Table of Contents

 

 

 

**UNITEDSTATES**

**SECURITIESAND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

**FORM 10-Q**

 

**x****      QUARTERLY REPORT PURSUANT TOSECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**

 

**For the quarterly period ended September 30, 2009**

** **

**OR**

 

**o****         TRANSITION REPORTPURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF1934**

##  

**For the transition period from                          to                          **

 

**Commission File Number 0-28312**

 

**FIRSTFEDERAL BANCSHARES OF ARKANSAS, 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 whetherthe registrant (1) has filed all reports required to be filed by Section 13or 15(d) of the Securities Exchange Act of 1934 during the preceding 12months (or for such shorter period that the registrant was required to filesuch reports), and (2) has been subject to such filing requirements forthe past 90 days.  Yes x  No o

 

Indicate by check mark whetherthe registrant has submitted electronically and posted on its corporate Website, if any, every Interactive Data File required to be submitted and postedpursuant to Rule 405 of Regulation S-T during the preceding 12 months (orfor such shorter period that the registrant was required to submit and postsuch files).  Yes o  No o

 

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

 

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

 

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

 

Indicate thenumber of shares outstanding of each of the issuer’s classes of common stock,as of the latest practicable date:  As ofNovember 23, 2009, there were issued and outstanding 4,846,785 shares ofthe Registrant’s Common Stock, par value $.01 per share.

 

 

 

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Tableof Contents

 

**FIRSTFEDERAL BANCSHARES OF ARKANSAS, INC.**

 

**TABLE OF CONTENTS**

 
| ** **        | ** **                                                                                                                                                                 | ** ** | **Page**   |
|-------------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------|
|              | **Financial  Information**                                                                                                                                                 |       |       |
|              |                                                                                                                                                                       |       |       |
| Item 1.           | Consolidated  Financial Statements                                                                                                                                         |       |       |
|              |                                                                                                                                                                       |       |       |
|              | Consolidated Statements of Financial Condition as of   September 30, 2009 and December 31, 2008 (unaudited)                                                      |       | 1          |
|              |                                                                                                                                                                       |       |       |
|              | Consolidated Statements of Operations for the three  and nine months ended   September 30, 2009 and 2008 (unaudited)                                                  |       | 2          |
|              |                                                                                                                                                                       |       |       |
|              | Consolidated Statement of Stockholders’ Equity for the  nine months ended   September 30, 2009 (unaudited)                                                       |       | 3          |
|              |                                                                                                                                                                       |       |       |
|              | Consolidated Statements of Cash Flows for the nine months  ended   September 30, 2009 and 2008 (unaudited)                                                            |       | 4          |
|              |                                                                                                                                                                       |       |       |
|              | Notes to Unaudited Consolidated Financial Statements                                                                                                                       |       | 6          |
|              |                                                                                                                                                                       |       |       |
| Item  2.          | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                                                                                |       | 15         |
|              |                                                                                                                                                                       |       |       |
| Item  3.          | Quantitative  and Qualitative Disclosures About Market Risk                                                                                                                |       | 32         |
|              |                                                                                                                                                                       |       |       |
| Item 4.           | Controls  and Procedures                                                                                                                                                   |       | 33         |
|              |                                                                                                                                                                       |       |       |
| **Part II.** | **Other  Information**                                                                                                                                                     | ** ** | ** ** |
|              |                                                                                                                                                                       |       |       |
| Item 1.           | Legal Proceedings                                                                                                                                                          |       | 34         |
| Item 1A.          | Risk Factors                                                                                                                                                               |       | 34         |
| Item  2.          | Unregistered  Sales of Equity Securities and Use of Proceeds                                                                                                               |       | 40         |
| Item  3.          | Defaults  Upon Senior Securities                                                                                                                                           |       | 40         |
| Item  4.          | Submission  of Matters to a Vote of Security Holders                                                                                                                       |       | 40         |
| Item 5.           | Other  Information                                                                                                                                                         |       | 40         |
| Item 6.           | Exhibits                                                                                                                                                                   |       | 40         |
|              |                                                                                                                                                                       |       |       |
| **Signatures**    | ** **                                                                                                                                                                 | ** ** | ** ** |
|              |                                                                                                                                                                       |       |       |
| **Exhibits**      | ** **                                                                                                                                                                 | ** ** | ** ** |
| 31.1              | Certification of Chief Executive Officer pursuant to  Rule 13a-14(a) of Exchange Act, as adopted pursuant to  Section 302 of the Sarbanes-Oxley Act of 2002 |       |       |
| 31.2              | Certification of Chief Financial Officer pursuant to  Rule 13a-14(a) of Exchange Act, as adopted pursuant to  Section 302 of the Sarbanes-Oxley Act of 2002 |       |       |
| 32.1              | Section 906 Certification of the CEO                                                                                                                                  |       |       |
| 32.2              | Section 906 Certification of the CFO                                                                                                                                  |       |       |

 

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Tableof Contents

 

**Part I.  Financial Information**

 

**Item 1.  Financial Statements.**

 

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

**CONSOLIDATEDSTATEMENTS OF FINANCIAL CONDITION**

(In thousands, except share data)

(Unaudited)

 
| ** **                                                                                                                                                                                                                                                                | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                                                                                                                                | ** ** | **2009**               | ** ** | **2008**              | ** ** |
| ASSETS                                                                                                                                                                                                                                                                    |       |                   |       |                  |       |
|                                                                                                                                                                                                                                                                      |       |                   |       |                  |       |
| Cash and cash equivalents                                                                                                                                                                                                                                                 |       | $                      | 7,946      |                  | $          | 9,367 |   |
| Investment securities held  to maturity                                                                                                                                                                                                                                   |       | 130,228                |       | 136,412               |       |
| Federal Home Loan Bank  stock                                                                                                                                                                                                                                             |       | 3,657                  |       | 4,825                 |       |
| Loans receivable, net of  allowance of $41,372 and $6,441                                                                                                                                                                                                                 |       | 503,198                |       | 566,537               |       |
| Loans held for sale                                                                                                                                                                                                                                                       |       | 1,522                  |       | 1,586                 |       |
| Accrued interest  receivable                                                                                                                                                                                                                                              |       | 4,419                  |       | 6,701                 |       |
| Real estate owned, net                                                                                                                                                                                                                                                    |       | 27,971                 |       | 22,385                |       |
| Office properties and  equipment, net                                                                                                                                                                                                                                     |       | 23,882                 |       | 24,694                |       |
| Cash surrender value of  life insurance                                                                                                                                                                                                                                   |       | 21,022                 |       | 20,412                |       |
| Deferred tax asset, net                                                                                                                                                                                                                                                   |       | 13,884                 |       | 1,105                 |       |
| Prepaid expenses and other  assets                                                                                                                                                                                                                                        |       | 847                    |       | 1,148                 |       |
|                                                                                                                                                                                                                                                                      |       |                   |       |                  |       |
| TOTAL ASSETS                                                                                                                                                                                                                                                              |       | $                      | 738,576    |                  | $          | 795,172 |   |
|                                                                                                                                                                                                                                                                      |       |                   |       |                  |       |
| LIABILITIES AND  STOCKHOLDERS’ EQUITY                                                                                                                                                                                                                                |       |                   |       |                  |       |
|                                                                                                                                                                                                                                                                      |       |                   |       |                  |       |
| LIABILITIES:                                                                                                                                                                                                                                                              |       |                   |       |                  |       |
| Deposits                                                                                                                                                                                                                                                                  |       | $                      | 603,992    |                  | $          | 618,003 |   |
| Other borrowings                                                                                                                                                                                                                                                          |       | 68,179                 |       | 92,212                |       |
| Advance payments by  borrowers for taxes and insurance                                                                                                                                                                                                                    |       | 631                    |       | 810                   |       |
| Other liabilities                                                                                                                                                                                                                                                         |       | 2,437                  |       | 11,030                |       |
| Total liabilities                                                                                                                                                                                                                                                         |       | 675,239                |       | 722,055               |       |
|                                                                                                                                                                                                                                                                      |       |                   |       |                  |       |
| STOCKHOLDERS’ EQUITY:                                                                                                                                                                                                                                                |       |                   |       |                  |       |
| Preferred stock, no par  value, 5,000,000 shares authorized; Series A fixed rate cumulative  perpetual; liquidation preference of $1,000 per share; 16,500 shares issued  and outstanding at September 30, 2009 and none outstanding at  December 31, 2008 |       | $                      | 16,178     |                  | $          | — |   |
| Common stock, $.01 par  value, 20,000,000 shares authorized, 10,307,502 shares issued, 4,846,785  shares outstanding at September 30, 2009 and December 31, 2008                                                                                                |       | 103                    |       | 103                   |       |
| Additional paid-in capital                                                                                                                                                                                                                                                |       | 56,986                 |       | 56,627                |       |
| Retained  earnings-substantially restricted                                                                                                                                                                                                                               |       | 60,688                 |       | 87,005                |       |
|                                                                                                                                                                                                                                                                      |       | 133,955                |       | 143,735               |       |
| Treasury stock, at cost,  5,460,717 shares at September 30, 2009 and December 31, 2008                                                                                                                                                                          |       | (70,618                | )          | (70,618               | )          |
| Total stockholders’ equity                                                                                                                                                                                                                                           |       | 63,337                 |       | 73,117                |       |
|                                                                                                                                                                                                                                                                      |       |                   |       |                  |       |
| TOTAL LIABILITIES ANDSTOCKHOLDERS’ EQUITY                                                                                                                                                                                                                            |       | $                      | 738,576    |                  | $          | 795,172 |   |

 

See notes to unaudited consolidated financial statements.

 

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

**CONSOLIDATEDSTATEMENTS OF OPERATIONS**

(In thousands, except share data)

(Unaudited)

 
| ** **                                                           | ** ** | **Three Months Ended**     | ** ** | **Nine Months Ended**      | ** ** |
|----------------------------------------------------------------------|------------|----------------------------|------------|----------------------------|------------|
| ** **                                                           | ** ** | **September ****30,** | ** ** | **September ****30,** | ** ** | **September ****30,** | ** ** | **September ****30,** | ** ** |
| ** **                                                           | ** ** | **2009**                   | ** ** | **2008**                   | ** ** | **2009** | ** ** | **2008** | ** ** |
|                                                                 |       |                       |       |                       |       |   |   |   |   |
| INTEREST INCOME:                                                     |       |                       |       |                       |       |   |   |   |   |
| Loans receivable                                                     |       | $                          | 6,988      |                       | $          | 8,601 |   | $ | 22,109 |   | $ | 28,096 |   |
| Investment securities:                                               |       |                       |       |                       |       |   |   |   |   |
| Taxable                                                              |       | 1,443                      |       | 1,540                      |       | 4,164 |   | 4,392 |   |
| Nontaxable                                                           |       | 259                        |       | 203                        |       | 718 |   | 579 |   |
| Other                                                                |       | 2                          |       | 107                        |       | 17 |   | 387 |   |
| Total interest income                                                |       | 8,692                      |       | 10,451                     |       | 27,008 |   | 33,454 |   |
|                                                                 |       |                       |       |                       |       |   |   |   |   |
| INTEREST EXPENSE:                                                    |       |                       |       |                       |       |   |   |   |   |
| Deposits                                                             |       | 3,102                      |       | 4,224                      |       | 10,396 |   | 14,572 |   |
| Other borrowings                                                     |       | 449                        |       | 931                        |       | 1,641 |   | 2,711 |   |
| Total interest expense                                               |       | 3,551                      |       | 5,155                      |       | 12,037 |   | 17,283 |   |
|                                                                 |       |                       |       |                       |       |   |   |   |   |
| NET INTEREST INCOME                                                  |       | 5,141                      |       | 5,296                      |       | 14,971 |   | 16,171 |   |
|                                                                 |       |                       |       |                       |       |   |   |   |   |
| PROVISION FOR LOAN LOSSES                                            |       | 30,196                     |       | 1,611                      |       | 36,161 |   | 4,110 |   |
|                                                                 |       |                       |       |                       |       |   |   |   |   |
| NET INTEREST INCOME (LOSS)  AFTER PROVISION FOR LOAN LOSSES          |       | (25,055                    | )          | 3,685                      |       | (21,190 | ) | 12,061 |   |
|                                                                 |       |                       |       |                       |       |   |   |   |   |
| NONINTEREST INCOME:                                                  |       |                       |       |                       |       |   |   |   |   |
| Deposit fee income                                                   |       | 1,396                      |       | 1,471                      |       | 3,916 |   | 4,027 |   |
| Earnings on life insurance  policies                                 |       | 213                        |       | 198                        |       | 610 |   | 1,760 |   |
| Gain on sale of loans                                                |       | 155                        |       | 51                         |       | 454 |   | 317 |   |
| Other                                                                |       | 345                        |       | 493                        |       | 1,074 |   | 1,362 |   |
| Total noninterest income                                             |       | 2,109                      |       | 2,213                      |       | 6,054 |   | 7,466 |   |
|                                                                 |       |                       |       |                       |       |   |   |   |   |
| NONINTEREST EXPENSES:                                                |       |                       |       |                       |       |   |   |   |   |
| Salaries and employee  benefits                                      |       | 2,890                      |       | 3,085                      |       | 8,703 |   | 9,717 |   |
| Net occupancy expense                                                |       | 705                        |       | 672                        |       | 2,045 |   | 1,957 |   |
| Real estate owned, net                                               |       | 4,537                      |       | 509                        |       | 6,017 |   | 1,207 |   |
| FDIC insurance premium                                               |       | 328                        |       | 127                        |       | 1,256 |   | 254 |   |
| Data processing                                                      |       | 370                        |       | 378                        |       | 1,116 |   | 1,065 |   |
| Professional fees                                                    |       | 330                        |       | 126                        |       | 806 |   | 399 |   |
| Advertising and public  relations                                    |       | 92                         |       | 188                        |       | 294 |   | 748 |   |
| Postage and supplies                                                 |       | 158                        |       | 200                        |       | 542 |   | 621 |   |
| Other                                                                |       | 485                        |       | 481                        |       | 1,521 |   | 1,518 |   |
| Total noninterest expenses                                           |       | 9,895                      |       | 5,766                      |       | 22,300 |   | 17,486 |   |
|                                                                 |       |                       |       |                       |       |   |   |   |   |
| INCOME (LOSS) BEFORE  INCOME TAXES                                   |       | (32,841                    | )          | 132                        |       | (37,436 | ) | 2,041 |   |
| INCOME TAX BENEFIT                                                   |       | (9,614                     | )          | (86                        | )          | (11,770 | ) | (273 | ) |
| NET INCOME (LOSS)                                                    |       | $                          | (23,227    | )                          | $          | 218 |   | $ | (25,666 | ) | $ | 2,314 |   |
| PREFERRED STOCK DIVIDENDS  AND ACCRETION OF PREFERRED STOCK DISCOUNT |       | 222                        |       | —                     |       | 506 |   | — |   |
| NET INCOME (LOSS)  AVAILABLE TO COMMON SHAREHOLDERS                  |       | $                          | (23,449    | )                          | $          | 218 |   | $ | (26,172 | ) | $ | 2,314 |   |
|                                                                 |       |                       |       |                       |       |   |   |   |   |
| EARNINGS (LOSS) PER COMMON  SHARE:                                   |       |                       |       |                       |       |   |   |   |   |
| Basic                                                                |       | $                          | (4.84      | )                          | $          | 0.05 |   | $ | (5.40 | ) | $ | 0.48 |   |
|                                                                 |       |                       |       |                       |       |   |   |   |   |
| Diluted                                                              |       | $                          | (4.84      | )                          | $          | 0.05 |   | $ | (5.40 | ) | $ | 0.48 |   |
|                                                                 |       |                       |       |                       |       |   |   |   |   |
| Cash Dividends Declared                                              |       | $                          | 0.01       |                       | $          | 0.16 |   | $ | 0.03 |   | $ | 0.48 |   |

 

See notes to unaudited consolidated financial statements.

 

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** **

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

**CONSOLIDATED STATEMENT OF STOCKHOLDERS’ EQUITY**

**FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2009**

(In thousands, except share data)

(Unaudited)

 
|                                                                                                   |   | ** **           | ** ** | ** **        | ** **   | ** **  | ** ** | ** **         | ** ** | ** **          | ** ** | **Retained**           | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
|--------------------------------------------------------------------------------------------------------|--------|----------------------|------------|-------------------|--------------|-------------|------------|--------------------|------------|---------------------|------------|------------------------|------------|------------|------------|------------|------------|------------|------------|
|                                                                                                   |   | ** **           | ** ** | ** **        | ** **   | ** **  | ** ** | ** **         | ** ** | **Additional**      | ** ** | **Earnings**           | ** ** | ** ** | ** ** | ** ** | ** ** | **Total**  | ** ** |
|                                                                                                   |   | **Preferred  Stock** | ** ** | **Common  Stock** | ** **   | **Paid-In** | ** ** | **(Substantially** | ** ** | **Treasury  Stock** | ** ** | **Stockholders’** | ** ** |
|                                                                                                   |   | **Shares**           | ** ** | **Amount**        | ** **   | **Shares**  | ** ** | **Amount**         | ** ** | **Capital**         | ** ** | **Restricted)**        | ** ** | **Shares** | ** ** | **Amount** | ** ** | **Equity** | ** ** |
|                                                                                                   |   |                 |       |              |         |        |       |               |       |                |       |                   |       |       |       |       |       |       |       |
| Balance, January 1,  2009                                                                         |   | —               |       | $                 |  — |        | 10,307,502 |               | $          | 103                 |       | $                      | 56,627     |       | $          | 87,005     |       | 5,460,717  |       | $ | (70,618 | ) | $ | 73,117 |   |
| Net loss                                                                                               |   |                 |       |              |         |        |       |               |       |                |       | (25,666                | )          |       |       |       |       | (25,666    | )          |
| Issuance of 16,500 shares  of preferred stock and a warrant to purchase 321,847 shares of common stock |   | 16,500               |       | 16,142            |         |        |       |               |       | 358                 |       |                   |       |       |       |       |       | 16,500     |       |
| Preferred stock dividends                                                                              |   |                 |       |              |         |        |       |               |       |                |       | (470                   | )          |       |       |       |       | (470       | )          |
| Accretion of preferred  stock discount                                                                 |   |                 |       | 36                |         |        |       |               |       |                |       | (36                    | )          |       |       |       |       | —     |       |
| Stock compensation                                                                                     |   |                 |       |              |         |        |       |               |       | 1                   |       |                   |       |       |       |       |       | 1          |       |
| Dividends paid, $0.03 per  common share                                                                |   |                 |       |              |         |        |       |               |       |                |       | (145                   | )          |       |       |       |       | (145       | )          |
|                                                                                                   |   |                 |       |              |         |        |       |               |       |                |       |                   |       |       |       |       |       |       |       |
| Balance,  September 30, 2009                                                                      |   | 16,500               |       | $                 | 16,178       |        | 10,307,502 |               | $          | 103                 |       | $                      | 56,986     |       | $          | 60,688     |       | 5,460,717  |       | $ | (70,618 | ) | $ | 63,337 |   |

 

See notes to unaudited consolidated financialstatements.

 

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

**CONSOLIDATED STATEMENTS OF CASH FLOWS**

(In Thousands)

(Unaudited)

 
| ** **                                                                                | ** ** | **Nine Months Ended September 30,** | ** ** |
|-------------------------------------------------------------------------------------------|------------|------------------------------------------|------------|
| ** **                                                                                | ** ** | **2009**                                 | ** ** | **2008** | ** ** |
|                                                                                      |       |                                     |       |   |   |
| OPERATING ACTIVITIES:                                                                     |       |                                     |       |   |   |
| Net income (loss)                                                                         |       | $                                        | (25,666    | ) | $ | 2,314 |   |
| Adjustments to reconcile  net income (loss) to net cash provided by operating activities: |       |                                     |       |   |   |
| Provision for loan losses                                                                 |       | 36,161                                   |       | 4,110 |   |
| Provision for real estate  losses                                                         |       | 4,410                                    |       | 480 |   |
| Deferred tax benefit                                                                      |       | (15,945                                  | )          | (714 | ) |
| Deferred tax asset  valuation allowance                                                   |       | 3,166                                    |       | — |   |
| Accretion of discounts on  investment securities, net                                     |       | (80                                      | )          | (58 | ) |
| Federal Home Loan Bank  stock dividends                                                   |       | (10                                      | )          | (108 | ) |
| Gain on disposition of  office properties and equipment, net                              |       | —                                   |       | (19 | ) |
| Loss on sale of  repossessed assets, net                                                  |       | 875                                      |       | 207 |   |
| Deferred gains on real  estate owned                                                      |       | (2                                       | )          | — |   |
| Originations of loans held  for sale                                                      |       | (34,988                                  | )          | (20,026 | ) |
| Proceeds from sales of  loans held for sale                                               |       | 35,506                                   |       | 22,853 |   |
| Gain on sale of loans  originated to sell                                                 |       | (454                                     | )          | (317 | ) |
| Depreciation                                                                              |       | 1,118                                    |       | 1,102 |   |
| Amortization of deferred  loan costs, net                                                 |       | 300                                      |       | 280 |   |
| Stock compensation expense                                                                |       | 1                                        |       | 18 |   |
| Earnings on life insurance  policies                                                      |       | (610                                     | )          | (580 | ) |
| Changes in operating  assets and liabilities:                                             |       |                                     |       |   |   |
| Accrued interest  receivable                                                              |       | 2,282                                    |       | 1,739 |   |
| Prepaid expenses and other  assets                                                        |       | 296                                      |       | 472 |   |
| Other liabilities                                                                         |       | 297                                      |       | 655 |   |
| Net cash provided by  operating activities                                                |       | 6,657                                    |       | 12,408 |   |
|                                                                                      |       |                                     |       |   |   |
| INVESTING ACTIVITIES:                                                                     |       |                                     |       |   |   |
| Purchases of investment  securities held to maturity                                      |       | (120,575                                 | )          | (113,030 | ) |
| Proceeds from  maturities/calls of investment securities held to maturity                 |       | 117,844                                  |       | 77,051 |   |
| Federal Home Loan Bank  stock redeemed                                                    |       | 1,178                                    |       | — |   |
| Federal Home Loan Bank  Stock purchased                                                   |       | —                                   |       | (261 | ) |
| Loan participations sold                                                                  |       | —                                   |       | 4,045 |   |
| Loan participations  purchased                                                            |       | (2,035                                   | )          | (1,966 | ) |
| Net loan repayments                                                                       |       | 16,522                                   |       | 13,224 |   |
| Proceeds from sales of  repossessed assets                                                |       | 1,679                                    |       | 2,796 |   |
| Improvements to real  estate owned                                                        |       | (152                                     | )          | (436 | ) |
| Proceeds from sales of  office properties and equipment                                   |       | —                                   |       | 30 |   |
| Purchases of office  properties and equipment                                             |       | (306                                     | )          | (1,811 | ) |
| Net cash provided by (used  in) investing activities                                      |       | 14,155                                   |       | (20,358 | ) |
|                                                                                      |       |                                     |       |   |   |
| FINANCING ACTIVITIES:                                                                     |       |                                     |       |   |   |
| Net decrease in deposits                                                                  |       | (14,011                                  | )          | (17,842 | ) |
| Advances from FHLB                                                                        |       | —                                   |       | 41,000 |   |
| Repayment of advances from  FHLB                                                          |       | (33,229                                  | )          | (28,945 | ) |
| Short-term FHLB advances,  net                                                            |       | 18,875                                   |       | — |   |
| Net increase (decrease) in  Federal Reserve Bank advances                                 |       | (9,679                                   | )          | 3,000 |   |
| Net increase (decrease) in  advance paymentsby borrowers for taxes and  insurance         |       | (179                                     | )          | 115 |   |
| Proceeds from issuance of  preferred stock and related common stock warrant               |       | 16,500                                   |       | — |   |
| Reissued treasury stock                                                                   |       | —                                   |       | 46 |   |
| Preferred dividends paid                                                                  |       | (365                                     | )          | — |   |
| Dividends paid, common  shares                                                            |       | (145                                     | )          | (2,327 | ) |
| Net cash used in financing  activities                                                    |       | (22,233                                  | )          | (4,953 | ) |
|                                                                                      |       |                                     |       |   |   |
| Net decrease in cash and  cash equivalents                                                |       | (1,421                                   | )          | (12,903 | ) |
|                                                                                           |            |                                          |            |  |  |  |  |

 

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

**CONSOLIDATED STATEMENTS OF CASH FLOWS**

(In Thousands)

(Unaudited)

 
| ** **                                                                     | ** ** | **Nine Months Ended September 30,** | ** ** |
|--------------------------------------------------------------------------------|------------|------------------------------------------|------------|
| ** **                                                                     | ** ** | **2009**                                 | ** ** | **2008** | ** ** |
|                                                                           |       |                                     |       |   |   |
| CASH AND CASH EQUIVALENTS:                                                     |       |                                     |       |   |   |
| Beginning of period                                                            |       | $                                        | 9,367      |   | $ | 27,387 |   |
| End of period                                                                  |       | $                                        | 7,946      |   | $ | 14,484 |   |
|                                                                           |       |                                     |       |   |   |
| SUPPLEMENTAL DISCLOSURES  OF CASH FLOW INFORMATION:                            |       |                                     |       |   |   |
| Cash paid for:                                                                 |       |                                     |       |   |   |
| Interest                                                                       |       | $                                        | 12,564     |   | $ | 17,412 |   |
| Income taxes                                                                   |       | $                                        | 1,044      |   | $ | — |   |
|                                                                           |       |                                     |       |   |   |
| SUPPLEMENTAL SCHEDULE OF  NONCASH INVESTING AND FINANCING ACTIVITIES:          |       |                                     |       |   |   |
| Real estate and other  assets acquired in settlement of loans                  |       | $                                        | 14,086     |   | $ | 17,349 |   |
| Loans to facilitate sales  of real estate owned                                |       | $                                        | 2,100      |   | $ | 5,071 |   |
| Investment securities  traded, recorded in investments not yet settled in cash |       | $                                        | —     |   | $ | 3,000 |   |
| Preferred stock dividends  accrued, not paid                                   |       | $                                        | 105        |   | $ | — |   |
|                                                                           |       |                                     |       |   |   |
|                                                                           |       |                                     |       | (Concluded) |   |

 

See notes to unaudited consolidated financialstatements.

 

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

**NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS**

 

# **Note1 - Basis of Presentation and Principles of Consolidation**

# ** **

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

 

The accompanying unaudited consolidated financial statements of theCompany have been prepared in accordance with instructions to Form 10-Q.  Accordingly, they do not include all of theinformation and footnotes required by generally accepted accounting principlesfor complete financial statements. However, such information reflects all adjustments which are, in theopinion of management, necessary for a fair statement of results for theinterim periods.

 

The accompanying unaudited consolidated financial statements includethe accounts of the Company and the Bank. All material intercompany transactions have been eliminated inconsolidation.

 

The results of operations for the three andnine months ended September 30, 2009, are not necessarily indicative ofthe results to be expected for the year ending December 31, 2009.  The unaudited consolidated financialstatements and notes thereto should be read in conjunction with the auditedfinancial statements and notes thereto for the year ended December 31,2008, contained in the Company’s 2008 Annual Report to Stockholders.

 

**Note 2 – Recently AdoptedAccounting Standards**

 

OnJune 29, 2009, the Financial Accounting Standards Board (“FASB”) issued *Accounting Standards Codification**and the Hierarchy of Generally Accepted Accounting Principles*which**establishesthe *FASB Accounting Standards Codification*(“ASC 105”) as the source of authoritative accounting principles recognized bythe FASB to be applied by nongovernmental entities in the preparation offinancial statements in conformity with U.S. generally accepted accountingprinciples. The statement is effective for financial statements issued forinterim and annual periods ending after September 15, 2009, for mostentities. On the effective date, all non-SEC accounting and reporting standardswere superseded. The Bank adopted this statement for the quarterly period endedSeptember 30, 2009, as required, and adoption did not have a materialimpact on the Bank’s consolidated financial statements.

 

We adopted AccountingStandards Codification (“ASC”) 815-10, formerly Statement of Financial AccountingStandards (“SFAS”) No. 161, *Disclosuresabout Derivative Instruments and Hedging Activities*, as of January 1,2009. The objective of this Statement is to provide enhanced disclosuresabout derivative instruments and related hedging items. This Statement did nothave an impact on the Company’s financial statements.

 

We adopted ASC 805-10, formerly SFAS No. 141R, *Business Combinations,* as of January 1,2009. The objective of this Statement is to improve the relevance,representational faithfulness, and comparability of the information that areporting entity provides in its financial reports about a business combinationand its effects. To accomplish that, this Statement establishes principles andrequirements for how the acquirer:

 

a.                          Recognizes and measuresin its financial statements the identifiable assets acquired, the liabilitiesassumed, and any noncontrolling interest in the acquiree

b.                         Recognizes andmeasures the goodwill acquired in the business combination or a gain from abargain purchase

c.                          Determines whatinformation to disclose to enable users of the financial statements to evaluatethe nature and financial effects of the business combination.

 

This Statement appliesprospectively to business combinations for which the acquisition date is on orafter the beginning of the first annual reporting period beginning on or after December 15,2008.  Based on our current activities, the adoption of this Statement didnot have an effect on the financial statements of the Company.

 

We adopted ASC 855-10,formerly FASB Statement 165, *Subsequent Events*,effective for financial statements issued for periods ending after June 15,2009.  This Statement addresses eventsthat occur after the balance sheet date but before the issuance of thefinancial statements, distinguishes which subsequent events that should berecognized in the financial statements, which nonrecognized events requiredisclosure and requires the disclosure of the date through which subsequentevents were evaluated.  See note 12 fordisclosure.

 

On April 9, 2009, theFASB issued ASC 825-10, formerly FASB Staff Position FAS No. 107-1 andAccounting Principles Bulletin 28-1, *InterimDisclosures about Fair Value of Financial Instruments,*which amended FASB No 107, *Disclosures about Fair Value of Financial Instruments*and is effective for financial statements issued for interim periods endingafter June 15, 2009. * *The Statement was amended torequire that the existing annual fair 

 

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valuedisclosure requirements under *Disclosuresabout Fair Value of Financial Instruments* be expanded to interimperiods.  This statement was adopted inthe second quarter of 2009. See note 10 for disclosure.

 

On April 9, 2009, theFASB issued ASC 320-10, formerly FSP FAS No. 115-2 and FAS No. 124-2,*Recognition and Presentation ofOther-Than-Temporary Impairments,*effective for financial statements issued for interim periods endingafter June 15, 2009. * *The statement was amended to makesignificant changes to the Other Than Temporary Impairment (“OTTI”) assertionsmade related to debt securities. The FSP also provided for additional interimdisclosures related to OTTI on debt securities. These Statements did not have a material effect on the financialstatements of the Company.

 

On April 9, 2009, theFASB issued ASC 820-10, formerly FAS 157-4, *DeterminingFair Value When the Volume and Level of Activity for the Asset or LiabilityHave Significantly Decreased and Identifying Transactions That Are Not Orderly*(FSPFAS 157-4), effective for financialstatements issued for interim periods ending after June 15, 2009. * *TheFSP provides additional guidance on determining fair value in inactive marketsfor financial assets under *Fair ValueMeasurements.** *ThisStatement did not have a material effect on the financial statements of theCompany.

 

**Note 3 – Accounting StandardsIssued Not Yet Effective**

 

OnJune 12, 2009, the FASB issued ASC 860, formerly FAS 166, *Accounting for Transfers of Financial Assets,*which**isa revision to ASC 860, formerly FAS 140, *Accountingfor Transfers and Servicing of Financial Assets and Extinguishments ofLiabilities*, and will require more information about transfers offinancial assets, including securitization transactions, and where companieshave continuing exposure to the risks related to transferred financial assets.The statement also eliminates the concept of a “qualifying special-purposeentity”, changes the requirements for derecognizing financial assets andrequires additional disclosures. It will be effective for financial statementsissued for interim and annual periods ending after November 15, 2009.  Earlier application is prohibited. Therecognition and measurement provisions shall be applied to transfers that occuron or after the effective date. The Bank will adopt on January 1, 2010, asrequired. Management has not determined the impact adoption may have on theBank’s consolidated financial statements.

 

OnJune 12, 2009, the FASB issued ASC 860, formerly FAS 167, *Amendments to FASB Interpretation**No. 46(R)* whichwill change the way entities account for securitizations and special-purposeentities. The statement is a revision to ASC 810, formerly FASB Interpretation No. 46(R),*Consolidation of Variable Interest Entities*,and changes how a company determines when an entity that is insufficientlycapitalized or is not controlled through voting (or similar rights) should beconsolidated. The determination of whether a company is required to consolidatean entity is based on, among other things, an entity’s purpose and design and acompany’s ability to direct the activities of the entity that mostsignificantly impact the entity’s economic performance. It will be effectivefor financial statements issued for interim and annual periods ending after November 15,2009.  Earlier application is prohibited.The Bank will adopt on January 1, 2010, as required. Management has notdetermined the impact adoption may have on the Bank’s consolidated financialstatements.

 

In August 2009, the FASBissued Accounting Standards Update (“ASU”) 2009-05, *MeasuringLiabilities at Fair Value,*which supplements and amends the guidancein ASC 820 on how to measure the fair value of liabilities.  Alternative valuation methods and a hierarchyare outlined in the update.  ASU 2009-05also clarifies that restrictions preventing the transfer of a liability shouldnot be considered as a separate input or adjustment in the measurement of itsfair value. ASU 2009-05 is effective as of October 1, 2009. Managementdoes not believe the adoption of ASU 2009-05 will have a material effect on thefinancial statements of the Company.

 

**Note 4 – Preferred Stock**

** **

OnMarch 6, 2009, as part of the Troubled Asset Relief Program (“TARP”)Capital Purchase Program, the Company entered into a Securities PurchaseAgreement (the “Purchase Agreement”) with the United States Department of theTreasury (“Treasury”), pursuant to which the Company, for a purchase price of$16.5 million in cash, (i) sold 16,500 shares of the Company’s Fixed RateCumulative Perpetual Preferred Stock, Series A (the “Series APreferred Stock”) and (ii) issued a warrant (the “Warrant”) to purchase321,847 shares of the Company’s common stock, par value $1.00 per share (the “CommonStock”), at an exercise price of $7.69 per share.  The Series A Preferred Stock qualifiesas Tier 1 capital and is entitled to cumulative dividends. The preferred stockdividend reduces earnings available to common shareholders and is computed atan annual rate of 5% per annum for the first five years, and 9% per annumthereafter. The Series A Preferred Stock is non-voting, other than classvoting rights on certain matters that could adversely affect the Series APreferred Stock. The Series A Preferred Stock may be redeemed by theCompany with regulatory approval and when such preferred shares are redeemed,the Treasury shall liquidate the Warrant associated with such preferredshares.  The Warrant has a 10-year termand was immediately exercisable upon its issuance, with an exercise price,subject to anti-dilution adjustments, equal to $7.69 per share of

 

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theCommon Stock.   Treasury has agreed notto exercise voting power with respect to any shares of Common Stock issued uponexercise of the Warrant that it holds.

 

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

 

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

 

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

 

**Note 5 - Earnings per CommonShare**

** **

The weighted average number of common shares used to calculate earningsper share for the periods ended September 30, 2009 and 2008 were asfollows:

 
| ** **                                | ** ** | **Three months ended  September 30,** | ** ** | **Nine months ended  September 30,** | ** ** |
|-------------------------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                | ** ** | **2009**                                   | ** ** | **2008**                                  | ** ** | **2009** | ** ** | **2008** | ** ** |
| Basic weighted - average  common shares   |       | 4,846,785                                  |       | 4,848,385                                 |       | 4,846,785 |   | 4,848,356 |   |
| Effect of dilutive  securities            |       | —                                     |       | —                                    |       | — |   | 647 |   |
| Diluted weighted - average  common shares |       | 4,846,785                                  |       | 4,848,385                                 |       | 4,846,785 |   | 4,849,003 |   |

 

Theincremental shares for the assumed exercise of the outstanding options weredetermined by application of the treasury stock method. The calculation ofdiluted earnings per share excludes 17,242 options outstanding for the threeand nine months ended September 30, 2009, which were antidilutive. Inaddition, the calculation excludes the Warrant to purchase 321,847 shares ofcommon stock outstanding for the three and nine month periods endedSeptember 30, 2009, which was antidilutive.

 

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**Note 6 – InvestmentSecurities**

** **

Investment securities consisted of the following (in thousands):

 
| ** **                              | ** ** | **September 30, 2009** | ** ** |
|-----------------------------------------|------------|-----------------------------|------------|
| ** **                              | ** ** | ** **                  | ** ** | **Gross** | ** ** | **Gross** | ** ** | ** ** | ** ** |
| ** **                              | ** ** | **Amortized**               | ** ** | **Unrealized** | ** ** | **Unrealized** | ** ** | **Fair** | ** ** |
| **Held To  Maturity**                   | ** ** | **Cost**                    | ** ** | **Gains** | ** ** | **Losses** | ** ** | **Value** | ** ** |
|                                    |       |                        |       |   |   |   |   |   |   |
| Municipal securities                    |       | $                           | 23,191     |   | $ | 493 |   | $ | (111 | ) | $ | 23,573 |   |
| U.S. Government and Agency  obligations |       | 107,037                     |       | 249 |   | (824 | ) | 106,462 |   |
|                                    |       |                        |       |   |   |   |   |   |   |
| Total                                   |       | $                           | 130,228    |   | $ | 742 |   | $ | (935 | ) | $ | 130,035 |   |

 
| ** **                              | ** ** | **December 31, 2008** | ** ** |
|-----------------------------------------|------------|----------------------------|------------|
| ** **                              | ** ** | ** **                 | ** ** | **Gross** | ** ** | **Gross** | ** ** | ** ** | ** ** |
| ** **                              | ** ** | **Amortized**              | ** ** | **Unrealized** | ** ** | **Unrealized** | ** ** | **Fair** | ** ** |
| **Held To  Maturity**                   | ** ** | **Cost**                   | ** ** | **Gains** | ** ** | **Losses** | ** ** | **Value** | ** ** |
|                                    |       |                       |       |   |   |   |   |   |   |
| Municipal securities                    |       | $                          | 19,565     |   | $ | 75 |   | $ | (599 | ) | $ | 19,041 |   |
| U.S. Government and Agency  obligations |       | 116,847                    |       | 233 |   | (66 | ) | 117,014 |   |
|                                    |       |                       |       |   |   |   |   |   |   |
| Total                                   |       | $                          | 136,412    |   | $ | 308 |   | $ | (665 | ) | $ | 136,055 |   |

 

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

 
| ** **                              | ** ** | **September 30, 2009** | ** ** |
|-----------------------------------------|------------|-----------------------------|------------|
| ** **                              | ** ** | **Less than 12 Months**     | ** ** | **12 Months or More** | ** ** | **Total** | ** ** |
| ** **                              | ** ** | **Fair**                    | ** ** | **Unrealized** | ** ** | **Fair** | ** ** | **Unrealized** | ** ** | **Fair** | ** ** | **Unrealized** | ** ** |
| ** **                              | ** ** | **Value**                   | ** ** | **Losses** | ** ** | **Value** | ** ** | **Losses** | ** ** | **Value** | ** ** | **Losses** | ** ** |
|                                    |       |                        |       |   |   |   |   |   |   |   |   |   |   |
| Municipal securities                    |       | $                           | 198        |   | $ | 2 |   | $ | 2,622 |   | $ | 109 |   | $ | 2,820 |   | $ | 111 |   |
| U.S. Government and Agency  obligations |       | 52,163                      |       | 824 |   | — |   | — |   | 52,163 |   | 824 |   |
|                                    |       |                        |       |   |   |   |   |   |   |   |   |   |   |
|                                    |       | $                           | 52,361     |   | $ | 826 |   | $ | 2,622 |   | $ | 109 |   | $ | 54,983 |   | $ | 935 |   |

 
| ** **                              | ** ** | **December 31, 2008** | ** ** |
|-----------------------------------------|------------|----------------------------|------------|
| ** **                              | ** ** | **Less than 12 Months**    | ** ** | **12 Months or More** | ** ** | **Total** | ** ** |
| ** **                              | ** ** | **Fair**                   | ** ** | **Unrealized** | ** ** | **Fair** | ** ** | **Unrealized** | ** ** | **Fair** | ** ** | **Unrealized** | ** ** |
| ** **                              | ** ** | **Value**                  | ** ** | **Losses** | ** ** | **Value** | ** ** | **Losses** | ** ** | **Value** | ** ** | **Losses** | ** ** |
|                                    |       |                       |       |   |   |   |   |   |   |   |   |   |   |
| Municipal securities                    |       | $                          | 5,493      |   | $ | 171 |   | $ | 3,926 |   | $ | 428 |   | $ | 9,419 |   | $ | 599 |   |
| U.S. Government and Agency  obligations |       | 15,503                     |       | 66 |   | — |   | — |   | 15,503 |   | 66 |   |
|                                    |       |                       |       |   |   |   |   |   |   |   |   |   |   |
|                                    |       | $                          | 20,996     |   | $ | 237 |   | $ | 3,926 |   | $ | 428 |   | $ | 24,922 |   | $ | 665 |   |

 

On a quarterly basis, management conducts a formal review of securitiesfor the presence of OTTI.  Management assesses whether an OTTI ispresent when the fair value of a security is less than its amortized cost basisat the balance sheet date.  For such securities, OTTI is consideredto have occurred if the Company intends to sell the security, if it is more likelythan not the Company will be required to sell the security before recovery ofits amortized cost basis or if the present values of expected cash flows is notsufficient to recover the entire amortized cost.

 

The unrealized losses are primarily a result of increases in marketyields from the time of purchase.  In general, as market yields rise,the fair value of securities will decrease; as market yields fall, the fairvalue of securities will increase. Management generally views changes in fairvalue caused by changes in interest rates as temporary; therefore, thesesecurities have not been classified as other-than-temporarilyimpaired.  Additionally, the impairment is also considered temporarybecause scheduled coupon payments have been made, it is anticipated that theentire principal balance will be collected as scheduled, and management neitherintends to sell the securities and it is not

 

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more likely than not that the Company will be required to sell thesecurities before the recovery of the remaining amortized cost amount.

 

The Company has pledged investment securities held to maturity withcarrying values of approximately $53.6 million at September 30, 2009, and$76.4 million at December 31, 2008 as collateral for certain deposits inexcess of $250,000.

 

The scheduled maturities of debt securities at September 30, 2009,by contractual maturity are shown below (in thousands). Expected maturities maydiffer from contractual maturities because borrowers may have the right to callor prepay obligations with or without call or prepayment penalties.

 
| ** **                        | ** ** | **September 30, 2009** | ** ** |
|-----------------------------------|------------|-----------------------------|------------|
| ** **                        | ** ** | **Amortized**               | ** ** | **Fair** | ** ** |
| ** **                        | ** ** | **Cost**                    | ** ** | **Value** | ** ** |
|                              |       |                        |       |   |   |
| Within one year                   |       | $                           | 425        |   | $ | 431 |   |
| Due from one year to five  years  |       | 2,100                       |       | 2,083 |   |
| Due from five years to ten  years |       | 10,271                      |       | 10,290 |   |
| Due after ten years               |       | 117,432                     |       | 117,231 |   |
|                              |       |                        |       |   |   |
| Total                             |       | $                           | 130,228    |   | $ | 130,035 |   |

 

As of September 30, 2009 and December 31,2008, investments with carrying values of approximately $123.1 million and$135.8 million, respectively, have call options held by the issuer, of whichapproximately $97.1 million and $124.8 million, respectively, are or werecallable within one year.

 

**Note 7 – Impaired Loans**

 

Impaired loans consistedof the following as of the dates indicated (in thousands):

 
| ** **                                              | ** ** | **September 30,  2009** | ** ** | **December 31,  2008** | ** ** |
|---------------------------------------------------------|------------|------------------------------|------------|-----------------------------|------------|
|                                                    |       |                         |       |                        |       |
| Impaired  loans with valuation allowance                |       | $                            | 44,016     |                        | $          | 5,102 |   |
| Impaired  loans without a valuation allowance           |       | 11,543                       |       | 4,815                       |       |
| Total  impaired loans                                   |       | 55,559                       |       | 9,917                       |       |
|                                                    |       |                         |       |                        |       |
| Specific  valuation allowances                          |       | (16,263                      | )          | (1,573                      | )          |
| Impaired  loans, net of specific valuation allowances   |       | $                            | 39,296     |                        | $          | 8,344 |   |
|                                                    |       |                         |       |                        |       |
| Nonaccrual  loans, net of specific valuation allowances |       | $                            | 45,922     |                        | $          | 22,503 |   |

 

**Note 8 – Allowances for Loanand Real Estate Losses**

** **

A summary of the activity in the allowances for loan and real estatelosses is as follows for the three and nine months ended September 30 (inthousands):

 
| ** **                       | ** ** | **Three Months Ended  September 30,****2009** | ** ** | **Three Months Ended  September 30,****2008** | ** ** |
|----------------------------------|------------|----------------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                       | ** ** | **Loans**                                          | ** ** | **Real Estate**                                    | ** ** | **Loans** | ** ** | **Real Estate** | ** ** |
|                             |       |                                               |       |                                               |       |   |   |   |   |
| Balance—beginning of period |       | $                                                  | 11,924     |                                               | $          | — |   | $ | 5,215 |   | $ | — |   |
|                             |       |                                               |       |                                               |       |   |   |   |   |
| Provisions for estimated losses  |       | 30,196                                             |       | 3,694                                              |       | 1,611 |   | 164 |   |
| Recoveries                       |       | 64                                                 |       | —                                             |       | 242 |   | — |   |
| Losses charged off               |       | (812                                               | )          | (211                                               | )          | (246 | ) | (164 | ) |
|                             |       |                                               |       |                                               |       |   |   |   |   |
| Balance—end of period       |       | $                                                  | 41,372     |                                               | $          | 3,483 |   | $ | 6,822 |   | $ | — |   |

 
| ** **                       | ** ** | **Nine Months Ended   September 30,****2009** | ** ** | **Nine Months Ended   September 30,****2008** | ** ** |
|----------------------------------|------------|----------------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                       | ** ** | **Loans**                                          | ** ** | **Real Estate**                                    | ** ** | **Loans** | ** ** | **Real Estate** | ** ** |
|                             |       |                                               |       |                                               |       |   |   |   |   |
| Balance—beginning of period |       | $                                                  | 6,441      |                                               | $          | — |   | $ | 5,162 |   | $ | — |   |
|                             |       |                                               |       |                                               |       |   |   |   |   |
| Provisions for estimated losses  |       | 36,161                                             |       | 4,410                                              |       | 4,110 |   | 480 |   |
| Recoveries                       |       | 819                                                |       | —                                             |       | 436 |   | — |   |
| Losses charged off               |       | (2,049                                             | )          | (927                                               | )          | (2,886 | ) | (480 | ) |
|                             |       |                                               |       |                                               |       |   |   |   |   |
| Balance—end of period       |       | $                                                  | 41,372     |                                               | $          | 3,483 |   | $ | 6,822 |   | $ | — |   |

 

The allowance for loan losses as of September 30, 2009 and 2008 includesgeneral valuation allowances of $21.1 million and $3.1 million, respectively, andspecific valuation allowances of $20.3 million and $3.7 million, respectively.  The provision for loan losses increasedbetween the periods listed above primarily due to increases in total nonaccrualloans and in the loss factors used in certain allowance categories, as well asan increase in specific loan loss allowances, in each respect due todeteriorating economic conditions.

 

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**Note 9 – Income Taxes**

** **

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

 
| ** **                       | ** ** | **Nine Months Ended**       | ** ** |
|----------------------------------|------------|-----------------------------|------------|
| ** **                       | ** ** | **September 30, 2009** | ** ** | **September 30, 2008** | ** ** |
|                             |       |                        |       |   |   |
| Income tax provision  (benefit): |       |                        |       |   |   |
| Current:                         |       |                        |       |   |   |
| Federal                          |       | $                           | 999        |   | $ | 457 |   |
| State                            |       | 10                          |       | (17 | ) |
| Total current                    |       | 1,009                       |       | 440 |   |
|                             |       |                        |       |   |   |
| Deferred:                        |       |                        |       |   |   |
| Federal                          |       | (13,247                     | )          | (581 | ) |
| State                            |       | (2,698                      | )          | (132 | ) |
| Valuation allowance              |       | 3,166                       |       | — |   |
| Total deferred                   |       | (12,779                     | )          | (713 | ) |
|                             |       |                        |       |   |   |
| Total                            |       | $                           | (11,770    | ) | $ | (273 | ) |

 

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

 
| ** **                           | ** ** | **Nine Months Ended September 30,** | ** ** |
|--------------------------------------|------------|------------------------------------------|------------|
| ** **                           | ** ** | **2009**                                 | ** ** | **2008** | ** ** |
|                                 |       |                                     |       |   |   |   |   |   |   |
| Taxes at statutory rate              |       | $                                        | (12,728    | ) | 34.0 | % | $ | 694 |   | 34.0 | % |
| Increase (decrease)  resulting from: |       |                                     |       |   |   |   |   |   |   |
| State income tax—net            |       | (1,748                                   | )          | 4.7 |   | (98 | ) | (4.8 | ) |
| Valuation allowance                  |       | 3,166                                    |       | (8.5 | ) | — |   | — |   |
| Earnings on life insurance  policies |       | (207                                     | )          | 0.5 |   | (598 | ) | (29.3 | ) |
| Nontaxable investments               |       | (231                                     | )          | 0.6 |   | (175 | ) | (8.6 | ) |
| Other—net                       |       | (22                                      | )          | 0.1 |   | (96 | ) | (4.7 | ) |
|                                 |       |                                     |       |   |   |   |   |   |   |
| Total                                |       | $                                        | (11,770    | ) | 31.4 | % | $ | (273 | ) | (13.4 | )% |

 

The Company’s net deferred tax asset account was comprised of thefollowing (in thousands):

 
| ** **                                      | ** ** | **September ****30,********2009** | ** ** | **December 31,  2008** | ** ** |
|-------------------------------------------------|------------|----------------------------------------|------------|-----------------------------|------------|
|                                            |       |                                   |       |                        |       |
| Deferred tax assets:                            |       |                                   |       |                        |       |
| Allowance for loan losses                       |       | $                                      | 15,841     |                        | $          | 2,466 |   |
| Real estate owned                               |       | 2,497                                  |       | 360                         |       |
| Other                                           |       | 246                                    |       | 14                          |       |
| Total deferred tax assets                       |       | 18,584                                 |       | 2,840                       |       |
| Valuation allowance                             |       | (3,166                                 | )          | —                      |       |
| Deferred tax asset, net of  valuation allowance |       | 15,418                                 |       | 2,840                       |       |
|                                            |       |                                   |       |                        |       |
| Deferred tax liabilities:                       |       |                                   |       |                        |       |
| Office properties                               |       | (921                                   | )          | (919                        | )          |
| Federal Home Loan Bank  stock                   |       | (426                                   | )          | (559                        | )          |
| Pension plan contribution                       |       | (17                                    | )          | (106                        | )          |
| Prepaid expenses                                |       | (153                                   | )          | (151                        | )          |
| Other                                           |       | (17                                    | )          | —                      |       |
| Total deferred tax  liabilities                 |       | (1,534                                 | )          | (1,735                      | )          |
|                                            |       |                                   |       |                        |       |
| Deferred tax asset, net                         |       | $                                      | 13,884     |                        | $          | 1,105 |   |

 

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Since December 31, 2008, the Company’s deferred tax asset hasincreased significantly, primarily due to additions to the allowance for loanlosses.  For income tax return purposes,only net charge-offs on uncollectible loan balances are deductible, not theprovision for loan losses. Under generally accepted accounting principles, avaluation allowance is required to be recognized unless it is “more likely thannot” that a deferred tax asset will be realized. Our assessment of thelikelihood of realization of the deferred tax assets is highly subjective anddependent upon judgment concerning management’s evaluation of both positive andnegative evidence, the forecasts of future income, applicable tax planningstrategies, and assessments of the current and future economic and businessconditions. Positive evidence includes the existence of taxes paid in availablecarryback years as well as the probability that taxable income will begenerated in future periods while negative evidence includes a significant lossin the current year as well as general business and economic trends.  At September 30, 2009, we determinedthat a valuation allowance relating to the state portion of our deferred taxasset was necessary. This determination was based largely on the negativeevidence represented by the level of state tax exempt interest income whichreduces state taxable income to a level that makes it unlikely the Company willrealize its state deferred tax asset. Therefore, a valuation allowance of $3.2million at September 30, 2009 was recorded to offset the state deferredtax asset.

 

Specifically exempted from deferred tax recognition requirements are baddebt reserves for tax purposes of U.S. savings and loans in the institution’sbase year, as defined. Base year reserves totaled approximately $4.2 million.Consequently, a deferred tax liability of approximately $1.6 million related tosuch reserves was not provided for in the consolidated statements of financialcondition at September 30, 2009 and December 31,2008. Payment of dividends to shareholders out of retained earnings deemed tohave been made out of earnings previously set aside as bad debt reserves maycreate taxable income to the Bank. No provision has been made for income tax onsuch a distribution as the Bank does not anticipate making such distributions.

 

The Company files income tax returns in the U.S. federal jurisdictionand the state of Arkansas. The Company is subject to U.S. federal and stateincome tax examinations by tax authorities for tax years ended December 31,2006 and forward.  The Company’s 2007federal income tax return was subject to a limited scope examination by theInternal Revenue Service during the first quarter of 2009.  As a result of the examination, the Companywas assessed approximately $45,000, including interest, for the 2007 tax year.

 

**Note 10 – Fair Value Measurement**

 

Effective January 1, 2008, the Bank adopted ASC 820, formerly SFAS157, *Fair Value Measurement*, which provides aframework for measuring fair value and defines fair value as the exchange pricethat would be received for an asset or paid to transfer a liability (an exitprice) in the principal or most advantageous market for the asset or liabilityin an orderly transaction between market participants on the measurement date.ASC 820 also establishes a fair value hierarchy which requires an entity tomaximize the use of observable inputs and minimize the use of unobservableinputs when measuring fair value. ASC 820 describes three levels of inputs thatmay be used to measure fair value:

 
| Level 1 |   | Unadjusted, quoted prices in active markets for identical assets or  liabilities at the measurement date.                                                                                                                                                                                                                          |
|--------------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|         |   |                                                                                                                                                                                                                                                                                                                               |
| Level 2 |   | Observable inputs other than Level 1 prices, such as quoted prices for  similar assets or liabilities; quoted prices in markets that are not active;  or other inputs that are observable or can be corroborated by observable  market data at the measurement date for substantially the full term of the  assets or liabilities. |
|         |   |                                                                                                                                                                                                                                                                                                                               |
| Level 3 |   | Unobservable inputs that reflect management’s best estimate of what  market participants would use in pricing the asset or liability at the  measurement date.                                                                                                                                                                |

 

The following is a description of valuation methodologies used forsignificant assets measured at fair value on a non-recurring basis.

 

*Loans Receivable*

 

Loans which meet certain criteria are evaluated individually forimpairment. A loan is considered impaired when, based upon current informationand events, it is probable the Bank will be unable to collect all amounts due,including principal and interest, according to the contractual terms of theloan agreement.  Substantially all of the Bank’s impaired loans at September 30,2009 are secured by real estate.  These impaired loans areindividually assessed to determine that the carrying value of the loan is notin excess of the fair value of the collateral, less estimated selling costs.Fair value is estimated through current appraisals, real estate brokers orlisting prices.  Fair values may be adjusted by management to reflectcurrent economic and market conditions and, as such, are classified asLevel 3.  Impaired loans at September 30, 2009 were $55.6million. Based on this evaluation, the Company maintains specific valuationallowances of $16.3 million at September 30, 2009 for such impaired loans.

 

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*REO, net*

 

REO represents real estate acquired as a result of foreclosure or bydeed in lieu of foreclosure and is carried at the lower of cost or fair valueless estimated selling costs.  Fair value is estimated throughcurrent appraisals, real estate brokers or listing prices.  As theseproperties are actively marketed, estimated fair values may be adjusted bymanagement to reflect current economic and market conditions and, as such, areclassified as Level 3.  REO at September 30, 2009 was $28.0million. During the nine months ended September 30, 2009, charge-offs tothe allowance for loan losses related to loans that were transferred toREO were $1.3 million on transfers to REO of $15.9 million.  Write downs related to REO that were chargedto expense were $4.4 million for the nine months ended September 30,2009.

 

The following table provides the level of valuation assumption used todetermine the carrying value of the Company’s assets measured at fair value ona non-recurring basis at September 30, 2009:

 
| ** **     | ** ** | **Fair Value** | ** ** | **Quoted Prices in  Active Markets for  Identical Assets  (Level 1)** | ** ** | **Significant********Other Observable  Inputs********(Level 2)** | ** ** | **Significant********Unobservable********Inputs********(Level 3)** | ** ** |
|----------------|------------|----------------|------------|-----------------------------------------------------------------------|------------|------------------------------------------------------------------|------------|--------------------------------------------------------------------|------------|
| Impaired loans |       | $              | 39,296     |                                                                  | $          | —                                                           |       | $                                                                  | —     |   | $ | 39,296 |   |
| REO, net (1)   |       | 28,922         |       | —                                                                |       | —                                                           |       | 28,922                                                             |       |
|           |       | $              | 68,218     |                                                                  | $          | —                                                           |       | $                                                                  | —     |   | $ | 68,218 |   |

 

----

(1)        Amounts listed reflectfair value measurements of the properties before deducting estimated costs tosell.

 

**FAIRVALUE OF FINANCIAL INSTRUMENTS**

** **

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

 
| ** **                                             | ** ** | **September 30,  2009** | ** ** | **December 31,  2008** | ** ** |
|--------------------------------------------------------|------------|------------------------------|------------|-----------------------------|------------|
| ** **                                             | ** ** | ** **                   | ** ** | **Estimated**               | ** ** | ** ** | ** ** | **Estimated** | ** ** |
| ** **                                             | ** ** | **Carrying**                 | ** ** | **Fair**                    | ** ** | **Carrying** | ** ** | **Fair** | ** ** |
| ** **                                             | ** ** | **Value**                    | ** ** | **Value**                   | ** ** | **Value** | ** ** | **Value** | ** ** |
| ASSETS:                                                |       |                         |       |                        |       |   |   |   |   |
| Cash and cash equivalents                              |       | $                            | 7,946      |                        | $          | 7,946 |   | $ | 9,367 |   | $ | 9,367 |   |
| Investment securities—held  to maturity           |       | 130,228                      |       | 130,035                     |       | 136,412 |   | 136,055 |   |
| Federal Home Loan Bank  stock                          |       | 3,657                        |       | 3,657                       |       | 4,825 |   | 4,825 |   |
| Loans receivable—net                              |       | 503,198                      |       | 509,387                     |       | 566,537 |   | 579,627 |   |
| Loans held for sale                                    |       | 1,522                        |       | 1,522                       |       | 1,586 |   | 1,586 |   |
| Cash surrender value of  life insurance                |       | 21,022                       |       | 21,022                      |       | 20,412 |   | 20,412 |   |
| Accrued interest receivable                            |       | 4,419                        |       | 4,419                       |       | 6,701 |   | 6,701 |   |
| Commitments                                            |       | 26                           |       | 26                          |       | 14 |   | 14 |   |
|                                                   |       |                         |       |                        |       |   |   |   |   |
| LIABILITIES:                                           |       |                         |       |                        |       |   |   |   |   |
| Deposits:                                              |       |                         |       |                        |       |   |   |   |   |
| Checking, money market and  savings accounts           |       | 233,656                      |       | 233,656                     |       | 231,509 |   | 231,509 |   |
| Certificates of deposit                                |       | 370,336                      |       | 374,364                     |       | 386,494 |   | 390,638 |   |
| Other borrowings                                       |       | 68,179                       |       | 69,163                      |       | 92,212 |   | 94,114 |   |
| Accrued interest payable                               |       | 383                          |       | 383                         |       | 910 |   | 910 |   |
| Advance payments by  borrowers for taxes and insurance |       | 631                          |       | 631                         |       | 810 |   | 810 |   |
| Commitments                                            |       | 26                           |       | 26                          |       | 14 |   | 14 |   |
|                                                        |            |                              |            |                             |            |  |  |  |  |  |  |  |  |

 

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

 

The fair value of checking accounts, savings accountsand money market deposits is the amount payable on demand at the reportingdate. The fair value of fixed-maturity certificates of deposit and Federal HomeLoan Bank advances is 

 

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estimated using the rates currently offered fordeposits of similar terms and advances of similar remaining maturities at thereporting date. For advance payments by borrowers, for taxes and insurance, accruedinterest payable and Federal Reserve Bank advances, the carrying value is areasonable estimate of fair value, primarily because of the short-term natureof the instruments.

 

The fair value estimates presented herein are basedon pertinent information available to management as of September 30, 2009and December 31, 2008. Although management is not aware of any factorsthat would significantly affect the estimated fair value amounts, such amountshave not been comprehensively revalued for purposes of these financialstatements since the reporting date and, therefore, current estimates of fairvalue may differ significantly from the amounts presented herein.

 

**Note 11 – Regulatory Capital**

 

The Bank is subject to various regulatory capital requirements administeredby the OTS. Failure to meet minimum capital requirements can initiate certainmandatory—and possible additional discretionary—actions by regulators that, ifundertaken, could have a direct and material effect on the Bank’s financialstatements. Under capital adequacy guidelines and the regulatory framework forprompt corrective action, the Bank must meet specific capital guidelines thatinvolve quantitative measures of the Bank’s assets, liabilities, and certainoff-balance sheet items as calculated under regulatory accounting practices.The Bank’s capital amounts and classification are also subject to qualitativejudgments by the regulators about components, risk weightings, and otherfactors.  Given the current bankingenvironment, regulatory agencies are increasingly addressing issues with formalenforcement actions.  Imposition of such an action could preclude the Bankfrom being considered well-capitalized and restrict or prohibit certainactivities by the Bank.

 

Quantitative measures established by regulation to ensure capitaladequacy require the Bank to maintain minimum amounts and ratios (set forth inthe following table) of tangible capital (as defined) to tangible assets (asdefined) and core capital (as defined) to adjusted tangible assets (asdefined), and of total risk-based capital (as defined) to risk-weighted assets(as defined). Management believes, as of September 30, 2009, that the Bankmeets all capital adequacy requirements to which it is subject.

 

The most recent notification from the OTS categorized the Bank as wellcapitalized under the regulatory framework for prompt corrective action. To becategorized as well capitalized the Bank must maintain minimum core (Tier Ileverage), Tier I risk-based, and total risk-based ratios as set forth in thetable.

 

The Bank’s actual capital amounts (in thousands) and ratios are alsopresented in the table:

 
| ** **                               | ** ** | ** ** | ** ** | ** **             | ** ** | ** **             | ** ** | ** **             | ** ** | **To  be Categorized** | ** ** |
|------------------------------------------|------------|------------|------------|------------------------|------------|------------------------|------------|------------------------|------------|------------------------|------------|
| ** **                               | ** ** | ** ** | ** ** | ** **             | ** ** | ** **             | ** ** | ** **             | ** ** | **as  Well**           | ** ** |
| ** **                               | ** ** | ** ** | ** ** | ** **             | ** ** | ** **             | ** ** | ** **             | ** ** | **Capitalized  Under** | ** ** |
| ** **                               | ** ** | ** ** | ** ** | ** **             | ** ** | **For  Capital**       | ** ** | **Prompt  Corrective** | ** ** |
| ** **                               | ** ** | **Actual** | ** ** | **Adequacy  Purposes** | ** ** | **Action  Provisions** | ** ** |
| ** **                               | ** ** | **Amount** | ** ** | **Ratio**              | ** ** | **Amount**             | ** ** | **Ratio**              | ** ** | **Amount**             | ** ** | **Ratio** | ** ** |
|                                     |       |       |       |                   |       |                   |       |                   |       |                   |       |   |   |
| As of September 30, 2009:           |       |       |       |                   |       |                   |       |                   |       |                   |       |   |   |
|                                     |       |       |       |                   |       |                   |       |                   |       |                   |       |   |   |
| Tangible Capital to Tangible Assets      |       | $          | 51,824     |                   | 7.11       | %                      | $          | 10,927                 |       | 1.50                   | %          | N/A |   | N/A |   |
|                                     |       |       |       |                   |       |                   |       |                   |       |                   |       |   |   |
| Core Capital to Adjusted Tangible Assets |       | 51,824     |       | 7.11                   | %          | 36,424                 |       | 5.00                   | %          | $                      | 36,424     |   | 5.00 | % |
|                                     |       |       |       |                   |       |                   |       |                   |       |                   |       |   |   |
| Total Capital to Risk-Weighted Assets    |       | 58,309     |       | 11.56                  | %          | 50,428                 |       | 10.00                  | %          | 50,428                 |       | 10.00 | % |
|                                     |       |       |       |                   |       |                   |       |                   |       |                   |       |   |   |
| Tier I Capital to Risk-Weighted Assets   |       | 51,824     |       | 10.28                  | %          | N/A                    |       | N/A                    |       | 30,257                 |       | 6.00 | % |
| ** **                               | ** ** | ** ** | ** ** | ** **             | ** ** | ** **             | ** ** | ** **             | ** ** | ** **             | ** ** | ** ** | ** ** |
| As of December 31, 2008:            |       |       |       |                   |       |                   |       |                   |       |                   |       |   |   |
|                                     |       |       |       |                   |       |                   |       |                   |       |                   |       |   |   |
| Tangible Capital to Tangible Assets      |       | $          | 70,703     |                   | 8.89       | %                      | $          | 11,925                 |       | 1.50                   | %          | N/A |   | N/A |   |
|                                     |       |       |       |                   |       |                   |       |                   |       |                   |       |   |   |
| Core Capital to Adjusted Tangible Assets |       | 70,703     |       | 8.89                   | %          | 31,799                 |       | 4.00                   | %          | $                      | 39,748     |   | 5.00 | % |
|                                     |       |       |       |                   |       |                   |       |                   |       |                   |       |   |   |
| Total Capital to Risk-Weighted Assets    |       | 74,144     |       | 13.35                  | %          | 44,436                 |       | 8.00                   | %          | 55,545                 |       | 10.00 | % |
|                                     |       |       |       |                   |       |                   |       |                   |       |                   |       |   |   |
| Tier I Capital to Risk-Weighted Assets   |       | 70,703     |       | 12.73                  | %          | N/A                    |       | N/A                    |       | 33,327                 |       | 6.00 | % |

 

**Note 12 –Subsequent Events**

 

Subsequent events have been evaluated through November 23, 2009,which is the date the financial statements were issued.  On November 19, 2009, the members of theboard of directors of the Company and the Bank received written notificationfrom the OTS of directives to address issues that arose in the Company’s andBank’s most recent regulatory examinations. The directives became effectiveupon receipt.  The directives require theCompany and the Bank to, among other things, obtain the prior written notice ofnon-objection of the OTS in order to (i) make or declare any dividends orpayments on their outstanding securities; (ii) renew, extend or revise anycontractual arrangement related to compensation or benefits of any director orexecutive officer, including change in control and severance payments; and (iii) increasethe Company’s debt position. The directives also require that the Company andBank notify the OTS at least 30 days in advance of the proposed addition of anyindividual to the board of directors, the employment of any individual as asenior executive officer or the change in responsibilities of any seniorexecutive officer. Further, the directives restrict the Company and Bank frommaking any golden parachute payment, including severance and change in controlpayments, except as permitted in limited circumstances by applicable OTSregulations.

 

The directives issued to the Bank also require the Bank to obtain theprior written notice of non-objection of the OTS in order to (i) engage incertain transactions with affiliates or insiders; (ii) enter into anythird-party contracts outside of the normal course of business; (iii) make,purchase, modify, renew, extend, refinance, or commit to make, purchase,modify, renew, refinance, or extend any commercial real estate loan exceeding$1,000,000; (iv) engage in any new activities, lending, or services inwhich the Bank was not actively engaged prior to the issuance of thedirectives; (v) open any agency, branch, or loan production office; and (vi) accept,renew or rollover any brokered deposits.

 

Inaddition, the directives also set forth certain limitations and restrictions onthe Bank and its business. For a further discussion of the directivesand the related limitations and restrictions, see Part II, Item 5. OtherInformation contained herein.

 

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**Item2.  MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITIONAND RESULTS OF OPERATIONS**

 

**EXECUTIVE SUMMARY**

 

Management’s discussion and analysis offinancial condition and results of operations is intended to assist a reader inunderstanding the consolidated financial condition and results ofoperations of the Company for the periods presented.  The information contained in this sectionshould be read in conjunction with the unaudited consolidated financialstatements and the notes to such financial statements found in this reportunder “Part I, Item 1, Consolidated Financial Statements”.

 

The Bank is a federally chartered stocksavings and loan association that was formed in 1934.  First Federal conducts business from its mainoffice and nineteen full-service branch offices, all of which are located in asix county area in Northcentral and Northwest Arkansas comprised of Benton,Marion, Washington, Carroll, Baxter and Boone counties. The Bank is a community-orientedfinancial institution offering a wide range of retail and commercial depositaccounts, including noninterest bearing and interest bearing checking, savingsand money market accounts, certificates of deposit, and individual retirementaccounts.  Loan products offered by theBank include residential real estate, consumer, construction, lines of credit,commercial real estate and commercial business loans. The Bank’slending activities are currently restricted as a result of directives from theOTS which became effective November 19, 2009.  For a further discussion of the directivesand the related limitations and restrictions, see Part II, Item 5. OtherInformation contained herein. Otherfinancial services include investment products offered through First FederalInvestment Services, Inc.; automated teller machines; 24-hour telephonebanking; internet banking, including account access, e-statements, bill paymentand online loan applications; Bounce ProtectionTM overdraft service; debitcards; and safe deposit boxes.

 

The Company’s results of operationsdepend primarily on its net interest income, which is the difference betweeninterest income on interest earning assets, such as loans and investments, andinterest expense on interest bearing liabilities, such as deposits andborrowings.  Net interest income isaffected by the level of nonperforming assets as they provide no interestearnings to the Bank.  The Company’sresults of operations are also affected by the provision for loan losses, thelevel of its noninterest income and expenses, and income tax expense.

 

The Companyrecorded a net loss of $23.2 million for the third quarter of 2009 compared tonet income of $218,000 during the third quarter of 2008.  For the nine months ended September 30,2009, net loss totaled $25.7 million compared to net income of $2.3 million forthe first nine months of 2008.  Thedecreases in net income for both the three month and nine month comparativeperiods were primarily due to an increase in the provision for loan losses andincreases in real estate owned expenses and FDIC insurance premiums.  The Company’s net loss available to commonshareholders was $4.84 per common share for the quarter ended September 30,2009 compared to net income of $0.05 per common share for the quarter ended September 30,2008.  The Company’s net loss availableto common shareholders was $5.40 per common share for the nine months ended September 30,2009 compared to net income of $0.48 per common share for the nine months endedSeptember 30, 2008.

 

The Company’s business activities and credit exposures are concentratedin Northwest Arkansas and the surrounding region which is subject to a weakhousing market and an oversupply of residential real estate, includingdeveloped and undeveloped land and residential development projects.  The continued recessionary forces in theCompany’s market area have had a negative impact on the Company’s financialcondition and results of operations. Nonaccrual loans, net of specific valuation allowances, have increasedfrom $22.5 million at December 31, 2008 to $45.9 million at September 30,2009 and, over the same period, total nonperforming assets have increased from$53.8 million or 6.8% of total assets to $75.1 million or 10.2% of the totalassets.  The level of nonperformingassets has and will continue to have an adverse effect on interest income, theprovision for loan losses, noninterest expenses and net income as well as theCompany’s interest rate spread and net interest margin.  The Company has devoted substantial resourcestoward the resolution of delinquent and nonperforming assets and, with respectto its REO properties, has committed an experienced special assets officer whois working full-time to liquidate the Bank’s properties in the NorthwestArkansas market.  The Company willcontinue to be proactive in taking steps to contain and reduce its nonperformingassets and minimize the negative impact on its financial condition and resultsof operations in future periods.

 

The Company and the Bank are subject to certain limitations andrestrictions on their business as a result of certain directives from the OTSwhich became effective November 19, 2009. For a further discussion of the directives and the related limitationsand restrictions, see Part II, Item 5. Other Information contained herein.

 

### **CRITICAL ACCOUNTING POLICIES**

### ** **

Various elements of our accountingpolicies, by their nature, are inherently subject to estimation techniques,valuation assumptions and other subjective assessments.  In particular, valuation of real estate ownedand the deferred tax asset and the methodology for the determination of ourallowance for loan losses, due to the judgments, estimates and assumptionsinherent in those policies are critical to the preparation of our financialstatements.  These policies and thejudgments, estimates and assumptions are described in greater detail insubsequent sections of Management’s Discussion and Analysis and in the notes tothe unaudited 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 

 

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these critical accountingpolicies, the use of other judgments, estimates and assumptions could result inmaterial differences in our financial condition or results 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 economy were to sustain aprolonged downturn, the loss factors applied to our portfolios may need to berevised, which may significantly impact the measurement of the allowance forloan losses.  For impaired loans that arecollateral-dependent, and for real estate owned, the estimated fair value ofthe collateral may deviate significantly from the proceeds received when thecollateral is sold.  During the thirdquarter of 2009, these factors significantly impacted our allowance for loanlosses and real estate owned.

 

Our assessment of thelikelihood of realization of the deferred tax assets is highly subjective anddependent upon judgment concerning management’s evaluation of both positive andnegative evidence, the forecasts of future income, applicable tax planningstrategies, and assessments of the current and future economic and businessconditions.

 

## **CHANGES IN FINANCIAL CONDITION**

##  

Changes in financialcondition between September 30, 2009 and December 31, 2008 arepresented in the following table (dollars in thousands).  Material changes between the periods arediscussed in the sections which follow the table.

 
| ** **                                     | ** ** | **September ****30,** | ** ** | **December 31,** | ** ** | **Increase**   | ** ** | **Percentage** | ** ** |
|------------------------------------------------|------------|----------------------------|------------|-----------------------|------------|----------------|------------|----------------|------------|
| ** **                                     | ** ** | **2009**                   | ** ** | **2008**              | ** ** | **(Decrease)** | ** ** | **Change**     | ** ** |
| **ASSETS**                                     |       |                       |       |                  |       |           |       |           |       |
| Cash and cash equivalents                      |       | $                          | 7,946      |                  | $          | 9,367          |       | $              | (1,421     | ) | (15.2 | )% |
| Investment securities held to maturity         |       | 130,228                    |       | 136,412               |       | (6,184         | )          | (4.5           | )          |
| Federal Home Loan Bank stock                   |       | 3,657                      |       | 4,825                 |       | (1,168         | )          | (24.2          | )          |
| Loans receivable, net                          |       | 503,198                    |       | 566,537               |       | (63,339        | )          | (11.2          | )          |
| Loans held for sale                            |       | 1,522                      |       | 1,586                 |       | (64            | )          | (4.0           | )          |
| Accrued interest receivable                    |       | 4,419                      |       | 6,701                 |       | (2,282         | )          | (34.1          | )          |
| Real estate owned, net                         |       | 27,971                     |       | 22,385                |       | 5,586          |       | 25.0           |       |
| Office properties and equipment, net           |       | 23,882                     |       | 24,694                |       | (812           | )          | (3.3           | )          |
| Deferred tax asset, net                        |       | 13,884                     |       | 1,105                 |       | 12,779         |       | 1,156.5        |       |
| Prepaid expenses and other assets              |       | 21,869                     |       | 21,560                |       | 309            |       | 1.4            |       |
|                                           |       |                       |       |                  |       |           |       |           |       |
| TOTAL                                          |       | $                          | 738,576    |                  | $          | 795,172        |       | $              | (56,596    | ) | (7.1 | ) |
|                                           |       |                       |       |                  |       |           |       |           |       |
| **LIABILITIES AND  STOCKHOLDERS’ EQUITY** |       |                       |       |                  |       |           |       |           |       |
| LIABILITIES:                                   |       |                       |       |                  |       |           |       |           |       |
| Deposits                                       |       | $                          | 603,992    |                  | $          | 618,003        |       | $              | (14,011    | ) | (2.3 | ) |
| Other borrowings                               |       | 68,179                     |       | 92,212                |       | (24,033        | )          | (26.1          | )          |
| Other liabilities                              |       | 3,068                      |       | 11,840                |       | (8,772         | )          | (74.1          | )          |
|                                           |       |                       |       |                  |       |           |       |           |       |
| Total liabilities                              |       | 675,239                    |       | 722,055               |       | (46,816        | )          | (6.5           | )          |
|                                           |       |                       |       |                  |       |           |       |           |       |
| STOCKHOLDERS’ EQUITY                      |       | 63,337                     |       | 73,117                |       | (9,780         | )          | (13.4          | )          |
|                                           |       |                       |       |                  |       |           |       |           |       |
| TOTAL                                          |       | $                          | 738,576    |                  | $          | 795,172        |       | $              | (56,596    | ) | (7.1 | )% |
|                                           |       |                       |       |                  |       |           |       |           |       |
| BOOK VALUE PER COMMON SHARE                    |       | $                          | 9.73       |                  | $          | 15.09          |       |           |       |   |   |
|                                           |       |                       |       |                  |       |           |       |           |       |
| COMMON EQUITY TO ASSETS                        |       | 6.4                        | %          | 9.2                   | %          |           |       |           |       |
|                                           |       |                       |       |                  |       |           |       |           |       |
| TOTAL EQUITY TO ASSETS                         |       | 8.6                        | %          | 9.2                   | %          |           |       |           |       |

 

16

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Table of Contents

 

**LoansReceivable. **Changes in loan composition between September 30,2009 and December 31, 2008 are presented in the following table (dollarsin thousands).

 
| ** **                                      | ** ** | **September ****30,** | ** ** | **December 31,** | ** ** | **Increase**   | ** ** | ** **   | ** ** |
|-------------------------------------------------|------------|----------------------------|------------|-----------------------|------------|----------------|------------|--------------|------------|
| ** **                                      | ** ** | **2009**                   | ** ** | **2008**              | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
|                                            |       |                       |       |                  |       |           |       |         |       |
| One- to four-family residences                  |       | $                          | 238,705    |                  | $          | 241,735        |       | $            | (3,030     | ) | (1.3 | )% |
| Home equity lines of credit and second mortgage |       | 28,759                     |       | 31,712                |       | (2,953         | )          | (9.3         | )          |
| Multifamily                                     |       | 25,096                     |       | 24,147                |       | 949            |       | 3.9          |       |
| Commercial real estate                          |       | 105,010                    |       | 115,935               |       | (10,925        | )          | (9.4         | )          |
| Land                                            |       | 50,844                     |       | 50,510                |       | 334            |       | 0.7          |       |
| Construction:                                   |       |                       |       |                  |       |           |       |         |       |
| One- to four-family residences                  |       | 8,388                      |       | 8,450                 |       | (62            | )          | (0.7         | )          |
| Speculative one-to four-family residences       |       | 14,085                     |       | 17,096                |       | (3,011         | )          | (17.6        | )          |
| Multifamily                                     |       | 14,641                     |       | 15,016                |       | (375           | )          | (2.5         | )          |
| Commercial real estate                          |       | 17,721                     |       | 18,297                |       | (576           | )          | (3.1         | )          |
| Land  development                               |       | 13,925                     |       | 18,457                |       | (4,532         | )          | (24.6        | )          |
| Total construction loans                        |       | 68,760                     |       | 77,316                |       | (8,556         | )          | (11.1        | )          |
| Total mortgage loans                            |       | 517,174                    |       | 541,355               |       | (24,181        | )          | (4.5         | )          |
|                                            |       |                       |       |                  |       |           |       |         |       |
| Commercial                                      |       | 16,292                     |       | 21,922                |       | (5,630         | )          | (25.7        | )          |
|                                            |       |                       |       |                  |       |           |       |         |       |
| Automobile                                      |       | 7,379                      |       | 8,631                 |       | (1,252         | )          | (14.5        | )          |
| Other                                           |       | 12,459                     |       | 12,291                |       | 168            |       | 1.4          |       |
| Total consumer                                  |       | 19,838                     |       | 20,922                |       | (1,084         | )          | (5.2         | )          |
|                                            |       |                       |       |                  |       |           |       |         |       |
| Total loans receivable                          |       | 553,304                    |       | 584,199               |       | (30,895        | )          | (5.3         | )          |
|                                            |       |                       |       |                  |       |           |       |         |       |
| Undisbursed loan funds                          |       | (8,881                     | )          | (11,750               | )          | 2,869          |       | (24.4        | )          |
| Deferred loan costs – net                  |       | 147                        |       | 529                   |       | (382           | )          | (72.2        | )          |
| Allowance for loan losses (1)                   |       | (41,372                    | )          | (6,441                | )          | (34,931        | )          | 542.3        |       |
|                                            |       |                       |       |                  |       |           |       |         |       |
| Loans receivable, net                           |       | $                          | 503,198    |                  | $          | 566,537        |       | $            | (63,339    | ) | (11.2 | ) |

 

----

(1)          The allowance for loan losses at September 30,2009 and December 31, 2008, is comprised of specific valuation allowancesof $20.3 million and $2.9 million, respectively, and general valuationallowances of $21.1 million and $3.5 million, respectively.

 

The decrease in the Bank’s loanportfolio was primarily due to a decrease in loan originations due to continuedsoftening of the housing market in the Bank’s market area and transfers of nonperformingloans to REO, net of loans to facilitate sales of REO as well as additionalallowance for loan loss provision during the year. Market data indicates anoverall decrease in home sales in Benton and Washington counties in 2008 and2007 as well as the first three quarters of 2009.  Although the Northwest Arkansas region’seconomy continues to experience population growth and a relatively good jobmarket, ranking number 4 on Forbes’ magazine’s latest ranking of bestmetropolitan areas for business and careers and ranking number 2 on Forbes’best cities for recession recovery, the supply of new residential lots and newspeculative homes for sale continues to outpace demand.  We expect this trend to continue for theforeseeable future given the level of oversupply in the market.

 

17

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**AssetQuality. **The following table sets forth the amounts andcategories of the Bank’s nonperforming assets at the dates indicated (dollars in thousands).

 
| ** **                                                    | ** ** | **September 30,  2009** | ** ** |
|---------------------------------------------------------------|------------|------------------------------|------------|
| ** **                                                    | ** ** | **Balance**                  | ** ** | **% Loans** | ** ** | **SVA(1)** | ** ** | **Net(2)** | ** ** | **% Assets** | ** ** |
| Nonaccrual Loans:                                             |       |                         |       |   |   |   |   |   |   |   |   |
| One- to four-family  residential                              |       | $                            | 13,662     |   | 2.47 | % | $ | 840 |   | $ | 12,822 |   | 1.74 | % |
| Home equity and second  mortgage                              |       | 1,951                        |       | 0.35 | % | 701 |   | 1,250 |   | 0.17 | % |
| Speculative one- to  four-family construction                 |       | 2,740                        |       | 0.50 | % | 474 |   | 2,266 |   | 0.31 | % |
| Multifamily residential                                       |       | 660                          |       | 0.12 | % | 500 |   | 160 |   | 0.02 | % |
| Land development                                              |       | 10,326                       |       | 1.87 | % | 4,364 |   | 5,962 |   | 0.81 | % |
| Land                                                          |       | 25,359                       |       | 4.58 | % | 8,423 |   | 16,936 |   | 2.29 | % |
| Commercial real estate                                        |       | 7,721                        |       | 1.40 | % | 2,292 |   | 5,429 |   | 0.74 | % |
| Commercial loans                                              |       | 3,429                        |       | 0.62 | % | 2,456 |   | 973 |   | 0.13 | % |
| Consumer loans                                                |       | 335                          |       | 0.06 | % | 211 |   | 124 |   | 0.02 | % |
|                                                          |       |                         |       |   |   |   |   |   |   |   |   |
| Total nonaccrual loans                                        |       | 66,183                       |       | 11.96 | % | 20,261 |   | 45,922 |   | 6.22 | % |
|                                                          |       |                         |       |   |   |   |   |   |   |   |   |
| Accruing loans 90 days or  more past due                      |       | 1,177                        |       | 0.21 | % | — |   | 1,177 |   | 0.16 | % |
|                                                          |       |                         |       |   |   |   |   |   |   |   |   |
| Real estate owned                                             |       | 27,971                       |       |   |   | — |   | 27,971 |   | 3.79 | % |
|                                                          |       |                         |       |   |   |   |   |   |   |   |   |
| Total nonperforming assets                                    |       | 95,331                       |       |   |   | 20,261 |   | 75,070 |   | 10.16 | % |
|                                                          |       |                         |       |   |   |   |   |   |   |   |   |
| Performing restructured  loans                                |       | 5,823                        |       | 1.05 | % | — |   | 5,823 |   | 0.79 | % |
|                                                          |       |                         |       |   |   |   |   |   |   |   |   |
| Total nonperforming assets  and performing restructured loans |       | $                            | 101,154    |   |   |   | $ | 20,261 |   | $ | 80,893 |   | 10.95 | % |

 
| ** **                                                    | ** ** | **December 31,  2008** | ** ** |
|---------------------------------------------------------------|------------|-----------------------------|------------|
| ** **                                                    | ** ** | **Balance**                 | ** ** | **% Loans** | ** ** | **SVA(1)** | ** ** | **Net(2)** | ** ** | **% Assets** | ** ** |
| Nonaccrual Loans:                                             |       |                        |       |   |   |   |   |   |   |   |   |
| One- to four-family  residential                              |       | $                           | 8,471      |   | 1.45 | % | $ | 149 |   | $ | 8,322 |   | 1.05 | % |
| Home equity and second  mortgage                              |       | 927                         |       | 0.16 | % | 30 |   | 897 |   | 0.11 | % |
| Speculative one- to  four-family construction                 |       | 1,466                       |       | 0.25 | % | 5 |   | 1,461 |   | 0.18 | % |
| Multifamily residential                                       |       | 441                         |       | 0.08 | % | — |   | 441 |   | 0.06 | % |
| Land development                                              |       | 2,577                       |       | 0.44 | % | 1,057 |   | 1,520 |   | 0.19 | % |
| Land                                                          |       | 2,537                       |       | 0.43 | % | 420 |   | 2,117 |   | 0.27 | % |
| Commercial real estate                                        |       | 6,702                       |       | 1.14 | % | 160 |   | 6,542 |   | 0.82 | % |
| Commercial loans                                              |       | 2,128                       |       | 0.36 | % | 964 |   | 1,164 |   | 0.15 | % |
| Consumer loans                                                |       | 170                         |       | 0.03 | % | 131 |   | 39 |   | 0.00 | % |
|                                                          |       |                        |       |   |   |   |   |   |   |   |   |
| Total nonaccrual loans                                        |       | 25,419                      |       | 4.34 | % | 2,916 |   | 22,503 |   | 2.83 | % |
|                                                          |       |                        |       |   |   |   |   |   |   |   |   |
| Accruing loans 90 days or  more past due                      |       | 8,961                       |       | 1.53 | % | — |   | 8,961 |   | 1.13 | % |
|                                                          |       |                        |       |   |   |   |   |   |   |   |   |
| Real estate owned                                             |       | 22,385                      |       |   |   | — |   | 22,385 |   | 2.82 | % |
|                                                          |       |                        |       |   |   |   |   |   |   |   |   |
| Total nonperforming assets                                    |       | 56,765                      |       |   |   | 2,916 |   | 53,849 |   | 6.77 | % |
|                                                          |       |                        |       |   |   |   |   |   |   |   |   |
| Performing restructured  loans                                |       | 1,886                       |       | 0.32 | % | — |   | 1,886 |   | 0.24 | % |
|                                                          |       |                        |       |   |   |   |   |   |   |   |   |
| Total nonperforming assets  and performing restructured loans |       | $                           | 58,651     |   |   |   | $ | 2,916 |   | $ | 55,735 |   | 7.01 | % |

 

----

(1)          Specificvaluation allowances

(2)          Balancesnet of related specific valuation allowances.

 

18

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Table of Contents

 

The increase in net nonaccrual loansfrom $22.5 million at December 31, 2008 to $45.9 million at September 30,2009 is primarily related to increases in nonaccrual land development loans,nonaccrual land loans and nonaccrual single family loans.  The increase in nonaccrual land and landdevelopment loans is primarily due to the addition of the nonaccrual loansindicated in the table below.   Thesignificant nonaccrual land and land development loans at September 30,2009 are listed in the table below (in thousands).

 
| ** **                                              | ** ** | **Location**     | ** ** | **Date  to  Nonaccrual** | ** ** | **Comments** | ** ** | **Loan  Balance** | ** **   | **SVA** | ** ** | **Net  of  SVA** | ** ** | **Valuation  Date** | ** ** | **Source** | ** ** |
|---------------------------------------------------------|------------|------------------|------------|--------------------------|------------|--------------|------------|-------------------|--------------|---------|------------|------------------|------------|---------------------|------------|------------|------------|
| **Land Development**                                    |       |             |       |                     |       |         |       |              |         |    |       |             |       |                |       |       |       |
| 42 single family lots                                   |       | Cave Springs, AR |       | 3Q2007                   |       | (A)          |       | $                 | 2,181        |    | $          | 1,141            |       | $                   | 1,040      |       | 11/10/2009 |   | (G) |   |
| 52 single family lots and 25 acres of undeveloped  land |       | Fayetteville, AR |       | 1Q2009                   |       | (B)          |       | 4,590             |         | 870     |       | 3,720            |       | 11/10/2009          |       | (G)        |       |
| 40 acres , proposed residential subdivision             |       | Farmington, AR   |       | 3Q2009                   |       | (C)          |       | 3,413             |         | 2,353   |       | 1,060            |       | 10/27/2009          |       | (G)        |       |
| Other - one loan                                        |       |             |       |                     |       |         |       | 142               |         | —  |       | 142              |       |                |       |       |       |
|                                                    |       |             |       |                     |       |         |       | $                 |  10,326 |    | $          | 4,364            |       | $                   | 5,962      |       |       |   |   |   |
| **Land**                                                |       |             |       |                     |       |         |       |              |         |    |       |             |       |                |       |       |       |
| 80 acres for future residential development             |       | Fayetteville, AR |       | 1Q2009                   |       | (D)          |       | $                 | 3,810        |    | $          | 1,563            |       | $                   | 2,247      |       | 10/27/2009 |   | (H) |   |
| 29 acres for future commercial development              |       | Springdale, AR   |       | 1Q2009                   |       | (D)          |       | 3,200             |         | 1,171   |       | 2,029            |       | 10/26/2009          |       | (H)        |       |
| 24 acres, commercial zoned                              |       | Lowell, AR       |       | 1Q2009                   |       | (D)          |       | 2,100             |         | 132     |       | 1,968            |       | 10/26/2009          |       | (H)        |       |
| 96 single family lots                                   |       | Fayetteville, AR |       | 1Q2009                   |       | (E)          |       | 2,839             |         | 104     |       | 2,735            |       | 3/31/2009           |       | (G)        |       |
| 2.49 acres commercial land                              |       | Rogers, AR       |       | 2Q2009                   |       | (F)          |       | 2,335             |         | 347     |       | 1,988            |       | 10/26/2009          |       | (H)        |       |
| 60 acres, residential zoned                             |       | Fayetteville, AR |       | 1Q2009                   |       | (B)          |       | 3,300             |         | 1,273   |       | 2,027            |       | 11/6/2009           |       | (H)        |       |
| 35 acres, proposed residential subdivision              |       | Fayetteville, AR |       | 3Q2009                   |       | (C)          |       | 3,407             |         | 2,255   |       | 1,152            |       | 10/27/2009          |       | (H)        |       |
| Other - 20 loans under $1 million each                  |       |             |       |                     |       |         |       | 4,368             |         | 1,578   |       | 2,790            |       |                |       |       |       |
|                                                    |       |             |       |                     |       |         |       | $                 |  25,359 |    | $          | 8,423            |       | $                   | 16,936     |       |       |   |   |   |

 

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| (A) – | This loan has been nonperforming for an extended period while the Bank  exercised forbearance with the borrowers to allow them to market and maintain  the property.  The Bank is currently  foreclosing on the property.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            |
|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| (B) – | These two loans are related to the same borrower. The Bank recently  financed the sale of a portion of the collateral/subdivision to a different  developer who has started 10 homes, 3 of which are under contract. The  balance set forth above reflects this sale. The borrowers are also  negotiating with another party to purchase an additional portion of the  collateral and are also considering construction of some single family  residences. In addition, the borrowers are pursuing legal action against the  party that originally contracted to purchase the entire subdivision and  failed to perform on their contract. The Bank believes the subdivision is a  viable concern and continues with reasonable and prudent workout efforts on  this credit. The land loan was originated to finance completion costs on the  subdivision. The land is currently being marketed for sale by the borrower. |
| (C) – | These two loans are related to the same borrower group. The Bank is  currently working with the borrowers to assess the feasibility of continuing  to develop the properties and at present is awaiting some key information for  that determination.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     |
| (D) – | These loans are all related to the same borrower and all are in  foreclosure.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             |
| (E) -      | This loan is in foreclosure. This property is also the subject of  litigation related to bonds that were sold without satisfying the first  mortgage with the Bank.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       |
| (F) – | A deed in lieu of foreclosure was obtained in the fourth quarter of  2009 and the property was transferred to real estate owned at that time.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             |
| (G) – | Discounted cash flow                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      |
| (H) – | Comparable sales                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |

 

We expect a significant amount of thenonaccrual real estate loans to eventually migrate to real estate owned as$27.9 million of the nonaccrual real estate loans, net of specific valuationallowances of $8.0 million, are in bankruptcy or some stage of the foreclosureprocess as of September 30, 2009. Therefore, we expect charge-offs, real estate owned and associatedexpenses to continue to increase in future periods as such loans migrate fromloans to real estate owned.

 

The following table sets forth theamounts and categories of the Bank’s real estate owned at the dates indicated.

 
| ** **                                      | ** ** | **September 30,  2009** | ** ** | **December 31,  2008** | ** ** | **Increase  (Decrease)** | ** ** | **Percentage Change** | ** ** |
|-------------------------------------------------|------------|------------------------------|------------|-----------------------------|------------|--------------------------|------------|-----------------------|------------|
| ** **                                      | ** ** | **(Dollars in Thousands)**   | ** ** | ** **                  | ** ** | ** **               | ** ** |
| Real estate owned                               |       |                         |       |                        |       |                     |       |                  |       |
| One- to four-family residential                 |       | $                            | 8,780      |                        | $          | 3,436                    |       | $                     | 5,344      |   | 155.5 | % |
| Speculative one- to four-family construction(1) |       | 1,656                        |       | 4,310                       |       | (2,654                   | )          | (61.6                 | )          |
| Multifamily                                     |       | 554                          |       | —                      |       | 554                      |       | —                |       |
| Land(2)                                         |       | 11,838                       |       | 13,314                      |       | (1,476                   | )          | (11.1                 | )          |
| Commercial real estate                          |       | 5,143                        |       | 1,325                       |       | 3,818                    |       | 288.2                 |       |
| Total real estate owned                         |       | $                            | 27,971     |                        | $          | 22,385                   |       | $                     | 5,586      |   | 25.0 | % |

 

----

(1)                        At September 30, 2009, $1.4 million of these properties were100% complete.  The remaining property is96% complete.

(2)                        At September 30, 2009, $8.8 million of the land balancerepresented 280 developed subdivision lots. The remainder consisted primarily of unimproved land originally intendedto be future phases of two subdivisions.

 

19

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Table of Contents

 

The land component of real estateowned is made up of the following at September 30, 2009 (in thousands):

 
| ** **                                     | ** ** | ** **       | ** ** | **Date to  real** | ** ** | ** **  | ** ** | ** **          | ** ** | ** ** | ** ** |
|------------------------------------------------|------------|------------------|------------|-------------------|------------|-------------|------------|---------------------|------------|------------|------------|
| ** **                                     | ** ** | **Location**     | ** ** | **estate  owned** | ** ** | **Balance** | ** ** | **Valuation  Date** | ** ** | **Source** | ** ** |
|                                           |       |             |       |              |       |        |       |                |       |       |       |
| **Land**                                       |       |             |       |              |       |        |       |                |       |       |       |
| 35 single family lots                          |       | Pea  Ridge, AR   |       | 12/30/2008        |       | $           | 654        |                | 11/9/2009  |       | (1)        |   |
| 48 single family lots                          |       | Elm  Springs, AR |       | 10/21/2008        |       | 1,285       |       | 11/8/2009           |       | (1)        |       |
| 110 single family lots                         |       | Springdale,  AR  |       | 4/17/2008         |       | 3,847       |       | 11/8/2009           |       | (1)        |       |
| 61 single family lots                          |       | Lowell,  AR      |       | 5/30/2008         |       | 1,689       |       | 11/8/2009           |       | (1)        |       |
| 30.7 acres for future  residential development |       | Lowell,  AR      |       | 5/30/2008         |       | 1,256       |       | 10/26/2009          |       | (2)        |       |
| 63.3 acres for future  residential development |       | Elm  Springs, AR |       | 10/21/2008        |       | 1,445       |       | 10/23/2009          |       | (2)        |       |
| 10 single family lots                          |       | Farmington,  AR  |       | 7/2/2009          |       | 593         |       | 4/13/2009           |       | (2)        |       |
| Other - 29 properties                          |       |             |       |              |       | 1,069       |       |                |       |       |       |
|                                           |       |             |       |              |       | $           | 11,838     |                |       |       |       |   |

 

----

(1) - Discounted cash flow

(2) - Comparable sales

 

The Bank is diligently working todispose of its REO and has dedicated an experienced special assets officer whois working full-time to liquidate the Bank’s properties in the NorthwestArkansas market. Each property is evaluated on a case-by-case basis todetermine the best course of action with respect to liquidation. Properties are marketed directly by the Bank or listed with local real estateagents utilizing appraisals, market information from realtors, market researchreports, and our own market evaluations to make pricing and sellingdecisions.   The Bank’s Chief Lending Officer, loan officers, creditmanager, special assets officer, and team members in the collections departmentall work together in this endeavor.   The Bank’s goal is to liquidatethese properties in an orderly and efficient manner without incurringextraordinary losses due to quick sale pricing.

 

**Classified Assets. **Federal regulations require that each insured savings associationclassify its assets on a regular basis. In addition, in connection with examinations of insured institutions,federal examiners have authority to identify problem assets and, ifappropriate, classify them.  There arethree classifications for problem assets: “substandard,” “doubtful” and “loss.”  Substandard assets have one or more definedweaknesses and are characterized by the distinct possibility that the insuredinstitution will sustain some loss if the deficiencies are not corrected.  Doubtful assets have the weaknesses ofsubstandard assets with the additional characteristic that the weaknesses makecollection or liquidation in full on the basis of currently existing facts,conditions and values questionable, and there is a high possibility of loss.  An asset classified loss is considereduncollectible and of such little value that continuance as an asset of theinstitution is not warranted.  At September 30, 2009, the Bank had $111.3 million ofclassified assets, all of which were classified as substandard including $45.9million of nonaccrual loans, $28.0 million of real estate owned, and $1.2million of loans 90 days or more past due and still accruing.  Substandard loans include $36.2 million ofloans not included in the nonperforming assets table.  Such loans have been reviewed and determinednot to be impaired or if impaired, were estimated to have no loss.  As a result, such loans remained on accrualstatus at September 30, 2009.

 

In addition, at September 30, 2009, the Bank had $45.3 million ofassets designated as special mention. Special mention assets have potentialweaknesses that deserve management’s close attention.  If left uncorrected, these potentialweaknesses may result in deterioration of the repayment prospects for the assetor the institution’s credit position at some future date.

 

**PotentialProblem Loans.** Based on the oversupply of lots in Northwest Arkansas, our landdevelopment portfolio poses a higher risk of default.  These loans are typically structured withinterest due at maturity and lot sales as the source of repayment.  Since lot sales in the Northwest Arkansasmarket are significantly slower than when these loans were originated, ourborrowers typically must rely on a secondary source of funds to pay theinterest as it becomes due.  Due to therelatively large balances of these types of loans, the interest due at maturityis usually significant.  At September 30, 2009, gross land development loans totaled $13.8 million.  Of this total, $10.3 million is on nonaccrualstatus with $1.3 million in nonaccrual interest, $792,000 with $19,000 inaccrued interest is classified as substandard and remains on accrual, and $2.6million with $40,000 in accrued interest is on our watch list.

 

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**DelinquentLoans.**  Loans past due 30 – 89 days not on nonaccrualstatus were as follows as of September 30, 2009 and December 31, 2008(in thousands):

 
| ** **                                    | ** ** | **September 30,  2009** | ** ** | **December 31,  2008** | ** ** |
|-----------------------------------------------|------------|------------------------------|------------|-----------------------------|------------|
| One-  to four-family residential              |       | $                            | 6,772      |                        | $          | 4,003 |   |
| Home  equity and second mortgage              |       | 780                          |       | 558                         |       |
| Speculative  one- to four-family construction |       | 123                          |       | 649                         |       |
| Multifamily  residential                      |       | 55                           |       | —                      |       |
| Land  development                             |       | —                       |       | —                      |       |
| Land                                          |       | 177                          |       | 326                         |       |
| Commercial  real estate                       |       | 288                          |       | 465                         |       |
| Commercial  loans                             |       | 67                           |       | 114                         |       |
| Consumer  loans                               |       | 296                          |       | 194                         |       |
|                                          |       | $                            | 8,558      |                        | $          | 6,309 |   |
|                                          |       |                         |       |                        |       |
| Percentage  of Portfolio                      |       | 1.55                         | %          | 1.08                        | %          |

 

Past due loans noton nonaccrual status are up since December 31, 2008 in categories of singlefamily, home equity and consumer loans. We believe the negative trend in these categories is due to economicconditions and we have increased our General Valuation Allowances (“GVA”) inthese categories accordingly.  See“Allowance for Loan Losses”.

 

**Allowancefor Loan Losses**.  A summary of the activity in the allowancefor loan losses is as follows (in thousands):

 
| ** **                       | ** ** | **Three  Months Ended  September 30,** | ** ** | **Nine  Months Ended  September 30,** | ** ** |
|----------------------------------|------------|---------------------------------------------|------------|--------------------------------------------|------------|
| ** **                       | ** ** | **2009**                                    | ** ** | **2008**                                   | ** ** | **2009** | ** ** | **2008** | ** ** |
| Balance  at beginning of period  |       | $                                           | 11,924     |                                       | $          | 5,215 |   | $ | 6,441 |   | $ | 5,162 |   |
| Provisions  for estimated losses |       | 30,196                                      |       | 1,611                                      |       | 36,161 |   | 4,110 |   |
| Recoveries                       |       | 64                                          |       | 242                                        |       | 819 |   | 436 |   |
| Losses  charged off              |       | (812                                        | )          | (246                                       | )          | (2,049 | ) | (2,886 | ) |
| Balance  at end of period        |       | $                                           | 41,372     |                                       | $          | 6,822 |   | $ | 41,372 |   | $ | 6,822 |   |

# ** **

A summary of theactivity in the allowance for losses by category for the nine months endedSeptember 30, 2009 is presented below (in thousands):

 
| ** **                                    | ** ** | **December 31,  2008** | ** ** | **Charge-offs(1)** | ** ** | **Recoveries** | ** ** | **Provisions** | ** ** | **September 30,  2009** | ** ** |
|-----------------------------------------------|------------|-----------------------------|------------|--------------------|------------|----------------|------------|----------------|------------|------------------------------|------------|
| One-  to four-family residential              |       | $                           | 502        |               | $          | 425            |       | $              | 3          |                         | $          | 3,224 |   | $ | 3,304 |   |
| Home  equity and second mortgage              |       | 350                         |       | 263                |       | 4              |       | 2,556          |       | 2,647                        |       |
| Speculative  one- to four-family construction |       | 153                         |       | 174                |       | 8              |       | 1,484          |       | 1,471                        |       |
| Multifamily  residential                      |       | 48                          |       | 77                 |       | 8              |       | 1,665          |       | 1,644                        |       |
| Land  development                             |       | 1,583                       |       | —             |       | 650            |       | 3,121          |       | 5,354                        |       |
| Land                                          |       | 869                         |       | 196                |       | 2              |       | 14,355         |       | 15,030                       |       |
| Commercial  real estate                       |       | 496                         |       | 342                |       | 14             |       | 6,410          |       | 6,578                        |       |
| Commercial  loans                             |       | 2,020                       |       | 138                |       | 2              |       | 2,572          |       | 4,456                        |       |
| Consumer  loans                               |       | 420                         |       | 434                |       | 128            |       | 774            |       | 888                          |       |
|                                          |       | $                           | 6,441      |               | $          | 2,049          |       | $              | 819        |                         | $          | 36,161 |   | $ | 41,372 |   |

 

----

(1)   As noted in the table above, charge-offs forthe nine months ended September 30, 2009, were $2.0 million.  At September 30, 2009, specificvaluation allowances were $20.3 million. Therefore, we expect charge-offs to increase in future periods.

 

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The composition ofthe allowance for loan losses by component and category as ofSeptember 30, 2009 and December 31, 2008 is presented below (inthousands):

 
| ** **                                    | ** ** | **September 30,  2009**       | ** ** | **December 31,  2008**       | ** ** |
|-----------------------------------------------|------------|------------------------------------|------------|-----------------------------------|------------|
| ** **                                    | ** ** | **Specific  Valuation  Allowance** | ** ** | **General  Valuation  Allowance** | ** ** | **GVA  % of  Portfolio** | ** ** | **Specific  Valuation  Allowance** | ** ** | **General  Valuation  Allowance** | ** ** | **GVA  % of  Portfolio** | ** ** |
| One-  to four-family residential              |       | $                                  | 840        |                              | $          | 2,464 |   | 1.00 | % | $ | 149 |   | $ | 353 |   | 0.14 | % |
| Home  equity and second mortgage              |       | 701                                |       | 1,946                             |       | 6.94 | % | 30 |   | 320 |   | 1.01 | % |
| Speculative  one- to four-family construction |       | 474                                |       | 997                               |       | 7.33 | % | 5 |   | 148 |   | 0.87 | % |
| Multifamily  residential                      |       | 500                                |       | 1,145                             |       | 2.92 | % | — |   | 48 |   | 0.12 | % |
| Land  development                             |       | 4,364                              |       | 990                               |       | 10.35 | % | 1,057 |   | 526 |   | 3.02 | % |
| Land                                          |       | 8,423                              |       | 6,606                             |       | 15.57 | % | 420 |   | 449 |   | 0.90 | % |
| Commercial  real estate                       |       | 2,292                              |       | 4,286                             |       | 3.56 | % | 160 |   | 336 |   | 0.25 | % |
| Commercial  loans                             |       | 2,456                              |       | 2,000                             |       | 14.45 | % | 964 |   | 1,056 |   | 5.04 | % |
| Consumer  loans                               |       | 227                                |       | 661                               |       | 3.37 | % | 131 |   | 289 |   | 1.39 | % |
|                                          |       | $                                  | 20,277     |                              | $          | 21,095 |   | 3.96 | % | $ | 2,916 |   | $ | 3,525 |   | 0.61 | % |

 

Changes in thecomposition of the allowance for loan losses between September 30, 2009and December 31, 2008 are presented in the following table (in thousands):

 
| ** ** | ** ** | **September 30,** | ** ** | **December 31,** | ** ** | ** **   | ** ** |
|------------|------------|------------------------|------------|-----------------------|------------|--------------|------------|
| ** ** | ** ** | **2009**               | ** ** | **2008**              | ** ** | **Increase** | ** ** |
| General    |       | $                      | 21,095     |                  | $          | 3,525        |       | $ | 17,570 |   |
| Specific   |       | 20,277                 |       | 2,916                 |       | 17,361       |       |
|       |       | $                      | 41,372     |                  | $          | 6,441        |       | $ | 34,931 |   |

 

The general component ofthe allowance for loan losses increased primarily due to increases in the lossfactors applied to the various allowance categories partially offset bydecreases in certain of the related loan balances.  These loss factors were increased due to therecent loss history on these types of loans as well as delinquency trends, thelevel of classified assets and economic factors such as unemployment,bankruptcy trends and home sale data. The specific component of the allowance for loan losses increasedprimarily due to allowances established since December 31, 2008 on landloans, land development loans, commercial real estate loans and commercialloans.  See “Asset Quality.”

 

The allowance for loanlosses is established as losses are estimated to have occurred through aprovision for loan losses charged to earnings. Loan losses are charged against the allowance when management believesit is likely that a loan balance is uncollectible.  Subsequent recoveries, if any, are creditedto the allowance.

 

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

 

A loan is consideredimpaired when, based on current information and events, it is probable that theBank will be unable to collect the scheduled payments of principal or interestwhen due according to the contractual terms of the loan agreement. Factorsconsidered by management in determining impairment include payment status,collateral value, and the probability of collecting scheduled principal andinterest payments when due. Loans that experience insignificant payment delaysand payment shortfalls generally are not classified as impaired. Managementdetermines the significance of payment delays and payment shortfalls on acase-by-case basis, taking into consideration all of the circumstancessurrounding the loan and the borrower, including the length of the delay, thereasons for the delay, the borrower’s prior payment record, and the amount ofthe short fall in relation to the principal and interest owed. Impairment ismeasured on a loan by loan basis by either the present value of expected futurecash flows discounted at the loan’s effective interest rate, the loan’sobtainable market price, or the fair value of the collateral if the loan iscollateral dependent.  Multifamilyresidential, commercial real estate, land and land development, and commercialloans that are delinquent or where the borrower’s total loan relationshipexceeds $1 million are evaluated on a loan by loan basis at least annually.

 

Large groups of smallerbalance homogeneous loans are collectively evaluated for impairment.Accordingly, the Bank does not separately identify individual consumer andresidential loans for impairment disclosures. Homogeneous loans are those that are considered to have commoncharacteristics that provide for evaluation on an aggregate or 

 

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pool basis. The Bankconsiders the characteristics of (1) one- to four-family residential firstmortgage loans; (2) unsecured consumer loans; and (3) collateralizedconsumer loans to permit consideration of the appropriateness of the allowancefor losses of each group of loans on a pool basis. The primary methodology usedto determine the appropriateness of the allowance for losses includessegregating certain specific, poorly performing loans based on theirperformance characteristics from the pools of loans as to type, valuing theseloans, and then applying a loss factor to the remaining pool balance based onseveral factors including past loss experience, inherent risks, and economicconditions in the primary market areas.

 

In estimating the amountof 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.  For impaired loans that arecollateral dependent, the estimated fair value of the collateral may deviatesignificantly from the proceeds received when the collateral is sold in theevent that the Bank has to foreclose or repossess the collateral.

 

Although we consider theallowance for loan losses of approximately $41.4 million, consisting of $21.1million of general valuation allowances and $20.3 million of specific valuationallowances, adequate to cover losses inherent in our loan portfolio atSeptember 30, 2009, no assurance can be given that we will not sustainloan losses that are significantly different from the amount recorded, or thatsubsequent evaluations of the loan portfolio, in light of factors thenprevailing, would not result in a significant change in the allowance for loanlosses.

 

**InvestmentSecurities. **Changes in the composition of investmentsecurities held to maturity between September 30, 2009 andDecember 31, 2008 are presented in the following table (in thousands).

 
| ** **                              | ** ** | **September 30,** | ** ** | **December 31,** | ** ** | **Increase**   | ** ** |
|-----------------------------------------|------------|------------------------|------------|-----------------------|------------|----------------|------------|
| ** **                              | ** ** | **2009**               | ** ** | **2008**              | ** ** | **(Decrease)** | ** ** |
| U.S.  Government and agency obligations |       | $                      | 107,037    |                  | $          | 116,847        |       | $ | (9,810 | ) |
| Municipal  securities                   |       | 23,191                 |       | 19,565                |       | 3,626          |       |
| Total                                   |       | $                      | 130,228    |                  | $          | 136,412        |       | $ | (6,184 | ) |

 

During the first ninemonths of 2009, investment securities totaling $111.6 million with an averagetax equivalent yield of 5.46% were purchased and $117.8 million with an averagetax equivalent yield of 5.95% matured or were called.

 

At September 30,2009, estimated fair values of investment securities held to maturity were asfollows (in thousands):

** **
| ** **                              | ** ** | **Amortized  Cost** | ** ** | **Fair  Value** | ** ** |
|-----------------------------------------|------------|---------------------|------------|-----------------|------------|
|                                    |       |                |       |            |       |
| U.S.  Government and agency obligations |       | $                   | 107,037    |            | $          | 106,462 |   |
| Municipal  securities                   |       | 23,191              |       | 23,573          |       |
| Total                                   |       | $                   | 130,228    |            | $          | 130,035 |   |

 

**AccruedInterest Receivable. ** The decrease in accrued interest receivablewas primarily due to an increase in nonaccrual loans, a decrease in the loansreceivable balance, and a decrease in the loan yield at September 30, 2009compared to December 31, 2008.

 

**RealEstate Owned, net.**  Changes in the composition of real estateowned between September 30, 2009 and December 31, 2008 are presentedin the following table (dollars in thousands).

 
| ** **                       | ** ** | **December 31,    2008** | ** ** | **Additions** | ** ** | **Fair  Value  Adjustments** | ** ** | **Net  Sales  Proceeds(1)** | ** ** | **Loss** | ** ** | **September 30,  2009** | ** ** |
|----------------------------------|------------|-------------------------------|------------|---------------|------------|------------------------------|------------|-----------------------------|------------|----------|------------|------------------------------|------------|
| One-  to four-family residential |       | $                             | 3,436      |          | $          | 6,728                        |       | $                           | (753       | )        | $          | 501                          |       | $ | (130 | ) | $ | 8,780 |   |
| Speculative  one- to four-family |       | 4,310                         |       | 804           |       | (437                         | )          | 2,736                       |       | (285     | )          | 1,656                        |       |
| Multifamily                      |       | —                        |       | 1,022         |       | (89                          | )          | 368                         |       | (11      | )          | 554                          |       |
| Land                             |       | 13,314                        |       | 1,365         |       | (2,477                       | )          | 365                         |       | 1        |       | 11,838                       |       |
| Commercial  real estate          |       | 1,325                         |       | 4,631         |       | (654                         | )          | 115                         |       | (44      | )          | 5,143                        |       |
|                             |       | $                             | 22,385     |          | $          | 14,550                       |       | $                           | (4,410     | )        | $          | 4,085                        |       | $ | (469 | ) | $ | 27,971 |   |

 

----

(1)          Net sales proceeds include $2.1 millionof loans made by the Bank to facilitate the sale of real estate owned.

 

**DeferredTax Asset, net.**  The increase in the deferred tax asset isrelated primarily to an increase in the provision for loan losses offset by theestablishment of a valuation allowance related to the state portion of thedeferred tax asset.  See Note 9 in theNotes to the Unaudited Consolidated Financial Statements.

 

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**Deposits. **Changes in the composition of deposits betweenSeptember 30, 2009 and December 31, 2008 are presented in thefollowing table (dollars in thousands).

 
| ** **               | ** ** | **September 30,** | ** ** | **December 31,** | ** ** | **Increase**   | ** ** | **Percentage** | ** ** |
|--------------------------|------------|------------------------|------------|-----------------------|------------|----------------|------------|----------------|------------|
| ** **               | ** ** | **2009**               | ** ** | **2008**              | ** ** | **(Decrease)** | ** ** | **Change**     | ** ** |
| ** **               | ** ** | ** **             | ** ** | ** **            | ** ** | ** **     | ** ** | ** **     | ** ** |
| Checking  accounts       |       | $                      | 163,305    |                  | $          | 163,468        |       | $              | (163       | ) | (0.1 | )% |
| Money  Market accounts   |       | 44,959                 |       | 45,022                |       | (63            | )          | (0.1           | )          |
| Savings  accounts        |       | 25,392                 |       | 23,019                |       | 2,373          |       | 10.3           |       |
| Certificates  of deposit |       | 370,336                |       | 386,494               |       | (16,158        | )          | (4.2           | )          |
|                     |       |                   |       |                  |       |           |       |           |       |
| Total  deposits          |       | $                      | 603,992    |                  | $          | 618,003        |       | $              | (14,011    | ) | (2.3 | ) |

 

Deposits decreased in thecomparison period, primarily due to a decrease in certificates of deposit. TheBank views checking accounts as an attractive source of funds and will continueto promote such accounts as they offer overall low-interest deposits, feeincome potential, and the opportunity to cross-sell other financial services.

 

**OtherBorrowings.**  The Bank experienced a $24.0 million or 26.1%decrease in other borrowings during the quarter primarily due to a decrease inFederal Reserve Bank borrowings of $9.7 million and a $14.3 million decrease inFHLB advances since December 31, 2008.

 

**OtherLiabilities.**  Other liabilities decreased primarily due toa decrease in investment security purchases which settled after period end of$9.0 million.

 

**Stockholders’Equity. **Stockholders’ equity decreased approximately $9.8million from December 31, 2008 to September 30, 2009.  The decrease in stockholders’ equity wasprimarily due to a net loss of $25.7 million during the first nine months of2009 offset by the issuance of 16,500 shares of preferred stock totaling $16.5million.  In addition, during the ninemonths ended September 30, 2009, dividends on common shares of approximately$145,000 and preferred dividends of approximately $470,000 were paid oraccrued.  See the Unaudited ConsolidatedStatement of Stockholders’ Equity for the nine months ended September 30,2009 for more detail.

 

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### **Average Balance Sheets**

### ** **

The following table setsforth certain information relating to the Company’s average balance sheets andreflects the average yield on assets and average cost of liabilities for theperiods indicated.  Such yields and costsare derived by dividing income or expense by the average balance of assets orliabilities, respectively, for the periods presented.  Average balances are based on daily balancesduring the period.

 
| ** **                                                        | ** ** | **Three  Months Ended September 30,** | ** ** |
|-------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                        | ** ** | **2009**                                   | ** ** | **2008** | ** ** |
| ** **                                                        | ** ** | **Average  Balance**                       | ** ** | **Interest** | ** ** | **Average  Yield/  Cost** | ** ** | **Average  Balance** | ** ** | **Interest** | ** ** | **Average  Yield/  Cost** | ** ** |
| ** **                                                        | ** ** | **(Dollars  in Thousands)**                | ** ** |
| Interest-earning  assets:                                         |       |                                       |       |   |   |   |   |   |   |   |   |   |   |
| Loans  receivable(1)                                              |       | $                                          | 559,007    |   | $ | 6,988 |   | 5.00 | % | $ | 572,572 |   | $ | 8,601 |   | 6.01 | % |
| Investment  securities(2)                                         |       | 141,192                                    |       | 1,702 |   | 4.82 |   | 132,143 |   | 1,743 |   | 5.28 |   |
| Other  interest-earning assets                                    |       | 279                                        |       | 2 |   | 2.25 |   | 20,949 |   | 107 |   | 2.04 |   |
| Total  interest-earning assets                                    |       | 700,478                                    |       | 8,692 |   | 4.96 |   | 725,664 |   | 10,451 |   | 5.76 |   |
| Noninterest-earning  assets                                       |       | 74,498                                     |       |   |   |   |   | 79,510 |   |   |   |   |   |
| Total  assets                                                     |       | 774,976                                    |       |   |   |   |   | 805,174 |   |   |   |   |   |
| Interest-bearing  liabilities:                                    |       |                                       |       |   |   |   |   |   |   |   |   |   |   |
| Deposits                                                          |       | 612,894                                    |       | 3,102 |   | 2.03 |   | 625,439 |   | 4,224 |   | 2.70 |   |
| Other  borrowings                                                 |       | 70,131                                     |       | 449 |   | 2.56 |   | 99,261 |   | 931 |   | 3.75 |   |
| Total  interest-bearing liabilities                               |       | 683,025                                    |       | 3,551 |   | 2.08 |   | 724,700 |   | 5,155 |   | 2.84 |   |
| Noninterest-bearing  liabilities                                  |       | 4,879                                      |       |   |   |   |   | 5,833 |   |   |   |   |   |
| Total  liabilities                                                |       | 687,904                                    |       |   |   |   |   | 730,533 |   |   |   |   |   |
| Stockholders’  equity                                        |       | 87,072                                     |       |   |   |   |   | 74,641 |   |   |   |   |   |
| Total  liabilities and stockholders’ equity                  |       | $                                          | 774,976    |   |   |   |   |   | $ | 805,174 |   |   |   |   |   |
|                                                              |       |                                       |       |   |   |   |   |   |   |   |   |   |   |
| Net  interest income                                              |       |                                       |       | $ | 5,141 |   |   |   |   |   | $ | 5,296 |   |   |   |
| Net  earning assets                                               |       | $                                          | 17,453     |   |   |   |   |   | $ | 964 |   |   |   |   |   |
| Interest  rate spread                                             |       |                                       |       |   |   | 2.88 | % |   |   |   |   | 2.92 | % |
| Net  interest margin                                              |       |                                       |       |   |   | 2.94 | % |   |   |   |   | 2.92 | % |
| Ratio  of interest-earning assets to interest-bearing liabilities |       |                                       |       |   |   | 102.56 | % |   |   |   |   | 100.13 | % |

** **
| ** **                                                        | ** ** | **Nine  Months Ended September 30,** | ** **           |       |
|-------------------------------------------------------------------|------------|-------------------------------------------|----------------------|------------|
| ** **                                                        | ** ** | **2009**                                  | ** **           | **2008**   | ** ** |   |
|                                                              | ** ** | ** **                                | **Average  Balance** | ** ** | **Interest** | ** ** | **Average  Yield/  Cost** | ** ** | **Average  Balance** | ** ** | **Interest** | ** ** | **Average  Yield/  Cost** | ** ** |
| ** **                                                        | ** ** | **(Dollars  in Thousands)**               | ** **           |       |
| Interest-earning  assets:                                         |       |                                      |                 |       |   |   |   |   |   |   |   |   |   |   |
| Loans  receivable(1)                                              |       | $                                         | 563,280              |       | $ | 22,109 |   | 5.23 | % | $ | 585,597 |   | $ | 28,096 |   | 6.40 | % |   |
| Investment  securities(2)                                         |       | 135,722                                   |                 | 4,882      |   | 4.80 |   | 124,259 |   | 4,971 |   | 5.33 |   |   |
| Other  interest-earning assets                                    |       | 10,376                                    |                 | 17         |   | 0.22 |   | 20,752 |   | 387 |   | 2.48 |   |   |
| Total  interest-earning assets                                    |       | 709,378                                   |                 | 27,008     |   | 5.08 |   | 730,608 |   | 33,454 |   | 6.10 |   |   |
| Noninterest-earning  assets                                       |       | 78,677                                    |                 |       |   |   |   | 76,527 |   |   |   |   |   |   |
| Total  assets                                                     |       | $                                         | 788,055              |       |   |   |   |   | 807,135 |   |   |   |   |   |   |
| Interest-bearing  liabilities:                                    |       |                                      |                 |       |   |   |   |   |   |   |   |   |   |   |
| Deposits                                                          |       | $                                         | 624,035              |       | 10,396 |   | 2.22 |   | 634,797 |   | 14,572 |   | 3.06 |   |   |
| Other  borrowings                                                 |       | 71,915                                    |                 | 1,641      |   | 3.04 |   | 91,413 |   | 2,711 |   | 3.96 |   |   |
| Total  interest-bearing liabilities                               |       | 695,950                                   |                 | 12,037     |   | 2.31 |   | 726,210 |   | 17,283 |   | 3.17 |   |   |
| Noninterest-bearing  liabilities                                  |       | 7,630                                     |                 |       |   |   |   | 6,583 |   |   |   |   |   |   |
| Total  liabilities                                                |       | 703,580                                   |                 |       |   |   |   | 732,793 |   |   |   |   |   |   |
| Stockholders’  equity                                        |       | 84,475                                    |                 |       |   |   |   | 74,342 |   |   |   |   |   |   |
| Total  liabilities and stockholders’ equity                  |       | $                                         | 788,055              |       |   |   |   |   | $ | 807,135 |   |   |   |   |   |   |
|                                                              |       |                                      |                 |       |   |   |   |   |   |   |   |   |   |   |
| Net  interest income                                              |       |                                      |                 | $          | 14,971 |   |   |   |   |   | $ | 16,171 |   |   |   |   |
| Net  earning assets                                               |       | $                                         | 13,428               |       |   |   |   |   | $ | 4,398 |   |   |   |   |   |   |
| Interest  rate spread                                             |       |                                      |                 |       |   | 2.77 | % |   |   |   |   | 2.93 | % |   |
| Net  interest margin                                              |       |                                      |                 |       |   | 2.81 | % |   |   |   |   | 2.95 | % |   |
| Ratio  of interest-earning assets to interest-bearing liabilities |       |                                      |                 |       |   | 101.93 | % |   |   |   |   | 100.61 | % |   |
|                                                                   |            |                                           |                      |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

----

(1)  Includesnonaccrual loans.

(2)  IncludesFHLB of Dallas stock.

 

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## ***Rate/VolumeAnalysis***

## *** ***

The table belowsets forth certain information regarding changes in interest income andinterest expense of the Company for the periods indicated.  For each category of interest-earning assetsand interest-bearing liabilities, information is provided on changesattributable to (i) changes in volume (changes in average volumemultiplied by prior rate); (ii) changes in rate (change in rate multipliedby prior average volume); (iii) changes in rate-volume (changes in ratemultiplied by the change in average volume); and (iv) the net change.

 
| ** **                          | ** ** | **Three  Months Ended September 30,** | ** ** |
|-------------------------------------|------------|--------------------------------------------|------------|
| ** **                          | ** ** | **2009  vs. 2008**                         | ** ** |
| ** **                          | ** ** | **Increase  (Decrease)  Due to**           | ** ** | **Total** | ** ** |
| ** **                          | ** ** | **Volume**                                 | ** ** | **Rate** | ** ** | **Rate/  Volume** | ** ** | **Increase  (Decrease)** | ** ** |
| ** **                          | ** ** | **(In  Thousands)**                        | ** ** |
| Interest  income:                   |       |                                       |       |   |   |   |   |   |   |
| Loans  receivable                   |       | $                                          | (204       | ) | $ | (1,443 | ) | $ | 34 |   | $ | (1,613 | ) |
| Investment  securities              |       | 119                                        |       | (150 | ) | (10 | ) | (41 | ) |
| Other  interest-earning assets      |       | (105                                       | )          | 11 |   | (11 | ) | (105 | ) |
| Total  interest-earning assets      |       | (190                                       | )          | (1,582 | ) | 13 |   | (1,759 | ) |
|                                |       |                                       |       |   |   |   |   |   |   |
| Interest  expense:                  |       |                                       |       |   |   |   |   |   |   |
| Deposits                            |       | (85                                        | )          | (1,058 | ) | 21 |   | (1,122 | ) |
| Other  borrowings                   |       | (273                                       | )          | (295 | ) | 86 |   | (482 | ) |
| Total  interest-bearing liabilities |       | (358                                       | )          | (1,353 | ) | 107 |   | (1,604 | ) |
| Net  change in net interest income  |       | $                                          | 168        |   | $ | (229 | ) | $ | (94 | ) | $ | (155 | ) |

** **
| ** **                          | ** ** | **Nine  Months Ended September 30,** | ** ** |
|-------------------------------------|------------|-------------------------------------------|------------|
| ** **                          | ** ** | **2009  vs. 2008**                        | ** ** |
| ** **                          | ** ** | **Increase  (Decrease)  Due to**          | ** ** | ** ** | ** ** |
| ** **                          | ** ** | **Volume**                                | ** ** | **Rate** | ** ** | **Rate/  Volume** | ** ** | **Total  Increase (Decrease)** | ** ** |
| ** **                          | ** ** | **(In  Thousands)**                       | ** ** |
| Interest  income:                   |       |                                      |       |   |   |   |   |   |   |
| Loans  receivable                   |       | $                                         | (1,071     | ) | $ | (5,111 | ) | $ | 195 |   | $ | (5,987 | ) |
| Investment  securities              |       | 459                                       |       | (502 | ) | (46 | ) | (89 | ) |
| Other  interest-earning assets      |       | (193                                      | )          | (353 | ) | 176 |   | (370 | ) |
| Total  interest-earning assets      |       | (805                                      | )          | (5,966 | ) | 325 |   | (6,446 | ) |
|                                |       |                                      |       |   |   |   |   |   |   |
| Interest  expense:                  |       |                                      |       |   |   |   |   |   |   |
| Deposits                            |       | (247                                      | )          | (3,997 | ) | 68 |   | (4,176 | ) |
| Other  borrowings                   |       | (578                                      | )          | (626 | ) | 134 |   | (1,070 | ) |
| Total  interest-bearing liabilities |       | (825                                      | )          | (4,623 | ) | 202 |   | (5,246 | ) |
| Net  change in net interest income  |       | $                                         | 20         |   | $ | (1,343 | ) | $ | 123 |   | $ | (1,200 | ) |

 

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**CHANGESIN RESULTS OF OPERATIONS**

 

The table belowpresents a comparison of results of operations for the three months endedSeptember 30, 2009 and 2008 (dollars in thousands).  Specific changes in captions are discussed inthe sections which follow the table.

 
| ** **                                                           | ** ** | **Three  Months Ended  September 30,** | ** ** | **Increase  (Decrease)** | ** ** |
|----------------------------------------------------------------------|------------|---------------------------------------------|------------|--------------------------|------------|
| ** **                                                           | ** ** | **2009**                                    | ** ** | **2008**                 | ** ** | **2009  vs 2008** | ** ** |
| Interest  income:                                                    |       |                                        |       |                     |       |   |   |
| Loans  receivable                                                    |       | $                                           | 6,988      |                     | $          | 8,601 |   | $ | (1,613 | ) |
| Investment  securities                                               |       | 1,702                                       |       | 1,743                    |       | (41 | ) |
| Other                                                                |       | 2                                           |       | 107                      |       | (105 | ) |
| Total  interest income                                               |       | 8,692                                       |       | 10,451                   |       | (1,759 | ) |
| Interest  expense:                                                   |       |                                        |       |                     |       |   |   |
| Deposits                                                             |       | 3,102                                       |       | 4,224                    |       | (1,122 | ) |
| Other  borrowings                                                    |       | 449                                         |       | 931                      |       | (482 | ) |
| Total  interest expense                                              |       | 3,551                                       |       | 5,155                    |       | (1,604 | ) |
| Net  interest income before provision for loan losses                |       | 5,141                                       |       | 5,296                    |       | (155 | ) |
| Provision  for loan losses                                           |       | 30,196                                      |       | 1,611                    |       | 28,585 |   |
| Net interest income  (loss) after provision for loan losses          |       | (25,055                                     | )          | 3,685                    |       | (28,740 | ) |
| Noninterest  income:                                                 |       |                                        |       |                     |       |   |   |
| Deposit  fee income                                                  |       | 1,396                                       |       | 1,471                    |       | (75 | ) |
| Earnings  on life insurance policies                                 |       | 213                                         |       | 198                      |       | 15 |   |
| Gain  on sale of loans                                               |       | 155                                         |       | 51                       |       | 104 |   |
| Other                                                                |       | 345                                         |       | 493                      |       | (148 | ) |
| Total  noninterest income                                            |       | 2,109                                       |       | 2,213                    |       | (104 | ) |
| Noninterest  expenses:                                               |       |                                        |       |                     |       |   |   |
| Salaries  and employee benefits                                      |       | 2,890                                       |       | 3,085                    |       | (195 | ) |
| Real  estate owned, net                                              |       | 4,537                                       |       | 509                      |       | 4,028 |   |
| FDIC  insurance premium                                              |       | 328                                         |       | 127                      |       | 201 |   |
| Professional  fees                                                   |       | 330                                         |       | 126                      |       | 204 |   |
| Advertising  and public relations                                    |       | 92                                          |       | 188                      |       | (96 | ) |
| Other                                                                |       | 1,718                                       |       | 1,731                    |       | (13 | ) |
| Total  noninterest expenses                                          |       | 9,895                                       |       | 5,766                    |       | 4,129 |   |
| Income  (loss) before income taxes                                   |       | (32,841                                     | )          | 132                      |       | (32,973 | ) |
| Income  tax benefit                                                  |       | (9,614                                      | )          | (86                      | )          | (9,528 | ) |
| Net  income (loss)                                                   |       | (23,227                                     | )          | 218                      |       | (23,445 | ) |
| Preferred  stock dividends and accretion of preferred stock discount |       | 222                                         |       | —                   |       | 222 |   |
| Net  income (loss) available to common shareholders                  |       | $                                           | (23,449    | )                        | $          | 218 |   | $ | (23,667 | ) |
|                                                                 |       |                                        |       |                     |       |   |   |
| Basic  earnings (loss) per common share                              |       | $                                           | (4.84      | )                        | $          | 0.05 |   | $ | (4.89 | ) |
| Diluted  earnings (loss) per common share                            |       | $                                           | (4.84      | )                        | $          | 0.05 |   | $ | (4.89 | ) |
|                                                                 |       |                                        |       |                     |       |   |   |
| Interest  rate spread                                                |       | 2.88                                        | %          | 2.92                     | %          |   |   |
| Net  interest margin                                                 |       | 2.94                                        | %          | 2.92                     | %          |   |   |
|                                                                 |       |                                        |       |                     |       |   |   |
| Average  full-time equivalents                                       |       | 271                                         |       | 300                      |       |   |   |
|                                                                 |       |                                        |       |                     |       |   |   |
| Full-service  offices                                                |       | 20                                          |       | 20                       |       |   |   |

 

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The table below presentsa comparison of results of operations for the nine months endedSeptember 30, 2009 and 2008 (dollars in thousands). Specific changes incaptions are discussed in the sections which follow the table.

 
| ** **                                                           | ** ** | **Nine  Months Ended  September 30,** | ** ** | **Increase  (Decrease)** | ** ** |
|----------------------------------------------------------------------|------------|--------------------------------------------|------------|--------------------------|------------|
| ** **                                                           | ** ** | **2009**                                   | ** ** | **2008**                 | ** ** | **2009  vs 2008** | ** ** |
| Interest  income:                                                    |       |                                       |       |                     |       |   |   |
| Loans  receivable                                                    |       | $                                          | 22,109     |                     | $          | 28,096 |   | $ | (5,987 | ) |
| Investment  securities                                               |       | 4,882                                      |       | 4,971                    |       | (89 | ) |
| Other                                                                |       | 17                                         |       | 387                      |       | (370 | ) |
| Total  interest income                                               |       | 27,008                                     |       | 33,454                   |       | (6,446 | ) |
| Interest  expense:                                                   |       |                                       |       |                     |       |   |   |
| Deposits                                                             |       | 10,396                                     |       | 14,572                   |       | (4,176 | ) |
| Other  borrowings                                                    |       | 1,641                                      |       | 2,711                    |       | (1,070 | ) |
| Total  interest expense                                              |       | 12,037                                     |       | 17,283                   |       | (5,246 | ) |
| Net  interest income before provision for loan losses                |       | 14,971                                     |       | 16,171                   |       | (1,200 | ) |
| Provision  for loan losses                                           |       | 36,161                                     |       | 4,110                    |       | 32,051 |   |
| Net interest income  (loss) after provision for loan losses          |       | (21,190                                    | )          | 12,061                   |       | (33,251 | ) |
| Noninterest  income:                                                 |       |                                       |       |                     |       |   |   |
| Deposit  fee income                                                  |       | 3,916                                      |       | 4,027                    |       | (111 | ) |
| Earnings  on life insurance policies                                 |       | 610                                        |       | 1,760                    |       | (1,150 | ) |
| Gain  on sale of loans                                               |       | 454                                        |       | 317                      |       | 137 |   |
| Other                                                                |       | 1,074                                      |       | 1,362                    |       | (288 | ) |
| Total  noninterest income                                            |       | 6,054                                      |       | 7,466                    |       | (1,412 | ) |
| Noninterest  expenses:                                               |       |                                       |       |                     |       |   |   |
| Salaries  and employee benefits                                      |       | 8,703                                      |       | 9,717                    |       | (1,014 | ) |
| Real  estate owned, net                                              |       | 6,017                                      |       | 1,207                    |       | 4,810 |   |
| FDIC  insurance premium                                              |       | 1,256                                      |       | 254                      |       | 1,002 |   |
| Professional  fees                                                   |       | 806                                        |       | 399                      |       | 407 |   |
| Advertising  and public relations                                    |       | 294                                        |       | 748                      |       | (454 | ) |
| Other                                                                |       | 5,224                                      |       | 5,161                    |       | 63 |   |
| Total  noninterest expenses                                          |       | 22,300                                     |       | 17,486                   |       | 4,814 |   |
| Income  before income taxes                                          |       | (37,436                                    | )          | 2,041                    |       | (39,477 | ) |
| Income  tax benefit                                                  |       | (11,770                                    | )          | (273                     | )          | (11,497 | ) |
| Net  income (loss)                                                   |       | (25,666                                    | )          | 2,314                    |       | (27,980 | ) |
| Preferred  stock dividends and accretion of preferred stock discount |       | 506                                        |       | —                   |       | 506 |   |
| Net  income (loss) available to common shareholders                  |       | $                                          | (26,172    | )                        | $          | 2,314 |   | $ | (28,486 | ) |
|                                                                 |       |                                       |       |                     |       |   |   |
| Basic  earnings per share                                            |       | $                                          | (5.40      | )                        | $          | 0.48 |   | $ | (5.88 | ) |
| Diluted  earnings per share                                          |       | $                                          | (5.40      | )                        | $          | 0.48 |   | $ | (5.88 | ) |
|                                                                 |       |                                       |       |                     |       |   |   |
| Interest  rate spread                                                |       | 2.77                                       | %          | 2.93                     | %          |   |   |
| Net  interest margin                                                 |       | 2.81                                       | %          | 2.95                     | %          |   |   |
|                                                                 |       |                                       |       |                     |       |   |   |
| Average  full-time equivalents                                       |       | 281                                        |       | 303                      |       |   |   |
|                                                                 |       |                                       |       |                     |       |   |   |
| Full-service  offices                                                |       | 20                                         |       | 20                       |       |   |   |

 

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**NetInterest Income. **Net interest income is determined by theCompany’s interest rate spread (i.e., the difference between the yields earnedon its interest-earning assets and the rates paid on its interest-bearingliabilities) and the relative amounts of interest-earning assets andinterest-bearing liabilities.

 

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

### ** **

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

 

**InterestIncome. **The decrease in interest income for the three and ninemonth comparative periods was primarily due to a decrease in the average yieldearned on loans receivable, as well as a decrease in the average balance ofloans receivable.  The decrease in theaverage yield earned on loans receivable was due to decreases in marketinterest rates and an increase in the level of nonaccrual loans.  The level of nonaccrual loans and othernonperforming assets will continue to negatively impact interest income,interest rate spread, and net interest margin. The average balance of loans receivable decreased due to repayments andmaturities as well as a decrease in loan originations.

 

**InterestExpense.  **The decrease in interest expense for thethree and nine month comparative periods was primarily due to a decrease in theaverage rates paid on deposits and other borrowings as well as a decrease inthe related average balances.  Thedecrease in the average rates paid on deposit accounts and other borrowingsreflects decreases in market interest rates.

 

**Provisionfor 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 provision forloan losses increased $28.6 million to $30.2 million for the quarter ended September 30,2009 compared to $1.6 million for the quarter ended September 30, 2008 andincreased $32.1 million to $36.2 million for the nine months ended September 30,2009 compared to $4.1 million for the same period ended September 30,2008.  The increase in the provision forloan losses was primarily due to increases in total nonaccrual loans and in theloss factors used in certain allowance categories and an increase in specificloan loss allowances recorded during the three and nine months ended September 30,2009, in each respect due to deteriorating economic conditions.

 

**NoninterestIncome.  **The decrease in other noninterest income for the ninemonth comparative period in 2009 was primarily due to $1.2 million innonrecurring earnings on life insurance policies due to a death benefit claimrecorded during the quarter ended March 31, 2008.

 

**NONINTERESTEXPENSE**

 

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

 
| ** **                        | ** ** | **Three Months Ended  September 30,** | ** ** | **Increase****(Decrease)** | ** ** | **Nine Months Ended  September 30,** | ** ** | **Increase  (Decrease)** | ** ** |
|-----------------------------------|------------|--------------------------------------------|------------|----------------------------|------------|-------------------------------------------|------------|--------------------------|------------|
| ** **                        | ** ** | **2009**                                   | ** ** | **2008**                   | ** ** | **2009 vs  2008**                         | ** ** | **2009**                 | ** ** | **2008** | ** ** | **2009 vs  2008** | ** ** |
| Salaries                          |       | $                                          | 2,337      |                       | $          | 2,511                                     |       | $                        | (174       | ) | $ | 7,207 |   | $ | 7,692 |   | $ | (485 | ) |
| Payroll taxes                     |       | 167                                        |       | 194                        |       | (27                                       | )          | 606                      |       | 666 |   | (60 | ) |
| Insurance                         |       | 149                                        |       | 169                        |       | (20                                       | )          | 463                      |       | 507 |   | (44 | ) |
| 401(k)(1)                         |       | —                                     |       | 78                         |       | (78                                       | )          | 38                       |       | 234 |   | (196 | ) |
| Defined benefit plan contribution |       | 201                                        |       | 88                         |       | 113                                       |       | 279                      |       | 480 |   | (201 | ) |
| Other                             |       | 36                                         |       | 45                         |       | (9                                        | )          | 110                      |       | 138 |   | (28 | ) |
| Total                             |       | $                                          | 2,890      |                       | $          | 3,085                                     |       | $                        | (195       | ) | $ | 8,703 |   | $ | 9,717 |   | $ | (1,014 | ) |

 

----

(1)   Represents Company matching contributionson the 401(k) plan.  Effective February 16,2009, the Company discontinued its matching contributions to the 401(k) plan.

 

The decrease in salaries and benefits was primarily due to a reduction infull time equivalent employees as well as cessation of the Company’s 401(k) matchingcontribution in February 2009.

 

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

 
| ** **          | ** ** | **Three Months Ended  September 30,** | ** ** | **Increase****(Decrease)** | ** ** | **Nine Months Ended  September 30,** | ** ** | **Increase  (Decrease)** | ** ** |
|---------------------|------------|--------------------------------------------|------------|----------------------------|------------|-------------------------------------------|------------|--------------------------|------------|
| ** **          | ** ** | **2009**                                   | ** ** | **2008**                   | ** ** | **2009 vs  2008**                         | ** ** | **2009**                 | ** ** | **2008** | ** ** | **2009 vs  2008** | ** ** |
| Loss provisions     |       | $                                          | 3,694      |                       | $          | 164                                       |       | $                        | 3,530      |   | $ | 4,410 |   | $ | 480 |   | $ | 3,930 |   |
| Net loss on sales   |       | 643                                        |       | 179                        |       | 464                                       |       | 875                      |       | 207 |   | 668 |   |
| Taxes and insurance |       | 83                                         |       | 42                         |       | 41                                        |       | 406                      |       | 321 |   | 85 |   |
| Other               |       | 117                                        |       | 124                        |       | (7                                        | )          | 326                      |       | 199 |   | 127 |   |
| Total               |       | $                                          | 4,537      |                       | $          | 509                                       |       | $                        | 4,028      |   | $ | 6,017 |   | $ | 1,207 |   | $ | 4,810 |   |

 

Duringthe third quarter of 2009, the Bank took steps to reduce real estate owned byreducing the list prices of certain of these assets.  As a result, the Bank recorded $3.7 millionin writedowns during the quarter.  Realestate owned is expected to increase in the foreseeable future and real estateowned expenses associated with maintaining the properties are expected toincrease accordingly.  Future levels ofloss provisions and net gains or losses on sales of real estate owned will bedependent on market conditions.

 

**FDICInsurance Premium.**  FDIC insurance increased during the three andnine month comparison periods due to assessment credits which were available topartially offset FDIC premium expense in the first quarter of 2008 as well asdue to an increase in the premium rate for 2009.  Further, in the second quarter of 2009, theFDIC imposed a five basis point special assessment, which resulted inadditional expense of $350,000 in that period. FDIC premium expense is expected to continue to increase.  See “Part II, Item 1A Risk Factors – FutureFDIC insurance premiums or special assessments may impact our earnings.”

 

**ProfessionalFees. **The professional fees increased primarily due to legalfees related to nonaccrual loans.

 

**Advertisingand Public Relations.**  The decrease in 2009 isprimarily related to a decrease in direct mail advertising as well as adecrease in expenses related to the “Thank You” gift program that wasdiscontinued in September 2008.

 

**IncomeTaxes. **The income tax benefit increased primarily due to anincrease in the federal deferred tax asset primarily related to the allowancefor loan losses and real estate owned for the nine months ended September 30,2009 and partially offset by the establishment of a valuation allowance relatedto the state portion of our deferred tax asset.

 

# **OFF-BALANCE SHEET ARRANGEMENTS**

# ** **

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

 

·                  theorigination, purchase or sale of loans;

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

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

 

At September 30,2009, the Bank’s off-balance sheet arrangements principally included lendingcommitments, which are described below. At September 30, 2009, the Company had no interests innon-consolidated special purpose entities.

 

At September 30,2009, commitments included:

 

·                  totalapproved commitments to originate or purchase loans amounting to $3.9 million;

·                  ratelock agreements with customers of $5.2 million, all of which have been lockedwith an investor;

·                  fundedmortgage loans committed to sell of $1.5 million;

·                  unadvancedportion of construction loans of $8.9 million;

·                  unusedlines of credit of $18.4 million;

·                  outstandingstandby letters of credit of approximately $3.8 million;

·                  totalpredetermined overdraft protection limits of $15.3 million; and

·                  certificatesof deposit scheduled to mature in one year or less totaling $231.5 million.

 

Total unfundedcommitments to originate loans for sale and the related commitments to sell of$5.2 million meet the definition of a derivative financial instrument.  The related asset and liability areconsidered immaterial at September 30, 2009.

 

Historically, avery small percentage of predetermined overdraft limits have been used.  At September 30, 2009, overdrafts ofaccounts with Bounce ProtectionTM represented usage of 3.76% of the limit.  We expect utilization of these overdraftlimits to remain at comparable levels in the future.

 

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Based onhistorical experience, management believes that a significant portion ofmaturing deposits will remain with the Bank. We anticipate that we will continue to have sufficient funds, throughrepayments, deposits and borrowings, to meet our current commitments.

 

### **LIQUIDITYAND CAPITAL RESOURCES**

 

The Bank’s liquidity, represented by cash and cash equivalents andeligible investment securities, is a product of its operating, investing andfinancing activities.  The Bank’s primarysources of funds are deposits, borrowings, payments on outstanding loans,maturities and calls of investment securities and other short-term investmentsand funds provided from operations. While scheduled loan amortization and maturing investment securities andshort-term investments are relatively predictable sources of funds, depositflows and loan prepayments are greatly influenced by general interest rates,economic conditions and competition. Calls of investment securities are determined by the issuer and aregenerally influenced by the level of market interest rates at the bond’s calldate compared to the coupon rate of the bond. The Bank manages the pricing of its deposits to maintain depositbalances at levels commensurate with the operating, investing and financingactivities of the Bank.  In addition, theBank invests excess funds in overnight deposits and other short-terminterest-earning assets that provide liquidity to meet lending requirements andpay deposit withdrawals. When funds from the retail deposit market are inadequatefor the liquidity needs of the Bank or the pricing of deposits is not asfavorable as other sources, the Bank has borrowed from the FHLB of Dallas andthe Federal Reserve Bank of St. Louis (“FRB”).    During the first nine months of 2009, theuse of FHLB and FRB borrowings decreased by $24.0 million or 26.1%.  The Bank uses U.S. government agencyinvestment securities and eligible one- to four-family loans as collateral forFHLB advances and commercial real estate and U.S. government agency investmentsecurities as collateral for FRB borrowings. The Bank’s borrowing capacity is based on the amount of securities andloans pledged to the FHLB and FRB.  TheBank may transfer additional collateral to provide additional borrowingcapacity if needed.  Currently, the Bankmay borrow only short-term FHLB advances with maturities up to thirtydays.   At September 30, 2009, the Bankhad short-term funds availability of approximately $105.1 million or 14.2% ofassets consisting of borrowing capacity at the FRB and FHLB, unpledgedinvestment securities, and overnight funds. The Bank anticipates it will continue to rely primarily on deposits,loan repayments and repayments of its investment securities to provide liquidity.  As necessary, the sources of borrowed fundsdescribed above will be used to augment the Bank’s funding sources.

 

Liquidity management is both a daily and long-term function ofbusiness management.  Excess liquidity isgenerally invested in short-term investments such as overnight deposits andcertificates of deposit.  On alonger-term basis, the Bank maintains a strategy of investing in variouslending products and investment securities.  The Bank uses its sources of funds primarily to meet its ongoingcommitments, to pay maturing savings certificates and savings withdrawals, torepay maturing borrowings, to fund loan commitments, and to purchase investmentsecurities.

 

For the quarters ended September 30, 2009 and 2008,the Company declared dividends of $0.01 and $0.16 per share, respectively.  Future dividend payments are subject torestrictions.  See Notes 4 and 12 to theunaudited consolidated financial statements for further information regardingdividend restrictions.

 

As of September 30,2009, the Bank’s regulatory capital was in excess of all applicableregulatory requirements and the Bank was considered well-capitalized under theregulatory framework for prompt corrective action.  At September 30, 2009, the Bank’stangible, core and risk-based capital ratios amounted to 7.11%, 7.11% and11.56%, respectively.  As a result of the current difficult economic environment and the uncertaintiessurrounding the timing of an economic recovery, the Bank has agreed withits primary regulator, the Office of Thrift Supervision (“OTS”)to maintain a core capital ratio of at least five percent and a risk-basedcapital ratio of at least ten percent.

 

### **IMPACTOF INFLATION AND CHANGING PRICES**

### ** **

The financialstatements and related financial data presented herein have been prepared inaccordance with generally accepted accounting principles, which require themeasurement of financial position and operating results in terms of historicaldollars, without considering changes in relative purchasing power over time dueto inflation.

 

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

 

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### **FORWARD-LOOKINGSTATEMENTS**

### ** **

The Company’s QuarterlyReport on Form 10-Q contains certain forward-looking statements andinformation relating to the Company that are based on the beliefs of managementas well as assumptions made by and information currently available tomanagement.  In addition, in thisdocument, the words “anticipate”, “believe,” “estimate,”****“expect,” “intend,” “should” and similarexpressions, or the negative thereof, as they relate to the Company or theCompany’s management, are intended to identify forward-looking statements.  Such statements reflect the current views ofthe Company with respect to future looking events and are subject to certainrisks, uncertainties and assumptions. Should one or more of these risks or uncertainties materialize or shouldunderlying assumptions prove incorrect, actual results may vary materially fromthose described herein as anticipated, believed, estimated, expected orintended.  The Company does not intend toupdate these forward-looking statements.

 

**Item3.  QUANTITATIVE AND QUALITATIVEDISCLOSURES ABOUT MARKET RISK**

 

Market risk is the potential loss arising from adverse changes inmarket prices and rates that principally arises from interest rate riskinherent in our lending, investing, deposit gathering and borrowingactivities.  We strive to maintain anacceptable level of interest rate risk over possible changes in interest rateswhile remaining responsive to market demand for loan and deposit products.  Our primary market risk is interest raterisk. The value of the Bank’s loan and investment portfolio will change asinterest rates change.  As of September30, 2009, the Bank estimates that the ratio of its one-year gap to total assetswas a negative 29.2% compared to a negative 18.0% at December 31, 2008 and itsratio of interest earning assets to interest bearing liabilities maturing orrepricing within one year was 50.3% compared to 70.6% at December 31, 2008.With a negative interest rate repricing gap, rising interest rates willgenerally decrease the Bank’s net portfolio value (“NPV”), while fallinginterest rates will generally increase the value of that portfolio.  NPV is the difference between incoming andoutgoing discounted cash flows from assets, liabilities, and off-balance sheetcontracts.  The following tables setforth, quantitatively, as of September 30, 2009 and December 31, 2008, the OTSestimate of the projected changes in NPV in the event of a 100, 200 and 300basis point instantaneous and permanent increase in market interest rates and a100 basis point instantaneous and permanent decrease in market interest ratesas of September 30, 2009 and December 31, 2008 Due to the current low interest rate environment, the changes in NPV arenot estimated for a decrease in interest rates of 200 basis points.

 
| **September 30, 2009**                                         | ** ** |
|--------------------------------------------------------------------------|------------|
| **Change in   Interest Rates   (basis points)** | ** ** | **Estimated NPV** | ** ** | **Estimated NPV as a  Percentage of********Present Value********of Assets** | ** ** | **Amount********of Change** | ** ** | **Percent********of Change** | ** ** |
| **(Dollars in Thousands)**                                     | ** ** |
| +300                                                                     |       | $ | 63,457 |   | 8.58 | % | $ | (21,526 | ) | (25 | )% |
| +200                                                                     |       | 72,257 |   | 9.61 |   | (12,726 | ) | (15 | ) |
| +100                                                                     |       | 79,608 |   | 10.44 |   | (5,375 | ) | (6 | ) |
| 0                                                                        |       | 84,983 |   | 11.01 |   | — |   | — |   |
| -100                                                                     |       | 83,943 |   | 10.85 |   | (1,040 | ) | (1 | ) |
|                                                                          |            |  |  |  |  |  |  |  |  |  |  |

 
| **December 31, 2008**                                          | ** ** |
|--------------------------------------------------------------------------|------------|
| **Change in   Interest Rates   (basis points)** | ** ** | **Estimated NPV** | ** ** | **Estimated NPV as a   Percentage of********Present Value********of Assets** | ** ** | **Amount********of Change** | ** ** | **Percent********of Change** | ** ** |
| **(Dollars in Thousands)**                                     | ** ** |
| +300                                                                     |       | $ | 55,809 |   | 7.11 | % | $ | (24,839 | ) | (31 | )% |
| +200                                                                     |       | 64,084 |   | 8.05 |   | (16,564 | ) | (21 | ) |
| +100                                                                     |       | 72,264 |   | 8.94 |   | (8,384 | ) | (10 | ) |
| 0                                                                        |       | 80,648 |   | 9.83 |   | — |   | — |   |
| -100                                                                     |       | 81,642 |   | 9.90 |   | 993 |   | 1 |   |
|                                                                          |            |  |  |  |  |  |  |  |  |  |  |

 

Computations ofprospective effects of hypothetical interest rate changes are calculated by theOTS from data provided by the Bank and are based on numerous assumptions,including relative levels of market interest rates, loan repayments, anddeposit runoffs, and should not be relied upon as indicative of actualresults.  Further, the computations donot contemplate any actions the Bank may undertake in response to changes ininterest rates.

 

Management cannot predictfuture interest rates or their effect on the Bank’s NPV.  Certain shortcomings are inherent in themethod of analysis presented in the computation of NPV.  For example, although certain assets andliabilities may have similar maturities or periods to repricing, they may reactin differing degrees to changes in market interest 

 

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rates.  Additionally, certain assets, such asadjustable rate loans, have features that restrict changes in interest ratesduring the initial term and over the remaining life of the asset.  In addition, the proportion of adjustablerate loans in the Bank’s portfolio could decrease in future periods due torefinancing activity if market rates decrease. Further, in the event of a change in interest rates, prepayment andearly withdrawal levels could deviate significantly from those assumed in thetable.  Finally, the ability of manyborrowers to service their adjustable rate debt may decrease in the event of aninterest rate increase.

 

**Item4.  CONTROLS AND PROCEDURES**

 

Our management evaluated,with the participation of our Chief Executive Officer and Chief FinancialOfficer, the effectiveness of the design and operation of our disclosurecontrols and procedures (as defined in Rules 13a-15(e) and 15d-15(e) underthe Securities Exchange Act of 1934) as of the end of the period covered bythis report.  Based on such evaluation,our Chief Executive Officer and Chief Financial Officer have concluded that ourdisclosure controls and procedures are operating effectively.

 

No change in the Company’sinternal control over financial reporting (as defined in Rules 13a-15(f) and15d-15(f) under the Securities Exchange Act) occurred during the mostrecent fiscal quarter that has materially affected, or is reasonably likely tomaterially affect, the Company’s internal control over financial reporting.

 

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**FIRSTFEDERAL BANCSHARES OF ARKANSAS, INC.**

 

**Part II**

 

Item 1.            Legal Proceedings

 

On June 22,2009, a lawsuit was filed in the Circuit Court of Benton County, Arkansas,Civil Division, Docket No. CIV2009-1936-3 styled Pinnacle Hills HotelGroup, LLC, Landside Acquisitions, LLC, Basic Construction, Inc., and GaryCombs vs. First Federal Bank of Harrison. The limited liability plaintiffs are direct or indirect affiliates ofGary Combs, a commercial and residential developer who is a resident ofWashington County, Arkansas.  Accordingto the complaint, the plaintiffs are borrowers and/or guarantors of certainloans made to the various borrowers and secured by a mortgage on property inWashington County, Arkansas and a mortgage secured by property in BentonCounty, Arkansas.  The complaint allegesthat the Bank has breached its agreement with Combs to provide financing,wrongfully shared details of a project with a third party, disseminatedproprietary information, among other allegations.  The plaintiffs seek damages under thecomplaint in the amount of $16 million.

 

On October 15,2009, a settlement agreement was executed by all parties to the above describedlawsuit. In conjunction with this settlement an order of dismissal withprejudice was entered by the court pursuant to the settlement agreement.  The settlement resulted in the Bank obtaininglien free ownership of its collateral.

 

Neither theCompany nor the Bank is involved in any other pending legal proceedings otherthan non-material legal proceedings occurring in the ordinary course ofbusiness.

 

Item1A.         Risk Factors

 

*In analyzing whether to make or to continue aninvestment in our securities, investors should consider, among other factors,the following risk factors.*

 

**The current economic environment poses significantchallenges for the Company and could adversely affect its financial condition andresults of operations.**

 

The Company is operating in a challenging and uncertain economicenvironment, including generally uncertain national and local conditions.  Financial institutions continue to beaffected by sharp declines in the real estate market and constrained financialmarkets.  Dramatic declines in thehousing market over the past year, with falling home prices and increasingforeclosures and unemployment, have resulted in significant write-downs of assetvalues by financial institutions.  Continueddeclines in real estate values, home sales volumes, and financial stress onborrowers as a result of the uncertain economic environment could have anadverse effect on the Bank’s borrowers or their customers, which couldadversely affect the Company’s financial condition and results ofoperations.  A worsening of theseconditions would likely exacerbate the adverse effects on the Company andothers in the financial services industry. For example, further deterioration in local economic conditions in theCompany’s markets could drive losses beyond that which is provided for in itsallowance for loan losses.  The Companymay also face the following risks in connection with these events:

 

·                  Economic conditions that negatively affect housingprices and the job market have resulted, and may continue to result, indeterioration in credit quality of the Bank’s loan portfolio, and suchdeterioration in credit quality has had, and could continue to have, a negativeimpact on the Company’s business.

·                  Market developments may affect consumer confidencelevels and may cause adverse changes in payment patterns, causing increases indelinquencies and default rates on loans and other credit facilities.

·                  The processes the Company uses to estimate theallowance for loan losses may no longer be reliable because they rely oncomplex judgments, including forecasts of economic conditions, which may nolonger be capable of accurate estimation.

·                  The Bank’s ability to assess the creditworthiness ofits customers may be impaired if the processes and approaches it uses toselect, manage, and underwrite its customers become less predictive of futurecharge-offs.

·                  The Company expects to face increased regulation ofits industry, and compliance with such regulation may increase its costs, limitits ability to pursue business opportunities, and increase compliancechallenges.

 

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As these conditions or similar ones continue to exist or worsen, theCompany could experience continuing or increased adverse effects on itsfinancial condition and results of operations.

 

**We are heavilyregulated, and that regulation could limit or restrict our activities andadversely affect our earnings.**

 

We operate in a highly regulated industry and are subject toexamination, supervision, and comprehensive regulation by various federal andstate agencies, including the OTS and the Federal Deposit Insurance Corporation(the “FDIC”). Our compliance with these regulations is costly and may restrictsome of our activities, including payment of dividends, mergers andacquisitions, investments, loans and interest rates and locations of offices.

 

In light of current conditions in the global financial markets and theglobal economy, regulators have increased their focus on the regulation of thefinancial services industry. In recent months, the U.S. financial regulatorsresponding to directives of the Obama Administration and Congress haveintervened on an unprecedented scale. New legislative proposals continue to beintroduced in the U.S. Congress that could further substantially increaseregulation of the financial services industry and impose restrictions on theoperations and general ability of firms within the industry to conduct businessconsistent with historical practices, including with respect to compensation,interest rates and the effect of bankruptcy proceedings on consumer realproperty mortgages. Further, federal and state regulatory agencies may adoptchanges to their regulations and/or change the manner in which existingregulations are applied. We cannot predict the substance or effect of pendingor future legislation or regulation or the application of laws and regulationto us. Compliance with current and potential regulation and scrutiny maysignificantly increase our costs, impede the efficiency of our internalbusiness processes, require us to increase our regulatory capital and limit ourability to pursue business opportunities in an efficient manner by requiring usto expend significant time, effort and resources to ensure compliance.Additionally, evolving regulations concerning executive compensation may imposelimitations on us that affect our ability to compete successfully for executiveand management talent.

 

On June 17, 2009, the Obama Administration proposed a white paper,“Financial Regulatory Reform—A New Foundation: Rebuilding Financial Supervisionand Regulation,” that provides recommendations for overhauling the nation’sfinancial regulatory system in the wake of the global financial crisis. Theplan urges Congress and regulators to adopt sweeping changes to financialsector regulation and oversight, dramatically increasing the federal government’srole in nearly every aspect of the financial markets. The administrationproposes both new substantive authorities and practices in governmentregulation and supervision, and a restructuring of the regulatory system,including the creation of new federal agencies, offices and councils. If thisproposal or some other similar proposal is adopted, it may result in additionalrestrictions, oversight or costs that may have an adverse effect on ourbusiness, results of operations or the price of our common stock.

 

In addition, given the current economic and financial environment, ourregulators may elect to alter standards or the interpretation of the standardsused to measure regulatory compliance or to determine the adequacy ofliquidity, certain risk management or other operational practices for financialservices companies in a manner that impacts our ability to implement ourstrategy and could affect us in substantial and unpredictable ways and couldhave an adverse effect on our business, financial condition and results ofoperations. Furthermore, the regulatory agencies have extremely broaddiscretion in their interpretation of the regulations and laws and theirinterpretation of the quality of our loan portfolio, securities portfolio andother assets. If any regulatory agency’s assessment of the quality of ourassets differs from our assessment, we may be required to take additionalcharges that would have the effect of materially reducing our earnings, capitalratios and stock price.

 

**We presentlyare subject to, and in the future may become subject to additional enforcementactions that could have a material adverse effect on our business, operations,financial condition, results of operations or the value of our common stock.**

 

Under federal laws and regulations pertainingto the safety and soundness of insured depository institutions the OTS andseparately the FDIC as the insurer of bank deposits, have the authority tocompel or restrict certain actions on our part if they determine that we haveinsufficient capital or are otherwise operating in a manner that may be deemedto be inconsistent with safe and sound banking practices. Under this authority,our bank regulators can require us to enter into informal or formal enforcementorders, including board resolutions, memoranda of understanding, writtenagreements and consent or cease and desist orders, pursuant to which we wouldbe required to take identified corrective actions to address cited concerns andto refrain from taking certain actions.

 

In November 2009, the members of theboard of directors of the Company and the Bank received written notificationfrom the OTS of directives to address issues that arose in the Company andBank’s most recent regulatory examinations. See Part II, Item 5 of this quarterlyreport on Form 10-Q for a discussion of the directives.

 

If we are unable to comply with the terms ofthe directives, or any future regulatory orders to which we may become subject,then we could become subject to additional, heightened supervisory actions andorders, possibly including cease and desist orders, prompt corrective actionsand/or other regulatory enforcement actions. If our regulators were to takesuch additional supervisory actions, then we could, among other things, becomesubject to significant restrictions on our ability to develop any new business,as well as restrictions on our existing business, and we could be required toraise capital and/or dispose of certain assets and liabilities within aprescribed period of time. The terms of any such supervisory action could havea material adverse effect on our business, operating flexibility, financialcondition and the value of our common stock.

 

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**Changes in interest rates could have a materialadverse effect on our operations.**

 

The operations of financial institutions such as the Bank are dependentto a large extent on net interest income, which is the difference between theinterest income earned on interest earning assets such as loans and investmentsecurities and the interest expense paid on interest bearing liabilities suchas deposits and borrowings.  Changes inthe general level of interest rates can affect our net interest income byaffecting the difference between the weighted average yield earned on ourinterest earning assets and the weighted average rate paid on our interestbearing liabilities, or interest rate spread, and the average life of ourinterest earning assets and interest bearing liabilities.  Changes in interest rates also can affect ourability to originate loans; the value of our interest earning assets; ourability to obtain and retain deposits in competition with other availableinvestment alternatives; and the ability of our borrowers to repay adjustableor variable rate loans.  Interest ratesare highly sensitive to many factors, including governmental monetary policies,domestic and international economic and political conditions and other factorsbeyond our control.  There can be noassurance that our profitability would not be adversely affected during anyperiod of changes in interest rates due to a number of factors which can have amaterial impact on the Bank’s interest rate risk position.  Such factors include among other items, callfeatures and interest rate caps and floors on various assets and liabilities,prepayments, the current interest rates on assets and liabilities to berepriced in each period, and the relative changes in interest rates ondifferent types of assets and liabilities.

 

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

 

Our lending activities include loans secured by existing commercialreal estate.  In addition, our portfolioincludes loans for the construction of single-family residential real estateand land development loans.  Commercialreal estate and construction lending generally is considered to involve ahigher degree of risk than single-family residential lending due to a varietyof factors, including generally larger loan balances, the dependency onsuccessful completion or operation of the project for repayment, thedifficulties in estimating construction costs and loan terms which often do notrequire full amortization of the loan over its term and, instead, provide for aballoon payment at stated maturity.  Ourlending activities also include commercial business loans to small- tomedium-sized businesses, which generally are secured by various equipment,machinery and other corporate assets, and a wide variety of consumer loans,including automobile loans, deposit account secured loans and unsecuredloans.  Although commercial businessloans and consumer loans generally have shorter terms and higher interest ratesthan mortgage loans, they generally involve more risk than mortgage loansbecause of the nature of, or in certain cases the absence of, the collateralwhich secures such loans.  The Bank’s lendingactivities are currently restricted as a result of directives from the OTSwhich became effective November 19, 2009. For a further discussion of the directives and the related limitationsand restrictions, see Part II, Item 5. Other Information contained herein.

 

**Our allowance for loanlosses may not be adequate to cover actual losses.**

 

If our allowance for loan losses is not sufficient to cover actual loanlosses, our earnings could decrease. Management maintains an allowance for loanlosses based upon, among other things:

 

· historical experience;

· repayment capacity of borrowers;

· an evaluation of local, regional andnational economic conditions;

 

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· regular reviews of delinquencies andloan portfolio quality;

· collateral evaluations;

· current trends regarding the volume andseverity of problem loans;

· the existence and effect ofconcentrations of credit; and

· results of regulatory examinations.

 

Based on those factors, management makes various assumptions andjudgments about the ultimate collectibility of the respective loanportfolios.  The determination of theappropriate level of the allowance for loan losses inherently involves a highdegree of subjectivity and requires management to make significant estimates ofcurrent credit risks and future trends, all of which may undergo materialchanges. In addition, our board of directors and the OTS periodically reviewour allowance for loan losses and may require an increase in the provision forpossible loan losses or the recognition of further loan charge-offs. The OTS’judgments may differ from those of our management. The amount of future loanlosses is susceptible to changes in economic, operating and other conditions,which may be beyond our control, including changes in interest rates, and theselosses may exceed current estimates. Federal regulatory agencies, as anintegral part of their examination process, review our loans and allowance forloan losses. While we believe that the allowance for loan losses is adequate tocover current losses, we cannot provide assurances that we will not need toincrease our allowance for loan losses or that regulators will not require anincrease in our allowance. Either of these occurrences could materially andadversely affect our financial condition and results of operations.

 

**The Company is subject to restrictions on itsability to declare or pay dividends and repurchase its shares as a result ofits participation in the Treasury’s Troubled Asset Relief Program CapitalPurchase Program.**

 

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

 

The Company’s ability to repurchase its shares is also restricted underthe terms of the Purchase Agreement.  TheTreasury’s consent generally is required for the Company to make any stockrepurchases until the third anniversary of the investment by the Treasuryunless all of the Series A Preferred Stock has been redeemed ortransferred.  Further, common, juniorpreferred or *pari passu* preferred shares maynot be repurchased if the Company is in arrears on the Series A PreferredStock dividends.

 

**We are subject torestrictions on executive compensation as a result of our participation in theCPP.**

 

Under the terms of the CPP, the U.S. Treasury has imposed specifiedstandards for executive compensation and corporate governance for the periodduring which the U.S. Treasury holds any equity or warrants issued pursuant tothe CPP. These standards generally apply to our chief executive officer, chieffinancial officer, chief operating officer, and the two next most highlycompensated senior executive officers. The standards include:

 

·                  ensuring that incentive compensation for seniorexecutives does not encourage unnecessary and excessive risks that threaten ourvalue;

·                  required clawback of any bonus or incentivecompensation paid to a senior executive based on statements of earnings, gainsor other criteria that are later proven to be materially inaccurate;

·                  prohibition on making golden parachute payments tosenior executives; and

·                  agreement not to deduct for tax purposes executivecompensation in excess of $500,000 for each senior executive.

 

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Under the American Recovery and Reinvestment Act of 2009 (the “ARRA”),further compensation restrictions, including significant limitations onincentive compensation, have been imposed on our senior executive officers andmost highly compensated employees. Those restrictions, and any futurerestrictions on executive compensation that may be adopted, could adverselyaffect our ability to hire and retain senior executive officers.

 

**Operating results mayrequire us to raise additional capital, but that capital may not be availableor may be dilutive.**

 

Our ability to raise capital will depend on conditions in the capitalmarkets, which are outside of our control, and on our financialperformance.  Accordingly, we cannot beassured of our ability to raise capital when needed or on favorable terms. Ifwe cannot raise additional capital when needed, we could be subject toincreased regulatory supervision and the imposition of further restrictions onour growth and business.

 

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

 

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

 

**Future FDIC insurance premiums orspecial assessments may adversely impact our earnings.**

 

On May 22, 2009, the FDICadopted a final rule levying a five basis point special assessment on eachinsured depository institution’s assets minus Tier 1 capital as of June 30,2009. We recorded an expense of approximately $350,000 during the quarter endedJune 30, 2009, to reflect the special assessment. The final rule permitsthe FDIC to levy up to twoadditional special assessments of up to five basis points each during 2009 ifthe FDIC estimates that theDeposit Insurance Fund reserve ratio will fall to a level that the FDIC believes would adversely affectpublic confidence or to a level that will be close to or below zero. Anyfurther special assessments that the FDIClevies will be recorded as an expense during the appropriate period. Inaddition, the FDIC increased thegeneral assessment rate and, therefore, our FDIC general insurance premium expense will increase compared toprior periods.

 

On November 12, 2009, the FDICadopted a final rule pursuant to which insured depositoryinstitutions will be required to prepay their estimated assessments for thefourth quarter of 2009, and for all of 2010, 2011 and 2012. This pre-paymentwill be due on December 30, 2009. Under the rule, the assessment rate forthe fourth quarter of 2009 and for 2010 is based on each institution’s totalbase assessment rate for the third quarter of 2009, modified to assume that theassessment rate in effect on September 30, 2009 had been in effect for theentire third quarter, and the assessment rate for 2011 and 2012 would be equalto the modified third quarter assessment rate plus an additional 3 basispoints. In addition, each institution’s base assessment rate for each period iscalculated using its third quarter assessment base, adjusted quarterly for anestimated 5% annual growth rate in the assessment base through the end of 2012.Pursuant to this rule, we may be required to make a payment of approximately$5.0 million to the FDIC on December 30,2009, and to record the payment as a prepaid expense, which will be amortizedover the fourth quarter of 2009 and the succeeding three years.  The Bank intends to apply to the FDIC torequest an exemption from this prepayment requirement.

 

Recent insured institution failures, as well as deterioration inbanking and economic conditions, have significantly increased the lossprovisions of the FDIC, resulting in a decline in the designated reserve ratioto historical lows. The FDIC expects a higher rate of insured institutionfailures in the next few years compared to recent years. Therefore, the reserveratio may continue to decline. These developments have caused the premiumsassessed on us by the FDIC to increase and materially increase other expenses.We are unable to predict the effect in future periods if the economic crisis continues.

 

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**We may incur increased employeebenefit costs.**

 

Our pension benefits are dependent upon multiple factors resulting fromactual plan experience and assumptions of future experience. Fluctuations inmarket performance and changes in interest rates may result in increased ordecreased pension costs in future periods. Changes in assumptions regardingexpected long-term rate of return on plan assets, changes in our discount rateor expected compensation levels could also increase or decrease pension costs.Future pension funding requirements, and the timing of funding payments, may besubject to changes in legislation.

 

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

 

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

 

**Our ability to successfully competemay be reduced if we are unable to make technological advances.**

 

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

 

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

 

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

 

**Liquidity needs couldadversely affect our results of operations and financial condition.**

 

The Bank’s primary sources of funds are deposits, maturing or calledsecurities, and loan repayments. While scheduled loan repayments are arelatively stable source of funds, they are subject to the ability of borrowersto repay the loans. The ability of borrowers to repay loans can be adverselyaffected by a number of factors outside of our control, including changes ineconomic conditions, adverse trends or events affecting business industrygroups, reductions in real estate values or markets, business closings orlay-offs, inclement weather, natural disasters and international instability.Additionally, deposit levels may be affected by a number of factors, includingrates paid by competitors, general interest rate levels, returns available tocustomers on alternative investments, financial condition or regulatory statusof the Bank, actions by the OTS and general economic conditions. Accordingly,we may be required from time to time to rely on secondary sources of liquidityto meet withdrawal demands or otherwise fund operations. Those sources mayinclude Federal Home Loan Bank advances, repurchase agreements and the FederalReserve discount window.

 

Our financial flexibility will be constrained if we continue to incurlosses and are unable to maintain our access to funding or if adequatefinancing is not available at acceptable interest 

 

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rates. We may seek additional debt in the future. Additionalborrowings, if sought, may not be available to us or, if available, may not beavailable on reasonable terms. If additional financing sources are unavailable,or are not available on reasonable terms, our financial condition, results ofoperations, growth and future prospects could be materially adversely affected.Finally, if we are required to rely more heavily on more expensive fundingsources to support future growth, our revenues may not increase proportionatelyto cover our costs. In addition, we may be required to slow or discontinue capitalexpenditures or make other investments or liquidate assets should those sourcesnot be adequate.

 

**We have a significantdeferred tax asset and cannot assure that it will be fully realized.**

 

We had net deferred tax assets of $13.9 million, net of a valuationallowance of $3.2 million as of September 30, 2009. We did not establish avaluation allowance against our federal net deferred tax assets as of September 30,2009 because we believe that it is more likely than not that all of theseassets will be realized. We determined that a valuation allowance relating tothe state portion of our deferred tax asset was necessary based largely on thenegative evidence represented by the level of state tax exempt interest incomewhich reduces state taxable income to a level that makes it unlikely theCompany will realize its state deferred tax asset. Therefore, a valuationallowance of $3.2 million at September 30, 2009 was recorded to offset thestate deferred tax asset.

 

In evaluating the need for a valuation allowance, we estimated futuretaxable income based on management forecasts. This process required significantjudgment by management about matters that are by nature uncertain. If futureevents differ significantly from our current forecasts, we may need toestablish a valuation allowance on the federal deferred tax asset, which wouldhave a material adverse effect on our results of operations and financialcondition.

 

Item 2.            Unregistered Sales of Equity Securitiesand Use of Proceeds

 

The Company did not repurchase any securitiesduring the third quarter of 2009.  TheCompany is in its 19th announced repurchase program, which was approved by theboard of directors on July 25, 2006, and publicly announced on November 8,2006.  Total shares approved to be purchasedin this program are 245,197 of which 214,587 have been purchased as of September 30,2009.  All treasury stock purchases aremade under publicly announced repurchase programs.  The repurchase program is currentlysuspended.

 

Item 3.            Defaults Upon Senior Securities

 

Not applicable.

 

Item 4.            Submission of Matters to a Vote ofSecurity Holders

 

None.

 

Item 5.            Other Information

 

On November 19, 2009, the members of the board of directors of theCompany and the Bank received written notification from the OTS of directivesto address issues that arose in the Company and Bank’s most recent regulatoryexaminations. The directives became effective upon receipt.

 

The directives require the Company and the Bank to, among other things,obtain the prior written notice of non-objection of the OTS in order to (i) makeor declare any dividends or payments on their outstanding securities, includingthe dividends payable on the series a preferred stock; (ii) renew, extendor revise any contractual arrangement related to compensation or benefits ofany director or executive officer, including change in control and severancepayments; and (iii) increase the Company’s debt position. The directivesalso require that the Company and Bank notify the OTS at least 30 days in advanceof the proposed addition of any individual to the board of directors, theemployment of any individual as a senior executive officer or the change inresponsibilities of any senior executive officer. Further, the directivesrestrict the Company and Bank from making any golden parachute payment,including severance and change in control payments, except as permitted inlimited circumstances by applicable OTS regulations.

 

The directives issued to the Bank also requirethe Bank to obtain the prior written notice of non-objection of the OTS inorder to (i) engage in certain transactions with affiliates or insiders; (ii) enterinto any third-party contracts outside of the normal course of business; (iii) make,purchase, modify, renew, extend, refinance, or commit to make, purchase,modify, renew, refinance, or extend any commercial real estate loan exceeding$1,000,000; (iv) engage in any new activities, lending, or services inwhich the Bank was not actively engaged prior to the issuance of thedirectives; (v) open any agency, branch, or loan production office; and (vi) accept,renew or rollover any brokered deposits.

 

In addition, the directives also set forthcertain limitations and restrictions on the Bank and its business, including:

 

·                  limiting assetgrowth during each calendar quarter to an amount not to exceed net interestcredited on deposit liabilities unless permitted in writing by the OTS;

 

·                  making,purchasing, or committing to make or purchase any new acquisition, developmentand construction (ADC) loans, except for a loan that is for the construction ofan owner-occupied one-to-four family dwelling with a least a 20 percent downpayment or that is subject to a firm pre-sold commitment;

 

·                  making,purchasing, renewing, refinancing, modifying, extending, or committing to make,purchase, renew, refinance, modify, or extend any loan in excess of thesupervisory loan-to-value limits set by the OTS;

 

·                  making,purchasing, modifying, renewing, extending, refinancing, or committing to make,purchase, modify, renew, extend, or refinance, any loan if the loan includesinterest carry or interest reserve;

 

·                  making,purchasing, modifying, renewing, extending, refinancing, or committing to make,purchase, modify, renew, extend, or refinance a loan for the purpose ofproviding operating funds to contractors and developers or to provide workingcapital for a project that is the subject of a loan from the Bank; and

 

·                  purchasing,trading, or committing to purchase or trade homes, buildings, vacant lots, orany other real property.

 

The Bank may fund legally binding commitmentsfor the types of loans noted above that were executed prior to November 20,2009.

 

Item 6.            Exhibits

 

Exhibit 31.1 – Certification of Chief Executive Officer,

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

Exhibit 31.2 – Certification of Chief Financial Officer,

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

Exhibit 32.1 – Certification of Chief Executive Officer,

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

Exhibit 32.2 – Certification of Chief Financial Officer,

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

 

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**SIGNATURES**

 

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

 

 
|                               | **FIRST  FEDERAL BANCSHARES OF ARKANSAS, INC.** |
|------------------------------------|-------------------------------------------------|
|                               |                                            |   |
|                               |                                            |   |
| Date:  November 23, 2009 | By:                                             | /s/ Larry J.  Brandt |
|                               |                                            | Larry J. Brandt |
|                               |                                            | Chief Executive  Officer |
|                               |                                            |   |
|                               |                                            |   |
| Date:  November 23, 2009 | By:                                             | /s/ Sherri R.  Billings |
|                               |                                            | Sherri R. Billings |
|                               |                                            | Chief Financial  Officer and Chief Accounting Officer |
|                                    |                                                 |  |  |

 

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