Table of Contents

 

 

 

**UNITEDSTATES**

**SECURITIESAND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

** **

**FORM 10-Q**

 

| **x**      | ** ** | **QUARTERLY REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**                                                                                                                        |
|------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|       |       |                                                                                                                                                                                                                          |
|       |       | **For  the quarterly period ended June 30, 2008**                                                                                                                                                                        |
| ** ** | ** ** | ** **                                                                                                                                                                                                                    |
| **OR**     |
|       |       |                                                                                                                                                                                                                          |
| **o**      | ** ** | **TRANSITION REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**                                                                                                                       |
| ** ** | ** ** | ** **                                                                                                                                                                                                                    |
| ** ** | ** ** | **For  the transition period from                  to                ** |

 

**Commission File Number 0-28312**

 

**FIRSTFEDERAL BANCSHARES OF ARKANSAS, INC.**

(Exact name of registrant as specified in its charter)

 

| **Texas**                                                       | ** ** | **71-0785261**                           |
|-----------------------------------------------------------------|------------|------------------------------------------|
| (State or other jurisdiction of incorporation

or organization) |       | (I.R.S. Employer

Identification Number) |

 

| **1401 Highway 62-65 North**

**Harrison, Arkansas** | ** ** | **72601**  |
|------------------------------------------------------|------------|------------|
| (Address of principal executive office)              |       | (Zip Code) |

 

**(870) 741-7641**

 (Registrant’s telephone number,including area code)

 

Indicate by check mark whether the registrant (1) has filed allreports required to be filed by Section 13 or 15(d) of the SecuritiesExchange Act of 1934 during the preceding 12 months (or for such shorter periodthat the registrant was required to file such reports), and (2) has beensubject to such filing requirements for the past 90 days.

Yes  x  No o

 

Indicate by check mark whether the registrant is a large acceleratedfiler, an accelerated filer, a non-accelerated filer, or a smaller reportingcompany. See definitions of “large accelerated filer,” “accelerated filer,” and“smaller reporting company” in Rule 12b-2 of the Exchange Act. (Checkone):

 

| Large  accelerated filer o | Accelerated  filer x | Non-accelerated  filer o                        | Smaller  reporting company o |
|----------------------------|---------------------------|-------------------------------------------------|-----------------------------------|
|                       |                      | (Do not check if a  smaller  reporting company) |                              |

 

Indicate by check mark whether the registrant is a shell company (asdefined in Rule 12b-2 of the Exchange Act).

Yes o  No x

 

Indicatethe number of shares outstanding of each of the issuer’s classes of commonstock, as of the latest practicable date: As of July 21, 2008, there were issued and outstanding 4,848,385shares of the Registrant’s Common Stock, par value $.01 per share.

 

 

 

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Table of Contents

 

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

 

**TABLE OF CONTENTS**

 
| ** **        | ** **                                                                                                                                                                  | **Page**   |
|-------------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
| **Part I.**  | **Financial  Information**                                                                                                                                                  | ** ** |
|              |                                                                                                                                                                        |       |
| Item  1.          | Consolidated  Financial Statements                                                                                                                                          |       |
|              |                                                                                                                                                                        |       |
|              | Consolidated  Statements of Financial Condition as of June 30, 2008 and  December 31, 2007 (unaudited)                                                            | 1          |
|              |                                                                                                                                                                        |       |
|              | Consolidated  Statements of Income for the three and six months ended June 30, 2008 and 2007  (unaudited)                                                              | 2          |
|              |                                                                                                                                                                        |       |
|              | Consolidated  Statement of Stockholders’ Equity for the six months ended June 30, 2008 (unaudited)                                                                | 3          |
|              |                                                                                                                                                                        |       |
|              | Consolidated  Statements of Cash Flows for the six months ended June 30, 2008 and 2007 (unaudited)                                                                     | 4          |
|              |                                                                                                                                                                        |       |
|              | Notes to Unaudited Consolidated Financial Statements                                                                                                                        | 6          |
|              |                                                                                                                                                                        |       |
| Item 2.           | Management’s Discussion and Analysis of Financial  Condition and Results of  Operations                                                                                | 9          |
|              |                                                                                                                                                                        |       |
| Item 3.           | Quantitative and Qualitative Disclosures About Market  Risk                                                                                                                 | 23         |
|              |                                                                                                                                                                        |       |
| Item  4.          | Controls  and Procedures                                                                                                                                                    | 23         |
|              |                                                                                                                                                                        |       |
| **Part II.** | **Other  Information**                                                                                                                                                      | ** ** |
|              |                                                                                                                                                                        |       |
| Item  1.          | Legal  Proceedings                                                                                                                                                          | 24         |
| Item  1A.         | Risk  Factors                                                                                                                                                               | 24         |
| Item 2.           | Unregistered Sales of Equity Securities and Use of  Proceeds                                                                                                                | 24         |
| Item 3.           | Defaults Upon Senior Securities                                                                                                                                             | 24         |
| Item 4.           | Submission of Matters to a Vote of Security Holders                                                                                                                         | 24         |
| Item  5.          | Other  Information                                                                                                                                                          | 25         |
| Item 6.           | Exhibits                                                                                                                                                                    | 25         |
|              |                                                                                                                                                                        |       |
| **Signatures**    | ** **                                                                                                                                                                  | ** ** |
|              |                                                                                                                                                                        |       |
| **Exhibits**      | ** **                                                                                                                                                                  | ** ** |
| 31.1              | Certification  of Chief Executive Officer pursuant to Rule 13a-14(a) of Exchange  Act, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of  2002 |       |
| 31.2              | Certification  of Chief Financial Officer pursuant to Rule 13a-14(a) of Exchange  Act, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of  2002 |       |
| 32.1              | Section 906  Certification of the CEO                                                                                                                                  |       |
| 32.2              | Section 906  Certification of the CFO                                                                                                                                  |       |
|              |                                                                                                                                                                        |       |

 

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

**CONSOLIDATEDSTATEMENTS OF FINANCIAL CONDITION**

(In thousands, except share data)

(Unaudited)

 
| ** **                                                                                                                                                                                        | ** ** | **June 30,** | ** ** | **December 31,** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                                                        | ** ** | **2008**          | ** ** | **2007**              | ** ** |
| ASSETS                                                                                                                                                                                            |       |              |       |                  |       |
|                                                                                                                                                                                              |       |              |       |                  |       |
| Cash and cash equivalents                                                                                                                                                                         |       | $                 | 42,370     |                  | $          | 27,387 |   |
| Investment securities held to maturity                                                                                                                                                            |       | 127,864           |       | 95,590                |       |
| Federal Home Loan Bank stock                                                                                                                                                                      |       | 4,779             |       | 4,433                 |       |
| Loans receivable, net                                                                                                                                                                             |       | 570,135           |       | 601,256               |       |
| Accrued interest receivable                                                                                                                                                                       |       | 7,923             |       | 9,042                 |       |
| Real estate owned, net                                                                                                                                                                            |       | 20,429            |       | 8,120                 |       |
| Office properties and equipment, net                                                                                                                                                              |       | 24,953            |       | 24,263                |       |
| Cash surrender value of life insurance                                                                                                                                                            |       | 20,012            |       | 20,159                |       |
| Prepaid expenses and other assets                                                                                                                                                                 |       | 2,021             |       | 1,728                 |       |
|                                                                                                                                                                                              |       |              |       |                  |       |
| TOTAL ASSETS                                                                                                                                                                                      |       | $                 | 820,486    |                  | $          | 791,978 |   |
|                                                                                                                                                                                              |       |              |       |                  |       |
| LIABILITIES AND STOCKHOLDERS’ EQUITY                                                                                                                                                         |       |              |       |                  |       |
|                                                                                                                                                                                              |       |              |       |                  |       |
| LIABILITIES:                                                                                                                                                                                      |       |              |       |                  |       |
| Deposits                                                                                                                                                                                          |       | $                 | 638,090    |                  | $          | 630,414 |   |
| Federal Home Loan Bank advances                                                                                                                                                                   |       | 104,100           |       | 82,087                |       |
| Advance payments by borrowers for taxes and  insurance                                                                                                                                            |       | 433               |       | 575                   |       |
| Other liabilities                                                                                                                                                                                 |       | 3,599             |       | 5,239                 |       |
| Total liabilities                                                                                                                                                                                 |       | 746,222           |       | 718,315               |       |
|                                                                                                                                                                                              |       |              |       |                  |       |
| STOCKHOLDERS’ EQUITY:                                                                                                                                                                        |       |              |       |                  |       |
| Preferred stock, no par value, 5,000,000  shares authorized, none issued                                                                                                                          |       |              |       |                  |       |
| Common stock, $.01 par value, 20,000,000 shares  authorized, 10,307,502 shares issued, 4,848,385 and 4,844,385 shares  outstanding at June 30, 2008 and December 31, 2007, respectively |       | 103               |       | 103                   |       |
| Additional paid-in capital                                                                                                                                                                        |       | 56,647            |       | 56,653                |       |
| Employee stock benefit plans                                                                                                                                                                      |       | (32               | )          | (42                   | )          |
| Retained earnings-substantially restricted                                                                                                                                                        |       | 88,145            |       | 87,600                |       |
|                                                                                                                                                                                              |       | 144,863           |       | 144,314               |       |
| Treasury stock, at cost, 5,459,117 and  5,463,117 shares at June 30, 2008 and December 31, 2007,  respectively                                                                          |       | (70,599           | )          | (70,651               | )          |
| Total stockholders’ equity                                                                                                                                                                   |       | 74,264            |       | 73,663                |       |
|                                                                                                                                                                                              |       |              |       |                  |       |
| TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY                                                                                                                                                   |       | $                 | 820,486    |                  | $          | 791,978 |   |

 

See notes to unaudited consolidated financial statements.

 

1

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

**CONSOLIDATEDSTATEMENTS OF INCOME**

(In thousands, except share data)

(Unaudited)

 
| ** **                                           | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|------------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                           | ** ** | **June 30,**                | ** ** | **June 30,**              | ** ** | **June 30,** | ** ** | **June 30,** | ** ** |
| ** **                                           | ** ** | **2008**                         | ** ** | **2007**                       | ** ** | **2008** | ** ** | **2007** | ** ** |
| INTEREST INCOME:                                     |       |                             |       |                           |       |   |   |   |   |
| Loans receivable                                     |       | $                                | 9,520      |                           | $          | 12,004 |   | $ | 19,495 |   | $ | 24,205 |   |
| Investment securities:                               |       |                             |       |                           |       |   |   |   |   |
| Taxable                                              |       | 1,645                            |       | 712                            |       | 2,852 |   | 1,367 |   |
| Nontaxable                                           |       | 190                              |       | 178                            |       | 376 |   | 359 |   |
| Other                                                |       | 112                              |       | 302                            |       | 280 |   | 490 |   |
| Total interest income                                |       | 11,467                           |       | 13,196                         |       | 23,003 |   | 26,421 |   |
|                                                 |       |                             |       |                           |       |   |   |   |   |
| INTEREST EXPENSE:                                    |       |                             |       |                           |       |   |   |   |   |
| Deposits                                             |       | 4,779                            |       | 6,044                          |       | 10,347 |   | 11,892 |   |
| Other borrowings                                     |       | 879                              |       | 1,106                          |       | 1,782 |   | 2,366 |   |
| Total interest expense                               |       | 5,658                            |       | 7,150                          |       | 12,129 |   | 14,258 |   |
|                                                 |       |                             |       |                           |       |   |   |   |   |
| NET INTEREST INCOME                                  |       | 5,809                            |       | 6,046                          |       | 10,874 |   | 12,163 |   |
|                                                 |       |                             |       |                           |       |   |   |   |   |
| PROVISION FOR LOAN LOSSES                            |       | 971                              |       | 370                            |       | 2,499 |   | 2,332 |   |
|                                                 |       |                             |       |                           |       |   |   |   |   |
| NET INTEREST INCOME AFTER PROVISION FOR  LOAN LOSSES |       | 4,838                            |       | 5,676                          |       | 8,375 |   | 9,831 |   |
|                                                 |       |                             |       |                           |       |   |   |   |   |
| NONINTEREST INCOME:                                  |       |                             |       |                           |       |   |   |   |   |
| Deposit fee income                                   |       | 1,344                            |       | 1,269                          |       | 2,555 |   | 2,426 |   |
| Earnings on life insurance policies                  |       | 191                              |       | 184                            |       | 1,562 |   | 373 |   |
| Gain on sale of loans                                |       | 91                               |       | 237                            |       | 266 |   | 463 |   |
| Other                                                |       | 422                              |       | 271                            |       | 870 |   | 559 |   |
| Total noninterest income                             |       | 2,048                            |       | 1,961                          |       | 5,253 |   | 3,821 |   |
|                                                 |       |                             |       |                           |       |   |   |   |   |
| NONINTEREST EXPENSES:                                |       |                             |       |                           |       |   |   |   |   |
| Salaries and employee benefits                       |       | 3,244                            |       | 3,287                          |       | 6,632 |   | 6,729 |   |
| Net occupancy expense                                |       | 645                              |       | 569                            |       | 1,285 |   | 1,193 |   |
| Real estate owned, net                               |       | 269                              |       | 121                            |       | 698 |   | 282 |   |
| Data processing                                      |       | 370                              |       | 351                            |       | 688 |   | 805 |   |
| Professional fees                                    |       | 142                              |       | 142                            |       | 272 |   | 282 |   |
| Advertising and public relations                     |       | 218                              |       | 251                            |       | 560 |   | 610 |   |
| Postage and supplies                                 |       | 182                              |       | 184                            |       | 421 |   | 459 |   |
| Other                                                |       | 578                              |       | 556                            |       | 1,164 |   | 1,166 |   |
| Total noninterest expenses                           |       | 5,648                            |       | 5,461                          |       | 11,720 |   | 11,526 |   |
|                                                 |       |                             |       |                           |       |   |   |   |   |
| INCOME BEFORE INCOME TAXES                           |       | 1,238                            |       | 2,176                          |       | 1,908 |   | 2,126 |   |
| INCOME TAX PROVISION (BENEFIT)                       |       | 229                              |       | 642                            |       | (188 | ) | 433 |   |
| NET INCOME                                           |       | $                                | 1,009      |                           | $          | 1,534 |   | $ | 2,096 |   | $ | 1,693 |   |
|                                                 |       |                             |       |                           |       |   |   |   |   |
| EARNINGS PER SHARE:                                  |       |                             |       |                           |       |   |   |   |   |
| Basic                                                |       | $                                | 0.21       |                           | $          | 0.32 |   | $ | 0.43 |   | $ | 0.35 |   |
|                                                 |       |                             |       |                           |       |   |   |   |   |
| Diluted                                              |       | $                                | 0.21       |                           | $          | 0.32 |   | $ | 0.43 |   | $ | 0.35 |   |
|                                                 |       |                             |       |                           |       |   |   |   |   |
| Cash Dividends Declared                              |       | $                                | 0.16       |                           | $          | 0.16 |   | $ | 0.32 |   | $ | 0.32 |   |

 

See notes to unaudited consolidated financialstatements.

 

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

**CONSOLIDATED STATEMENT OF STOCKHOLDERS’ EQUITY**

**FOR THE SIX MONTHS ENDEDJUNE 30, 2008**

(In thousands, except share data)

(Unaudited)

 
| ** **                                                 | ** ** | **Issued  Common Stock** | ** ** | **Additional  Paid-In ** | ** ** | **Employee  Stock  Benefit ** | ** ** | **Retained  Earnings  (Substantially** | ** ** |
|------------------------------------------------------------|------------|-------------------------------|------------|-------------------------------|------------|------------------------------------|------------|----------------------------------------|------------|
| ** **                                                 | ** ** | **Shares**                    | ** ** | **Amount**                    | ** ** | **Capital**                        | ** ** | **Plans**                              | ** ** | **Restricted)** | ** ** |
|                                                       |       |                          |       |                          |       |                               |       |                                   |       |   |   |
| Balance, January 1, 2008                              |       | 10,307,502                    |       | $                             | 103        |                               | $          | 56,653                                 |       | $ | (42 | ) | $ | 87,600 |   |
| Net income                                                 |       |                          |       |                          |       |                               |       |                                   |       | 2,096 |   |
| Tax effect of stock compensation plan                      |       |                          |       |                          |       | (2                                 | )          |                                   |       |   |   |
| Treasury shares reissued due to exercise of  stock options |       |                          |       |                          |       | (6                                 | )          |                                   |       |   |   |
| Stock compensation expense                                 |       |                          |       |                          |       | 2                                  |       | 10                                     |       |   |   |
| Dividends paid                                             |       |                          |       |                          |       |                               |       |                                   |       | (1,551 | ) |
|                                                       |       |                          |       |                          |       |                               |       |                                   |       |   |   |
| Balance, June 30, 2008                                |       | 10,307,502                    |       | $                             | 103        |                               | $          | 56,647                                 |       | $ | (32 | ) | $ | 88,145 |   |

 
| ** **                                                 | ** ** | **Treasury Stock** | ** ** | **Total  Stockholders’** | ** ** | ** ** | ** ** | ** ** | ** ** |
|------------------------------------------------------------|------------|-------------------------|------------|-------------------------------|------------|------------|------------|------------|------------|
| ** **                                                 | ** ** | **Shares**              | ** ** | **Amount**                    | ** ** | **Equity** | ** ** | ** ** | ** ** | ** ** | ** ** |
|                                                       |       |                    |       |                          |       |       |       |       |       |   |   |
| Balance, January 1, 2008                              |       | 5,463,117               |       | $                             | (70,651    | )          | $          | 73,663     |       |   |   |   |   |
| Net income                                                 |       |                    |       |                          |       | 2,096      |       |       |       |   |   |
| Tax effect of stock compensation plan                      |       |                    |       |                          |       | (2         | )          |       |       |   |   |
| Treasury shares reissued due to exercise of  stock options |       | (4,000                  | )          | 52                            |       | 46         |       |       |       |   |   |
| Stock compensation expense                                 |       |                    |       |                          |       | 12         |       |       |       |   |   |
| Dividends paid                                             |       |                    |       |                          |       | (1,551     | )          |       |       |   |   |
|                                                       |       |                    |       |                          |       |       |       |       |       |   |   |
| Balance, June 30, 2008                                |       | 5,459,117               |       | $                             | (70,599    | )          | $          | 74,264     |       |   |   |   |   |

 

Seenotes to unaudited consolidated financial statements.

 

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

**CONSOLIDATED STATEMENTS OF CASH FLOWS**

(In Thousands)

(Unaudited)

 
| ** **                                                                         | ** ** | **Six Months Ended June 30,** | ** ** |
|------------------------------------------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                                                         | ** ** | **2008**                                          | ** ** | **2007** | ** ** |
| OPERATING ACTIVITIES:                                                              |       |                                              |       |   |   |
| Net income                                                                         |       | $                                                 | 2,096      |   | $ | 1,693 |   |
| Adjustments to reconcile net income to net  cash provided by operating activities: |       |                                              |       |   |   |
| Provision for loan losses                                                          |       | 2,499                                             |       | 2,332 |   |
| Provision for real estate losses                                                   |       | 316                                               |       | 77 |   |
| Deferred tax benefit                                                               |       | (83                                               | )          | (1,006 | ) |
| Accretion of discounts on investment  securities, net                              |       | (50                                               | )          | (12 | ) |
| Federal Home Loan Bank stock dividends                                             |       | (85                                               | )          | (179 | ) |
| Gain on disposition of office properties  and equipment                            |       | (19                                               | )          | (5 | ) |
| Loss on sale of repossessed assets, net                                            |       | 28                                                |       | 51 |   |
| Originations of loans held for sale                                                |       | (17,336                                           | )          | (35,468 | ) |
| Proceeds from sales of loans held for sale                                         |       | 19,069                                            |       | 33,138 |   |
| Gain on sale of loans originated to sell                                           |       | (265                                              | )          | (354 | ) |
| Depreciation                                                                       |       | 726                                               |       | 701 |   |
| Amortization of deferred loan fees, net                                            |       | 179                                               |       | 220 |   |
| Stock compensation expense                                                         |       | 12                                                |       | 24 |   |
| Earnings on life insurance policies                                                |       | (382                                              | )          | (373 | ) |
| Changes in operating assets and  liabilities:                                      |       |                                              |       |   |   |
| Accrued interest receivable                                                        |       | 1,119                                             |       | (1,055 | ) |
| Prepaid expenses and other assets                                                  |       | 333                                               |       | 960 |   |
| Other liabilities                                                                  |       | 351                                               |       | 350 |   |
| Net cash provided by operating activities                                          |       | 8,508                                             |       | 1,094 |   |
|                                                                               |       |                                              |       |   |   |
| INVESTING ACTIVITIES:                                                              |       |                                              |       |   |   |
| Purchases of investment securities held to  maturity                               |       | (96,693                                           | )          | (15,439 | ) |
| Proceeds from maturities/calls of  investment securities held to maturity          |       | 62,474                                            |       | 5,050 |   |
| Federal Home Loan Bank stock purchased                                             |       | (261                                              | )          | — |   |
| Federal Home Loan Bank stock redeemed                                              |       | —                                            |       | 2,404 |   |
| Loan participations sold                                                           |       | 4,045                                             |       | 7,208 |   |
| Loan participations purchased                                                      |       | (1,147                                            | )          | — |   |
| Net loan repayments                                                                |       | 10,672                                            |       | 38,608 |   |
| Proceeds from sales of repossessed assets                                          |       | 1,001                                             |       | 1,738 |   |
| Improvements to real estate owned                                                  |       | (261                                              | )          | (343 | ) |
| Proceeds from sales of office properties  and equipment                            |       | 30                                                |       | 10 |   |
| Purchases of office properties and  equipment                                      |       | (1,427                                            | )          | (1,013 | ) |
| Net cash provided by (used in) investing activities                                |       | (21,567                                           | )          | 38,223 |   |
|                                                                               |       |                                              |       |   |   |
| FINANCING ACTIVITIES:                                                              |       |                                              |       |   |   |
| Net increase (decrease) in deposits                                                |       | 7,676                                             |       | (4,073 | ) |
| Advances from FHLB                                                                 |       | 51,500                                            |       | 4,000 |   |
| Repayment of advances from FHLB                                                    |       | (29,487                                           | )          | (32,489 | ) |
| Net decrease in advance payments by borrowers for taxes and  insurance             |       | (142                                              | )          | (322 | ) |
| Purchase of treasury stock                                                         |       | —                                            |       | (1,998 | ) |
| Reissued treasury stock                                                            |       | 46                                                |       | 324 |   |
| Dividends paid                                                                     |       | (1,551                                            | )          | (1,557 | ) |
| Net cash provided by (used in) financing  activities                               |       | 28,042                                            |       | (36,115 | ) |
|                                                                               |       |                                              |       |   |   |
| Net increase in cash and cash equivalents                                          |       | 14,983                                            |       | 3,202 |   |
|                                                                                    |            |                                                   |            |  |  |  |  |

 

(Continued)

 

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

**CONSOLIDATED STATEMENTS OF CASH FLOWS**

(In Thousands)

(Unaudited)

 
| ** **                                                                     | ** ** | **Six Months Ended June 30,** | ** ** |
|--------------------------------------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                                                     | ** ** | **2008**                                          | ** ** | **2007** | ** ** |
|                                                                           |       |                                              |       |   |   |
| CASH AND CASH EQUIVALENTS:                                                     |       |                                              |       |   |   |
| Beginning of period                                                            |       | $                                                 | 27,387     |   | $ | 35,518 |   |
| End of period                                                                  |       | $                                                 | 42,370     |   | $ | 38,720 |   |
|                                                                           |       |                                              |       |   |   |
| SUPPLEMENTAL DISCLOSURES OF CASH FLOW  INFORMATION:                            |       |                                              |       |   |   |
| Cash paid for:                                                                 |       |                                              |       |   |   |
| Interest                                                                       |       | $                                                 | 12,244     |   | $ | 14,516 |   |
| Income taxes                                                                   |       | $                                                 | —     |   | $ | 236 |   |
|                                                                           |       |                                              |       |   |   |
| SUPPLEMENTAL SCHEDULE OF NONCASH INVESTING  ACTIVITIES:                        |       |                                              |       |   |   |
| Real estate and other assets acquired in  settlement of loans                  |       | $                                                 | 16,369     |   | $ | 5,005 |   |
| Loans to facilitate sales of real estate  owned                                |       | $                                                 | 2,964      |   | $ | 252 |   |
| Investment securities traded, recorded in  investments not yet settled in cash |       | $                                                 | 1,195      |   | $ | 3,070 |   |

 

(Concluded)

 

See notes to unaudited consolidated financial statements.

 

5

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

 

**NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS**

 

# **Note 1 - Basis of Presentation and Principles ofConsolidation**

#  

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

 

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

 

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

 

The results of operations for the three and six months ended June 30,2008, are not necessarily indicative of the results to be expected for the yearending December 31, 2008.  Theunaudited consolidated financial statements and notes thereto should be read inconjunction with the audited financial statements and notes thereto for theyear ended December 31, 2007, contained in the Company’s 2007 AnnualReport to Stockholders.

 

# **Note 2 – Recently Adopted Accounting Standards**

#  

We adopted Financial Accounting Standards Board (“FASB”) Statement ofFinancial Accounting Standards (“SFAS”) No. 157, *Fair Value Measurements*, as of January 1,2008.  See Note 6.

 

We adopted SFAS No. 159, *TheFair Value Option for Financial Assets and Financial Liabilities*, asof January 1, 2008 and have elected not to measure any of our currenteligible financial assets or liabilities at fair value upon adoption; however,we may elect to measure future eligible financial assets or liabilities at fairvalue.

 

**Note 3 – AccountingStandards Issued Not Yet Effective**

 

InDecember 2007, the FASB issued SFAS No. 141R, *Business Combinations.* The objective ofthis statement is to improve the relevance, representational faithfulness, andcomparability of the information that a reporting entity provides in itsfinancial reports about a business combination and its effects. To accomplishthat, this statement establishes principles and requirements for how theacquirer:

 

| a. |   | Recognizes  and measures in its financial statements the identifiable assets acquired,  the liabilities assumed, and any noncontrolling interest in the acquiree |
|----|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| b. |   | Recognizes  and measures the goodwill acquired in the business combination or a gain from  a bargain purchase                                                    |
| c. |   | Determines  what information to disclose to enable users of the financial statements to  evaluate the nature and financial effects of the business combination.  |

 

Thisstatement applies prospectively to business combinations for which theacquisition date is on or after the beginning of the first annual reportingperiod beginning on or after December 15, 2008. An entity may not apply itbefore that date.  Based on our currentactivities, we estimate that the adoption of this statement will not have amaterial effect on the financial statements of the Company.

 

InMarch 2008, the FASB issued SFAS 161, *Disclosuresabout Derivative Instruments and Hedging Activities*, effective forfinancial statements issued for fiscal years beginning after November 15, 2008.  The objective of this statement is to provideenhanced disclosures about derivative instruments and related hedgingitems.  Based on the Bank’s currentactivities, we estimate that the adoption of this statement will not have amaterial effect on the financial statements of the Company.

 

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**Note 4 - Earnings perShare**

 

The weighted average number of common shares used to calculate earningsper share for the periods ended June 30, 2008 and 2007 were as follows:

 
| ** **                        | ** ** | **Three months ended June 30,** | ** ** | **Six months ended June 30,** | ** ** |
|-----------------------------------|------------|-----------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                        | ** ** | **2008**                                            | ** ** | **2007**                                          | ** ** | **2008** | ** ** | **2007** | ** ** |
| Basic weighted - average shares   |       | 4,848,385                                           |       | 4,868,377                                         |       | 4,848,341 |   | 4,869,112 |   |
| Effect of dilutive securities     |       | 1,091                                               |       | 16,140                                            |       | 1,748 |   | 27,271 |   |
| Diluted weighted - average shares |       | 4,849,476                                           |       | 4,884,517                                         |       | 4,850,089 |   | 4,896,383 |   |

 

**Note 5 – Allowances forLoan and Real Estate Losses**

 

Asummary of the activity in the allowances for loan and real estate losses is asfollows for the quarters ended June 30 (in thousands):

 
| ** **                       | ** ** | **Three Months Ended  June 30,  2008** | ** ** | **Three Months Ended  June 30,  2007** | ** ** |
|----------------------------------|------------|-------------------------------------------------------|------------|-------------------------------------------------------|------------|
| ** **                       | ** ** | **Loans**                                             | ** ** | **Real Estate**                                  | ** ** | **Loans** | ** ** | **Real Estate** | ** ** |
|                             |       |                                                  |       |                                                  |       |   |   |   |   |
| Balance—beginning of period |       | $                                                     | 6,107      |                                                  | $          | — |   | $ | 4,294 |   | $ | — |   |
|                             |       |                                                  |       |                                                  |       |   |   |   |   |
| Provisions for estimated losses  |       | 971                                                   |       | 87                                                    |       | 370 |   | 3 |   |
| Recoveries                       |       | 58                                                    |       | —                                                |       | 39 |   | — |   |
| Losses charged off               |       | (1,921                                                | )          | (87                                                   | )          | (412 | ) | (3 | ) |
|                             |       |                                                  |       |                                                  |       |   |   |   |   |
| Balance—end of period       |       | $                                                     | 5,215      |                                                  | $          | — |   | $ | 4,291 |   | $ | — |   |

 
| ** **                       | ** ** | **Six Months Ended  June 30,  2008** | ** ** | **Six Months Ended  June 30,  2007** | ** ** |
|----------------------------------|------------|-----------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                       | ** ** | **Loans**                                           | ** ** | **Real Estate**                                | ** ** | **Loans** | ** ** | **Real Estate** | ** ** |
|                             |       |                                                |       |                                                |       |   |   |   |   |
| Balance—beginning of period |       | $                                                   | 5,162      |                                                | $          | — |   | $ | 2,572 |   | $ | — |   |
|                             |       |                                                |       |                                                |       |   |   |   |   |
| Provisions for estimated losses  |       | 2,499                                               |       | 316                                                 |       | 2,332 |   | 77 |   |
| Recoveries                       |       | 194                                                 |       | —                                              |       | 88 |   | — |   |
| Losses charged off               |       | (2,640                                              | )          | (316                                                | )          | (701 | ) | (77 | ) |
|                             |       |                                                |       |                                                |       |   |   |   |   |
| Balance—end of period       |       | $                                                   | 5,215      |                                                | $          | — |   | $ | 4,291 |   | $ | — |   |

 

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**Note 6 – Fair Value Measurement**

 

EffectiveJanuary 1, 2008, the Bank adopted SFAS 157, which provides a framework formeasuring fair value. SFAS 157 defines fair value as the exchange price thatwould be received for an asset or paid to transfer a liability (an exit price)in the principal or most advantageous market for the asset or liability in anorderly transaction between market participants on the measurement date. SFAS157 also establishes a fair value hierarchy which requires an entity tomaximize the use of observable inputs and minimize the use of unobservableinputs when measuring fair value. The standard describes three levels of inputsthat may be used to measure fair value:

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

 

Theassets presented at fair value on the Bank’s financial statements are relatedto real estate owned, net, and impaired loans, both of which are valued basedon Level 3 inputs. Management utilizes appraisals, listing prices, marketinformation from local realtors and market research reports to base the fairvalue measurement.

 

Thetable below presents a reconciliation for all assets and liabilities measuredat fair value on a recurring basis using significant unobservable inputs (Level3):

 
| ** **             | ** ** | **December 31,  2007** | ** ** | **Additions** | ** ** | **Fair Value  Adjustments** | ** ** | **Transfers  Out** | ** ** | **Gain  (Loss)** | ** ** | **June 30,  2008** | ** ** |
|------------------------|------------|-----------------------------|------------|---------------|------------|----------------------------------|------------|--------------------|------------|------------------|------------|-------------------------|------------|
| ** **             | ** ** | **(in  thousands)**         | ** ** |
| Real estate owned, net |       | $                           | 8,120      |          | $          | 18,867                           |       | $                  | (2,458     | )                | $          | (4,085                  | )          | $ | (15 | ) | $ | 20,429 |   |
| Impaired loans         |       | $                           | 14,894     |          | $          | 1,088                            |       | $                  | (515       | )                | $          | (8,970                  | )          | $ | — |   | $ | 6,497 |   |

#  

# Realizedand unrealized gains and losses on real estate owned are recognized innoninterest expenses in the consolidated statements of income under the caption“Real estate owned, net.”  Gains on salesof real estate owned which are financed by the Bank are deferred in certaincircumstances and recognized as the borrower pays down the related loan.  Fair value adjustments to impaired loans arerecorded through the allowance for loan losses.

 

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# Table of Contents

 

# **MANAGEMENT’S DISCUSSION ANDANALYSIS**

**OF FINANCIAL CONDITIONAND RESULTS OF OPERATIONS**

 

### **CRITICAL ACCOUNTINGPOLICIES**

###  

Various elements of ouraccounting policies, by their nature, are inherently subject to estimationtechniques, valuation assumptions and other subjective assessments.  In particular, valuation of real estate ownedand the methodology for the determination of our allowance for loan losses, dueto the judgments, estimates and assumptions inherent in those policies, arecritical to preparation of our financial statements.  These policies and the judgments, estimatesand assumptions are described in greater detail in subsequent sections ofManagement’s Discussion and Analysis and in the notes to the unauditedfinancial statements included herein.  Webelieve that the judgments, estimates and assumptions used in the preparationof our financial statements are appropriate given the factual circumstances atthe time.  However, given the sensitivityof our financial statements to these critical accounting policies, the use ofother judgments, estimates and assumptions could result in material differencesin our financial condition or results of operations.

 

In estimating the amount of credit losses inherent in our loanportfolio, various judgments and assumptions are made.  For example, when assessing the condition ofthe overall economic environment, assumptions are made regarding future marketconditions and their impact on the loan portfolio.  In the event the local or national economywere to sustain a prolonged downturn, the loss factors applied to ourportfolios may need to be revised, which may significantly impact themeasurement of the allowance for loan losses. For impaired loans that are collateral-dependent and for real estateowned, the estimated fair value of the collateral may deviate significantlyfrom the proceeds received when the collateral is sold.

 

## **CHANGES IN FINANCIALCONDITION**

##  

Changes in financial condition between June 30, 2008 and December 31,2007 are presented in the following table (dollars in thousands).  Material changes between the periods arediscussed in the sections which follow the table.

 
| ** **                                    | ** ** | **June 30,** | ** ** | **December 31,** | ** ** | **Increase**   | ** ** | **Percentage** | ** ** |
|-----------------------------------------------|------------|-------------------|------------|-----------------------|------------|----------------|------------|----------------|------------|
| ** **                                    | ** ** | **2008**          | ** ** | **2007**              | ** ** | **(Decrease)** | ** ** | **Change**     | ** ** |
| **ASSETS**                                    |       |              |       |                  |       |           |       |           |       |
| Cash and cash equivalents                     |       | $                 | 42,370     |                  | $          | 27,387         |       | $              | 14,983     |   | 54.7 | % |
| Investment securities held to maturity        |       | 127,864           |       | 95,590                |       | 32,274         |       | 33.8           |       |
| Federal Home Loan Bank stock                  |       | 4,779             |       | 4,433                 |       | 346            |       | 7.8            |       |
| Loans receivable, net                         |       | 570,135           |       | 601,256               |       | (31,121        | )          | (5.2           | )          |
| Accrued interest receivable                   |       | 7,923             |       | 9,042                 |       | (1,119         | )          | (12.4          | )          |
| Real estate owned, net                        |       | 20,429            |       | 8,120                 |       | 12,309         |       | 151.6          |       |
| Office properties and equipment, net          |       | 24,953            |       | 24,263                |       | 690            |       | 2.8            |       |
| Prepaid expenses and other assets             |       | 22,033            |       | 21,887                |       | 146            |       | 0.7            |       |
|                                          |       |              |       |                  |       |           |       |           |       |
| TOTAL                                         |       | $                 | 820,486    |                  | $          | 791,978        |       | $              | 28,508     |   | 3.6 | % |
|                                          |       |              |       |                  |       |           |       |           |       |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY** |       |              |       |                  |       |           |       |           |       |
| LIABILITIES:                                  |       |              |       |                  |       |           |       |           |       |
| Deposits                                      |       | $                 | 638,090    |                  | $          | 630,414        |       | $              | 7,676      |   | 1.2 | % |
| Federal Home Loan Bank advances               |       | 104,100           |       | 82,087                |       | 22,013         |       | 26.8           |       |
| Other liabilities                             |       | 4,032             |       | 5,814                 |       | (1,782         | )          | (30.7          | )          |
|                                          |       |              |       |                  |       |           |       |           |       |
| Total liabilities                             |       | 746,222           |       | 718,315               |       | 27,907         |       | 3.9            |       |
|                                          |       |              |       |                  |       |           |       |           |       |
| STOCKHOLDERS’ EQUITY                     |       | 74,264            |       | 73,663                |       | 601            |       | 0.8            |       |
|                                          |       |              |       |                  |       |           |       |           |       |
| TOTAL                                         |       | $                 | 820,486    |                  | $          | 791,978        |       | $              | 28,508     |   | 3.6 | % |
|                                          |       |              |       |                  |       |           |       |           |       |
| BOOK VALUE PER SHARE                          |       | $                 | 15.32      |                  | $          | 15.21          |       |           |       |   |   |
|                                          |       |              |       |                  |       |           |       |           |       |
| EQUITY TO ASSETS                              |       | 9.1%              |       | 9.3                   | %          |           |       |           |       |

 

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**Loans Receivable. **Changes in loancomposition between June 30, 2008 and December 31, 2007 are presentedin the following table (dollars in thousands).

 
| ** **                                       | ** ** | **June 30,** | ** ** | **December 31,** | ** ** | **Increase**   | ** ** | ** **        | ** ** |
|--------------------------------------------------|------------|-------------------|------------|-----------------------|------------|----------------|------------|-------------------|------------|
| ** **                                       | ** ** | **2008**          | ** ** | **2007**              | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
|                                             |       |              |       |                  |       |           |       |              |       |
| One- to four-family residences                   |       | $                 | 229,481    |                  | $          | 230,005        |       | $                 | (524       | ) | (0.2 | )% |
| Home equity lines of credit and second  mortgage |       | 33,631            |       | 34,315                |       | (684           | )          | (2.0              | )          |
| Multifamily                                      |       | 18,170            |       | 15,616                |       | 2,554          |       | 16.4              |       |
| Commercial real estate                           |       | 114,570           |       | 117,548               |       | (2,978         | )          | (2.5              | )          |
| Land                                             |       | 43,471            |       | 42,843                |       | 628            |       | 1.5               |       |
| Construction:                                    |       |              |       |                  |       |           |       |              |       |
| One-to four-family residences                    |       | 15,046            |       | 20,815                |       | (5,769         | )          | (27.7             | )          |
| Speculative one-to four-family residences        |       | 26,217            |       | 40,893                |       | (14,676        | )          | (35.9             | )          |
| Multifamily                                      |       | 18,505            |       | 18,632                |       | (127           | )          | (0.7              | )          |
| Commercial real estate                           |       | 16,941            |       | 31,239                |       | (14,298        | )          | (45.8             | )          |
| Land development                                 |       | 32,389            |       | 42,145                |       | (9,756         | )          | (23.1             | )          |
| Total construction loans                         |       | 109,098           |       | 153,724               |       | (44,626        | )          | (29.0             | )          |
| Total mortgage loans                             |       | 548,421           |       | 594,051               |       | (45,630        | )          | (7.7              | )          |
|                                             |       |              |       |                  |       |           |       |              |       |
| Commercial                                       |       | 24,808            |       | 24,846                |       | (38            | )          | (0.2              | )          |
|                                             |       |              |       |                  |       |           |       |              |       |
| Automobile                                       |       | 9,140             |       | 9,531                 |       | (391           | )          | (4.1              | )          |
| Other                                            |       | 13,284            |       | 14,537                |       | (1,253         | )          | (8.6              | )          |
| Total consumer                                   |       | 22,424            |       | 24,068                |       | (1,644         | )          | (6.8              | )          |
|                                             |       |              |       |                  |       |           |       |              |       |
| Total loans receivable                           |       | 595,653           |       | 642,965               |       | (47,312        | )          | (7.4              | )          |
|                                             |       |              |       |                  |       |           |       |              |       |
| Undisbursed loan funds                           |       | (20,768           | )          | (36,868               | )          | 16,100         |       | (43.7             | )          |
| Deferred loan costs – net                   |       | 465               |       | 321                   |       | 144            |       | 44.9              |       |
| Allowance for loan losses                        |       | (5,215            | )          | (5,162                | )          | (53            | )          | 1.0               |       |
|                                             |       |              |       |                  |       |           |       |              |       |
| Loans receivable, net                            |       | $                 | 570,135    |                  | $          | 601,256        |       | $                 | (31,121    | ) | (5.2 | )% |

 

Thedecrease in the Bank’s loan portfolio was primarily due to the continuedsoftening of the housing market in the Bank’s market area.  Market data indicates an overall decrease inhome sales in Benton and Washington counties in 2008 and 2007.  The Bank’s loan originations were down 4.1%for the quarter ended June 30, 2008, compared to the second quarter of2007 and 13.2% for the six months ended June 30, 2008 compared to thefirst six months in 2007.  Although theNorthwest Arkansas region continues to experience job market and populationgrowth, the supply of new residential lots and new speculative homes for salehas outpaced demand during the past several years.  We expect this trend to continue for theforeseeable future given the level of oversupply in the market.

 

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**Asset Quality. **The followingtable sets forth the amounts and categories of the Bank’s nonperforming assetsat the dates indicated.

 
| ** **                                                                                              | ** ** | **June 30,  2008**              | ** ** | **December 31,  2007** | ** ** | **Increase  (Decrease)** | ** ** | **Percentage  Change** | ** ** |
|---------------------------------------------------------------------------------------------------------|------------|--------------------------------------|------------|-----------------------------|------------|--------------------------|------------|------------------------|------------|
| ** **                                                                                              | ** ** | **(Dollars in Thousands)** | ** ** | ** **                  | ** ** | ** **               | ** ** |
| Nonaccrual loans:                                                                                       |       |                                 |       |                        |       |                     |       |                   |       |
| One- to four-family residential                                                                         |       | $                                    | 7,105      |                        | $          | 6,800                    |       | $                      | 305        |   | 4.5 | % |
| Home equity and second mortgage                                                                         |       | 904                                  |       | 1,194                       |       | (290                     | )          | (24.3                  | )          |
| Speculative one- to four-family  construction                                                           |       | 1,765                                |       | 4,934                       |       | (3,169                   | )          | (64.2                  | )          |
| Land development                                                                                        |       | 2,565                                |       | 11,428                      |       | (8,863                   | )          | (77.6                  | )          |
| Land                                                                                                    |       | 2,156                                |       | 1,311                       |       | 845                      |       | 64.5                   |       |
| Commercial real estate                                                                                  |       | 4,534                                |       | 4,027                       |       | 507                      |       | 12.6                   |       |
| Commercial loans                                                                                        |       | 2,609                                |       | 3,367                       |       | (758                     | )          | (22.5                  | )          |
| Consumer loans                                                                                          |       | 212                                  |       | 268                         |       | (56                      | )          | (20.9                  | )          |
| Total nonaccrual loans                                                                                  |       | 21,850                               |       | 33,329                      |       | (11,479                  | )          | (34.4                  | )          |
|                                                                                                    |       |                                 |       |                        |       |                     |       |                   |       |
| Accruing loans 90 days or more past due                                                                 |       | 2,798                                |       | 2,412                       |       | 386                      |       | 16.0                   |       |
| Real estate owned                                                                                       |       | 20,429                               |       | 8,120                       |       | 12,309                   |       | 151.6                  |       |
|                                                                                                    |       |                                 |       |                        |       |                     |       |                   |       |
| Total nonperforming assets                                                                              |       | $                                    | 45,077     |                        | $          | 43,861                   |       | $                      | 1,216      |   | 2.8 | % |
|                                                                                                    |       |                                 |       |                        |       |                     |       |                   |       |
| Total nonaccrual and accruing loans 90 days  or more past due as a percentage of total loans receivable |       | 4.14                                 | %          | 5.56                        | %          |                     |       |                   |       |
|                                                                                                    |       |                                 |       |                        |       |                     |       |                   |       |
| Total nonperforming assets as a percentage  of total assets                                             |       | 5.49                                 | %          | 5.54                        | %          |                     |       |                   |       |

 

Thedecrease in nonaccrual loans is primarily related to the transfer of nonaccrualland development and speculative single family construction loans to realestate owned, which was offset somewhat by an increase in nonaccrual land loansand commercial real estate loans.  TheNorthwest Arkansas market continues to experience an oversupply of lots andspeculative homes. Certain of the Bank’s homebuilders are experiencing extendedmarketing times for the sale of their homes which has resulted in inadequatecash flow to service the interest carry on their loans.  The specific loan loss allowance related toloans to builders and developers was approximately $1.5 million at June 30,2008.

 

Weexpect a significant amount of the nonaccrual real estate loans to eventuallymigrate to real estate owned as $10.2 million of the nonaccrual real estateloans reported above are in some stage of the foreclosure process as of June 30,2008.  Therefore, we expect real estateowned and associated expenses to continue to increase in future periods as suchloans migrate from loans to real estate owned.

 

Thelevel of nonaccrual speculative construction loans, land development loans andcommercial real estate loans is attributable primarily to four loanrelationships totaling $8.0 million, or 37% of nonaccrual loans.  These relationships are described in moredetail in the paragraphs that follow.

 

Thefirst relationship totaled $2.2 million with a specific loan loss allowance of $885,000at June 30, 2008, and is comprised of a subdivision located in CaveSprings, Arkansas.  The subdivision is100% complete.  The Bank obtained anupdated valuation on the subdivision using discounted cash flow analysis.  Due to the market conditions and theoversupply of lots in Northwest Arkansas, the valuation indicated lower lotprices and an extended marketing time over that in the original appraisalobtained when the loan was originated. Based on the nature of this loan and the possibility of continuedadverse changes in the market conditions, we may incur losses in the future inexcess of the amount estimated as of June 30, 2008.

 

Thesecond relationship totaled $2.6 million at June 30, 2008, and consists ofa $1.9 commercial loan secured by commercial real estate, franchise rights,inventory and equipment, a $650,000 loan on the borrower’s primary residence,and a $20,000 unsecured loan. The loans in this relationship became over 90days past due during the third quarter of 2007. Based on the borrower’s workout plans, these loans were maintained onaccrual status at that time.  However,due to the passage of time with no progress on the workout plan, we placed theloans on nonaccrual status during the fourth quarter of 2007.  The borrower is selling all of the collateralsecuring his loans and has entered into sales contracts on some of thefranchises. During the first quarter of 2008 one of the franchise sales closedand the Bank received proceeds from this sale. However, the Bank agreed to accept less than the full amount of proceedsas part of the workout.  Based on thisand other valuation changes during the first and second quarters of 2008, theBank recorded an additional $515,000 in specific loan loss allowances, bringingthe total specific allowance to $536,000 with respect to this relationship asof June 30, 2008.

 

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Thethird relationship totaled $2.1 million and represents a single commercial realestate loan secured by a convenience store, car wash, and retail space.  This loan became over 90 days past due duringthe third quarter of 2007.  Based on ourexpectation that the guarantors would cooperate with us on a workout plan andour assessment of their financial strength, these loans were maintained onaccrual status at that time.  However,due to the passage of time with no progress on a workout plan, we placed thisloan on nonaccrual status during the fourth quarter of 2007.  In the event of a foreclosure and a possibledeficiency judgment, we believe sufficient net worth exists among theguarantors to satisfy their obligation. As of June 30, 2008, based on the then current estimated fair valueof the collateral, the Bank estimates it will incur no loss.

 

Thefourth relationship totaled $1.1 million at June 30, 2008, and iscomprised primarily of loans totaling $1.0 million for 35 completed lots in asubdivision located in Pea Ridge, Arkansas, and a $96,000 loan on a completedspeculative home.  As of June 30,2008, based on the then current estimated fair value of the collateral, theBank estimates it will incur no loss.

 

Accruingloans 90 days or more past due at June 30, 2008, primarily consisted ofone loan whose past due interest is expected to be paid after June 30,2008.

 

Thefollowing table sets forth the amounts and categories of the Bank’s real estateowned at the dates indicated.

 
| ** **                                       | ** ** | **June 30,  2008**              | ** ** | **December 31,  2007** | ** ** | **Increase** | ** ** | **Percentage  Change** | ** ** |
|--------------------------------------------------|------------|--------------------------------------|------------|-----------------------------|------------|--------------|------------|------------------------|------------|
| ** **                                       | ** ** | **(Dollars in Thousands)** | ** ** | ** **                  | ** ** | ** **   | ** ** |
| Real estate owned                                |       |                                 |       |                        |       |         |       |                   |       |
| One- to four-family residential                  |       | $                                    | 3,887      |                        | $          | 1,566        |       | $                      | 2,321      |   | 148.2 | % |
| Speculative one- to four-family  construction(1) |       | 7,008                                |       | 5,956                       |       | 1,052        |       | 17.7                   |       |
| Land                                             |       | 8,706                                |       | 598                         |       | 8,108        |       | 1,355.9                |       |
| Commercial real estate                           |       | 828                                  |       | —                      |       | 828          |       | —                 |       |
| Total real estate owned                          |       | $                                    | 20,429     |                        | $          | 8,120        |       | $                      | 12,309     |   | 151.6 | % |

 

----

(1)                        At June 30, 2008 $5.5 million of theseproperties were 100% complete.  Theremainder range from 75% to 97% complete.

 

Theincrease in real estate owned from December 31, 2007 to June 30, 2008is primarily related to two subdivisions. The first totaled $4.0 million, and represents two phases of the samesubdivision located in Lowell, Arkansas, one of which is complete and the otheris approximately 10% complete.  Thesecond subdivision totaled $3.8 million for a 110 lot subdivision inSpringdale, Arkansas.  During the firstsix months of 2008, fourteen single family residential properties weretransferred to REO and five were sold. During the same period, fourteen speculative single family propertieswere transferred to REO and sixteen were sold. At June 30, 2008, the Bank owned seventeen foreclosed one- tofour-family residential properties and twenty-six speculative single familyresidential properties compared to eight and twenty-eight properties,respectively, at December 31, 2007.

 

TheBank is diligently working to dispose of its REO and has dedicated anexperienced special assets officer who is working full-time to liquidate theBank’s properties in the Northwest Arkansas market. Each property is evaluatedon a case-by-case basis to determine the best course of action with respect toliquidation.  Properties are marketed directly by the Bank or listed withlocal real estate agents utilizing appraisals, market information fromrealtors, market research reports, and our own market evaluations to makepricing and selling decisions.   The Bank’s Chief Lending Officer,loan officers, credit manager, special assets officer, and team members in thecollections department all work together in this endeavor.   The Bank’sgoal is to liquidate these properties as soon as possible without incurringextraordinary losses due to quick sale pricing. During the six months ended June 30, 2008, the Bank originatedloans to facilitate the sales of real estate owned totaling $3.0 million.  The Bank offers attractive rates andfinancing options to prospective buyers of real estate owned to help facilitatesales.

 

**Potential Problem Loans.**  Basedon the oversupply of lots in Northwest Arkansas, our land development portfolioposes a higher risk of default.   Theseloans are typically structured with interest due at maturity and lot sales asthe source of repayment.  Since lot salesin the Northwest Arkansas market are significantly slower than when these loanswere originated, our borrowers typically must rely on a secondary source offunds to pay the interest as it becomes due. Due to the relatively large balances of these types of loans, the interestdue at maturity is usually significant. At June 30, 2008, gross land development loans totaled $32.4million with $1.8 million of accrued interest. Of this total, $2.6 million is on nonaccrual status with $454,000 inaccrued interest, $16.9 million with $818,000 in accrued interest is classifiedas special mention, and $12.9 million with $537,000 in accrued interest is onour watch list.   There are three maturedland development loans at June 30, 2008 with a total principal balance of$8.3 million and accrued interest of $768,000.  We are working with all three borrowers and, as of the date of this 

 

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report, expect to be repaid in full. However, should any of these land development loans default, the Bankmay incur losses in the event of a decline in value of the land securing theseloans.

 

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

 

| ** **                      | ** ** | **Three Months Ended June 30,** | ** ** | **Six Months Ended June 30,** | ** ** |
|---------------------------------|------------|-----------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                      | ** ** | **2008**                                            | ** ** | **2007**                                          | ** ** | **2008** | ** ** | **2007** | ** ** |
| Balance at beginning of period  |       | $                                                   | 6,107      |                                              | $          | 4,294 |   | $ | 5,162 |   | $ | 2,572 |   |
| Provisions for estimated losses |       | 971                                                 |       | 370                                               |       | 2,499 |   | 2,332 |   |
| Recoveries                      |       | 58                                                  |       | 39                                                |       | 194 |   | 88 |   |
| Losses charged off              |       | (1,921                                              | )          | (412                                              | )          | (2,640 | ) | (701 | ) |
| Balance at end of period        |       | $                                                   | 5,215      |                                              | $          | 4,291 |   | $ | 5,215 |   | $ | 4,291 |   |

#  

Changes in the composition of the allowance for loan losses between June 30,2008 and December 31, 2007 are presented in the following table (inthousands):

 
| ** ** | ** ** | **June 30,** | ** ** | **December 31,** | ** ** | **Increase**   | ** ** |
|------------|------------|-------------------|------------|-----------------------|------------|----------------|------------|
| ** ** | ** ** | **2008**          | ** ** | **2007**              | ** ** | **(Decrease)** | ** ** |
| General    |       | $                 | 2,939      |                  | $          | 2,267          |       | $ | 672 |   |
| Specific   |       | 2,276             |       | 2,895                 |       | (619           | )          |
|       |       | $                 | 5,215      |                  | $          | 5,162          |       | $ | 53 |   |

 

Thegeneral component of the allowance for loan losses increased primarily due toincreases in the loss factors applied to single family residential loans andland development loans, partially offset by decreases in the related loanbalances.  These loss factors wereincreased due to the recent loss history on these types of loans.  The specific component of the allowance forloan losses decreased primarily due to the chargeoff of a specific valuationallowance of $1.4 million in connection with the transfer of a subdivision toREO, offset by an increase of $515,000 in specific valuation allowances on oneborrower.  See “Asset Quality.”

 

Theallowance for loan losses is established as losses are estimated to haveoccurred through a provision for loan losses charged to earnings.  Loan losses are charged against the allowancewhen management believes it is likely that a loan balance isuncollectible.  Subsequent recoveries, ifany, are credited to the allowance.

 

Theallowance for loan losses represents management’s estimate of incurred creditlosses inherent in the Company’s loan portfolio as of the balance sheetdate.  The estimation of the allowance isbased on a variety of factors, including past loan loss experience, the currentcredit profile of the Company’s borrowers, adverse situations that haveoccurred that may affect the borrowers’ ability to repay, the estimated valueof underlying collateral, and general economic conditions.  Losses are recognized when availableinformation indicates that it is probable that a loss has been incurred and theamount of the loss can be reasonably estimated. This evaluation is inherentlysubjective as it requires estimates that are susceptible to significantrevision as more information becomes available or conditions change.

 

Indetermining the allowance for loan losses, the Company allocates a portion ofthe allowance to its various loan categories based on an analysis of individualloans and pools of loans.  However, theentire allowance is available to absorb credit losses inherent in the totalloan portfolio as of the balance sheet date.

 

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

 

Largegroups of smaller balance homogeneous loans are collectively evaluated forimpairment. Accordingly, the Bank does not separately identify individualconsumer and residential loans for impairment disclosures.  Homogeneous loans are those that areconsidered to have common characteristics that provide for evaluation on anaggregate or pool basis. The Bank considers the characteristics of (1) one-to four-family residential first mortgage loans; (2) 

 

13

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unsecuredconsumer loans; and (3) collateralized consumer loans to permitconsideration of the appropriateness of the allowance for losses of each groupof 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.

 

Inestimating the amount of credit losses inherent in our loan portfolio, variousjudgments and assumptions are made.  Forexample, when assessing the condition of the overall economic environment,assumptions are made regarding future market conditions and their impact on theloan portfolio.  In the event thenational or local economy were to sustain a prolonged downturn, the lossfactors applied to our portfolios may need to be revised, which maysignificantly impact the measurement of the allowance for loan losses.  For impaired loans that are collateraldependent, the estimated fair value of the collateral may deviate significantlyfrom the proceeds received when the collateral is sold in the event that theBank has to foreclose or repossess the collateral.

 

Althoughwe consider the allowance for loan losses of approximately $5.2 millionadequate to cover losses inherent in our loan portfolio at June 30, 2008,no assurance can be given that we will not sustain loan losses that aresignificantly different from the amount recorded, or that subsequentevaluations of the loan portfolio, in light of factors then prevailing, wouldnot result in a significant change in the allowance for loan losses.

 

**Investment Securities. **Changes in thecomposition of investment securities held to maturity between June 30,2008 and December 31, 2007 are presented in the following table (inthousands).

 
| ** **                             | ** ** | **June 30,** | ** ** | **December 31,** | ** ** | ** **   | ** ** |
|----------------------------------------|------------|-------------------|------------|-----------------------|------------|--------------|------------|
| ** **                             | ** ** | **2008**          | ** ** | **2007**              | ** ** | **Increase** | ** ** |
| U.S. Government and agency obligations |       | $                 | 110,148    |                  | $          | 78,501       |       | $ | 31,647 |   |
| Municipal securities                   |       | 17,716            |       | 17,089                |       | 627          |       |
| Total                                  |       | $                 | 127,864    |                  | $          | 95,590       |       | $ | 32,274 |   |

 

Duringthe first six months of 2008, investment securities totaling $94.7 million witha weighted average tax equivalent yield of 6.05% were purchased and $62.5million with a weighted average tax equivalent yield of 6.06% matured or werecalled.

 

AtJune 30, 2008, estimated fair values of investment securities held tomaturity were as follows (in thousands):

** **
| ** **                             | ** ** | **Amortized  Cost** | ** ** | **Fair  Value** | ** ** | ** ** | ** ** |
|----------------------------------------|------------|---------------------|------------|-----------------|------------|------------|------------|
| ** **                             | ** ** | ** **          | ** ** | ** **      | ** ** | ** ** | ** ** |
| U.S. Government and agency obligations |       | $                   | 110,148    |            | $          | 109,056    |       |   |   |
| Municipal securities                   |       | 17,716              |       | 17,472          |       |       |       |
| Total                                  |       | $                   | 127,864    |            | $          | 126,528    |       |   |   |

 

**Accrued Interest Receivable. ** The decrease in accrued interestreceivable was primarily due to a decrease in the loans receivable balance aswell as a decrease in the loan yield and the number of days accrued at June 30,2008 compared to December 31, 2007.

 

**Real Estate Owned, net.** Changes in the composition of real estate owned between June 30,2008 and December 31, 2007 are presented in the following table (dollarsin thousands).

 
| ** **                      | ** ** | **December 31,  2007** | ** ** | **Additions** | ** ** | **Fair Value  Adjustments** | ** ** | **Net Sales  Proceeds(1)** | ** ** | **Gain (Loss)** | ** ** | **June 30,  2008** | ** ** |
|---------------------------------|------------|-----------------------------|------------|---------------|------------|----------------------------------|------------|---------------------------------|------------|----------------------|------------|-------------------------|------------|
| One- to four-family residential |       | $                           | 1,566      |          | $          | 3,196                            |       | $                               | (265       | )                    | $          | (596                    | )          | $ | (14 | ) | $ | 3,887 |   |
| Speculative one- to four-family |       | 5,956                       |       | 4,887         |       | (643                             | )          | (3,155                          | )          | (37                  | )          | 7,008                   |       |
| Land                            |       | 598                         |       | 9,926         |       | (1,520                           | )          | (334                            | )          | 36                   |       | 8,706                   |       |
| Commercial real estate          |       | —                      |       | 858           |       | (30                              | )          | —                          |       | —               |       | 828                     |       |
|                            |       | $                           | 8,120      |          | $          | 18,867                           |       | $                               | (2,458     | )                    | $          | (4,085                  | )          | $ | (15 | ) | $ | 20,429 |   |

 

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(1) Net sales proceeds include $3.0 million of loans made by theBank to facilitate the sale of real estate owned.

 

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**Deposits. **Changes in the composition of deposits betweenJune 30, 2008 and December 31, 2007 are presented in the followingtable (dollars in thousands).

 
| ** **              | ** ** | **June 30,** | ** ** | **December 31,** | ** ** | **Increase**   | ** ** | **Percentage** | ** ** |
|-------------------------|------------|-------------------|------------|-----------------------|------------|----------------|------------|----------------|------------|
| ** **              | ** ** | **2008**          | ** ** | **2007**              | ** ** | **(Decrease)** | ** ** | **Change**     | ** ** |
|                    |       |              |       |                  |       |           |       |           |       |
| Checking accounts       |       | $                 | 168,842    |                  | $          | 127,491        |       | $              | 41,351     |   | 32.4 | % |
| Money Market accounts   |       | 50,095            |       | 51,424                |       | (1,329         | )          | (2.6           | )          |
| Savings accounts        |       | 25,332            |       | 25,088                |       | 244            |       | 1.0            |       |
| Certificates of deposit |       | 393,821           |       | 426,411               |       | (32,590        | )          | (7.6           | )          |
|                    |       |              |       |                  |       |           |       |           |       |
| Total deposits          |       | $                 | 638,090    |                  | $          | 630,414        |       | $              | 7,676      |   | 1.2 | % |

 

Depositsincreased in the comparison period, primarily due to an increase in checkingaccounts related to public unit deposits and focused marketing efforts toincrease checking accounts with a checking product which has a higher interestrate than the Bank’s other checking account products.  To earn the maximum rate under the newproduct, customers must qualify based on usage of electronic banking servicessuch as debit card transactions, e-statements, and direct deposits or automaticpayments. The Bank will continue to promote checking accounts as they are anattractive source of funds for the Bank as they offer overall low-interestdeposits, fee income potential, and the opportunity to cross-sell otherfinancial services.

 

**Other Liabilities.**  Other liabilities decreasedprimarily due to a decrease in investment security purchases which settledafter period end from $3.2 million at December 31, 2007, to $1.2 millionat June 30, 2008.

 

**Stockholders’ Equity. **Stockholders’ equity increased approximately$601,000 from December 31, 2007 to June 30, 2008.  The increase in stockholders’ equity wasprimarily due to net income totaling $2.1 million during the first six monthsof 2008.  In addition, during the sixmonths ended June 30, 2008, cash dividends of approximately $1.6 millionwere paid.  See the Unaudited ConsolidatedStatement of Stockholders’ Equity for the six months ended June 30, 2008for more detail.

 

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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. Such yields and costs are derived by dividing income or expense by theaverage balance of assets or liabilities, respectively, for the periodspresented.  Average balances are based ondaily balances during the period.

 
| ** **                                                        | ** ** | **Three Months Ended June 30,** | ** ** |
|-------------------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                        | ** ** | **2008**                                            | ** ** | **2007** | ** ** |
| ** **                                                        | ** ** | **Average  Balance**                                | ** ** | **Interest** | ** ** | **Average  Yield/  Cost** | ** ** | **Average  Balance** | ** ** | **Interest** | ** ** | **Average  Yield/  Cost** | ** ** |
| ** **                                                        | ** ** | **(Dollars in Thousands)**                | ** ** |
| Interest-earning assets:                                          |       |                                                |       |   |   |   |   |   |   |   |   |   |   |
|                                                              |       |                                                |       |   |   |   |   |   |   |   |   |   |   |
| Loans receivable(1)                                               |       | $                                                   | 582,318    |   | $ | 9,520 |   | 6.54 | % | $ | 665,367 |   | $ | 12,004 |   | 7.22 | % |
| Investment securities(2)                                          |       | 135,380                                             |       | 1,835 |   | 5.42 |   | 70,154 |   | 890 |   | 5.07 |   |
| Other interest-earning assets                                     |       | 20,149                                              |       | 112 |   | 2.22 |   | 23,428 |   | 302 |   | 5.16 |   |
| Total interest-earning assets                                     |       | 737,847                                             |       | 11,467 |   | 6.22 |   | 758,949 |   | 13,196 |   | 6.95 |   |
| Noninterest-earning assets                                        |       | 77,659                                              |       |   |   |   |   | 67,146 |   |   |   |   |   |
| Total assets                                                      |       | 815,506                                             |       |   |   |   |   | 826,095 |   |   |   |   |   |
| Interest-bearing liabilities:                                     |       |                                                |       |   |   |   |   |   |   |   |   |   |   |
| Deposits                                                          |       | 645,999                                             |       | 4,779 |   | 2.96 |   | 649,338 |   | 6,044 |   | 3.72 |   |
| FHLB advances                                                     |       | 90,106                                              |       | 879 |   | 3.90 |   | 96,945 |   | 1,106 |   | 4.57 |   |
| Total interest-bearing liabilities                                |       | 736,105                                             |       | 5,658 |   | 3.08 |   | 746,283 |   | 7,150 |   | 3.83 |   |
| Noninterest-bearing liabilities                                   |       | 5,167                                               |       |   |   |   |   | 4,930 |   |   |   |   |   |
| Total liabilities                                                 |       | 741,272                                             |       |   |   |   |   | 751,213 |   |   |   |   |   |
| Stockholders’ equity                                         |       | 74,234                                              |       |   |   |   |   | 74,882 |   |   |   |   |   |
| Total liabilities and stockholders’ equity                   |       | $                                                   | 815,506    |   |   |   |   |   | $ | 826,095 |   |   |   |   |   |
|                                                              |       |                                                |       |   |   |   |   |   |   |   |   |   |   |
| Net interest income                                               |       |                                                |       | $ | 5,809 |   |   |   |   |   | $ | 6,046 |   |   |   |
| Net earning assets                                                |       | $                                                   | 1,742      |   |   |   |   |   | $ | 12,666 |   |   |   |   |   |
| Interest rate spread                                              |       |                                                |       |   |   | 3.14 | % |   |   |   |   | 3.12 | % |
| Net interest margin                                               |       |                                                |       |   |   | 3.15 | % |   |   |   |   | 3.19 | % |
| Ratio of interest-earning assets to  interest-bearing liabilities |       |                                                |       |   |   | 100.24 | % |   |   |   |   | 101.70 | % |

 
| ** **                                                        | ** ** | **Six Months Ended June 30,** | ** ** |
|-------------------------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                                        | ** ** | **2008**                                          | ** ** | **2007** | ** ** |
| ** **                                                        | ** ** | **Average  Balance**                              | ** ** | **Interest** | ** ** | **Average  Yield/  Cost** | ** ** | **Average  Balance** | ** ** | **Interest** | ** ** | **Average  Yield/  Cost** | ** ** |
| ** **                                                        | ** ** | **(Dollars in Thousands)**              | ** ** |
| Interest-earning assets:                                          |       |                                              |       |   |   |   |   |   |   |   |   |   |   |
| Loans receivable(1)                                               |       | $                                                 | 592,157    |   | $ | 19,495 |   | 6.58 | % | $ | 675,893 |   | $ | 24,205 |   | 7.16 | % |
| Investment securities(2)                                          |       | 120,317                                           |       | 3,228 |   | 5.37 |   | 68,558 |   | 1,726 |   | 5.04 |   |
| Other interest-earning assets                                     |       | 20,654                                            |       | 280 |   | 2.71 |   | 19,039 |   | 490 |   | 5.15 |   |
| Total interest-earning assets                                     |       | 733,128                                           |       | 23,003 |   | 6.28 |   | 763,490 |   | 26,421 |   | 6.92 |   |
| Noninterest-earning assets                                        |       | 75,042                                            |       |   |   |   |   | 66,676 |   |   |   |   |   |
| Total assets                                                      |       | 808,170                                           |       |   |   |   |   | 830,166 |   |   |   |   |   |
| Interest-bearing liabilities:                                     |       |                                              |       |   |   |   |   |   |   |   |   |   |   |
| Deposits                                                          |       | 639,476                                           |       | 10,347 |   | 3.24 |   | 645,486 |   | 11,892 |   | 3.68 |   |
| FHLB advances                                                     |       | 87,488                                            |       | 1,782 |   | 4.07 |   | 103,717 |   | 2,366 |   | 4.56 |   |
| Total interest-bearing liabilities                                |       | 726,964                                           |       | 12,129 |   | 3.34 |   | 749,203 |   | 14,258 |   | 3.80 |   |
| Noninterest-bearing liabilities                                   |       | 7,012                                             |       |   |   |   |   | 5,567 |   |   |   |   |   |
| Total liabilities                                                 |       | 733,976                                           |       |   |   |   |   | 754,770 |   |   |   |   |   |
| Stockholders’ equity                                         |       | 74,194                                            |       |   |   |   |   | 75,396 |   |   |   |   |   |
| Total liabilities and stockholders’ equity                   |       | $                                                 | 808,170    |   |   |   |   |   | $ | 830,166 |   |   |   |   |   |
|                                                              |       |                                              |       |   |   |   |   |   |   |   |   |   |   |
| Net interest income                                               |       |                                              |       | $ | 10,874 |   |   |   |   |   | $ | 12,163 |   |   |   |
| Net earning assets                                                |       | $                                                 | 6,164      |   |   |   |   |   | $ | 14,287 |   |   |   |   |   |
| Interest rate spread                                              |       |                                              |       |   |   | 2.94 | % |   |   |   |   | 3.12 | % |
| Net interest margin                                               |       |                                              |       |   |   | 2.97 | % |   |   |   |   | 3.19 | % |
| Ratio of interest-earning assets to  interest-bearing liabilities |       |                                              |       |   |   | 100.85 | % |   |   |   |   | 101.91 | % |

 

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(1)  Includes nonaccrual loans.

(2)  Includes FHLB of Dallas stock.

 

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**Rate/VolumeAnalysis**

 

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

 
| ** **                         | ** ** | **Three Months Ended June 30,** | ** ** |
|------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                         | ** ** | **2008 vs. 2007**                         | ** ** |
| ** **                         | ** ** | **Increase (Decrease)**                        | ** ** | ** ** | ** ** |
| ** **                         | ** ** | **Due to**                                     | ** ** | **Total** | ** ** |
| ** **                         | ** ** | **Volume**                                          | ** ** | **Rate** | ** ** | **Rate/  Volume** | ** ** | **Increase  (Decrease)** | ** ** |
| ** **                         | ** ** | **(In  Thousands)**                                 | ** ** |
| Interest income:                   |       |                                                |       |   |   |   |   |   |   |
| Loans receivable                   |       | $                                                   | (1,498     | ) | $ | (1,126 | ) | $ | 140 |   | $ | (2,484 | ) |
| Investment securities              |       | 827                                                 |       | 61 |   | 57 |   | 945 |   |
| Other interest-earning assets      |       | (42                                                 | )          | (172 | ) | 24 |   | (190 | ) |
| Total interest-earning assets      |       | (713                                                | )          | (1,237 | ) | 221 |   | (1,729 | ) |
|                               |       |                                                |       |   |   |   |   |   |   |
| Interest expense:                  |       |                                                |       |   |   |   |   |   |   |
| Deposits                           |       | (31                                                 | )          | (1,240 | ) | 6 |   | (1,265 | ) |
| FHLB advances                      |       | (77                                                 | )          | (161 | ) | 11 |   | (227 | ) |
| Total interest-bearing liabilities |       | (108                                                | )          | (1,401 | ) | 17 |   | (1,492 | ) |
| Net change in net interest income  |       | $                                                   | (605       | ) | $ | 164 |   | $ | 204 |   | $ | (237 | ) |

 
| ** **                         | ** ** | **Six Months Ended June 30,** | ** ** |
|------------------------------------|------------|---------------------------------------------------|------------|
| ** **                         | ** ** | **2008 vs. 2007**                       | ** ** |
| ** **                         | ** ** | **Increase (Decrease)  Due to**         | ** ** | **Total** | ** ** |
| ** **                         | ** ** | **Volume**                                        | ** ** | **Rate** | ** ** | **Rate/  Volume** | ** ** | **Increase  (Decrease)** | ** ** |
| ** **                         | ** ** | **(In Thousands)**                           | ** ** |
| Interest income:                   |       |                                              |       |   |   |   |   |   |   |
| Loans receivable                   |       | $                                                 | (2,999     | ) | $ | (1,953 | ) | $ | 242 |   | $ | (4,710 | ) |
| Investment securities              |       | 1,304                                             |       | 113 |   | 85 |   | 1,502 |   |
| Other interest-earning assets      |       | 42                                                |       | (232 | ) | (20 | ) | (210 | ) |
| Total interest-earning assets      |       | (1,653                                            | )          | (2,072 | ) | 307 |   | (3,418 | ) |
|                               |       |                                              |       |   |   |   |   |   |   |
| Interest expense:                  |       |                                              |       |   |   |   |   |   |   |
| Deposits                           |       | (111                                              | )          | (1,447 | ) | 13 |   | (1,545 | ) |
| FHLB advances                      |       | (370                                              | )          | (254 | ) | 40 |   | (584 | ) |
| Total interest-bearing liabilities |       | (481                                              | )          | (1,701 | ) | 53 |   | (2,129 | ) |
| Net change in net interest income  |       | $                                                 | (1,172     | ) | $ | (371 | ) | $ | 254 |   | $ | (1,289 | ) |

 

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**CHANGES IN RESULTS OF OPERATIONS**

 

The table below presents a comparison of results of operations for thethree months ended June 30, 2008 and 2007 (dollars in thousands).  Specific changes in captions are discussed inthe sections which follow the table.

 
| ** **                                            | ** ** | **Three Months Ended  June 30,** | ** ** | **Increase  (Decrease)** | ** ** | **Percentage  Change**     | ** ** |
|-------------------------------------------------------|------------|-------------------------------------------------|------------|--------------------------|------------|----------------------------|------------|
| ** **                                            | ** ** | **2008**                                        | ** ** | **2007**                 | ** ** | **2008 vs 2007** | ** ** | **2008 vs 2007** | ** ** |
| Interest income:                                      |       |                                            |       |                     |       |                       |       |   |   |
| Loans receivable                                      |       | $                                               | 9,520      |                     | $          | 12,004                     |       | $ | (2,484 | ) | (20.7 | )% |
| Investment securities                                 |       | 1,835                                           |       | 890                      |       | 945                        |       | 106.2 |   |
| Other                                                 |       | 112                                             |       | 302                      |       | (190                       | )          | (62.9 | ) |
| Total interest income                                 |       | 11,467                                          |       | 13,196                   |       | (1,729                     | )          | (13.1 | ) |
| Interest expense:                                     |       |                                            |       |                     |       |                       |       |   |   |
| Deposits                                              |       | 4,779                                           |       | 6,044                    |       | (1,265                     | )          | (20.9 | ) |
| FHLB advances                                         |       | 879                                             |       | 1,106                    |       | (227                       | )          | (20.5 | ) |
| Total interest expense                                |       | 5,658                                           |       | 7,150                    |       | (1,492                     | )          | (20.9 | ) |
| Net interest income before provision for  loan losses |       | 5,809                                           |       | 6,046                    |       | (237                       | )          | (3.9 | ) |
| Provision for loan losses                             |       | 971                                             |       | 370                      |       | 601                        |       | 162.4 |   |
| Net interest income after provision for  loan losses  |       | 4,838                                           |       | 5,676                    |       | (838                       | )          | (14.8 | ) |
| Noninterest income:                                   |       |                                            |       |                     |       |                       |       |   |   |
| Deposit fee income                                    |       | 1,344                                           |       | 1,269                    |       | 75                         |       | 5.9 |   |
| Earnings on life insurance policies                   |       | 191                                             |       | 184                      |       | 7                          |       | 3.8 |   |
| Gain on sale of loans                                 |       | 91                                              |       | 237                      |       | (146                       | )          | (61.6 | ) |
| Other                                                 |       | 422                                             |       | 271                      |       | 151                        |       | 55.7 |   |
| Total noninterest income                              |       | 2,048                                           |       | 1,961                    |       | 87                         |       | 4.4 |   |
| Noninterest expenses:                                 |       |                                            |       |                     |       |                       |       |   |   |
| Salaries and employee benefits                        |       | 3,244                                           |       | 3,287                    |       | (43                        | )          | (1.3 | ) |
| Real estate owned, net                                |       | 269                                             |       | 121                      |       | 148                        |       | 122.3 |   |
| Other                                                 |       | 2,135                                           |       | 2,053                    |       | 82                         |       | 4.0 |   |
| Total noninterest expenses                            |       | 5,648                                           |       | 5,461                    |       | 187                        |       | 3.4 |   |
| Income before income taxes                            |       | 1,238                                           |       | 2,176                    |       | (938                       | )          | (43.1 | ) |
| Income tax provision                                  |       | 229                                             |       | 642                      |       | (413                       | )          | (64.3 | ) |
| Net income                                            |       | $                                               | 1,009      |                     | $          | 1,534                      |       | $ | (525 | ) | (34.2 | )% |
|                                                  |       |                                            |       |                     |       |                       |       |   |   |
| Basic earnings per share                              |       | $                                               | 0.21       |                     | $          | 0.32                       |       | $ | (0.11 | ) | (34.4 | )% |
| Diluted earnings per share                            |       | $                                               | 0.21       |                     | $          | 0.32                       |       | $ | (0.11 | ) | (34.4 | )% |
|                                                  |       |                                            |       |                     |       |                       |       |   |   |
| Interest rate spread                                  |       | 3.14                                            | %          | 3.12                     | %          |                       |       |   |   |
| Net interest margin                                   |       | 3.15                                            | %          | 3.19                     | %          |                       |       |   |   |
|                                                  |       |                                            |       |                     |       |                       |       |   |   |
| Average full-time equivalents                         |       | 303                                             |       | 306                      |       |                       |       |   |   |
|                                                  |       |                                            |       |                     |       |                       |       |   |   |
| Full-service offices                                  |       | 19                                              |       | 18                       |       |                       |       |   |   |

 

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The table below presents a comparison of results of operations for thesix months ended June 30, 2008 and 2007 (dollars in thousands).  Specific changes in captions are discussed inthe sections which follow the table.

 
| ** **                                            | ** ** | **Six Months Ended  June 30,** | ** ** | **Increase  (Decrease)** | ** ** | **Percentage  Change**     | ** ** |
|-------------------------------------------------------|------------|-----------------------------------------------|------------|--------------------------|------------|----------------------------|------------|
| ** **                                            | ** ** | **2008**                                      | ** ** | **2007**                 | ** ** | **2008 vs 2007** | ** ** | **2008 vs 2007** | ** ** |
| Interest income:                                      |       |                                          |       |                     |       |                       |       |   |   |
| Loans receivable                                      |       | $                                             | 19,495     |                     | $          | 24,205                     |       | $ | (4,710 | ) | (19.5 | )% |
| Investment securities                                 |       | 3,228                                         |       | 1,726                    |       | 1,502                      |       | 87.0 |   |
| Other                                                 |       | 280                                           |       | 490                      |       | (210                       | )          | (42.9 | ) |
| Total interest income                                 |       | 23,003                                        |       | 26,421                   |       | (3,418                     | )          | (12.9 | ) |
| Interest expense:                                     |       |                                          |       |                     |       |                       |       |   |   |
| Deposits                                              |       | 10,347                                        |       | 11,892                   |       | (1,545                     | )          | (13.0 | ) |
| Other borrowings                                      |       | 1,782                                         |       | 2,366                    |       | (584                       | )          | (24.7 | ) |
| Total interest expense                                |       | 12,129                                        |       | 14,258                   |       | (2,129                     | )          | (14.9 | ) |
| Net interest income before provision for  loan losses |       | 10,874                                        |       | 12,163                   |       | (1,289                     | )          | (10.6 | ) |
| Provision for loan losses                             |       | 2,499                                         |       | 2,332                    |       | 167                        |       | 7.2 |   |
| Net interest income after provision for  loan losses  |       | 8,375                                         |       | 9,831                    |       | (1,456                     | )          | (14.8 | ) |
| Noninterest income:                                   |       |                                          |       |                     |       |                       |       |   |   |
| Deposit fee income                                    |       | 2,555                                         |       | 2,426                    |       | 129                        |       | 5.3 |   |
| Earnings on life insurance policies                   |       | 1,562                                         |       | 373                      |       | 1,189                      |       | 318.8 |   |
| Gain on sale of loans                                 |       | 266                                           |       | 463                      |       | (197                       | )          | (42.6 | ) |
| Other                                                 |       | 870                                           |       | 559                      |       | 311                        |       | 55.6 |   |
| Total noninterest income                              |       | 5,253                                         |       | 3,821                    |       | 1,432                      |       | 37.5 |   |
| Noninterest expenses:                                 |       |                                          |       |                     |       |                       |       |   |   |
| Salaries and employee benefits                        |       | 6,632                                         |       | 6,729                    |       | (97                        | )          | (1.4 | ) |
| Real estate owned, net                                |       | 698                                           |       | 282                      |       | 416                        |       | 147.5 |   |
| Data processing                                       |       | 688                                           |       | 805                      |       | (117                       | )          | (14.5 | ) |
| Other                                                 |       | 3,702                                         |       | 3,710                    |       | (8                         | )          | (0.2 | ) |
| Total noninterest expenses                            |       | 11,720                                        |       | 11,526                   |       | 194                        |       | 1.7 |   |
| Income before income taxes                            |       | 1,908                                         |       | 2,126                    |       | (218                       | )          | (10.3 | ) |
| Income tax provision (benefit)                        |       | (188                                          | )          | 433                      |       | (621                       | )          | (143.4 | ) |
| Net income                                            |       | $                                             | 2,096      |                     | $          | 1,693                      |       | $ | 403 |   | 23.8 | % |
|                                                  |       |                                          |       |                     |       |                       |       |   |   |
| Basic earnings per share                              |       | $                                             | 0.43       |                     | $          | 0.35                       |       | $ | 0.08 |   | 22.9 | % |
| Diluted earnings per share                            |       | $                                             | 0.43       |                     | $          | 0.35                       |       | $ | 0.08 |   | 22.9 | % |
|                                                  |       |                                          |       |                     |       |                       |       |   |   |
| Interest rate spread                                  |       | 2.94                                          | %          | 3.12                     | %          |                       |       |   |   |
| Net interest margin                                   |       | 2.97                                          | %          | 3.19                     | %          |                       |       |   |   |
|                                                  |       |                                          |       |                     |       |                       |       |   |   |
| Average full-time equivalents                         |       | 304                                           |       | 306                      |       |                       |       |   |   |
|                                                  |       |                                          |       |                     |       |                       |       |   |   |
| Full-service offices                                  |       | 19                                            |       | 18                       |       |                       |       |   |   |

 

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**Net Interest Income. **Net interest income is determined by theCompany’s interest rate spread (i.e., the difference between the yields earnedon its interest-earning assets and the rates paid on its interest-bearingliabilities) and the relative amounts of interest-earning assets andinterest-bearing liabilities.  Thedecrease in net interest income was primarily due to the level of nonperformingloans.

 

### **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 decrease in interest income for the threeand six month comparative periods was primarily due to a decrease in theaverage balance of loans receivable and an increase in the level of deferredinterest on nonperforming loans, as well as a decrease in the average yieldearned on loans receivable.  Thesedecreases were offset by an increase in the average balance of investmentsecurities.  The decrease in averageyields earned on loans receivable was due to decreases in market interest ratesand the level of nonaccrual loans.  Theaverage balance of loans receivable decreased due to repayments and maturitiesas well as a decrease in loan originations.

 

**Interest Expense.  **The decrease in interest expense for the threeand six month comparative periods was primarily due to a decrease in theaverage rates paid on deposits and FHLB advances and decreases in the averagebalances of deposits and FHLB advances. The decrease in the average rates paid on deposit accounts reflects therecent decreases in market interest rates.

 

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

 

Theprovision for loan losses increased $601,000 to $971,000 for the quarter ended June 30,2008 compared to $370,000 for the quarter ended June 30, 2007 andincreased $167,000 to $2.5 million for the six months ended June 30, 2008compared to $2.3 million for the same period in 2007.  The increases in the provisions for loanlosses in both comparable periods were primarily due to an increase in our lossexperience on single family residential loans and land development loans.

 

**Noninterest Income. **The increase in other noninterest income forthe six month comparative period in 2008 was primarily due to a $1.2 millionincrease in earnings on life insurance policies due to a death benefit claimrecorded during the first quarter in 2008.

 

**Noninterest Expense**

 

**Salaries and Employee Benefits. **The changes in the composition of this line item are presented below (inthousands):

 
| ** **                        | ** ** | **Three Months Ended June 30,** | ** ** | **Increase  (Decrease)** | ** ** | **Six Months Ended June 30,** | ** ** | **Increase  (Decrease)** | ** ** |
|-----------------------------------|------------|-----------------------------------------------------|------------|--------------------------|------------|---------------------------------------------------|------------|--------------------------|------------|
| ** **                        | ** ** | **2008**                                            | ** ** | **2007**                 | ** ** | **2008 vs 2007**                        | ** ** | **2008**                 | ** ** | **2007** | ** ** | **2008 vs 2007** | ** ** |
| Salaries                          |       | $                                                   | 2,539      |                     | $          | 2,566                                             |       | $                        | (27        | ) | $ | 5,181 |   | $ | 5,230 |   | $ | (49 | ) |
| Payroll taxes                     |       | 217                                                 |       | 215                      |       | 2                                                 |       | 472                      |       | 478 |   | (6 | ) |
| Insurance                         |       | 167                                                 |       | 170                      |       | (3                                                | )          | 338                      |       | 340 |   | (2 | ) |
| 401(k)                            |       | 79                                                  |       | 76                       |       | 3                                                 |       | 157                      |       | 156 |   | 1 |   |
| Stock compensation (1)            |       | 6                                                   |       | 10                       |       | (4                                                | )          | 12                       |       | 24 |   | (12 | ) |
| Defined benefit plan contribution |       | 196                                                 |       | 210                      |       | (14                                               | )          | 391                      |       | 420 |   | (29 | ) |
| Other                             |       | 40                                                  |       | 40                       |       | —                                            |       | 81                       |       | 81 |   | — |   |
| Total                             |       | $                                                   | 3,244      |                     | $          | 3,287                                             |       | $                        | (43        | ) | $ | 6,632 |   | $ | 6,729 |   | $ | (97 | ) |

 

----

(1)   Includes stock options and ManagementRecognition and Retention Plan (“MRP”) expense.

 

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**Real estate owned, net. **The changes inthe composition of this line item are presented below (in thousands):

 
| ** **               | ** ** | **Three Months Ended June 30,** | ** ** | **Increase  (Decrease)** | ** ** | **Six Months Ended June 30,** | ** ** | **Increase  (Decrease)** | ** ** |
|--------------------------|------------|-----------------------------------------------------|------------|--------------------------|------------|---------------------------------------------------|------------|--------------------------|------------|
| ** **               | ** ** | **2008**                                            | ** ** | **2007**                 | ** ** | **2008 vs 2007**                        | ** ** | **2008**                 | ** ** | **2007** | ** ** | **2008 vs 2007** | ** ** |
| Loss provisions          |       | $                                                   | 87         |                     | $          | 3                                                 |       | $                        | 84         |   | $ | 316 |   | $ | 77 |   | $ | 239 |   |
| Net loss (gain) on sales |       | (25                                                 | )          | 9                        |       | (34                                               | )          | 28                       |       | 51 |   | (23 | ) |
| Taxes and insurance      |       | 169                                                 |       | 87                       |       | 82                                                |       | 279                      |       | 92 |   | 187 |   |
| Other                    |       | 38                                                  |       | 22                       |       | 16                                                |       | 75                       |       | 62 |   | 13 |   |
| Total                    |       | $                                                   | 269        |                     | $          | 121                                               |       | $                        | 148        |   | $ | 698 |   | $ | 282 |   | $ | 416 |   |

 

Expenses associated with real estate owned have increased due to theincrease in real estate owned balances as discussed in “Asset Quality.”   Real estate owned is expected to continue toincrease in the foreseeable future and real estate owned expenses associatedwith maintaining the properties are expected to increase accordingly.  Future levels of loss provisions and netgains or losses on sales of real estate owned will be dependent on marketconditions.

 

**Data Processing.**  Thedecrease in the six month comparative period in 2008 was primarily due tocredits received in the first quarter of 2008 associated with upgrading ourcomputer system in the first quarter of 2007.

 

**Income Taxes. **The income tax benefit increased in 2008primarily due to an increase in nontaxable life insurance earnings for the sixmonth comparative period.  The decreasein income tax provision for the three month comparative period was related to adecrease in taxable income resulting from decreased earnings and increasednontaxable interest from investment securities.

 

# **OFF-BALANCE SHEET ARRANGEMENTS**

#  

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

 

·      theorigination, purchase or sale of loans;

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

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

 

At June 30, 2008, the Bank’s off-balance sheet arrangementsprincipally included lending commitments, which are described below.  At June 30, 2008, the Company had nointerests in non-consolidated special purpose entities.

 

At June 30, 2008, commitments included:

 

·      totalapproved commitments to originate or purchase loans amounting to $3.4 million,including $415,000 of loans committed to sell;

·      rate lock agreements with customers of $2.2million, all of which have been locked with an investor;

·      funded mortgage loans committed to sell of$1.4 million;

·      unadvanced portion of construction loans of$20.8 million;

·      unused lines of credit of $21.4 million;

·      outstanding standby letters of credit ofapproximately $565,000;

·      total predetermined overdraft protection limitsof $14.6 million; and

·      certificates of deposit scheduled to mature inone year or less totaling $265.6 million.

 

Totalunfunded commitments to originate loans for sale and the related commitments tosell of $2.2 million meet the definition of a derivative financialinstrument.  The related asset andliability are considered immaterial at June 30, 2008.

 

Historically,a very small percentage of predetermined overdraft limits have been used.  At June 30, 2008, overdrafts of accountswith Bounce ProtectionTM represented usage of 4.4% of thelimit.  We expect utilization of theseoverdraft limits 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.

 

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### **LIQUIDITY AND CAPITAL RESOURCES**

###  

TheBank’s liquidity, represented by cash and cash equivalents and eligibleinvestment securities, is a product of its operating, investing and financingactivities.  The Bank’s primary sourcesof funds are deposits, borrowings, payments on outstanding loans, maturitiesand calls of investment securities and other short-term investments and fundsprovided from operations.  While scheduledloan amortization and maturing investment securities and short-term investmentsare relatively predictable sources of funds, deposit flows and loan prepaymentsare greatly influenced by general interest rates, economic conditions andcompetition.  Calls of investmentsecurities are determined by the issuer and are generally influenced by thelevel of market interest rates at the bond’s call date compared to the couponrate of the bond.  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 that provideliquidity to meet lending requirements and pay deposit withdrawals.  The Bank has generally been able to generateenough cash through the retail deposit market, its traditional funding source,to offset the cash utilized in investing activities.  As an additional source of funds, the Bankhas borrowed from the FHLB of Dallas.   During the first six months of 2008, the use of FHLB advances increasedby $22.0 million or 26.8%.  The Bank usesU.S. government agency investment securities and eligible one- to four-familyloans as collateral for FHLB advances. The Bank’s borrowing capacity at the FHLB of Dallas is based on theamount of securities and loans held in custody by the FHLB.  The Bank may transfer additional collateralto provide additional borrowing capacity if needed.  Currently, the Bank may borrow short-termadvances with maturities up to thirty days. In addition, brokered deposits may be used to augment the Bank’s primaryfunding sources.  At June 30, 2008,the Bank had outstanding brokered deposits of $2.2 million.

 

Foreach of the six months ended June 30, 2008 and 2007, the Company paiddividends of $0.32 per share.  Thedetermination of future dividends on the Company’s common stock will depend onconditions existing at that time with consideration given to the Company’searnings, capital, and liquidity needs.

 

Liquiditymanagement is both a daily and long-term function of business management.  Excess liquidity is generally invested inshort-term investments such as overnight deposits and certificates ofdeposit.  On a longer-term basis, theBank maintains a strategy of investing in various lending products andinvestment securities.   The Bank usesits sources of funds primarily to meet its ongoing commitments, to pay maturingsavings certificates and savings withdrawals, to repay maturing FHLB of Dallasadvances, to fund loan commitments, and to purchase investment securities.

 

Asof June 30, 2008, the Bank’s regulatory capital was in excess of allapplicable regulatory requirements.  At June 30,2008, the Bank’s tangible, core and risk-based capital ratios amounted to8.57%, 8.57% and 12.98%, respectively, compared to regulatory requirements of1.5%, 4.0% and 8.0%, respectively.

 

### **IMPACT OF INFLATION 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.

 

Unlikemost industrial companies, virtually all of the Bank’s assets and liabilitiesare monetary in nature.  As a result,interest rates generally have a more significant impact on a financialinstitution’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.

 

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**QUANTITATIVEAND QUALITATIVE DISCLOSURES**

**ABOUT MARKET RISK**

 

Therehas been no material change in the market value of the Bank’s portfolio equitysince December 31, 2007.  Similarly,while there has been no material change in the Company’s asset and liabilityposition since such time, the Bank’s increased level of nonperforming assetscontinued to impact the level of net interest income during the three monthsended June 30, 2008. Correspondingly, the Bank’s net interest margin decreased from 3.19% forthe three months ended June 30, 2007 to 3.15% for the same period in2008.   Based on the level ofnonperforming assets and competitive pressures on loan and deposit rates,management anticipates continued pressure on the Bank’s interest rate spreadand interest margin for the third quarter of 2008 although the level ofmaturing certificate of deposits repricing to lower rates will somewhat offsetthe pressure on the interest rate spread and margin.

 

**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 rules andregulations 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 ExchangeAct) occurred during the most recent fiscal quarter that has materiallyaffected, or is reasonably likely to materially affect, the Company’s internalcontrol over financial reporting.

 

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

 

**Part II**

 

Item 1.                                      LegalProceedings

 

Neitherthe Company nor the Bank is involved in any pending legal proceedings otherthan non-material legal proceedings occurring in the ordinary course ofbusiness.

 

Item 1A.                            Risk Factors

 

Therehave been no material changes in the Company’s risk factors from thosepreviously disclosed in the Company’s Form 10-K for the year ended December 31,2007.

 

Item 2.                                      UnregisteredSales of Equity Securities and Use of Proceeds

 

ISSUER PURCHASES OF EQUITY SECURITIES

 
| **Period**                          | ** ** | **(a) Total  Number of  Shares  Purchased** | ** ** | **(b)  Average  Price Paid  per Share** | ** ** | **(c) Total Number of  Shares Purchased as  Part of Publicly  Announced Plans or  Programs** | ** ** | **(d) Maximum Number  of Shares that May  Yet Be Purchased  Under the Plans or  Programs** | ** ** |
|-------------------------------------|------------|-------------------------------------------------------|------------|---------------------------------------------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------|------------|
| ** **                          | ** ** | ** **                                            | ** ** | ** **                                        | ** ** | ** **                                                                                                                                | ** ** | ** **                                                                                                                                   | ** ** |
| April 1 to April 30, 2008 |       | —                                                |       | —                                            |       | —                                                                                                                                    |       | —                                                                                                                                       |       |
| May 1 to May 31, 2008     |       | —                                                |       | —                                            |       | —                                                                                                                                    |       | —                                                                                                                                       |       |
| June 1 to June 30, 2008   |       | —                                                |       | —                                            |       | —                                                                                                                                    |       | —                                                                                                                                       |       |

 

TheCompany is in its 19th announced repurchase program, which was approved by theboard of directors on July 25, 2006, and publicly announced on November 8,2006.  Total shares approved to bepurchased in this program are 245,197 of which 214,587 have been purchased asof June 30, 2008.  All treasurystock purchases are made under publicly announced repurchase programs.

 

Item 3.                                      Defaults UponSenior Securities

 

Notapplicable.

 

Item 4.                                      Submission ofMatters to a Vote of Security Holders

 

OnApril 23, 2008, the Corporation held an annual meeting of stockholders forthe following purposes:

 

(1)                           To elect onedirector for a term of three years; and

 

(2)                           To ratify theappointment by the Board of Directors of Deloitte and Touche LLP as theCorporation’s independent auditors for the year ending December 31, 2008.

 

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Theresults of the voting are set forth below:

 

ProposalOne (Election of Directors):

 
| **NAME**           | ** ** | **FOR**   | ** ** | **AGAINST/  WITHHELD** | ** ** | **NOT VOTED** | ** ** |
|--------------------|------------|-----------|------------|------------------------|------------|--------------------|------------|
| Kenneth C. Savells |       | 4,287,697 |       | 102,441                |       | 458,247            |       |

 

Proposal Two (Ratification of Auditors):

 
| **FOR**   | ** ** | **AGAINST** | ** ** | **ABSTAIN** | ** ** | **NOT VOTED** | ** ** |
|-----------|------------|-------------|------------|-------------|------------|--------------------|------------|
| 4,386,243 |       | 3,285       |       | 610         |       | 458,247            |       |

 

Item 5.                                    OtherInformation

 

None.

 

Item 6.                                   Exhibits

Exhibit 31.1– Certification of Chief Executive Officer,

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

Exhibit 31.2– Certification of Chief Financial Officer,

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

Exhibit 32.1– Certification of Chief Executive Officer,

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

Exhibit 32.2– Certification of Chief Financial Officer,

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

 

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**SIGNATURES**

 

Pursuantto the requirements of the Securities Exchange Act of 1934, the Registrant hasduly caused this report to be signed on its behalf by the undersigned thereuntoduly authorized.

 

 

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

 

 
| Date:  | July 24,  2008 | By:    | /s/ Larry J. Brandt                                   |
|--------|---------------------|--------|-------------------------------------------------------|
|   |                |   | Larry J. Brandt                                       |
|   |                |   | Chief Executive Officer                               |
|   |                |   |                                                  |
|   |                |   |                                                  |
| Date:  | July 24,  2008 | By:    | /s/ Sherri R. Billings                                |
|   |                |   | Sherri R. Billings                                    |
|   |                |   | Chief Financial Officer and Chief Accounting  Officer |

 

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