 | % |
| Income  before income taxes                                 |       | 8,765                                |       | 8,511                    |       | 254                    |       |   |   |
| Provision  for income taxes                                 |       | 2,815                                |       | 2,723                    |       | 92                     |       |   |   |
| Net income                                                  |       | $                                    | 5,950      |                     | $          | 5,788                  |       | $ | 162 |   | 2.8 | % |
|                                                        |       |                                 |       |                     |       |                   |       |   |   |
| Basic  earnings per share                                   |       | $                                    | 1.19       |                     | $          | 1.14                   |       | $ | 0.05 |   | 4.7 | % |
| Diluted  earnings per share                                 |       | $                                    | 1.14       |                     | $          | 1.07                   |       | $ | 0.07 |   | 6.5 | % |
|                                                        |       |                                 |       |                     |       |                   |       |   |   |
| Interest  rate spread                                       |       | 3.44                                 | %          | 3.65                     | %          |                   |       |   |   |
| Net interest  margin                                        |       | 3.54                                 | %          | 3.76                     | %          |                   |       |   |   |
|                                                        |       |                                 |       |                     |       |                   |       |   |   |
| Average  full-time equivalents                              |       | 261                                  |       | 248                      |       |                   |       |   |   |
|                                                        |       |                                 |       |                     |       |                   |       |   |   |
| Full-service  offices                                       |       | 16                                   |       | 15                       |       |                   |       |   |   |

 

15

----

 

**Net Interest Income. **Net interest incomeis determined by the Company’s interest rate spread (i.e., the differencebetween the yields earned on its interest-earning assets and the rates paid onits interest-bearing liabilities) and the relative amounts of interest-earningassets and interest-bearing liabilities.

 

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

 

Dollar changes in interest income andinterest expense for the comparison periods are presented in the rate/volumeanalysis table which appears on page 14.

 

**Interest Income. **The increase ininterest income for the three month comparative period was primarily due to anincrease in the average balance of loans and an increase in the average yieldearned on loans, partially offset by a decrease in the average balance ofinvestment securities.  The increase ininterest income for the nine month comparative period was primarily due to anincrease in the average balance of loans and an increase in the average yieldearned on other interest-earning assets, partially offset by a decrease in theaverage yield earned on loans and a decrease in the average balance ofinvestment securities.   The increase inthe average yield earned on loans for the three month period was due toconcerted efforts to raise rates on new loans, particularly constructionloans.  The decrease in the average yieldearned on loans for the nine month period was primarily due to an increase innonaccrual loans and an increase in construction loans, which typically havelower rates at origination than those charged for permanent loans due to theirshorter-term nature.  The average balanceof loans increased primarily due to increased construction loan originationactivity.  The average balance ofinvestment securities decreased due to calls and maturities.

 

**Interest Expense.  **The increases ininterest expense for both the three and nine month comparative periods wereprimarily due to an increase in the average balance of FHLB advances and anincrease in the average rate paid on deposits. The average balance of FHLB advances increased due to advances beingused to fund loan growth.  The averagerate paid on deposits increased due to the rising interest rate environment.

 

**Provision for Loan Losses.**  The provision for loan losses includescharges to maintain an allowance for loan losses adequate to cover probablecredit losses related to specifically identified loans as well as probablecredit losses inherent in the remainder of the loan portfolio that have beenincurred as of the balance sheet date. Such provision and the adequacy of the allowance for loan losses isevaluated quarterly by management of the Bank based on the Bank’s past loanloss experience, known and inherent risks in the portfolio, adverse situationsthat may affect the borrower’s ability to repay, the estimated value of anyunderlying collateral and current economic conditions.

 

The increase in the provision for loan lossesin both the three and nine month comparative periods was due primarily to anincrease in charge-offs on overdrafts.

 

**Noninterest Income. **Deposit fee incomeincreased for both the three and nine month comparative periods as a result ofthe Bank’s continued promotion of BounceProtectionTM overdraft service as well as an increase in thenumber of checking accounts.  The numberof checking accounts increased approximately 6.4% from September 30, 2004 toSeptember 30, 2005.  The Bank plans tocontinue to aggressively promote checking accounts in 2005 through direct mailcampaigns to expand its checking accounts and increase deposit fee income.

 

Gain on sale of loans increased for both thethree and nine month comparative periods due to an increase in volume of loanssold in the third quarter.

 

The decrease in other noninterest income forthe nine month comparative period was primarily due to a decrease in loan feescollected.

 

16

----

 

**NoninterestExpense**

 

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

 
| ** **                        | ** ** | **Three Months Ended  September 30,** | ** ** | **Increase****(Decrease)** | ** ** | **Nine Months Ended  September 30,** | ** ** | **Increase  (Decrease)** | ** ** |
|-----------------------------------|------------|---------------------------------------|------------|----------------------------|------------|--------------------------------------|------------|--------------------------|------------|
| ** **                        | ** ** | **2005**                              | ** ** | **2004**                   | ** ** | **2005 vs 2004**                     | ** ** | **2005**                 | ** ** | **2004** | ** ** | **2005 vs 2004** | ** ** |
| Salaries                          |       | $                                     | 2,187      |                       | $          | 1,947                                |       | $                        | 240        |   | $ | 6,187 |   | $ | 5,710 |   | $ | 477 |   |
| Payroll taxes                     |       | 174                                   |       | 156                        |       | 18                                   |       | 582                      |       | 535 |   | 47 |   |
| Insurance                         |       | 161                                   |       | 138                        |       | 23                                   |       | 461                      |       | 430 |   | 31 |   |
| ESOP expense (1)                  |       | 502                                   |       | 426                        |       | 76                                   |       | 1,478                    |       | 1,230 |   | 248 |   |
| MRP expense (2)                   |       | 7                                     |       | 7                          |       | —                               |       | 20                       |       | 20 |   | — |   |
| Defined benefit plan contribution |       | 186                                   |       | 121                        |       | 65                                   |       | 431                      |       | 234 |   | 197 |   |
| Other                             |       | 39                                    |       | 35                         |       | 4                                    |       | 113                      |       | 107 |   | 6 |   |
| Total                             |       | $                                     | 3,256      |                       | $          | 2,830                                |       | $                        | 426        |   | $ | 9,272 |   | $ | 8,266 |   | $ | 1,006 |   |

 

----

(1)                                  Employee Stock Ownership Plan

(2)                                  Management Recognition and Retention Plan

 

The increase in salaries for the three andnine months ended September 30, 2005, was due primarily to an increase in thenumber of employees and normal salary and merit increases.  Payroll taxes increased during both periodsdue to the increase in salaries.  Theincrease in employee stock ownership plan expense during both comparisonperiods was due to an increase in the Company’s average stock price in 2005compared to the same periods in 2004. Defined benefit plan expense increased in the nine month comparativeperiod due to an unusual credit during the first quarter of 2004.

 

The loan to the ESOP matures on March 31, 2006 and will be repaid infull at such time. Absent further leveraged purchases by the ESOP, expenses relatedto the ESOP will decrease subsequent to March 31, 2006.

 

**NetOccupancy Expense.**  Net occupancy expense increased in both thethree and nine month periods ended September 30 due to the opening of a newbranch in July 2005.

 

**Advertisingand Public Relations.**  Advertising and public relations increasedfor the three and nine months ended September 30, 2005, compared to the sameperiods in 2004, primarily due to a full nine months of costs in 2005associated with the new checking account marketing program that began in April2004, including direct mail, “thank you” gifts, marketing brochures, postersand billboards, and the start-up of the business account marketing program inthe second quarter of 2005.

 

**Other Expenses.**  The changes in the composition of this lineitem are presented below (in thousands):

 
| ** **                      | ** ** | **Three Months Ended  September 30,** | ** ** | **Increase****(Decrease)** | ** ** | **Nine Months Ended  September 30,** | ** ** | **Increase  (Decrease)** | ** ** |
|---------------------------------|------------|---------------------------------------|------------|----------------------------|------------|--------------------------------------|------------|--------------------------|------------|
| ** **                      | ** ** | **2005**                              | ** ** | **2004**                   | ** ** | **2005 vs 2004**                     | ** ** | **2005**                 | ** ** | **2004** | ** ** | **2005 vs 2004** | ** ** |
| Consultant  and management fees |       | $                                     | 31         |                       | $          | 14                                   |       | $                        | 17         |   | $ | 101 |   | $ | 216 |   | $ | (115 | ) |
| Postage and  supplies           |       | 186                                   |       | 151                        |       | 35                                   |       | 566                      |       | 503 |   | 63 |   |
| Other                           |       | 990                                   |       | 952                        |       | 38                                   |       | 2,911                    |       | 2,826 |   | 85 |   |
| Total                           |       | $                                     | 1,207      |                       | $          | 1,117                                |       | $                        | 90         |   | $ | 3,578 |   | $ | 3,545 |   | $ | 33 |   |

 

Other expenses increased in the three monthcomparative period primarily due to expenses associated with the start up ofnew branches.  For the nine month periodended September 30, 2005, these increases were offset by a decrease inconsultant and management fees due to non-recurring fees paid to a consultingfirm for assistance in implementation of the program to promote checkingaccounts in 2004.

 

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**IncomeTaxes. **The decrease inincome tax expense for the three months ended September 30 was primarily due toa decrease in taxable income.  Theincrease in income tax expense for the nine month comparable period endedSeptember 30 was primarily due to an increase in taxable income.  The effective tax rate remained relativelyconsistent for all reporting periods at approximately 32%.

 

# **OFF-BALANCE SHEET ARRANGEMENTS**

 

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

 

•                  the origination,purchase or sale of loans;

•                  the fulfillmentof commitments under letters-of-credit, extensions of credit on home equitylines of credit, construction loans, and predetermined overdraft protectionlimits; and

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

 

At September 30, 2005, the Bank’s off-balancesheet arrangements principally included lending commitments, which aredescribed below.  At September 30, 2005,the Company had no interests in non-consolidated special purpose entities.

 

At September 30, 2005, commitments included:

 

•                  total approvedcommitments to originate loans amounting to $16.6 million, including $2.8million of loans committed to sell;

•                  rate lockagreements with customers of $12.8 million, all of which have been locked withan investor;

•                  funded mortgageloans committed to sell of $2.8 million;

•                  unadvancedportion of construction loans of $83.7 million;

•                  unused lines ofcredit of $27.5 million;

•                  outstandingstandby letters of credit of approximately $900,000;

•                  totalpredetermined overdraft protection limits of $10.6 million; and

•                  certificates ofdeposit scheduled to mature in one year or less totaling $163.5 million.

 

Total unfunded commitments to originate loansfor sale and the related commitments to sell of $12.8 million meet thedefinition of a derivative financial instrument.  The related asset and liability areconsidered immaterial at September 30, 2005.

 

Historically, a very small percentage ofpredetermined overdraft limits have been used. At September 30, 2005, overdrafts of accounts with Bounce ProtectionTMrepresented usage of 2.5% of the limit. We expect utilization of these overdraft limits to remain at comparablelevels in the future.

 

Based on historical experience, managementbelieves that a significant portion of maturing deposits will remain with theBank.  We anticipate that we willcontinue to have sufficient funds, through repayments, deposits and borrowings,to meet our current commitments.

 

### **LIQUIDITY AND CAPITAL RESOURCES**

 

The Bank’s liquidity,represented by cash and cash equivalents and eligible investment securities, isa product of its operating, investing and financing activities.  The Bank’s primary sources of funds aredeposits, borrowings, collections on outstanding loans, maturities and calls ofinvestment securities and other short-term investments and funds provided fromoperations.  While scheduled loanamortization and maturing investment securities and short-term investments arerelatively predictable sources of funds, deposit flows and loan prepayments aregreatly influenced by general interest rates, economic conditions andcompetition.  The Bank manages thepricing of its deposits to maintain a steady deposit balance.  In addition, the Bank invests excess funds inovernight deposits and other short-term interest-earning assets which provideliquidity to meet lending requirements.  During2005, the use of FHLB advances increased due to increased demand for the Bank’sloan products.  At September 30, 2005,available borrowing capacity with the FHLB was in excess of $113 million.

 

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Liquidity management is botha daily and long-term function of business management.  Excess liquidity is generally invested inshort-term investments such as overnight deposits and certificates of deposit.  On a longer-term basis, the Bank maintains astrategy of investing in various lending products.   The Bank uses its sources of funds primarilyto meet its ongoing commitments, to pay maturing savings certificates andsavings withdrawals, to repay maturing FHLB of Dallas advances, and to fundloan commitments.

 

As of September 30, 2005, theBank’s regulatory capital was in excess of all applicable regulatoryrequirements.  At September 30, 2005,the Bank’s tangible, core and risk-based capital ratios amounted to 8.83%, 8.83%and 12.17%, respectively, compared to regulatory requirements of 1.5%, 4.0% and8.0%, respectively.

 

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

 

The financial statements and related financialdata presented herein have been prepared in accordance with generally acceptedaccounting principles, which require the measurement of financial position andoperating results in terms of historical dollars, without considering changesin relative purchasing power over time due to inflation.

 

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

 

### **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, thewords “anticipate”, “believe,” “estimate,”****“expect,”“intend,” “should” and similar expressions, or the negative thereof, as theyrelate to the 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 and assumptions.  Should one or more of these risks oruncertainties materialize or should underlying assumptions prove incorrect,actual results may vary materially from those described herein as anticipated,believed, estimated, expected or intended. The Company does not intend to update these forward-looking statements.

 

**QUANTITATIVE AND QUALITATIVE DISCLOSURES****ABOUT MARKET RISK**

 

There has been no materialchange in the market value of the Bank’s portfolio equity since December 31,2004.  Similarly, while there has been nomaterial change in the Company’s asset and liability position since such time,the Bank’s negative gap position has adversely impacted net income as interestexpense during both the three and nine months ended September 30, 2005increased at a greater pace than the comparable increase in interestincome.  Correspondingly, the Bank’s netinterest margin decreased from 3.83% and 3.76% for the three and nine monthsended September 30, 2004 to 3.55% and 3.54% for the same periods in 2005.   Based on the current market interest rateenvironment and increased competition, management anticipates continuedpressure on the Bank’s interest rate spread and interest margin for the fourthquarter of 2005.

 

**CONTROLS AND PROCEDURES**

 

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

 

No change in the Company’s internal controlover financial 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.

 

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**FIRSTFEDERAL BANCSHARES OF ARKANSAS, INC.**

** **

**Part II**

 

Item1.                                                             Legal Proceedings

 

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

 

Item 2.                                                             Unregistered Sales of Equity Securities andUse of Proceeds

 

 
| ISSUER  PURCHASES OF EQUITY SECURITIES | ** ** |
|----------------------------------------|------------|
|                                   | ** ** |
| ** **                             | ** ** | **(a) Total Number of Shares Purchased** | ** ** | **(b) Average Price Paid per Share** | ** ** | **(c) Total Number of Shares Purchased as Part of  Publicly Announced Plans or Programs** | ** ** | **(d) Maximum Number of Shares that May Yet Be  Purchased Under the Plans or Programs** | ** ** |
| ** **                             | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| July 1, to   July 31, 2005             |       | — |   | — |   | — |   | — |   |
| August 1, to   August 31, 2005         |       | 20,000 |   | $ | 25.30 |   | 20,000 |   | 67,792 |   |
| September 1, to   September 30, 2005   |       | — |   | — |   | — |   | — |   |
|                                        |            |  |  |  |  |  |  |  |  |  |

 

The Company is in its 17thannounced repurchase program, which was approved by the board of directors onNovember 30, 2004, and publicly announced on February 8, 2005. Total sharesapproved to be purchased in this program are 251,801, of which 184,009 havebeen purchased as of September 30, 2005. All treasury stock purchases are madeunder publicly announced repurchase programs.

 

Item 3.                                                             Defaults Upon Senior Securities

 

Not applicable.

 

Item 4.                                                             Submission of Matters to a Vote of SecurityHolders

 

Not applicable.

 

Item5.                                                             Other Information

 

None.

 

Item6.                                                             Exhibits

 

Exhibit31.1 — Certification of Chief Executive Officer,Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 (18 U.S.C. 1350)

 

Exhibit31.2 — Certification of Chief Financial Officer,Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 (18 U.S.C. 1350)

 

Exhibit32.1 — Certification of Chief Executive Officer,Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (18 U.S.C. 1350)

 

Exhibit32.2 — Certification of Chief Financial Officer,Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (18 U.S.C. 1350)

 

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**SIGNATURES**

 

 

Pursuant to the requirements ofthe Securities Exchange Act of 1934, the Registrant has duly caused this reportto be signed on its behalf by the undersigned thereunto duly authorized.

 

 

 

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

 

 

 
| Date:  October 31, 2005 | By:    | /s/Larry J.  Brandt    |
|-------------------------|--------|------------------------|
|                    |   | Larry J.  Brandt       |
|                    |   | President/CEO          |
|                    |   |                   |
|                    |   |                   |
|                    |   |                   |
| Date:  October 31, 2005 | By:    | /s/Sherri R.  Billings |
|                    |   | Sherri R.  Billings    |
|                    |   | EVP/CFO                |

 

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