** **

**UNITED STATES**

**SECURITIESAND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

**FORM 10-Q**

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

**For thequarterly period ended June 30, 2006**

**OR**

**o****           ****TRANSITION REPORT PURSUANT TO SECTION13 OR 15(d) OF THESECURITIES EXCHANGE ACT OF 1934**

**For thetransition period from _____________ to ____________**

**CommissionFile Number 0-28312**

**FIRSTFEDERAL BANCSHARES OF ARKANSAS, INC.**

(Exact name ofregistrant as specified in its charter)

** **

| **Texas**                                                  | ** ** | **71-0785261**          |
|------------------------------------------------------------|------------|-------------------------|
| (State or other  jurisdiction of incorporation             |       | (I.R.S. Employer        |
| or organization)                                           |       | Identification  Number) |
|                                                       |       |                    |
|                                                       |       |                    |
|                                                       |       |                    |
| **1401 Highway 62-65 North**                               | ** ** | ** **              |
| **Harrison,  Arkansas**                                    | ** ** | **72601**               |
| (Address of  principal executive office)                   |       | (Zip Code)              |
|                                                       |       |                    |
|                                                       |       |                    |
| **(870)  741-7641**                                        |
| (Registrant’s  telephone number, including area code) |

 

Indicateby check mark whether the registrant (1) has filed all reports required to befiled by Section 13 or 15(d) of the Securities Exchange Act of 1934 during thepreceding 12 months (or for such shorter period that the registrant wasrequired to file such reports), and (2) has been subject to such filingrequirements for the past 90 days.

Yes  x   No  o

Indicate by checkmark whether the registrant is a large accelerated filer, an accelerated fileror a non-accelerated filer.

Large acceleratedfiler  o      Acceleratedfiler  x      Non-acceleratedfiler  o  

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

Yes  o   No  x

Indicate the number of shares outstanding of each of theissuer’s classes of common stock, as of the latest practicable date:  As of July 25, 2006, there were issued andoutstanding 5,020,256 shares of the Registrant’s Common Stock, par value $.01per share.

 

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**FIRSTFEDERAL BANCSHARES OF ARKANSAS, INC.**

**TABLEOF CONTENTS**
|                | ** ** | ** **                                                                                                                                                  | ** ** | ** ** |
|----------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------|
| **Part I.**    | ** ** | **Financial Information**                                                                                                                                   |       |       |
|           |       |                                                                                                                                                        |       |       |
| Item 1.        |       | Consolidated Financial  Statements                                                                                                                          |       |       |
|           |       |                                                                                                                                                        |       |       |
|           |       | Consolidated Statements of Financial Condition as of  June 30, 2006 and December 31, 2005 (unaudited)                                                       |       |       |
|           |       |                                                                                                                                                        |       |       |
|           |       | Consolidated Statements of Income for the three and  six months ended June 30, 2006 and 2005 (unaudited)                                               |       |       |
|           |       |                                                                                                                                                        |       |       |
|           |       | Consolidated Statement of Stockholders’ Equity for the  six months ended June 30, 2006 (unaudited)                                                     |       |       |
|           |       |                                                                                                                                                        |       |       |
|           |       | Consolidated Statements of Cash Flows for the six  months ended June 30, 2006 and 2005 (unaudited)                                                          |       |       |
|           |       |                                                                                                                                                        |       |       |
|           |       | Notes to Unaudited Consolidated Financial Statements                                                                                                        |       |       |
|           |       |                                                                                                                                                        |       |       |
| Item 2.        |       | Management’s Discussion and Analysis of Financial  Condition and Results of Operations                                                                 |       |       |
|           |       |                                                                                                                                                        |       |       |
| Item 3.        |       | Quantitative and Qualitative Disclosures About Market  Risk                                                                                                 |       |       |
|           |       |                                                                                                                                                        |       |       |
| Item 4.        |       | Controls  and Procedures                                                                                                                                    |       |       |
|           |       |                                                                                                                                                        |       |       |
| **Part II.**   | ** ** | **Other Information**                                                                                                                                       |       |       |
|           |       |                                                                                                                                                        |       |       |
| Item  1.       |       | Legal  Proceedings                                                                                                                                          |       |       |
| Item 1A.       |       | Risk  Factors                                                                                                                                               |       |       |
| Item 2.        |       | Unregistered Sales of Equity Securities and Use of  Proceeds                                                                                                |       |       |
| Item 3.        |       | Defaults Upon Senior Securities                                                                                                                             |       |       |
| Item 4.        |       | Submission of Matters to a Vote of Security Holders                                                                                                         |       |       |
| Item  5.       |       | Other  Information                                                                                                                                          |       |       |
| Item 6.        |       | Exhibits                                                                                                                                                    |       |       |
|           |       |                                                                                                                                                        |       |       |
| **Signatures** |       |                                                                                                                                                        |       |       |
|           |       |                                                                                                                                                        |       |       |
| **Exhibits**   |       |                                                                                                                                                        |       |       |
| 31.1           |       | Certification of Chief  Executive Officer pursuant to Rule 13a-14(a) of Exchange Act, as adopted  pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 |       |       |
| 31.2           |       | Certification of Chief  Financial Officer pursuant to Rule 13a-14(a) of Exchange Act, as adopted pursuant  to Section 302 of the Sarbanes-Oxley Act of 2002 |       |       |
| 32.1           |       | Section 906  Certification of the CEO                                                                                                                       |       |       |
| 32.2           |       | Section 906  Certification of the CFO                                                                                                                       |       |       |

 

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**FIRSTFEDERAL BANCSHARES OF ARKANSAS, INC.**

**CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION**

(In thousands, exceptshare data)

(Unaudited)

 
| ** **                                                                                                                                                                               | ** ** | **June 30,  2006** | ** ** | **December 31,  2005** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|-----------------------------|------------|
| ASSETS                                                                                                                                                                                   |       |                    |       |                        |       |
|                                                                                                                                                                                     |       |                    |       |                        |       |
| Cash and cash  equivalents                                                                                                                                                               |       | $                       | 25,812     |                        | $          | 21,109 |   |
| Investment securities  held to maturity                                                                                                                                                  |       | 60,534                  |       | 56,695                      |       |
| Federal Home  Loan Bank stock                                                                                                                                                            |       | 8,228                   |       | 8,412                       |       |
| Loans  receivable, net                                                                                                                                                                   |       | 738,665                 |       | 719,214                     |       |
| Accrued interest  receivable                                                                                                                                                             |       | 9,627                   |       | 7,490                       |       |
| Real estate  acquired in settlement of loans, net                                                                                                                                        |       | 569                     |       | 892                         |       |
| Office properties  and equipment, net                                                                                                                                                    |       | 19,172                  |       | 18,522                      |       |
| Cash surrender  value of life insurance                                                                                                                                                  |       | 19,023                  |       | 18,654                      |       |
| Prepaid expenses  and other assets                                                                                                                                                       |       | 1,436                   |       | 1,423                       |       |
|                                                                                                                                                                                     |       |                    |       |                        |       |
| TOTAL ASSETS                                                                                                                                                                             |       | $                       | 883,066    |                        | $          | 852,411 |   |
|                                                                                                                                                                                     |       |                    |       |                        |       |
| LIABILITIES AND  STOCKHOLDERS’ EQUITY                                                                                                                                               |       |                    |       |                        |       |
|                                                                                                                                                                                     |       |                    |       |                        |       |
| LIABILITIES:                                                                                                                                                                             |       |                    |       |                        |       |
| Deposits                                                                                                                                                                                 |       | $                       | 630,790    |                        | $          | 611,667 |   |
| Federal Home  Loan Bank advances                                                                                                                                                         |       | 168,452                 |       | 158,240                     |       |
| Advance payments  by borrowers for taxes and insurance                                                                                                                                   |       | 450                     |       | 847                         |       |
| Other  liabilities                                                                                                                                                                       |       | 4,404                   |       | 3,815                       |       |
| Total liabilities                                                                                                                                                                        |       | 804,096                 |       | 774,569                     |       |
|                                                                                                                                                                                     |       |                    |       |                        |       |
| STOCKHOLDERS’ EQUITY:                                                                                                                                                               |       |                    |       |                        |       |
| Preferred stock, no par  value, 5,000,000 shares authorized, none issued                                                                                                                 |       |                    |       |                        |       |
| Common stock,  $.01 par value, 20,000,000 shares authorized, 10,307,502 shares issued,  5,020,256 and 5,048,662 shares outstanding at June 30, 2006 and December 31,  2005, respectively |       | 103                     |       | 103                         |       |
| Additional  paid-in capital                                                                                                                                                              |       | 56,728                  |       | 56,252                      |       |
| Employee stock  benefit plans                                                                                                                                                            |       | (95                     | )          | (140                        | )          |
| Retained  earnings-substantially restricted                                                                                                                                              |       | 86,430                  |       | 83,584                      |       |
|                                                                                                                                                                                     |       | 143,166                 |       | 139,799                     |       |
| Treasury stock,  at cost, 5,287,246 and 5,258,840 shares at June 30, 2006 and December 31,  2005, respectively                                                                           |       | (64,196                 | )          | (61,957                     | )          |
| Total stockholders’ equity                                                                                                                                                          |       | 78,970                  |       | 77,842                      |       |
|                                                                                                                                                                                     |       |                    |       |                        |       |
| TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY                                                                                                                                          |       | $                       | 883,066    |                        | $          | 852,411 |   |

 

See notes tounaudited consolidated financial statements.

1

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**FIRSTFEDERAL BANCSHARES OF ARKANSAS, INC.**

**CONSOLIDATED STATEMENTS OF INCOME**

(In thousands, exceptshare data)

(Unaudited)

 
| ** **                                           | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|------------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                           | ** ** | **June 30,  2006**          | ** ** | **June 30,  2005**        | ** ** | **June 30,  2006** | ** ** | **June 30,  2005** | ** ** |
|                                                 |       |                             |       |                           |       |   |   |   |   |
| INTEREST INCOME:                                     |       |                             |       |                           |       |   |   |   |   |
| Loans receivable                                     |       | $                                | 12,849     |                           | $          | 10,266 |   | $ | 25,075 |   | $ | 20,150 |   |
| Investment securities:                               |       |                             |       |                           |       |   |   |   |   |
| Taxable                                              |       | 623                              |       | 532                            |       | 1,203 |   | 1,050 |   |
| Nontaxable                                           |       | 187                              |       | 178                            |       | 373 |   | 358 |   |
| Other                                                |       | 78                               |       | 25                             |       | 175 |   | 39 |   |
| Total interest income                                |       | 13,737                           |       | 11,001                         |       | 26,826 |   | 21,597 |   |
|                                                 |       |                             |       |                           |       |   |   |   |   |
| INTEREST  EXPENSE:                                   |       |                             |       |                           |       |   |   |   |   |
| Deposits                                             |       | 4,926                            |       | 3,480                          |       | 9,371 |   | 6,764 |   |
| Other borrowings                                     |       | 1,778                            |       | 1,108                          |       | 3,520 |   | 1,952 |   |
| Total interest expense                               |       | 6,704                            |       | 4,588                          |       | 12,891 |   | 8,716 |   |
|                                                 |       |                             |       |                           |       |   |   |   |   |
| NET INTEREST  INCOME                                 |       | 7,033                            |       | 6,413                          |       | 13,935 |   | 12,881 |   |
|                                                 |       |                             |       |                           |       |   |   |   |   |
| PROVISION FOR  LOAN LOSSES                           |       | 359                              |       | 287                            |       | 643 |   | 536 |   |
|                                                 |       |                             |       |                           |       |   |   |   |   |
| NET INTEREST  INCOME AFTER PROVISION FOR LOAN LOSSES |       | 6,674                            |       | 6,126                          |       | 13,292 |   | 12,345 |   |
|                                                 |       |                             |       |                           |       |   |   |   |   |
| NONINTEREST  INCOME:                                 |       |                             |       |                           |       |   |   |   |   |
| Deposit fee income                                   |       | 1,237                            |       | 1,105                          |       | 2,315 |   | 2,114 |   |
| Earnings on life insurance policies                  |       | 185                              |       | 191                            |       | 369 |   | 389 |   |
| Gain on sale of loans                                |       | 278                              |       | 182                            |       | 475 |   | 316 |   |
| Other                                                |       | 385                              |       | 246                            |       | 1,243 |   | 475 |   |
| Total noninterest income                             |       | 2,085                            |       | 1,724                          |       | 4,402 |   | 3,294 |   |
|                                                 |       |                             |       |                           |       |   |   |   |   |
| NONINTEREST  EXPENSES:                               |       |                             |       |                           |       |   |   |   |   |
| Salaries and employee benefits                       |       | 3,259                            |       | 3,013                          |       | 6,979 |   | 6,016 |   |
| Net occupancy expense                                |       | 582                              |       | 506                            |       | 1,171 |   | 1,005 |   |
| Data processing                                      |       | 320                              |       | 412                            |       | 764 |   | 752 |   |
| Professional fees                                    |       | 90                               |       | 105                            |       | 195 |   | 220 |   |
| Advertising and public relations                     |       | 317                              |       | 241                            |       | 640 |   | 482 |   |
| Postage and supplies                                 |       | 196                              |       | 190                            |       | 417 |   | 380 |   |
| Other                                                |       | 614                              |       | 512                            |       | 1,234 |   | 1,021 |   |
| Total noninterest expenses                           |       | 5,378                            |       | 4,979                          |       | 11,400 |   | 9,876 |   |
|                                                 |       |                             |       |                           |       |   |   |   |   |
| INCOME BEFORE  INCOME TAXES                          |       | 3,381                            |       | 2,871                          |       | 6,294 |   | 5,763 |   |
| INCOME TAX  PROVISION                                |       | 1,106                            |       | 922                            |       | 2,034 |   | 1,850 |   |
| NET INCOME                                           |       | $                                | 2,275      |                           | $          | 1,949 |   | $ | 4,260 |   | $ | 3,913 |   |
|                                                 |       |                             |       |                           |       |   |   |   |   |
| EARNINGS PER  SHARE:                                 |       |                             |       |                           |       |   |   |   |   |
| Basic                                                |       | $                                | 0.45       |                           | $          | 0.39 |   | $ | 0.85 |   | $ | 0.79 |   |
|                                                 |       |                             |       |                           |       |   |   |   |   |
| Diluted                                              |       | $                                | 0.44       |                           | $          | 0.37 |   | $ | 0.83 |   | $ | 0.75 |   |
|                                                 |       |                             |       |                           |       |   |   |   |   |
| Cash Dividends  Declared                             |       | $                                | 0.14       |                           | $          | 0.12 |   | $ | 0.28 |   | $ | 0.24 |   |

 

See notes tounaudited consolidated financial statements.

2

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

**CONSOLIDATEDSTATEMENT OF STOCKHOLDERS’ EQUITY**

**FOR THE SIX MONTHS ENDED JUNE 30, 2006**

(In thousands,except share data)

(Unaudited)

 
| ** **                                                 | ** ** | **Issued  Common Stock** | ** ** | **Additional  Paid-In** | ** ** | **Employee  Stock  Benefit** | ** ** | **Retained** | ** ** |
|------------------------------------------------------------|------------|-------------------------------|------------|-------------------------|------------|------------------------------|------------|--------------|------------|
| ** **                                                 | ** ** | **Shares**                    | ** ** | **Amount**              | ** ** | **Capital**                  | ** ** | **Plans**    | ** ** | **Earnings** | ** ** |
|                                                       |       |                          |       |                    |       |                         |       |         |       |   |   |
| Balance, January  1, 2006                                  |       | 10,307,502                    |       | $                       | 103        |                         | $          | 56,252       |       | $ | (140 | ) | $ | 83,584 |   |
| Net income                                                 |       |                          |       |                    |       |                         |       |         |       | 4,260 |   |
| Release of ESOP  shares                                    |       |                          |       |                    |       | 407                          |       | 104          |       |   |   |
| Tax effect of  stock compensation plan                     |       |                          |       |                    |       | 249                          |       |         |       |   |   |
| Treasury shares  reissued due to exercise of stock options |       |                          |       |                    |       | (239                         | )          |         |       |   |   |
| Purchase of  treasury stock, at cost                       |       |                          |       |                    |       |                         |       |         |       |   |   |
| Stock  compensation expense                                |       |                          |       |                    |       | 59                           |       | (59          | )          |   |   |
| Dividends paid                                             |       |                          |       |                    |       |                         |       |         |       | (1,414 | ) |
|                                                       |       |                          |       |                    |       |                         |       |         |       |   |   |
| Balance, June 30, 2006                                     |       | 10,307,502                    |       | $                       | 103        |                         | $          | 56,728       |       | $ | (95 | ) | $ | 86,430 |   |

 
| ** **                                                 | ** ** | **Treasury Stock** | ** ** | **Total  Stockholders’** | ** ** |
|------------------------------------------------------------|------------|-------------------------|------------|-------------------------------|------------|
| ** **                                                 | ** ** | **Shares**              | ** ** | **Amount**                    | ** ** | **Equity** | ** ** |
|                                                       |       |                    |       |                          |       |   |   |
| Balance, January  1, 2006                                  |       | 5,258,840               |       | $                             | (61,957    | ) | $ | 77,842 |   |
| Net income                                                 |       |                    |       |                          |       | 4,260 |   |
| Release of ESOP  shares                                    |       |                    |       |                          |       | 511 |   |
| Tax effect of  stock compensation plan                     |       |                    |       |                          |       | 249 |   |
| Treasury shares  reissued due to exercise of stock options |       | (97,731                 | )          | 982                           |       | 743 |   |
| Purchase of  treasury stock, at cost                       |       | 130,137                 |       | (3,267                        | )          | (3,267 | ) |
| Stock  compensation expense                                |       | (4,000                  | )          | 46                            |       | 46 |   |
| Dividends paid                                             |       |                    |       |                          |       | (1,414 | ) |
|                                                       |       |                    |       |                          |       |   |   |
| Balance, June 30, 2006                                     |       | 5,287,246               |       | $                             | (64,196    | ) | $ | 78,970 |   |

 

See notes tounaudited consolidated financial statements.

3

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**FIRSTFEDERAL BANCSHARES OF ARKANSAS, INC.**

**CONSOLIDATEDSTATEMENTS OF CASH FLOWS**

(In Thousands)

(Unaudited)

 
| ** **                                                                         | ** ** | **Six Months Ended June 30,** | ** ** |
|------------------------------------------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                                                         | ** ** | **2006**                                          | ** ** | **2005** | ** ** |
|                                                                               |       |                                              |       |   |   |
| OPERATING  ACTIVITIES:                                                             |       |                                              |       |   |   |
| Net income                                                                         |       | $                                                 | 4,260      |   | $ | 3,913 |   |
| Adjustments to reconcile net income to net cash  provided by operating activities: |       |                                              |       |   |   |
| Provision for loan losses                                                          |       | 643                                               |       | 536 |   |
| Provision for real estate losses                                                   |       | —                                            |       | 24 |   |
| Deferred tax (benefit) provision                                                   |       | 47                                                |       | (91 | ) |
| Accretion of discounts on investment securities, net                               |       | (4                                                | )          | (1 | ) |
| Federal Home Loan Bank stock dividends                                             |       | (193                                              | )          | (95 | ) |
| Loss (gain) on disposition of office properties and  equipment                     |       | (235                                              | )          | 3 |   |
| Gain on sale of repossessed assets, net                                            |       | (81                                               | )          | (15 | ) |
| Originations of loans held for sale                                                |       | (35,722                                           | )          | (24,087 | ) |
| Proceeds from sales of loans held for sale                                         |       | 33,508                                            |       | 23,559 |   |
| Gain on sale of loans originated to sell                                           |       | (475                                              | )          | (316 | ) |
| Depreciation                                                                       |       | 637                                               |       | 585 |   |
| Amortization of deferred loan fees, net                                            |       | 105                                               |       | 80 |   |
| Release of ESOP shares                                                             |       | 511                                               |       | 1,000 |   |
| Stock compensation expense                                                         |       | 46                                                |       | 13 |   |
| Earnings on life insurance policies                                                |       | (369                                              | )          | (389 | ) |
| Changes in operating assets and liabilities:                                       |       |                                              |       |   |   |
| Accrued interest receivable                                                        |       | (2,137                                            | )          | (998 | ) |
| Prepaid expenses and other assets                                                  |       | 19                                                |       | 85 |   |
| Other liabilities                                                                  |       | (209                                              | )          | (17 | ) |
| Net cash provided by operating activities                                          |       | 351                                               |       | 3,789 |   |
|                                                                               |       |                                              |       |   |   |
| INVESTING  ACTIVITIES:                                                             |       |                                              |       |   |   |
| Purchases of investment securities held to maturity                                |       | (3,125                                            | )          | (1,640 | ) |
| Proceeds from maturities/calls of investment  securities held to maturity          |       | 290                                               |       | 3,416 |   |
| Purchases of FHLB stock                                                            |       | —                                            |       | (2,153 | ) |
| Redemptions of FHLB stock                                                          |       | 377                                               |       | — |   |
| Loan participations sold                                                           |       | 3,419                                             |       | 1,787 |   |
| Loan originations, net of repayments                                               |       | (22,257                                           | )          | (53,514 | ) |
| Proceeds from sales of repossessed assets                                          |       | 1,700                                             |       | 471 |   |
| Proceeds from sales of office properties and  equipment                            |       | 251                                               |       | — |   |
| Purchases of office properties and equipment                                       |       | (1,303                                            | )          | (2,000 | ) |
| Net cash used in investing activities                                              |       | (20,648                                           | )          | (53,633 | ) |
|                                                                               |       |                                              |       |   |   |
| FINANCING  ACTIVITIES:                                                             |       |                                              |       |   |   |
| Net increase in deposits                                                           |       | 19,123                                            |       | 2,594 |   |
| Advances from FHLB                                                                 |       | 55,000                                            |       | 88,423 |   |
| Repayment of advances from FHLB                                                    |       | (44,788                                           | )          | (38,128 | ) |
| Net decrease in advance payments by borrowers for  taxes and insurance             |       | (397                                              | )          | (238 | ) |
| Purchase of treasury stock                                                         |       | (3,267                                            | )          | (5,215 | ) |
| Reissued treasury stock                                                            |       | 743                                               |       | 1,667 |   |
| Dividends paid                                                                     |       | (1,414                                            | )          | (1,215 | ) |
| Net cash provided by financing activities                                          |       | 25,000                                            |       | 47,888 |   |
|                                                                               |       |                                              |       |   |   |
| Net increase  (decrease) in cash and cash equivalents                              |       | 4,703                                             |       | (1,956 | ) |
|                                                                               |       |                                              |       |   |   |
|                                                                               |       |                                              |       |   |   |
|                                                                                    |            |                                                   |            |  |  |  |  |

 

(Continued)

4

----

 
|                                                                           |   | **Six Months Ended June 30,** |   |
|--------------------------------------------------------------------------------|--------|-------------------------------|--------|
|                                                                           |   | **2006**                      |   | **2005** |   |
|                                                                           |   |                          |   |   |   |
| CASH AND CASH  EQUIVALENTS:                                                    |   |                          |   |   |   |
| Beginning of period                                                            |   | $                             | 21,109 |   | $ | 16,003 |   |
| End of period                                                                  |   | $                             | 25,812 |   | $ | 14,047 |   |
|                                                                           |   |                          |   |   |   |
| SUPPLEMENTAL DISCLOSURES  OF CASH FLOW INFORMATION:                            |   |                          |   |   |   |
| Cash paid for:                                                                 |   |                          |   |   |   |
| Interest                                                                       |   | $                             | 12,789 |   | $ | 8,467 |   |
| Income taxes                                                                   |   | $                             | 1,371  |   | $ | 1,132 |   |
|                                                                           |   |                          |   |   |   |
| SUPPLEMENTAL  SCHEDULE OF NONCASH INVESTING ACTIVITIES:                        |   |                          |   |   |   |
| Real estate and other assets acquired in settlement  of loans                  |   | $                             | 1,328  |   | $ | 233 |   |
| Loans to facilitate sales of real estate owned                                 |   | $                             | — |   | $ | — |   |
| Investment securities traded, recorded in  investments not yet settled in cash |   | $                             | 1,000  |   | $ | 1,000 |   |
|                                                                           |   |                          |   |   |   |

 

(Concluded)

 

See notes tounaudited consolidated financial statements.

5

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**FIRST FEDERALBANCSHARES OF ARKANSAS, INC.**

**NOTES TO UNAUDITEDCONSOLIDATED FINANCIAL STATEMENTS**

**Note 1 - Basis ofPresentation and Principles of Consolidation**

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

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

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

Theresults of operations for the six months ended June 30, 2006, are notnecessarily indicative of the results to be expected for the year endingDecember 31, 2006.  The unauditedconsolidated financial statements and notes thereto should be read inconjunction with the audited financial statements and notes thereto for theyear ended December 31, 2005, contained in the Company’s 2005 AnnualReport to Stockholders.

Certain amounts inthe June 30, 2005, unaudited consolidated financial statements have beenreclassified to conform to the classifications adopted for reporting in 2006.

# **Note 1 - Recently AdoptedAccounting Standard**

Weadopted SFAS No. 123(R), *Share-Based Payment*,as of January 1, 2006, using the modified prospective approach.  The adoption of this Statement did not have amaterial effect on the financial statements of the Company nor is it expectedto have a material effect on any future periods.

**Note 2 - Earnings per Share**

The weightedaverage number of common shares used to calculate earnings per share for theperiods ended June 30, 2006 and 2005 were as follows:
| ** **                         | ** ** | **Three months ended June 30,** | ** ** | **Six months ended June 30,** | ** ** |
|------------------------------------|------------|-----------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                         | ** ** | **2006**                                            | ** ** | **2005**                                          | ** ** | **2006** | ** ** | **2005** | ** ** |
| Basic weighted -  average shares   |       | 5,024,563                                           |       | 4,975,893                                         |       | 5,028,420 |   | 4,981,529 |   |
| Effect of  dilutive securities     |       | 118,702                                             |       | 250,552                                           |       | 130,796 |   | 265,657 |   |
| Diluted weighted -  average shares |       | 5,143,265                                           |       | 5,226,445                                         |       | 5,159,216 |   | 5,247,186 |   |

 

6

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**MANAGEMENT’SDISCUSSION AND ANALYSISOF FINANCIAL CONDITION AND RESULTS OF OPERATIONS**

**CRITICALACCOUNTING POLICIES**

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

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

## **CHANGES INFINANCIAL CONDITION**

Changes in financial conditionbetween June 30, 2006 and December 31, 2005 are presented in the followingtable (dollars in thousands).  Materialchanges between the periods are discussed in the sections which follow thetable.
| ** **                                     | ** ** | **June 30,2006** | ** ** | **December 31,  2005** | ** ** | **Increase  (Decrease)** | ** ** | **PercentageChange** | ** ** |
|------------------------------------------------|------------|-----------------------|------------|-----------------------------|------------|--------------------------|------------|----------------------|------------|
| **ASSETS**                                     |       |                  |       |                        |       |                     |       |                 |       |
| Cash and cash equivalents                      |       | $                     | 25,812     |                        | $          | 21,109                   |       | $                    | 4,703      |   | 22.3 | % |
| Investment securities held to maturity         |       | 60,534                |       | 56,695                      |       | 3,839                    |       | 6.8                  | %          |
| Federal Home Loan Bank stock                   |       | 8,228                 |       | 8,412                       |       | (184                     | )          | (2.2                 | )%         |
| Loans receivable, net                          |       | 738,665               |       | 719,214                     |       | 19,451                   |       | 2.7                  | %          |
| Accrued interest receivable                    |       | 9,627                 |       | 7,490                       |       | 2,137                    |       | 28.5                 | %          |
| Office properties and equipment, net           |       | 19,172                |       | 18,522                      |       | 650                      |       | 3.5                  | %          |
| Prepaid expenses and other assets              |       | 21,028                |       | 20,969                      |       | 59                       |       | 0.3                  | %          |
|                                           |       |                  |       |                        |       |                     |       |                 |       |
| TOTAL                                          |       | $                     | 883,066    |                        | $          | 852,411                  |       | $                    | 30,655     |   | 3.6 | % |
|                                           |       |                  |       |                        |       |                     |       |                 |       |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY** |       |                  |       |                        |       |                     |       |                 |       |
| LIABILITIES:                                   | ** ** | ** **            | ** ** | ** **                  | ** ** | ** **               | ** ** | ** **           | ** ** |
| Deposits                                       |       | $                     | 630,790    |                        | $          | 611,667                  |       | $                    | 19,123     |   | 3.1 | % |
| Federal Home Loan Bank advances                |       | 168,452               |       | 158,240                     |       | 10,212                   |       | 6.5                  | %          |
| Other liabilities                              |       | 4,854                 |       | 4,662                       |       | 192                      |       | 4.1                  | %          |
|                                           |       |                  |       |                        |       |                     |       |                 |       |
| Total liabilities                              |       | 804,096               |       | 774,569                     |       | 29,527                   |       | 3.8                  | %          |
|                                           |       |                  |       |                        |       |                     |       |                 |       |
| STOCKHOLDERS’  EQUITY                     |       | 78,970                |       | 77,842                      |       | 1,128                    |       | 1.5                  | %          |
|                                           |       |                  |       |                        |       |                     |       |                 |       |
| TOTAL                                          |       | $                     | 883,066    |                        | $          | 852,411                  |       | $                    | 30,655     |   | 3.6 | % |
|                                           |       |                  |       |                        |       |                     |       |                 |       |
| BOOK VALUE PER  SHARE                          |       | $                     | 15.73      |                        | $          | 15.42                    |       |                 |       |   |   |
|                                           |       |                  |       |                        |       |                     |       |                 |       |
| EQUITY TO ASSETS                               |       | 8.9%                  |       | 9.1%                        |       |                     |       |                 |       |

 

7

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**LoansReceivable. **Changesin loancomposition between June 30, 2006 and December 31, 2005 are presented in thefollowing table (dollars in thousands).
| ** **                                     | ** ** | **June 30,  2006** | ** ** | **December 31,  2005** | ** ** | **Increase  (Decrease)** | ** ** | **Percentage  Change** | ** ** |
|------------------------------------------------|------------|-------------------------|------------|-----------------------------|------------|--------------------------|------------|------------------------|------------|
|                                           |       |                    |       |                        |       |                     |       |                   |       |
| One- to four-family  residences                |       | $                       | 263,628    |                        | $          | 269,660                  |       | $                      | (6,032     | ) |   |   |
| Multi-family                                   |       | 12,085                  |       | 12,900                      |       | (815                     | )          |                   |       |
| Commercial real  estate                        |       | 120,342                 |       | 119,323                     |       | 1,019                    |       |                   |       |
| Land                                           |       | 39,879                  |       | 38,355                      |       | 1,524                    |       |                   |       |
| Construction:                                  |       |                    |       |                        |       |                     |       |                   |       |
| One-to four-family residences                  |       | 45,704                  |       | 51,579                      |       | (5,875                   | )          |                   |       |
| Speculative one-to four-family residences      |       | 106,997                 |       | 104,001                     |       | 2,996                    |       |                   |       |
| Multi-family                                   |       | 19,237                  |       | 20,919                      |       | (1,682                   | )          |                   |       |
| Commercial real estate                         |       | 23,998                  |       | 22,331                      |       | 1,667                    |       |                   |       |
| Land  development                              |       | 50,010                  |       | 40,232                      |       | 9,778                    |       |                   |       |
| Total first mortgage loans                     |       | 681,880                 |       | 679,300                     |       | 2,580                    |       | 0.4                    | %          |
|                                           |       |                    |       |                        |       |                     |       |                   |       |
| Commercial                                     |       | 36,702                  |       | 32,693                      |       | 4,009                    |       | 12.3                   | %          |
|                                           |       |                    |       |                        |       |                     |       |                   |       |
| Home equity and  second mortgage               |       | 53,993                  |       | 49,680                      |       | 4,313                    |       |                   |       |
| Automobile                                     |       | 13,433                  |       | 15,748                      |       | (2,315                   | )          |                   |       |
| Other                                          |       | 13,783                  |       | 13,149                      |       | 634                      |       |                   |       |
| Total consumer                                 |       | 81,209                  |       | 78,577                      |       | 2,632                    |       | 3.3                    | %          |
|                                           |       |                    |       |                        |       |                     |       |                   |       |
| Total loans  receivable                        |       | 799,791                 |       | 790,570                     |       | 9,221                    |       | 1.2                    | %          |
| Less:                                          |       |                    |       |                        |       |                     |       |                   |       |
| Undisbursed  construction loan funds           |       | (58,686                 | )          | (69,086                     | )          | 10,400                   |       |                   |       |
| Unearned  discounts and net deferred loan fees |       | 8                       |       | (156                        | )          | 164                      |       |                   |       |
| Allowance for  loan losses                     |       | (2,448                  | )          | (2,114                      | )          | (334                     | )          |                   |       |
|                                           |       |                    |       |                        |       |                     |       |                   |       |
| Loans receivable, net                          |       | $                       | 738,665    |                        | $          | 719,214                  |       | $                      | 19,451     |   | 2.7 | % |

 

Thegrowth in the Bank’s loan portfolio was primarily due to a $17.3 millionincrease in construction loans, including undisbursed construction loan funds,resulting from opportunities afforded by the economic growth in the NorthwestArkansas area. However, loan growth in the first and second quarters of 2006occurred at a slower rate than in previous quarters, with annualized loangrowth as of June 30, 2006 of 5.4% compared to actual loan growth for the yearended December 31, 2005 of 13.4%.

TheBank will continue to emphasize commercial real estate lending, constructionlending, and commercial lending to take advantage of market opportunities inthese types of loans, as well as to provide opportunities to cross-sell itsother banking products, as long as prudent lending opportunities areavailable.  The Bank also emphasizesoriginations of single-family loans for sale in the secondary market in order togenerate non-interest income. Originations of single-family loans for sale in the secondary marketincreased from $24.1 million for the six months ended June 30, 2005, to $35.7million for the six months ended June 30, 2006.

8

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

 
| ** **                                                                                                                   | ** ** | **June 30, 2006**          | ** ** | **December 31, 2005** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------|------------|---------------------------------|------------|
| ** **                                                                                                                   | ** ** | **(Dollars in Thousands)** | ** ** |
| Nonaccrual loans:                                                                                                            |       |                                 |       |                            |       |
| One- to four-family residential                                                                                              |       | $                                    | 2,628      |                            | $          | 2,630 |   |
| Construction loans                                                                                                           |       | 2,040                                |       | 1,177                           |       |
| Commercial real estate                                                                                                       |       | —                               |       | 707                             |       |
| Commercial loans                                                                                                             |       | 268                                  |       | 236                             |       |
| Consumer loans                                                                                                               |       | 1,248                                |       | 556                             |       |
| Total nonaccrual loans                                                                                                       |       | 6,184                                |       | 5,306                           |       |
|                                                                                                                         |       |                                 |       |                            |       |
| Accruing loans  90 days or more past due                                                                                     |       | 1,232                                |       | 1,600                           |       |
| Restructured  loans                                                                                                          |       | 6,221                                |       | 6,264                           |       |
| Real estate  owned                                                                                                           |       | 569                                  |       | 892                             |       |
|                                                                                                                         |       |                                 |       |                            |       |
| Total nonperforming assets                                                                                                   |       | $                                    | 14,206     |                            | $          | 14,062 |   |
|                                                                                                                         |       |                                 |       |                            |       |
| Total  nonaccrual, accruing loans 90 days or more past due and restructured loans as  a percentage of total loans receivable |       | 1.70%                                |       | 1.67%                           |       |
|                                                                                                                         |       |                                 |       |                            |       |
| Total nonperforming  assets as a percentage of total assets                                                                  |       | 1.61%                                |       | 1.65%                           |       |

 

The increase in nonaccrualloans of approximately $878,000 is primarily due to increases in theconstruction and consumer loan categories. This increase includes two borrowers with loans totaling $1.4 million.

One borrower is a builder withspeculative construction loans on two properties totaling $822,000.  We have estimated losses on these propertiesbased on estimated costs to complete the homes and the most recent appraisalsand as a result have provided $285,000 of specific loan loss allowances againstthese loans.

The other borrower has loanstotaling $589,000 on a primary residence and two duplexes.  We have commenced foreclosure proceedings onthe properties.  Based on the appraisedvalues of the properties, we estimate that we will incur no loss on the sale ofthese properties.

AtJune 30, 2006and December 31, 2005, restructured loans consisted of commercial andcommercial real estate loans to two borrowers. At June 30, 2006, $3.5 million of the restructured loans were currentand $2.7 million were over 60 days past due. Based on facts and circumstances at June 30, 2006, including marketconditions, we believe we will not incur a loss on either relationship.

9

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**Allowance for Loan Losses**. A summary of the activity in the allowance for loan losses is asfollows (in thousands):
| ** **                      | ** ** | **Three Months Ended June 30,** | ** ** | **Six Months Ended June 30,** | ** ** |
|---------------------------------|------------|-----------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                      | ** ** | **2006**                                            | ** ** | **2005**                                          | ** ** | **2006** | ** ** | **2005** | ** ** |
| Balance at  beginning of period |       | $                                                   | 2,251      |                                              | $          | 1,950 |   | $ | 2,114 |   | $ | 1,846 |   |
| Provisions for estimated losses |       | 359                                                 |       | 287                                               |       | 643 |   | 536 |   |
| Recoveries                      |       | 37                                                  |       | 25                                                |       | 85 |   | 51 |   |
| Losses charged off              |       | (199                                                | )          | (240                                              | )          | (394 | ) | (411 | ) |
| Balance at end of  period       |       | $                                                   | 2,448      |                                              | $          | 2,022 |   | $ | 2,448 |   | $ | 2,022 |   |

#  

Changes in the composition ofthe allowance for loan losses between June 30, 2006 and December 31, 2005 arepresented in the following table (in thousands):

|             | ** ** | **June 30,2006** | ** ** | **December 31,  2005** | ** ** | **Increase  (Decrease)** | ** ** |
|-------------|------------|-----------------------|------------|-----------------------------|------------|--------------------------|------------|
| General     |       | $                     | 1,899      |                        | $          | 1,831                    |       | $ | 68 |   |
| Specific    |       | 486                   |       | 183                         |       | 303                      |       |
| Unallocated |       | 63                    |       | 100                         |       | (37                      | )          |
|        |       | $                     | 2,448      |                        | $          | 2,114                    |       | $ | 334 |   |

 

Thegeneral component of the allowance for loan losses increased due to loangrowth.  The specific component of theallowance for loan losses increased primarily due to specific allowances onspeculative single-family construction loans on four properties.

The allowance for loan lossesis evaluated on a regular basis by management and is based upon management’speriodic review of the collectibility of the loans in light of historicalexperience, the nature and volume of the loan portfolio, adverse situationsthat may affect the borrower’s ability to repay, the estimated value of anyunderlying collateral and prevailing economic conditions.  This evaluation is inherently subjective asit requires estimates that are susceptible to significant revision asconditions change and more information becomes available.

The allowance consists of specific,general and unallocated components. The specific component relates to loansthat are classified as loss, doubtful, substandard or special mention. For suchloans that are also classified as impaired, an allowance is established whenthe discounted cash flows (or collateral value or observable market price) ofthe impaired loan is lower than the carrying value of that loan. The generalcomponent covers non-classified loans and is based primarily on historical lossexperience. An unallocated component is maintained to cover uncertainties thatcould affect management’s estimate of probable losses. The unallocatedcomponent of the allowance reflects the margin of imprecision inherent in theunderlying assumptions used in the methodologies for estimating specific andgeneral losses in the portfolio.

The Bank reviews itsnon-homogeneous loans for impairment on a quarterly basis.  The Bank considers commercial real estate,construction, multi-family, and commercial loans to be non-homogeneousloans.  A loan is considered impairedwhen, based on current information and events, it is probable that the Bankwill be unable to collect the scheduled payments of principal or interest whendue according to the contractual terms of the loan agreement.  Factors considered by management indetermining impairment include payment status, collateral value, and theprobability of collecting scheduled principal and interest payments whendue.  Loans that experience insignificantpayment delays and payment shortfalls generally are not classified asimpaired.  Management determines thesignificance of payment delays and payment shortfalls on a case-by-case basis,taking into consideration all of the circumstances surrounding the loan and theborrower, including the length of the delay, the reasons for the delay, theborrower’s prior payment record, and the amount of the shortfall in relation tothe principal and interest owed. Impairment is measured on a loan by loan basis by either the presentvalue of expected future cash flows discounted at the loan’s effective interestrate, the loan’s obtainable market price, or the fair value of the collateralif the loan is collateral dependent.

10

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Large groups of smaller balance homogeneous loans are collectivelyevaluated for impairment.  Accordingly,the Bank does not separately identify individual consumer and residential loansfor impairment disclosures.  Homogeneousloans are those that are considered to have common characteristics that providefor evaluation on an aggregate or pool basis. The Bank considers the characteristics of (1) one- to- four familyresidential first mortgage loans; (2) unsecured consumer loans; and (3)collateralized consumer loans to permit consideration of the appropriateness ofthe allowance for losses of each group of loans on a pool basis.  The primary methodology used to determine theappropriateness of the allowance for losses includes segregating certainspecific, poorly performing loans based on their performance characteristicsfrom the pools of loans as to type, valuing these loans, and then applying aloss factor to the remaining pool balance based on several factors, includingpast loss experience, inherent risks, and economic conditions in the primarymarket areas.

In estimating 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 national economy were tosustain a prolonged downturn, the loss factors applied to our portfolios mayneed to be revised, which may significantly impact the measurement of theallowance for loan losses.  For impairedloans that are collateral-dependent, the estimated fair value of the collateralmay deviate significantly from the proceeds received when the collateral issold.

Although we consider theallowance for loan losses of approximately $2.4 million appropriate andadequate to cover losses inherent in our loan portfolio at June 30, 2006, noassurance can be given that we will not sustain loan losses that aresignificantly different from the amount provided, or that subsequentevaluations of the loan portfolio, in light of factors then prevailing, wouldnot result in a significant change in the allowance for loan losses.

**Investment Securities. **Changes in the composition of investment securities held to maturitybetween June 30, 2006 and December 31, 2005 are presented in the followingtable (in thousands).

|                                         | ** ** | **June 30,  2006** | ** ** | **December 31,  2005** | ** ** | **Increase  (Decrease)** | ** ** |
|-----------------------------------------|------------|-------------------------|------------|-----------------------------|------------|--------------------------|------------|
| U.S. Government  and agency obligations |       | $                       | 44,038     |                        | $          | 40,034                   |       | $ | 4,004 |   |
| Municipal  securities                   |       | 16,496                  |       | 16,661                      |       | (165                     | )          |
| Total                                   |       | $                       | 60,534     |                        | $          | 56,695                   |       | $ | 3,839 |   |

 

During the first six months of2006, investment securities totaling $4.1 million were purchased and $290,000 maturedor were called.

AtJune 30, 2006,estimated fair values of investment securities held to maturity were as follows(in thousands):

|                                        | ** ** | **Amortized Cost** | ** ** | **Fair Value** | ** ** |
|----------------------------------------|------------|-------------------------|------------|---------------------|------------|
|                                   |       |                    |       |                |       |
| U.S. Government and agency obligations |       | $                       | 44,038     |                | $          | 41,857 |   |
| Municipal securities                   |       | 16,496                  |       | 16,274              |       |
| Total                                  |       | $                       | 60,534     |                | $          | 58,131 |   |

 

**Accrued Interest Receivable. ** The increase in accrued interest receivablewas primarily due to an increase in the number of days accrued as well as anincrease in the loan yield at June 30, 2006 compared to December 31, 2005.

11

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**Deposits. **Changes in the composition of depositsbetween June 30, 2006 and December 31, 2005 are presented in the followingtable (dollars in thousands).

 
| ** **               | ** ** | **June 30,  2006** | ** ** | **December 31,  2005** | ** ** | **Increase  (Decrease)** | ** ** | **Percentage  Change** | ** ** |
|--------------------------|------------|-------------------------|------------|-----------------------------|------------|--------------------------|------------|------------------------|------------|
|                     |       |                    |       |                        |       |                     |       |                   |       |
| DDA and NOW  accounts    |       | $                       | 141,235    |                        | $          | 125,397                  |       | $                      | 15,838     |   | 12.6 | % |
| Money Market  accounts   |       | 56,348                  |       | 64,021                      |       | (7,673                   | )          | (12.0                  | )%         |
| Savings accounts         |       | 30,173                  |       | 30,521                      |       | (348                     | )          | (1.1                   | )%         |
| Certificates of  deposit |       | 403,034                 |       | 391,728                     |       | 11,306                   |       | 2.9                    | %          |
|                     |       |                    |       |                        |       |                     |       |                   |       |
| Total deposits           |       | $                       | 630,790    |                        | $          | 611,667                  |       | $                      | 19,123     |   | 3.1 | % |

 

Deposits increasedin the comparison period, primarily due to an increase in public unit accounts,focused marketing efforts to increase checking accounts and the offering of CDspecials.  During the period, DDA and NOWaccount balances increased by $15.8 million and the number of such accountsincreased by 3.1%.  The Bank will continue to aggressivelypromote checking accounts by targeting households and small- and medium-sizedbusiness accounts with its direct mail campaign and “thank you” gifts.   Checkingaccounts are an attractive source of funds for the Bank as they offerlow-interest deposits, fee income potential, and the opportunity to cross-sellother financial services.

Certificates of deposit havecontinued to increase as interest rates continue to rise.  Further, the Bank has advertised several CDproducts with special rates and terms ranging from 7 to 40 months.  The cost of deposit funds increased from2.85% at December 31, 2005 to 3.24% at June 30, 2006.

**Federal Home Loan Bank Advances. **The Bank experienced growth of $10.2 million or 6.5% in FHLBof Dallas advances during the first six months of 2006.  The advances were used primarily to fund loangrowth during the year.  The balance ofadvances at June 30, 2006 of $168.5 million consisted of $104.7 million offixed rate advances with an average cost of 4.2% and $63.8 million of floatingrate advances with an average cost of 5.3%.

**Stockholders’Equity. **Stockholders’equity increased $1.1 million from December 31, 2005 to June 30, 2006.  The increase in stockholders’ equity wasprimarily due to net income of $4.3 million and the issuance of treasury stockdue to proceeds received from the exercise of stock options of $743,000, offsetby the purchase of treasury stock totaling $3.3 million during the first sixmonths of 2006.  In addition, during the sixmonths ended June 30, 2006, cash dividends of $1.4 million were paid.  See the Unaudited Consolidated Statement ofStockholders’ Equity for the six months ended June 30, 2006 for more detail.

12

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**AverageBalance Sheets**

Thefollowing table sets forth certain information relating to the Company’saverage balance sheets and reflects the average yield on assets and averagecost of liabilities for the periods indicated and the yields earned and ratespaid at June 30, 2006.  Such yields andcosts are derived by dividing income or expense by the average balance ofassets or liabilities, respectively, for the periods presented and outstandingbalances at June 30, 2006.  Averagebalances are based on daily balances during the period.
| ** **                                                       | ** ** | **June 30,**                    | ** ** | **Three Months Ended June 30,** | ** ** |
|------------------------------------------------------------------|------------|--------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                       | ** ** | **2006**                             | ** ** | **2006**                                            | ** ** | **2005** | ** ** |
| ** **                                                       | ** ** | **Yield/Cost**                       | ** ** | **Average  Balance**                                | ** ** | **Interest** | ** ** | **Average  Yield/  Cost** | ** ** | **Average  Balance** | ** ** | **Interest** | ** ** | **Average  Yield/  Cost** | ** ** |
| ** **                                                       | ** ** | **(Dollars in Thousands)** | ** ** |
| Interest-earning assets:                                         |       |                                 |       |                                                |       |   |   |   |   |   |   |   |   |   |   |
| Loans receivable(1)                                              |       | 7.13                                 | %          | $                                                   | 740,135    |   | $ | 12,849 |   | 6.94 | % | $ | 678,547 |   | $ | 10,266 |   | 6.05 | % |
| Investment  securities(2)                                        |       | 4.83                                 |       | 67,136                                              |       | 810 |   | 4.82 |   | 61,237 |   | 710 |   | 4.64 |   |
| Other interest-earning  assets                                   |       | 5.14                                 |       | 6,624                                               |       | 78 |   | 4.70 |   | 3,529 |   | 25 |   | 2.86 |   |
| Total  interest-earning assets                                   |       | 6.92                                 |       | 813,895                                             |       | 13,737 |   | 6.75 |   | 743,313 |   | 11,001 |   | 5.92 |   |
| Noninterest-earning assets                                       |       |                                 |       | 61,082                                              |       |   |   |   |   | 52,997 |   |   |   |   |   |
| Total assets                                                     |       |                                 |       | $                                                   | 874,977    |   |   |   |   |   | $ | 796,310 |   |   |   |   |   |
| Interest-bearing liabilities:                                    |       |                                 |       |                                                |       |   |   |   |   |   |   |   |   |   |   |
| Deposits                                                         |       | 3.24                                 |       | 630,727                                             |       | 4,926 |   | 3.12 |   | 589,009 |   | 3,480 |   | 2.36 |   |
| FHLB advances                                                    |       | 4.62                                 |       | 159,596                                             |       | 1,778 |   | 4.46 |   | 126,229 |   | 1,108 |   | 3.51 |   |
| Total  interest-bearing liabilities                              |       | 3.53                                 |       | 790,323                                             |       | 6,704 |   | 3.39 |   | 715,238 |   | 4,588 |   | 2.57 |   |
| Noninterest-bearing liabilities                                  |       |                                 |       | 5,989                                               |       |   |   |   |   | 5,155 |   |   |   |   |   |
| Total liabilities                                                |       |                                 |       | 796,312                                             |       |   |   |   |   | 720,393 |   |   |   |   |   |
| Stockholders’ equity                                        |       |                                 |       | 78,665                                              |       |   |   |   |   | 75,917 |   |   |   |   |   |
| Total liabilities  and stockholders’ equity                 |       |                                 |       | $                                                   | 874,977    |   |   |   |   |   | $ | 796,310 |   |   |   |   |   |
| Net interest income                                              |       |                                 |       |                                                |       | $ | 7,033 |   |   |   |   |   | $ | 6,413 |   |   |   |
| Net earning assets                                               |       |                                 |       | $                                                   | 23,572     |   |   |   |   |   | $ | 28,075 |   |   |   |   |   |
| Interest rate spread                                             |       | 3.39                                 | %          |                                                |       |   |   | 3.36 | % |   |   |   |   | 3.35 | % |
| Net interest margin                                              |       |                                 |       |                                                |       |   |   | 3.46 | % |   |   |   |   | 3.45 | % |
| Ratio of interest-earning assets to interest-bearing liabilities |       |                                 |       |                                                |       |   |   | 102.98 | % |   |   |   |   | 103.93 | % |

 
| ** **                                                       | ** ** | **Six Months Ended June 30,** | ** ** |
|------------------------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                                       | ** ** | **2006**                                          | ** ** | **2005** | ** ** |
| ** **                                                       | ** ** | **Average  Balance**                              | ** ** | **Interest** | ** ** | **Average  Yield/  Cost** | ** ** | **Average  Balance** | ** ** | **Interest** | ** ** | **Average  Yield/  Cost** | ** ** |
| ** **                                                       | ** ** | **(Dollars in Thousands)**              | ** ** |
| Interest-earning assets:                                         |       |                                              |       |   |   |   |   |   |   |   |   |   |   |
| Loans receivable(1)                                              |       | $                                                 | 735,448    |   | $ | 25,075 |   | 6.82 | % | $ | 665,064 |   | $ | 20,150 |   | 6.06 | % |
| Investment  securities(2)                                        |       | 66,128                                            |       | 1,576 |   | 4.77 |   | 61,510 |   | 1,408 |   | 4.58 |   |
| Other  interest-earning assets                                   |       | 7,667                                             |       | 175 |   | 4.54 |   | 2,939 |   | 39 |   | 2.64 |   |
| Total  interest-earning assets                                   |       | 809,243                                           |       | 26,826 |   | 6.63 |   | 729,513 |   | 21,597 |   | 5.92 |   |
| Noninterest-earning assets                                       |       | 60,570                                            |       |   |   |   |   | 51,956 |   |   |   |   |   |
| Total assets                                                     |       | $                                                 | 869,813    |   |   |   |   |   | $ | 781,469 |   |   |   |   |   |
| Interest-bearing liabilities:                                    |       |                                              |       |   |   |   |   |   |   |   |   |   |   |
| Deposits                                                         |       | 622,495                                           |       | 9,371 |   | 3.01 |   | 585,715 |   | 6,764 |   | 2.31 |   |
| FHLB advances                                                    |       | 162,846                                           |       | 3,520 |   | 4.32 |   | 114,886 |   | 1,952 |   | 3.40 |   |
| Total  interest-bearing liabilities                              |       | 785,341                                           |       | 12,891 |   | 3.28 |   | 700,601 |   | 8,716 |   | 2.49 |   |
| Noninterest-bearing liabilities                                  |       | 6,183                                             |       |   |   |   |   | 5,164 |   |   |   |   |   |
| Total liabilities                                                |       | 791,524                                           |       |   |   |   |   | 705,765 |   |   |   |   |   |
| Stockholders’ equity                                        |       | 78,289                                            |       |   |   |   |   | 75,704 |   |   |   |   |   |
| Total liabilities  and stockholders’ equity                 |       | $                                                 | 869,813    |   |   |   |   |   | $ | 781,469 |   |   |   |   |   |
| Net interest income                                              |       |                                              |       | $ | 13,935 |   |   |   |   |   | $ | 12,881 |   |   |   |
| Net earning assets                                               |       | $                                                 | 23,902     |   |   |   |   |   | $ | 28,912 |   |   |   |   |   |
| Interest rate spread                                             |       |                                              |       |   |   | 3.35 | % |   |   |   |   | 3.43 | % |
| Net interest margin                                              |       |                                              |       |   |   | 3.44 | % |   |   |   |   | 3.53 | % |
| Ratio of interest-earning assets to interest-bearing liabilities |       |                                              |       |   |   | 103.04 | % |   |   |   |   | 104.13 | % |

----

(1)             Includes nonaccrual loans.

(2)             Includes FHLB of Dallas stock.

 

13

----

## **Rate/VolumeAnalysis**

Thetable below sets forth certain information regarding changes in interest incomeand interest 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 volume multiplied byprior rate); (ii) changes in rate (change in rate multiplied by prior averagevolume); (iii) changes in rate-volume (changes in rate multiplied by the changein average volume); and (iv) the net change.
| ** **                          | ** ** | **Three Months Ended June 30,  2006 vs. 2005** | ** ** |
|-------------------------------------|------------|------------------------------------------------------------------------------|------------|
| ** **                          | ** ** | **Increase (Decrease)  Due to**                                    | ** ** | ** ** | ** ** |
| ** **                          | ** ** | **Volume**                                                                   | ** ** | **Rate** | ** ** | **Rate/  Volume** | ** ** | **Total  Increase** | ** ** |
| ** **                          | ** ** | **(In Thousands)**                                                      | ** ** |
| Interest income:                    |       |                                                                         |       |   |   |   |   |   |   |
| Loans receivable                    |       | $                                                                            | 932        |   | $ | 1,514 |   | $ | 137 |   | $ | 2,583 |   |
| Investment  securities              |       | 68                                                                           |       | 29 |   | 3 |   | 100 |   |
| Other  interest-earning assets      |       | 22                                                                           |       | 16 |   | 15 |   | 53 |   |
| Total  interest-earning assets      |       | 1,022                                                                        |       | 1,559 |   | 155 |   | 2,736 |   |
|                                |       |                                                                         |       |   |   |   |   |   |   |
| Interest expense:                   |       |                                                                         |       |   |   |   |   |   |   |
| Deposits                            |       | 247                                                                          |       | 1,119 |   | 80 |   | 1,446 |   |
| FHLB advances                       |       | 293                                                                          |       | 299 |   | 78 |   | 670 |   |
| Total  interest-bearing liabilities |       | 540                                                                          |       | 1,418 |   | 158 |   | 2,116 |   |
| Net change in net interest income   |       | $                                                                            | 482        |   | $ | 141 |   | $ | (3 | ) | $ | 620 |   |

 
| ** **                          | ** ** | **Six Months Ended June 30,  2006 vs. 2005** | ** ** |
|-------------------------------------|------------|----------------------------------------------------------------------------|------------|
| ** **                          | ** ** | **Increase (Decrease)  Due to**                                  | ** ** | ** ** | ** ** |
| ** **                          | ** ** | **Volume**                                                                 | ** ** | **Rate** | ** ** | **Rate/  Volume** | ** ** | **Total  Increase** | ** ** |
| ** **                          | ** ** | **(In Thousands)**                                                    | ** ** |
| Interest income:                    |       |                                                                       |       |   |   |   |   |   |   |
| Loans receivable                    |       | $                                                                          | 2,132      |   | $ | 2,526 |   | $ | 267 |   | $ | 4,925 |   |
| Investment  securities              |       | 105                                                                        |       | 59 |   | 4 |   | 168 |   |
| Other  interest-earning assets      |       | 63                                                                         |       | 28 |   | 45 |   | 136 |   |
| Total  interest-earning assets      |       | 2,300                                                                      |       | 2,613 |   | 316 |   | 5,229 |   |
|                                |       |                                                                       |       |   |   |   |   |   |   |
| Interest expense:                   |       |                                                                       |       |   |   |   |   |   |   |
| Deposits                            |       | 424                                                                        |       | 2,054 |   | 129 |   | 2,607 |   |
| FHLB advances                       |       | 815                                                                        |       | 531 |   | 222 |   | 1,568 |   |
| Total  interest-bearing liabilities |       | 1,239                                                                      |       | 2,585 |   | 351 |   | 4,175 |   |
| Net change in net interest income   |       | $                                                                          | 1,061      |   | $ | 28 |   | $ | (35 | ) | $ | 1,054 |   |

 

14

----

**CHANGES IN RESULTS OF OPERATIONS**

The table below presents acomparison of results of operations for the three months ended June 30, 2006 and 2005 (dollarsin thousands).  Specific changes incaptions are discussed in the sections which follow the table.

 
| ** **                                            | ** ** | **Three Months Ended  June 30,** | ** ** | **Increase  (Decrease)** | ** ** | **Percentage  Change**     | ** ** |
|-------------------------------------------------------|------------|-------------------------------------------------|------------|--------------------------|------------|----------------------------|------------|
| ** **                                            | ** ** | **2006**                                        | ** ** | **2005**                 | ** ** | **2006 vs 2005** | ** ** | **2006 vs 2005** | ** ** |
| Interest income:                                      |       |                                            |       |                     |       |                       |       |   |   |
| Loans receivable                                      |       | $                                               | 12,849     |                     | $          | 10,266                     |       | $ | 2,583 |   | 25.2 | % |
| Investment securities                                 |       | 810                                             |       | 710                      |       | 100                        |       | 14.1 | % |
| Other                                                 |       | 78                                              |       | 25                       |       | 53                         |       | 212.0 | % |
| Total interest income                                 |       | 13,737                                          |       | 11,001                   |       | 2,736                      |       | 24.9 | % |
| Interest  expense:                                    |       |                                            |       |                     |       |                       |       |   |   |
| Deposits                                              |       | 4,926                                           |       | 3,480                    |       | 1,446                      |       | 41.6 | % |
| Other borrowings                                      |       | 1,778                                           |       | 1,108                    |       | 670                        |       | 60.5 | % |
| Total interest expense                                |       | 6,704                                           |       | 4,588                    |       | 2,116                      |       | 46.1 | % |
| Net interest  income before provision for loan losses |       | 7,033                                           |       | 6,413                    |       | 620                        |       | 9.7 | % |
| Provision for  loan losses                            |       | 359                                             |       | 287                      |       | 72                         |       | 25.1 | % |
| Net interest  income after provision for loan losses  |       | 6,674                                           |       | 6,126                    |       | 548                        |       | 9.0 | % |
| Noninterest  income:                                  |       |                                            |       |                     |       |                       |       |   |   |
| Deposit fee income                                    |       | 1,237                                           |       | 1,105                    |       | 132                        |       | 12.0 | % |
| Gain on sale of loans                                 |       | 278                                             |       | 182                      |       | 96                         |       | 52.7 | % |
| Other                                                 |       | 570                                             |       | 437                      |       | 133                        |       | 30.4 | % |
| Total noninterest income                              |       | 2,085                                           |       | 1,724                    |       | 361                        |       | 20.9 | % |
| Noninterest  expenses:                                |       |                                            |       |                     |       |                       |       |   |   |
| Salaries and employee benefits                        |       | 3,259                                           |       | 3,013                    |       | 246                        |       | 8.2 | % |
| Net occupancy expense                                 |       | 582                                             |       | 506                      |       | 76                         |       | 15.0 | % |
| Advertising and public relations                      |       | 317                                             |       | 241                      |       | 76                         |       | 31.5 | % |
| Other                                                 |       | 1,220                                           |       | 1,219                    |       | 1                          |       | 0.1 | % |
| Total noninterest expenses                            |       | 5,378                                           |       | 4,979                    |       | 399                        |       | 8.0 | % |
| Income before  income taxes                           |       | 3,381                                           |       | 2,871                    |       | 510                        |       | 17.8 | % |
| Provision for  income taxes                           |       | 1,106                                           |       | 922                      |       | 184                        |       | 20.0 | % |
| Net income                                            |       | $                                               | 2,275      |                     | $          | 1,949                      |       | $ | 326 |   | 16.7 | % |
|                                                  |       |                                            |       |                     |       |                       |       |   |   |
| Basic earnings  per share                             |       | $                                               | 0.45       |                     | $          | 0.39                       |       | $ | 0.06 |   | 15.4 | % |
| Diluted earnings  per share                           |       | $                                               | 0.44       |                     | $          | 0.37                       |       | $ | 0.07 |   | 18.9 | % |
|                                                  |       |                                            |       |                     |       |                       |       |   |   |
| Interest rate  spread                                 |       | 3.36                                            | %          | 3.35                     | %          |                       |       |   |   |
| Net interest  margin                                  |       | 3.46                                            | %          | 3.45                     | %          |                       |       |   |   |
|                                                  |       |                                            |       |                     |       |                       |       |   |   |
| Full-time  equivalents                                |       | 303.8                                           |       | 261.5                    |       |                       |       |   |   |
|                                                  |       |                                            |       |                     |       |                       |       |   |   |
| Full-service offices                                  |       | 18                                              |       | 15                       |       |                       |       |   |   |

 

15

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The table below presents acomparison of results of operations for the six months ended June 30, 2006 and 2005 (dollarsin thousands).  Specific changes incaptions are discussed in the sections which follow the table.
| ** **                                            | ** ** | **Six Months Ended  June 30,** | ** ** | **Increase  (Decrease)** | ** ** | **Percentage  Change**     | ** ** |
|-------------------------------------------------------|------------|-----------------------------------------------|------------|--------------------------|------------|----------------------------|------------|
| ** **                                            | ** ** | **2006**                                      | ** ** | **2005**                 | ** ** | **2006 vs 2005** | ** ** | **2006 vs 2005** | ** ** |
| Interest income:                                      |       |                                          |       |                     |       |                       |       |   |   |
| Loans receivable                                      |       | $                                             | 25,075     |                     | $          | 20,150                     |       | $ | 4,925 |   | 24.4 | % |
| Investment securities                                 |       | 1,576                                         |       | 1,408                    |       | 168                        |       | 11.9 | % |
| Other                                                 |       | 175                                           |       | 39                       |       | 136                        |       | 348.7 | % |
| Total interest income                                 |       | 26,826                                        |       | 21,597                   |       | 5,229                      |       | 24.2 | % |
| Interest expense:                                     |       |                                          |       |                     |       |                       |       |   |   |
| Deposits                                              |       | 9,371                                         |       | 6,764                    |       | 2,607                      |       | 38.5 | % |
| Other borrowings                                      |       | 3,520                                         |       | 1,952                    |       | 1,568                      |       | 80.3 | % |
| Total interest expense                                |       | 12,891                                        |       | 8,716                    |       | 4,175                      |       | 47.9 | % |
| Net interest  income before provision for loan losses |       | 13,935                                        |       | 12,881                   |       | 1,054                      |       | 8.2 | % |
| Provision for  loan losses                            |       | 643                                           |       | 536                      |       | 107                        |       | 20.0 | % |
| Net interest  income after provision for loan losses  |       | 13,292                                        |       | 12,345                   |       | 947                        |       | 7.7 | % |
| Noninterest income:                                   |       |                                          |       |                     |       |                       |       |   |   |
| Deposit fee income                                    |       | 2,315                                         |       | 2,114                    |       | 201                        |       | 9.5 | % |
| Gain on sale of loans                                 |       | 475                                           |       | 316                      |       | 159                        |       | 50.3 | % |
| Other                                                 |       | 1,612                                         |       | 864                      |       | 748                        |       | 86.6 | % |
| Total noninterest income                              |       | 4,402                                         |       | 3,294                    |       | 1,108                      |       | 33.6 | % |
| Noninterest expenses:                                 |       |                                          |       |                     |       |                       |       |   |   |
| Salaries and employee benefits                        |       | 6,979                                         |       | 6,016                    |       | 963                        |       | 16.0 | % |
| Net occupancy expense                                 |       | 1,171                                         |       | 1,005                    |       | 166                        |       | 16.5 | % |
| Advertising and public relations                      |       | 640                                           |       | 482                      |       | 158                        |       | 32.8 | % |
| Other                                                 |       | 2,610                                         |       | 2,373                    |       | 237                        |       | 10.0 | % |
| Total noninterest expenses                            |       | 11,400                                        |       | 9,876                    |       | 1,524                      |       | 15.4 | % |
| Income before  income taxes                           |       | 6,294                                         |       | 5,763                    |       | 531                        |       | 9.2 | % |
| Provision for  income taxes                           |       | 2,034                                         |       | 1,850                    |       | 184                        |       | 10.0 | % |
| Net income                                            |       | $                                             | 4,260      |                     | $          | 3,913                      |       | $ | 347 |   | 8.9 | % |
|                                                  |       |                                          |       |                     |       |                       |       |   |   |
| Basic earnings  per share                             |       | $                                             | 0.85       |                     | $          | 0.79                       |       | $ | 0.06 |   | 7.6 | % |
| Diluted earnings  per share                           |       | $                                             | 0.83       |                     | $          | 0.75                       |       | $ | 0.08 |   | 10.7 | % |
|                                                  |       |                                          |       |                     |       |                       |       |   |   |
| Interest rate  spread                                 |       | 3.35                                          | %          | 3.43                     | %          |                       |       |   |   |
| Net interest  margin                                  |       | 3.44                                          | %          | 3.53                     | %          |                       |       |   |   |
|                                                  |       |                                          |       |                     |       |                       |       |   |   |
| Average  full-time equivalents                        |       | 303.8                                         |       | 254.4                    |       |                       |       |   |   |
|                                                  |       |                                          |       |                     |       |                       |       |   |   |
| Full-service offices                                  |       | 18                                            |       | 15                       |       |                       |       |   |   |

 

16

----

**Net Interest Income. **Net interest income isdetermined by the Company’s interest rate spread (i.e., the difference betweenthe yields earned on its interest-earning assets and the rates paid on itsinterest-bearing liabilities) and the relative amounts of interest-earningassets and interest-bearing liabilities.

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

Dollarchanges in interest income and interest expense for the comparison periods arepresented in the Rate/Volume Analysis table which appears on a previous page.

**Interest Income. **The increase in interest incomefor the three and six month comparative periods was primarily due to anincrease in the average balance of loans and an increase in the average yieldearned on loans.  The increase in theaverage yield earned on loans was due to increased rates on new loans,particularly construction loans, in conjunction with recent increases in marketinterest rates.  The average balance ofloans increased primarily due to increased construction loan originationactivity.

**Interest Expense.  **The increase in interest expensefor the three and six month comparative periods was primarily due to anincrease in the average rate paid on deposits and an increase in the averagebalance of and rate paid on  FHLBadvances.  The increase in the averagerates paid on deposit accounts reflects both the shift in deposits from moneymarket accounts to higher rate certificates of deposit as well as increases inmarket interest rates.  The averagebalance of FHLB advances increased due to advances being used to fund loangrowth.  The rates paid on FHLB advancesincreased due to increases in market interest rates.

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

Theincrease in the provision for loan losses in the three and six monthcomparative periods was due primarily to an increase in specific loan lossallowances related to speculative construction loans.

**Noninterest Income. **Deposit fee income increased forboth the three and six month comparative periods as a result of the Bank’scontinued promotion of Bounce ProtectionTM overdraft service as well as an increase in thenumber of checking accounts.  The numberof checking accounts increased approximately 5.6% from June 30, 2005 to June30, 2006.  The Bank plans to continue toaggressively promote checking accounts in 2006 through direct mail campaigns toexpand its checking accounts and increase deposit fee income.

Gainon sale of loans increased for the three and six month comparative period dueto an increase in volume of loans sold.

Theincrease in other noninterest income for the six month comparative period was primarilydue to nonrecurring gains on the sales of two properties totaling approximately$528,000 during the first quarter.  Theseproperties represented excess land and a building adjacent to two existingbranches.

17

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**NoninterestExpense**

**Salaries and Employee Benefits. **The changes in the composition of this line item arepresented below (in thousands):
| ** **                         | ** ** | **Three Months Ended June 30,** | ** ** | **Increase  (Decrease)** | ** ** | **Six Months Ended June 30,** | ** ** | **Increase  (Decrease)** | ** ** |
|------------------------------------|------------|-----------------------------------------------------|------------|--------------------------|------------|---------------------------------------------------|------------|--------------------------|------------|
| ** **                         | ** ** | **2006**                                            | ** ** | **2005**                 | ** ** | **2006 vs 2005**                        | ** ** | **2006**                 | ** ** | **2005** | ** ** | **2006 vs 2005** | ** ** |
| Salaries                           |       | $                                                   | 2,606      |                     | $          | 2,027                                             |       | $                        | 579        |   | $ | 5,125 |   | $ | 4,005 |   | $ | 1,120 |   |
| Payroll taxes                      |       | 211                                                 |       | 174                      |       | 37                                                |       | 467                      |       | 408 |   | 59 |   |
| Insurance                          |       | 173                                                 |       | 153                      |       | 20                                                |       | 344                      |       | 300 |   | 44 |   |
| ESOP (1)                           |       | —                                              |       | 495                      |       | (495                                              | )          | 508                      |       | 975 |   | (467 | ) |
| 401(k)                             |       | 22                                                  |       | —                   |       | 22                                                |       | 22                       |       | — |   | 22 |   |
| Stock  compensation (2)            |       | 12                                                  |       | 7                        |       | 5                                                 |       | 42                       |       | 13 |   | 29 |   |
| Defined benefit  plan contribution |       | 196                                                 |       | 122                      |       | 74                                                |       | 393                      |       | 245 |   | 148 |   |
| Other                              |       | 39                                                  |       | 35                       |       | 4                                                 |       | 78                       |       | 70 |   | 8 |   |
| Total                              |       | $                                                   | 3,259      |                     | $          | 3,013                                             |       | $                        | 246        |   | $ | 6,979 |   | $ | 6,016 |   | $ | 963 |   |
|                               |       |                                                |       |                     |       |                                              |       |                     |       |   |   |   |   |

----

(1)             Employee StockOwnership Plan

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

Theincreases in salaries for the three and six months ended June 30, 2006 comparedto the same periods in 2005, were due primarily to an increase in the number ofemployees and normal salary and merit increases.  Payroll taxes increased during the periodsdue to the increase in salaries.  Thedecreases in employee stock ownership plan expense during the three and sixmonth comparative periods were due to the plan shares becoming fully allocatedas of March 31, 2006.  Defined benefitplan expense increased due to an increase in the required contribution to ourmulti-employer plan primarily resulting from an increase in amortization cost.

TheCompany implemented a 401(k) Plan on June 1, 2006.  Employer matching of employee 401(k)contributions averages approximately 2.5% of salary expense compared to ESOPexpense of approximately 20% of salary expense for the quarter ended March 31,2006.

**NetOccupancy Expense.**  Netoccupancy expense increased in the three and six month periods ended June 30due to the opening of three new branches since the second quarter of 2005.

**Advertisingand Public Relations.** Advertising and public relations increased for the three and six monthsended June 30, 2006, compared to the same periods in 2005, primarily due toincreased costs in 2006 associated with the checking account marketing program,including direct mail, “thank you” gifts, marketing brochures, posters andbillboards, and the business account marketing program that began in the secondquarter of 2005.

**Other Expenses.**  The changes in thecomposition of this line item are presented below (in thousands):
| ** **              | ** ** | **Three Months Ended June 30,** | ** ** | **Increase  (Decrease)** | ** ** | **Six Months Ended June 30,** | ** ** | **Increase** | ** ** |
|-------------------------|------------|-----------------------------------------------------|------------|--------------------------|------------|---------------------------------------------------|------------|--------------|------------|
| ** **              | ** ** | **2006**                                            | ** ** | **2005**                 | ** ** | **2006 vs 2005**                        | ** ** | **2006**     | ** ** | **2005** | ** ** | **2006 vs 2005** | ** ** |
| Data processing expense |       | $                                                   | 320        |                     | $          | 412                                               |       | $            | (92        | ) | $ | 764 |   | $ | 752 |   | $ | 12 |   |
| Other                   |       | 900                                                 |       | 807                      |       | 93                                                |       | 1,846        |       | 1,621 |   | 225 |   |
| Total                   |       | $                                                   | 1,220      |                     | $          | 1,219                                             |       | $            | 1          |   | $ | 2,610 |   | $ | 2,373 |   | $ | 237 |   |

 

Otherexpenses increased in the three and six month comparative periods due toexpenses associated with the start up of new branches. Data processing expensedecreased in the three month comparative period due to credits received in thesecond quarter of 2006 related to the renegotiation of the Bank’s contract withits service provider.  Similar creditswere received in the first quarter of 2005, which explains why the six monthperiod balances were comparable.

18

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**IncomeTaxes. **The increase inincome tax expense for the three and six month comparable periods ended June 30was primarily due to an increase in taxable income.

**OFF-BALANCE SHEETARRANGEMENTS**

TheCompany, in the normal course of business, makes commitments to buy or sellassets or to incur or fund liabilities. Commitments include, but are not limited to:

·                  the origination, purchase orsale of loans;

·                  the fulfillment of commitmentsunder letters-of-credit, extensions of credit on home equity lines of credit,construction loans, and predetermined overdraft protection limits; and

·                  the commitment to fundwithdrawals of certificates of deposit at maturity.

AtJune 30, 2006, the Bank’s off-balance sheet arrangements principally includedlending commitments, which are described below. At June 30, 2006, the Company had no interests in non-consolidatedspecial purpose entities.

AtJune 30, 2006, commitments included:

·                  total approved commitments tooriginate loans amounting to $9.0 million, including $1.6 million of loanscommitted to sell;

·                  rate lock agreements withcustomers of $9.3 million, all of which have been locked with an investor;

·                  funded mortgage loans committedto sell of $5.3 million;

·                  unadvanced portion ofconstruction loans of $58.7 million;

·                  unused lines of credit of $33.6million;

·                  outstanding standby letters ofcredit of approximately $4.0 million;

·                  total predetermined overdraftprotection limits of $10.9 million; and

·                  certificates of depositscheduled to mature in one year or less totaling $276.7 million.

 

Totalunfunded commitments to originate loans for sale and the related commitments tosell of $9.3 million meet the definition of a derivative financialinstrument.  The related asset andliability are considered immaterial at June 30, 2006.

Historically,a very small percentage of predetermined overdraft limits have been used.  At June 30, 2006, overdrafts of accounts withBounce ProtectionTM represented usage of 2.5% of the limit.  We expect utilization of these overdraftlimits to remain at comparable levels in the future.

Basedon historical 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.

**LIQUIDITY ANDCAPITAL RESOURCES**

The Bank’s liquidity,represented by cash and cash equivalents and eligible investment securities, isa product of its operating, investing and financing activities.  The Bank’s primary sources of funds aredeposits, borrowings, collections on outstanding loans, maturities and calls ofinvestment securities and other short-term investments and funds provided fromoperations.  While scheduled loanamortization and maturing investment securities and short-term investments arerelatively predictable sources of funds, deposit flows and loan prepayments aregreatly influenced by general interest rates, economic conditions andcompetition.  The Bank manages thepricing of its deposits to maintain a steady deposit balance.  In addition, the Bank invests excess funds inovernight deposits and other short-term interest-earning assets which provideliquidity to meet lending requirements.  During2006, the use of FHLB advances increased due to increased demand for the Bank’sloan products.  At June 30, 2006,available borrowing capacity with the FHLB was in excess of $111.7 million.

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

As of June 30, 2006,the Bank’s regulatory capital was in excess of all applicable regulatoryrequirements.  At June 30, 2006,the Bank’s tangible, core and risk-based capital ratios amounted to 8.77%, 8.77%and 11.86%, respectively, compared to regulatory requirements of 1.5%, 4.0% and8.0%, respectively.

**IMPACT OFINFLATION AND CHANGING PRICES**

Thefinancial statements and related financial data presented herein have beenprepared in accordance with generally accepted accounting principles, whichrequire the measurement of financial position and operating results in terms ofhistorical dollars, without considering changes in relative purchasing powerover time due to inflation.

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

**FORWARD-LOOKING STATEMENTS**

TheCompany’s Quarterly Report on Form 10-Q contains certain forward-lookingstatements and information relating to the Company that are based on thebeliefs of management as well as assumptions made by and information currentlyavailable to management.  In addition, inthis document, 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.

**QUANTITATIVE ANDQUALITATIVE DISCLOSURESABOUT MARKET RISK**

There has been nomaterial change in the market value of the Bank’s portfolio equity sinceDecember 31, 2005.  Similarly, whilethere has been no material change in the Company’s asset and liability positionsince such time, the Bank’s negative gap position has adversely impacted netincome as interest expense during the six months ended June 30, 2006 increasedat a greater pace than the comparable increase in interest income.  Correspondingly, the Bank’s net interest margindecreased from 3.53% for the six months ended June 30, 2005 to 3.44% for thesame period in 2006.   Based on thecurrent market interest rate environment and increased competition, managementanticipates continued pressure on the Bank’s interest rate spread and interestmargin for the third quarter of 2006.

**CONTROLS ANDPROCEDURES**

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

Nochange in the Company’s internal control over financial reporting (as definedin Rules 13a-15(f) and 15d-15(f)) under the Securities Exchange Act) occurredduring the most recent fiscal quarter that has materially affected, or isreasonably likely to materially affect, the Company’s internal control overfinancial reporting.

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**FIRSTFEDERAL BANCSHARES OF ARKANSAS, INC.**

**Part II**

Item 1.                                              LegalProceedings

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

Item 1A.                                    RiskFactors

There have been nomaterial changes in the Company’s risk factors from those previously disclosedin the Company’s Form 10-K for the year ended December 31, 2005.

Item 2.                                              UnregisteredSales of Equity Securities and Use of Proceeds

 

**ISSUER PURCHASESOF EQUITY SECURITIES**
| ** **                  | ** ** | **(a) Total  Number of  Shares  Purchased** | ** ** | **(b) Average  Price Paid  per Share** | ** ** | **(c) Total Number of  Shares Purchased as  Part of Publicly  Announced Plans or  Programs** | ** ** | **(d) Maximum Number  of Shares that May Yet  Be Purchased Under the  Plans or Programs** | ** ** |
|-----------------------------|------------|-------------------------------------------------------|------------|-------------------------------------------------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------|------------|
| ** **                  | ** ** | ** **                                            | ** ** | ** **                                            | ** ** | ** **                                                                                                                                | ** ** | ** **                                                                                                                                       | ** ** |
| April 1, to  April 30, 2006 |       | —                                                |       | —                                                |       | —                                                                                                                                    |       | —                                                                                                                                           |       |
| May 1, to May  31, 2006     |       | —                                                |       | —                                                |       | —                                                                                                                                    |       | —                                                                                                                                           |       |
| June 1, to June 30,  2006   |       | 5,236                                                 |       | $                                                     | 22.40      |                                                                                                                                      | —     |                                                                                                                                             | 111,084    |   |
|                             |            |                                                       |            |                                                       |            |                                                                                                                                           |            |                                                                                                                                                  |            |  |

 

The Company is inits 18th announced repurchase program, which was approved by the board ofdirectors on July 28, 2005, and publicly announced on December 2, 2005.  Total shares approved to be purchased in thisprogram are 248,316 of which 137,232 have been purchased as of June 30, 2006.

Item 3.                                              DefaultsUpon Senior Securities

Not applicable.

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Item 4.                                              Submissionof Matters to a Vote of Security Holders

On April 25, 2006, the Corporation held an annual meeting ofstockholders for the following purposes:

(1)                          To electtwo directors for a term of three years; and

(2)                          Toratify the appointment by the Board of Directors of Deloitte and Touche LLP asthe Corporation’s independent auditors for the year ending December 31,2006.

The results of thevoting are set forth below:

Proposal One(Election of Director):

| NAME                  | ** ** | **FOR**   | ** ** | **AGAINST/  WITHHELD** | ** ** | **NOT VOTED** | ** ** |
|-----------------------|------------|-----------|------------|------------------------|------------|--------------------|------------|
| Jeffrey L.  Brandt    |       | 4,150,864 |       | 37,756                 |       | 891,490            |       |
| John P. Hammerschmidt |       | 4,147,790 |       | 40,830                 |       | 891,490            |       |

 

Proposal Two(Ratification of Auditors):

| FOR       | ** ** | **AGAINST** | ** ** | **ABSTAIN** | ** ** | **NOT VOTED** |
|-----------|------------|-------------|------------|-------------|------------|--------------------|
| 4,175,113 |       | 1,611       |       | 11,896      |       | 891,490            |

 

Item 5.                                              OtherInformation

None.

Item 6.                                              Exhibits

Exhibit 31.1 —Certification of Chief Executive Officer,

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

Exhibit 31.2 —Certification of Chief Financial Officer,

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

Exhibit 32.1 —Certification of Chief Executive Officer,

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

Exhibit 32.2 —Certification of Chief Financial Officer,

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

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**SIGNATURES**

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

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

 
| Date: July 25, 2006  |   | By:    |   | /s/ Larry J. Brandt     |
|----------------------|--------|--------|--------|-------------------------|
|                 |   |   |   | Larry J. Brandt  CEO    |
|                 |   |   |   |                    |
|                 |   |   |   |                    |
| Date: July 25,  2006 |   | By:    |   | /s/ Sherri R. Billings  |
|                 |   |   |   | Sherri R. Billings  CFO |

 

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