** **

**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

** **

**FORM 10-Q**

** **

**x**                               QUARTERLYREPORT PURSUANT TO SECTION 13 OR 15(d) OF THESECURITIES EXCHANGE ACT OF 1934

 

**For the quarterly period ended September 30, 2006**

** **

**OR**

 

**o**                                  TRANSITIONREPORT 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**

** **

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

(Exact name of registrant as specified in its charter)

 

| **Texas**                                      |   | **71-0785261**          |
|------------------------------------------------|--------|-------------------------|
| (State or other  jurisdiction of incorporation |   | (I.R.S. Employer        |
| or organization)                               |   | Identification  Number) |

 

| **1401 Highway 62-65 North**             |   |       |
|------------------------------------------|--------|------------|
| **Harrison,  Arkansas**                  |   | **72601**  |
| (Address of  principal executive office) |   | (Zip Code) |

 

**(870) 741-7641**

(Registrant’s telephone number, including area code)

 

Indicate by check markwhether the registrant (1) has filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding12 months (or for such shorter period that the registrant was required to filesuch reports), and (2) has been subject to such filing requirements for thepast 90 days.  Yes x  No o

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

| Large accelerated filer  o |   | Accelerated  filer  x |   | Non-accelerated  filer  o |
|---------------------------------|--------|----------------------------|--------|--------------------------------|

 

Indicate by checkmark whether the registrant is a shell company (as defined in Rule 12b-2 of theExchange Act).  Yes o  No x

Indicate thenumber of shares outstanding of each of the issuer’s classes of common stock,as of the latest practicable date:  As ofOctober 23, 2006, there were issued and outstanding 4,977,393 shares of theRegistrant’s Common Stock, par value $.01 per share.

 

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**FIRSTFEDERAL BANCSHARES OF ARKANSAS, INC.**

**TABLEOF CONTENTS**
| Part I.   | ** ** | **Financial Information**                                                                                                                              | ** ** | **Page** | ** ** |
|----------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------|------------|
|           |       |                                                                                                                                                        |       |     |       |
| Item  1.       |       | Consolidated Financial  Statements                                                                                                                          |       |     |       |
|           |       |                                                                                                                                                        |       |     |       |
|           |       | Consolidated Statements of Financial Condition as of  September 30, 2006 and December 31, 2005 (unaudited)                                                  |       | 1        |       |
|           |       |                                                                                                                                                        |       |     |       |
|           |       | Consolidated Statements of Income for the three and  nine months ended September 30, 2006 and 2005 (unaudited)                                              |       | 2        |       |
|           |       |                                                                                                                                                        |       |     |       |
|           |       | Consolidated Statement of Stockholders’ Equity for the  nine months ended September 30, 2006 (unaudited)                                               |       | 3        |       |
|           |       |                                                                                                                                                        |       |     |       |
|           |       | Consolidated Statements of Cash Flows for the nine  months ended September 30, 2006 and 2005 (unaudited)                                                    |       | 4        |       |
|           |       |                                                                                                                                                        |       |     |       |
|           |       | Notes to Unaudited Consolidated Financial Statements                                                                                                        |       | 6        |       |
|           |       |                                                                                                                                                        |       |     |       |
| Item  2.       |       | Management’s Discussion and Analysis of Financial  Condition and Results of Operations                                                                 |       | 7        |       |
|           |       |                                                                                                                                                        |       |     |       |
| Item  3.       |       | Quantitative and Qualitative Disclosures About Market  Risk                                                                                                 |       | 20       |       |
|           |       |                                                                                                                                                        |       |     |       |
| Item  4.       |       | Controls  and Procedures                                                                                                                                    |       | 20       |       |
|           |       |                                                                                                                                                        |       |     |       |
| **Part II.**   | ** ** | **Other Information**                                                                                                                                       |       |     |       |
|           |       |                                                                                                                                                        |       |     |       |
| Item  1.       |       | Legal  Proceedings                                                                                                                                          |       | 21       |       |
| Item  1A.      |       | Risk  Factors                                                                                                                                               |       | 21       |       |
| Item 2.        |       | Unregistered Sales of Equity Securities and Use of  Proceeds                                                                                                |       | 21       |       |
| Item 3.        |       | Defaults Upon Senior Securities                                                                                                                             |       | 21       |       |
| Item 4.        |       | Submission of Matters to a Vote of Security Holders                                                                                                         |       | 21       |       |
| Item  5.       |       | Other  Information                                                                                                                                          |       | 21       |       |
| Item 6.        |       | Exhibits                                                                                                                                                    |       | 21       |       |
|           |       |                                                                                                                                                        |       |     |       |
| **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                                                                                                                        |       |     |       |
|           |       |                                                                                                                                                        |       |     |       |

 

 

** **

----

 

**FIRST FEDERAL BANCSHARES OF ARKANSAS,INC.CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION**(In thousands, except share data)(Unaudited)
| ** **                                                                                                                                                                                    | ** ** | ** September 30, ** | ** ** | ** December 31, ** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------------|------------|-----------------------------------|------------|
| ** **                                                                                                                                                                                    | ** ** | **2006**                           | ** ** | **2005**                          | ** ** |
| ASSETS                                                                                                                                                                                        |       |                               |       |                              |       |
|                                                                                                                                                                                          |       |                               |       |                              |       |
| Cash and cash  equivalents                                                                                                                                                                    |       | $                                  | 30,671     |                              | $          | 21,109 |   |
| Investment securities  held to maturity                                                                                                                                                       |       | 60,855                             |       | 56,695                            |       |
| Federal Home Loan Bank  stock                                                                                                                                                                 |       | 8,329                              |       | 8,412                             |       |
| Loans receivable, net                                                                                                                                                                         |       | 716,669                            |       | 719,214                           |       |
| Accrued interest  receivable                                                                                                                                                                  |       | 10,011                             |       | 7,490                             |       |
| Real estate acquired in  settlement of loans, net                                                                                                                                             |       | 1,688                              |       | 892                               |       |
| Office properties and  equipment, net                                                                                                                                                         |       | 19,509                             |       | 18,522                            |       |
| Cash surrender value of  life insurance                                                                                                                                                       |       | 19,210                             |       | 18,654                            |       |
| Prepaid expenses and  other assets                                                                                                                                                            |       | 1,237                              |       | 1,423                             |       |
|                                                                                                                                                                                          |       |                               |       |                              |       |
| TOTAL ASSETS                                                                                                                                                                                  |       | $                                  | 868,179    |                              | $          | 852,411 |   |
|                                                                                                                                                                                          |       |                               |       |                              |       |
| LIABILITIES AND  STOCKHOLDERS’ EQUITY                                                                                                                                                    |       |                               |       |                              |       |
|                                                                                                                                                                                          |       |                               |       |                              |       |
| LIABILITIES:                                                                                                                                                                                  |       |                               |       |                              |       |
| Deposits                                                                                                                                                                                      |       | $                                  | 641,600    |                              | $          | 611,667 |   |
| Federal Home Loan Bank  advances                                                                                                                                                              |       | 144,032                            |       | 158,240                           |       |
| Advance payments by  borrowers for taxes and insurance                                                                                                                                        |       | 528                                |       | 847                               |       |
| Other liabilities                                                                                                                                                                             |       | 3,317                              |       | 3,815                             |       |
| Total  liabilities                                                                                                                                                                            |       | 789,477                            |       | 774,569                           |       |
|                                                                                                                                                                                          |       |                               |       |                              |       |
| STOCKHOLDERS’ EQUITY:                                                                                                                                                                    |       |                               |       |                              |       |
| Preferred stock, no par  value, 5,000,000 shares authorized, none issued                                                                                                                      |       |                               |       |                              |       |
| Common stock, $.01 par  value, 20,000,000 shares authorized, 10,307,502 shares issued, 4,977,393 and  5,048,662 shares outstanding at September 30, 2006 and December 31, 2005,  respectively |       | 103                                |       | 103                               |       |
| Additional paid-in  capital                                                                                                                                                                   |       | 56,708                             |       | 56,252                            |       |
| Employee stock benefit  plans                                                                                                                                                                 |       | (83                                | )          | (140                              | )          |
| Retained  earnings-substantially restricted                                                                                                                                                   |       | 87,376                             |       | 83,584                            |       |
|                                                                                                                                                                                          |       | 144,104                            |       | 139,799                           |       |
| Treasury stock, at  cost, 5,330,109 and 5,258,840 shares at September 30, 2006 and December 31,  2005, respectively                                                                           |       | (65,402                            | )          | (61,957                           | )          |
| Total  stockholders’ equity                                                                                                                                                              |       | 78,702                             |       | 77,842                            |       |
|                                                                                                                                                                                          |       |                               |       |                              |       |
| TOTAL LIABILITIES AND  STOCKHOLDERS’ EQUITY                                                                                                                                              |       | $                                  | 868,179    |                              | $          | 852,411 |   |

 

See notes tounaudited consolidated financial statements.

 

1

----

 

**FIRSTFEDERAL BANCSHARES OF ARKANSAS, INC.CONSOLIDATED STATEMENTS OF INCOME**(In thousands, except share data)(Unaudited)
| ** **                                           | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|------------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                           | ** ** | **September 30,**           | ** ** | **September 30,**          | ** ** | **September 30,** | ** ** | **September 30,** | ** ** |
| ** **                                           | ** ** | **2006**                         | ** ** | **2005**                        | ** ** | **2006** | ** ** | **2005** | ** ** |
|                                                 |       |                             |       |                            |       |   |   |   |   |
| INTEREST INCOME:                                     |       |                             |       |                            |       |   |   |   |   |
| Loans receivable                                     |       | $                                | 12,627     |                            | $          | 11,150 |   | $ | 37,703 |   | $ | 31,300 |   |
| Investment  securities:                              |       |                             |       |                            |       |   |   |   |   |
| Taxable                                              |       | 650                              |       | 561                             |       | 1,853 |   | 1,610 |   |
| Nontaxable                                           |       | 185                              |       | 180                             |       | 558 |   | 538 |   |
| Other                                                |       | 219                              |       | 25                              |       | 393 |   | 64 |   |
| Total interest  income                               |       | 13,681                           |       | 11,916                          |       | 40,507 |   | 33,512 |   |
|                                                 |       |                             |       |                            |       |   |   |   |   |
| INTEREST EXPENSE:                                    |       |                             |       |                            |       |   |   |   |   |
| Deposits                                             |       | 5,449                            |       | 3,742                           |       | 14,819 |   | 10,505 |   |
| Other borrowings                                     |       | 1,858                            |       | 1,393                           |       | 5,378 |   | 3,345 |   |
| Total interest  expense                              |       | 7,307                            |       | 5,135                           |       | 20,197 |   | 13,850 |   |
|                                                 |       |                             |       |                            |       |   |   |   |   |
| NET INTEREST INCOME                                  |       | 6,374                            |       | 6,781                           |       | 20,310 |   | 19,662 |   |
|                                                 |       |                             |       |                            |       |   |   |   |   |
| PROVISION FOR LOAN  LOSSES                           |       | 484                              |       | 285                             |       | 1,128 |   | 820 |   |
|                                                 |       |                             |       |                            |       |   |   |   |   |
| NET INTEREST INCOME  AFTER PROVISION FOR LOAN LOSSES |       | 5,890                            |       | 6,496                           |       | 19,182 |   | 18,842 |   |
|                                                 |       |                             |       |                            |       |   |   |   |   |
| NONINTEREST INCOME:                                  |       |                             |       |                            |       |   |   |   |   |
| Deposit fee  income                                  |       | 1,264                            |       | 1,193                           |       | 3,579 |   | 3,307 |   |
| Earnings on life  insurance policies                 |       | 187                              |       | 191                             |       | 556 |   | 579 |   |
| Gain on sale of  loans                               |       | 252                              |       | 195                             |       | 727 |   | 511 |   |
| Other                                                |       | 327                              |       | 239                             |       | 1,570 |   | 714 |   |
| Total  noninterest income                            |       | 2,030                            |       | 1,818                           |       | 6,432 |   | 5,111 |   |
|                                                 |       |                             |       |                            |       |   |   |   |   |
| NONINTEREST EXPENSES:                                |       |                             |       |                            |       |   |   |   |   |
| Salaries and  employee benefits                      |       | 3,195                            |       | 3,256                           |       | 10,174 |   | 9,272 |   |
| Net occupancy  expense                               |       | 613                              |       | 532                             |       | 1,784 |   | 1,537 |   |
| Data processing                                      |       | 341                              |       | 392                             |       | 1,100 |   | 1,145 |   |
| Professional  fees                                   |       | 93                               |       | 101                             |       | 288 |   | 321 |   |
| Advertising and  public relations                    |       | 342                              |       | 318                             |       | 982 |   | 801 |   |
| Postage and  supplies                                |       | 188                              |       | 186                             |       | 605 |   | 566 |   |
| Other                                                |       | 694                              |       | 528                             |       | 1,934 |   | 1,546 |   |
| Total  noninterest expenses                          |       | 5,466                            |       | 5,313                           |       | 16,867 |   | 15,188 |   |
|                                                 |       |                             |       |                            |       |   |   |   |   |
| INCOME BEFORE INCOME  TAXES                          |       | 2,454                            |       | 3,001                           |       | 8,747 |   | 8,765 |   |
| INCOME TAX PROVISION                                 |       | 754                              |       | 965                             |       | 2,787 |   | 2,815 |   |
| NET INCOME                                           |       | $                                | 1,700      |                            | $          | 2,036 |   | $ | 5,960 |   | $ | 5,950 |   |
|                                                 |       |                             |       |                            |       |   |   |   |   |
| EARNINGS PER SHARE:                                  |       |                             |       |                            |       |   |   |   |   |
| Basic                                                |       | $                                | 0.34       |                            | $          | 0.41 |   | $ | 1.19 |   | $ | 1.19 |   |
|                                                 |       |                             |       |                            |       |   |   |   |   |
| Diluted                                              |       | $                                | 0.33       |                            | $          | 0.39 |   | $ | 1.16 |   | $ | 1.14 |   |
|                                                 |       |                             |       |                            |       |   |   |   |   |
| Cash Dividends  Declared                             |       | $                                | 0.15       |                            | $          | 0.13 |   | $ | 0.43 |   | $ | 0.37 |   |

 

See notes tounaudited consolidated financial statements.

2

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**FIRSTFEDERAL BANCSHARES OF ARKANSAS, INC.CONSOLIDATED STATEMENT OF STOCKHOLDERS’ EQUITYFOR THE NINE MONTHS ENDED SEPTEMBER 30,2006**(In thousands, except share data)(Unaudited)
| ** **                                                 | ** ** | ** **            | ** ** | ** **     | ** ** | ** **  | ** ** | **Employee** | ** ** | ** **   | ** ** |
|------------------------------------------------------------|------------|-----------------------|------------|----------------|------------|-------------|------------|--------------|------------|--------------|------------|
| ** **                                                 | ** ** | **Issued**            | ** ** | **Additional** | ** ** | **Stock**   | ** ** | ** **   | ** ** |
| ** **                                                 | ** ** | **Common Stock** | ** ** | **Paid-In**    | ** ** | **Benefit** | ** ** | **Retained** | ** ** |
| ** **                                                 | ** ** | **Shares**            | ** ** | **Amount**     | ** ** | **Capital** | ** ** | **Plans**    | ** ** | **Earnings** | ** ** |
|                                                       |       |                  |       |           |       |        |       |         |       |         |       |
| Balance, January 1,  2006                                  |       | 10,307,502            |       | $              | 103        |        | $          | 56,252       |       | $            | (140       | ) | $ | 83,584 |   |
| Net income                                                 |       |                  |       |           |       |        |       |         |       | 5,960        |       |
| Release of ESOP shares                                     |       |                  |       |           |       | 407         |       | 104          |       |         |       |
| Tax effect of stock  compensation plan                     |       |                  |       |           |       | 252         |       |         |       |         |       |
| Treasury shares  reissued due to exercise of stock options |       |                  |       |           |       | (270        | )          |         |       |         |       |
| Purchase of treasury  stock, at cost                       |       |                  |       |           |       |        |       |         |       |         |       |
| Stock compensation  expense                                |       |                  |       |           |       | 67          |       | (47          | )          |         |       |
| Dividends paid                                             |       |                  |       |           |       |        |       |         |       | (2,168       | )          |
|                                                       |       |                  |       |           |       |        |       |         |       |         |       |
| Balance, September 30, 2006                                |       | 10,307,502            |       | $              | 103        |        | $          | 56,708       |       | $            | (83        | ) | $ | 87,376 |   |

 
| ** **                                                  | ** ** | ** **              | ** ** | ** **             | ** ** | **Total**  | ** ** |
|-------------------------------------------------------------|------------|-------------------------|------------|------------------------|------------|------------|------------|
| ** **                                                  | ** ** | **Treasury Stock** | ** ** | **Stockholders’** | ** ** |
| ** **                                                  | ** ** | **Shares**              | ** ** | **Amount**             | ** ** | **Equity** | ** ** |
| Balance, January 1,  2006                                   |       | 5,258,840               |       | $                      | (61,957    | )          | $          | 77,842 |   |
| Net income                                                  |       |                    |       |                   |       | 5,960      |       |
| Release of ESOP shares                                      |       |                    |       |                   |       | 511        |       |
| Tax effect of stock  compensation plan                      |       |                    |       |                   |       | 252        |       |
| Treasury shares  reissued due to exercise of  stock options |       | (113,631                | )          | 1,176                  |       | 906        |       |
| Purchase of treasury  stock, at cost                        |       | 188,900                 |       | (4,667                 | )          | (4,667     | )          |
| Stock compensation  expense                                 |       | (4,000                  | )          | 46                     |       | 66         |       |
| Dividends paid                                              |       |                    |       |                   |       | (2,168     | )          |
|                                                        |       |                    |       |                   |       |       |       |
| Balance, September 30, 2006                                 |       | 5,330,109               |       | $                      | (65,402    | )          | $          | 78,702 |   |

 

See notes to unauditedconsolidated financial statements

3

----

 

**FIRSTFEDERAL BANCSHARES OF ARKANSAS, INC.CONSOLIDATED STATEMENTS OF CASH FLOWS**(In Thousands)(Unaudited)
| ** **                                                                         | ** ** | **Nine Months Ended September 30,** | ** ** |
|------------------------------------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                                                                         | ** ** | **2006**                                                | ** ** | **2005** | ** ** |
|                                                                               |       |                                                    |       |   |   |
| OPERATING ACTIVITIES:                                                              |       |                                                    |       |   |   |
| Net income                                                                         |       | $                                                       | 5,960      |   | $ | 5,950 |   |
| Adjustments to  reconcile net income to net cash provided by operating activities: |       |                                                    |       |   |   |
| Provision for  loan losses                                                         |       | 1,128                                                   |       | 820 |   |
| Provision for  real estate losses                                                  |       | —                                                  |       | 30 |   |
| Deferred tax  provision (benefit)                                                  |       | 9                                                       |       | (95 | ) |
| Accretion of  discounts on investment securities, net                              |       | (5                                                      | )          | (1 | ) |
| Federal Home  Loan Bank stock dividends                                            |       | (294                                                    | )          | (168 | ) |
| (Gain) loss on  disposition of office properties and equipment                     |       | (233                                                    | )          | 4 |   |
| Gain on sale of  repossessed assets, net                                           |       | (43                                                     | )          | (14 | ) |
| Originations of  loans held for sale                                               |       | (52,436                                                 | )          | (37,565 | ) |
| Proceeds from  sales of loans held for sale                                        |       | 53,404                                                  |       | 36,901 |   |
| Gain on sale of  loans originated to sell                                          |       | (727                                                    | )          | (511 | ) |
| Depreciation                                                                       |       | 966                                                     |       | 885 |   |
| Amortization of  deferred loan fees, net                                           |       | 192                                                     |       | 115 |   |
| Release of ESOP  shares                                                            |       | 511                                                     |       | 1,503 |   |
| Stock  compensation expense                                                        |       | 66                                                      |       | 20 |   |
| Earnings on life  insurance policies                                               |       | (556                                                    | )          | (579 | ) |
| Changes in  operating assets and liabilities:                                      |       |                                                    |       |   |   |
| Accrued interest  receivable                                                       |       | (2,521                                                  | )          | (2,042 | ) |
| Prepaid expenses  and other assets                                                 |       | 187                                                     |       | 323 |   |
| Other  liabilities                                                                 |       | (255                                                    | )          | 1,056 |   |
| Net cash  provided by operating activities                                         |       | 5,353                                                   |       | 6,632 |   |
|                                                                               |       |                                                    |       |   |   |
| INVESTING ACTIVITIES:                                                              |       |                                                    |       |   |   |
| Purchases of  investment securities held to maturity                               |       | (6,445                                                  | )          | (3,939 | ) |
| Proceeds from  maturities/calls of investment securities held to maturity          |       | 2,290                                                   |       | 4,416 |   |
| Purchases of  FHLB stock                                                           |       | —                                                  |       | (3,285 | ) |
| Redemptions of  FHLB stock                                                         |       | 377                                                     |       | — |   |
| Loan  participations sold                                                          |       | 3,419                                                   |       | 1,787 |   |
| Loan  originations, net of repayments                                              |       | (5,964                                                  | )          | (81,199 | ) |
| Proceeds from  sales of repossessed assets                                         |       | 2,775                                                   |       | 492 |   |
| Proceeds from  sales of office properties and equipment                            |       | 251                                                     |       | 4 |   |
| Purchases of  office properties and equipment                                      |       | (1,971                                                  | )          | (3,340 | ) |
| Net cash used in  investing activities                                             |       | (5,268                                                  | )          | (85,064 | ) |
|                                                                               |       |                                                    |       |   |   |
| FINANCING ACTIVITIES:                                                              |       |                                                    |       |   |   |
| Net increase in  deposits                                                          |       | 29,933                                                  |       | 6,874 |   |
| Advances from  FHLB                                                                |       | 55,000                                                  |       | 131,243 |   |
| Repayment of advances  from FHLB                                                   |       | (69,208                                                 | )          | (51,508 | ) |
| Net decrease in  advance payments by borrowers for taxes and insurance             |       | (319                                                    | )          | (162 | ) |
| Purchase of  treasury stock                                                        |       | (4,667                                                  | )          | (5,722 | ) |
| Reissued  treasury stock                                                           |       | 906                                                     |       | 1,952 |   |
| Dividends paid                                                                     |       | (2,168                                                  | )          | (1,872 | ) |
| Net cash provided  by financing activities                                         |       | 9,477                                                   |       | 80,805 |   |
|                                                                               |       |                                                    |       |   |   |
| Net increase in cash  and cash equivalents                                         |       | 9,562                                                   |       | 2,373 |   |
|                                                                               |       |                                                    |       |   |   |
|                                                                                    |            |                                                         |            |  |  |  |  |

 

(Continued)

 

4

----

 
| ** **                                                    | ** ** | **Nine Months Ended September 30,** | ** ** |
|---------------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                                                    | ** ** | **2006**                                                | ** ** | **2005** | ** ** |
| ** **                                                    | ** ** | ** **                                              | ** ** | ** ** | ** ** |
| CASH AND CASH  EQUIVALENTS:                                   |       |                                                    |       |   |   |
| Beginning of  period                                          |       | $                                                       | 21,109     |   | $ | 16,003 |   |
| End of period                                                 |       | $                                                       | 30,671     |   | $ | 18,376 |   |
|                                                          |       |                                                    |       |   |   |
| SUPPLEMENTAL  DISCLOSURES OF CASH FLOW INFORMATION:           |       |                                                    |       |   |   |
| Cash paid for:                                                |       |                                                    |       |   |   |
| Interest                                                      |       | $                                                       | 19,820     |   | $ | 13,443 |   |
| Income taxes                                                  |       | $                                                       | 2,625      |   | $ | 2,053 |   |
|                                                          |       |                                                    |       |   |   |
| SUPPLEMENTAL SCHEDULE  OF NONCASH INVESTING ACTIVITIES:       |       |                                                    |       |   |   |
| Real estate and  other assets acquired in settlement of loans |       | $                                                       | 3,529      |   | $ | 293 |   |

 

(Concluded)

 

See notes tounaudited consolidated financial statements.

5

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**FIRSTFEDERAL BANCSHARES OF ARKANSAS, INC.**

**NOTESTO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS**

# **Note 1 — Basis of Presentationand Principles of Consolidation**

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

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

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

The results of operationsfor the nine months ended September 30, 2006, are not necessarily indicative ofthe results to be expected for the year ending December 31, 2006.  The unaudited consolidated financialstatements and notes thereto should be read in conjunction with the auditedfinancial statements and notes thereto for the year ended December 31,2005, contained in the Company’s 2005 Annual Report to Stockholders.

# **Note 2 — Recent AccountingStandards**

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

In July 2006, theFinancial Accounting Standards Board (FASB) issued Financial Interpretation(FIN) No. 48, *Accounting for Uncertainty inIncome Taxes, an Interpretation of FASB Statement No. 109* which iseffective for fiscal years beginning after December 15, 2006. FIN No. 48provides guidance regarding the recognition, measurement, presentation anddisclosure in the financial statements of tax positions taken or expected to betaken on a tax return, including the decision whether to file or not file in aparticular jurisdiction.  The cumulative effect of the changes arisingfrom the initial application of FIN 48 is required to be reported as anadjustment to the opening balance of retained earnings in the period ofadoption. We are currently evaluating the impact, if any, of the adoption ofFIN 48 on our financial statements.

**Note 3 — Earnings per Share**

The weightedaverage number of common shares used to calculate earnings per share for theperiods ended September 30, 2006 and 2005 were as follows:
| ** **                         | ** ** | **Three months ended September 30,** | ** ** | **Nine months ended September 30,** | ** ** |
|------------------------------------|------------|----------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                         | ** ** | **2006**                                                 | ** ** | **2005**                                                | ** ** | **2006** | ** ** | **2005** | ** ** |
| Basic weighted -  average shares   |       | 5,006,730                                                |       | 4,990,081                                               |       | 5,021,110 |   | 4,984,411 |   |
| Effect of  dilutive securities     |       | 111,206                                                  |       | 222,985                                                 |       | 124,131 |   | 251,165 |   |
| Diluted weighted -  average shares |       | 5,117,936                                                |       | 5,213,066                                               |       | 5,145,241 |   | 5,235,576 |   |

 

6

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

### **CRITICALACCOUNTING POLICIES**

Various elements of our accounting policies, by their nature, areinherently subject to estimation techniques, valuation assumptions and othersubjective assessments.  In particular,the methodology for the determination of our allowance for loan losses, due tothe judgments, estimates and assumptions inherent in that policy, is criticalto preparation of our financial statements. This policy and the judgments, estimates and assumptions are describedin greater detail in subsequent sections of Management’s Discussion andAnalysis.  We believe that the judgments,estimates and assumptions used in the preparation of our financial statementsare appropriate given the factual circumstances at the time.  However, given the sensitivity of ourfinancial statements to this critical accounting policy, the use of other judgments,estimates and assumptions could result in material differences in our financialcondition 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, the estimated fairvalue of the collateral may deviate significantly from the proceeds receivedwhen the collateral is sold.

## **CHANGES INFINANCIAL CONDITION**

Changes in financial condition between September 30, 2006 and December 31, 2005 arepresented in the following table (dollars in thousands).  Material changes between the periods arediscussed in the sections which follow the table.
| ** **                                        | ** ** | **September **30, | ** ** | **December 31,** | ** ** | **Increase**   | ** ** | **Percentage** | ** ** |
|---------------------------------------------------|------------|------------------------|------------|-----------------------|------------|----------------|------------|----------------|------------|
| ** **                                        | ** ** | **2006**               | ** ** | **2005**              | ** ** | **(Decrease)** | ** ** | **Change**     | ** ** |
| **ASSETS**                                        |       |                   |       |                  |       |           |       |           |       |
| Cash and cash  equivalents                        |       | $                      | 30,671     |                  | $          | 21,109         |       | $              | 9,562      |   | 45.3 | % |
| Investment  securities held to maturity           |       | 60,855                 |       | 56,695                |       | 4,160          |       | 7.3            | %          |
| Loans  receivable, net                            |       | 716,669                |       | 719,214               |       | (2,545         | )          | (0.4           | )%         |
| Accrued interest  receivable                      |       | 10,011                 |       | 7,490                 |       | 2,521          |       | 33.7           | %          |
| Real estate  acquired in settlement of loans, net |       | 1,688                  |       | 892                   |       | 796            |       | 89.2           | %          |
| Office  properties and equipment, net             |       | 19,509                 |       | 18,522                |       | 987            |       | 5.3            | %          |
| Prepaid expenses  and other assets                |       | 28,776                 |       | 28,489                |       | 287            |       | 1.0            | %          |
|                                              |       |                   |       |                  |       |           |       |           |       |
| TOTAL                                             |       | $                      | 868,179    |                  | $          | 852,411        |       | $              | 15,768     |   | 1.9 | % |
|                                              |       |                   |       |                  |       |           |       |           |       |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**    |       |                   |       |                  |       |           |       |           |       |
| LIABILITIES:                                      | ** ** | ** **             | ** ** | ** **            | ** ** | ** **     | ** ** | ** **     | ** ** |
| Deposits                                          |       | $                      | 641,600    |                  | $          | 611,667        |       | $              | 29,933     |   | 4.9 | % |
| Federal Home Loan Bank advances                   |       | 144,032                |       | 158,240               |       | (14,208        | )          | (9.0           | )%         |
| Other liabilities                                 |       | 3,845                  |       | 4,662                 |       | (817           | )          | (17.5          | )%         |
|                                              |       |                   |       |                  |       |           |       |           |       |
| Total liabilities                                 |       | 789,477                |       | 774,569               |       | 14,908         |       | 1.9            | %          |
|                                              |       |                   |       |                  |       |           |       |           |       |
| STOCKHOLDERS’  EQUITY                        |       | 78,702                 |       | 77,842                |       | 860            |       | 1.1            | %          |
|                                              |       |                   |       |                  |       |           |       |           |       |
| TOTAL                                             |       | $                      | 868,179    |                  | $          | 852,411        |       | $              | 15,768     |   | 1.9 | % |
|                                              |       |                   |       |                  |       |           |       |           |       |
| BOOK VALUE PER  SHARE                             |       | $                      | 15.81      |                  | $          | 15.42          |       |           |       |   |   |
|                                              |       |                   |       |                  |       |           |       |           |       |
| EQUITY TO ASSETS                                  |       | 9.1                    | %          | 9.1                   | %          |           |       |           |       |

** **

7

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**Loans Receivable. **Changesin loan compositionbetween September 30,2006 and December 31, 2005 are presented in the following table (dollars inthousands).
| ** **                                             | ** ** | **September 30,** | ** ** | **December 31,** | ** ** | **Increase**   | ** ** | **Percentage** | ** ** |
|--------------------------------------------------------|------------|------------------------|------------|-----------------------|------------|----------------|------------|----------------|------------|
| ** **                                             | ** ** | **2006**               | ** ** | **2005**              | ** ** | **(Decrease)** | ** ** | **Change**     | ** ** |
|                                                   |       |                   |       |                  |       |           |       |           |       |
| One- to  four-family residences                        |       | $                      | 257,678    |                  | $          | 269,660        |       | $              | (11,982    | ) |   |   |
| Multi-family                                           |       | 9,974                  |       | 12,900                |       | (2,926         | )          |           |       |
| Commercial real  estate                                |       | 116,789                |       | 119,323               |       | (2,534         | )          |           |       |
| Land                                                   |       | 43,509                 |       | 38,355                |       | 5,154          |       |           |       |
| Construction:                                          |       |                   |       |                  |       |           |       |           |       |
| One- to four-family residences                         |       | 40,110                 |       | 51,579                |       | (11,469        | )          |           |       |
| Speculative one- to four-family residences             |       | 91,702                 |       | 104,001               |       | (12,299        | )          |           |       |
| Multi-family                                           |       | 10,220                 |       | 20,919                |       | (10,699        | )          |           |       |
| Commercial real estate                                 |       | 24,729                 |       | 22,331                |       | 2,398          |       |           |       |
| Land  development                                      |       | 47,680                 |       | 40,232                |       | 7,448          |       |           |       |
| Total first mortgage loans                             |       | 642,391                |       | 679,300               |       | (36,909        | )          | (5.4           | )%         |
|                                                   |       |                   |       |                  |       |           |       |           |       |
| Commercial                                             |       | 39,818                 |       | 32,693                |       | 7,125          |       | 21.8           | %          |
|                                                   |       |                   |       |                  |       |           |       |           |       |
| Home equity and  second mortgage                       |       | 53,795                 |       | 49,680                |       | 4,115          |       |           |       |
| Automobile                                             |       | 13,186                 |       | 15,748                |       | (2,562         | )          |           |       |
| Other                                                  |       | 14,114                 |       | 13,149                |       | 965            |       |           |       |
| Total consumer                                         |       | 81,095                 |       | 78,577                |       | 2,518          |       | 3.2            | %          |
|                                                   |       |                   |       |                  |       |           |       |           |       |
| Total loans  receivable                                |       | 763,304                |       | 790,570               |       | (27,266        | )          | (3.4           | )%         |
| Less:                                                  |       |                   |       |                  |       |           |       |           |       |
| Undisbursed  construction loan funds                   |       | (44,290                | )          | (69,086               | )          | 24,796         |       |           |       |
| Unearned  discounts and net deferred loan costs (fees) |       | 86                     |       | (156                  | )          | 242            |       |           |       |
| Allowance for  loan losses                             |       | (2,431                 | )          | (2,114                | )          | (317           | )          |           |       |
|                                                   |       |                   |       |                  |       |           |       |           |       |
| Loans receivable, net                                  |       | $                      | 716,669    |                  | $          | 719,214        |       | $              | (2,545     | ) | (0.4 | )% |

 

The decrease in the Bank’sloan portfolio was primarily due to a softening of the housing market inNorthwest Arkansas.  Market dataindicates an overall decrease in home sales in Benton and Washington countiesin 2006 compared to 2005.   The Bank’smortgage loan originations were down 32% for the nine months ended September30, 2006, compared to the same period in 2005, with half of this reductionoccurring in the third quarter.  Althoughthe economy in the Northwest Arkansas region continues to be strong asreflected in sustained job and population growth, the supply of new residentiallots and new speculative homes for sale has outpaced demand in recentmonths.  The $34 million decrease in one-to four-family, speculative and multi-family construction loans was both aresult of a general slowdown in housing finance and the Bank’s decision toreduce its lending activity in these areas due to the oversupply in theNorthwest Arkansas market.

Originations of loans forsale in the secondary market increased by 40% for the nine months endedSeptember 30, 2006, compared to the same period in 2005.  This component of our mortgage loan businesshas remained strong due to continued low long-term secondary market mortgageinterest rates.

The Bank will continue toemphasize residential, consumer, and commercial real estate lending and to alesser degree construction lending. Construction lending will generally be reduced and will primarily befocused on custom homes for primary residences and to a lesser degree onspeculative construction loans. The loans will also be used as an opportunityto cross-sell its other banking products, as long as prudent lendingopportunities are available.

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**Asset Quality.** The following table sets forththe amounts and categories of the Bank’s nonperforming assets at the datesindicated.
| ** **                                                                         | ** ** | **September 30, 2006**     | ** ** | **December 31, 2005** | ** ** |
|------------------------------------------------------------------------------------|------------|--------------------------------------|------------|---------------------------------|------------|
| ** **                                                                         | ** ** | **(Dollars in Thousands)** | ** ** |
| Nonaccrual  loans:                                                                 |       |                                 |       |                            |       |
| One- to four-family residential                                                    |       | $                                    | 2,811      |                            | $          | 2,630 |   |
| Construction loans                                                                 |       | 6,734                                |       | 1,177                           |       |
| Commercial real estate                                                             |       | 1,015                                |       | 707                             |       |
| Commercial loans                                                                   |       | 1,977                                |       | 236                             |       |
| Consumer loans                                                                     |       | 1,186                                |       | 556                             |       |
| Total nonaccrual loans                                                             |       | 13,723                               |       | 5,306                           |       |
|                                                                               |       |                                 |       |                            |       |
| Accruing loans  90 days or more past due                                           |       | 3,009                                |       | 1,600                           |       |
| Restructured  loans                                                                |       | —                               |       | 6,264                           |       |
| Real estate owned                                                                  |       | 1,688                                |       | 892                             |       |
|                                                                               |       |                                 |       |                            |       |
| Total nonperforming assets                                                         |       | $                                    | 18,420     |                            | $          | 14,062 |   |
|                                                                               |       |                                 |       |                            |       |
| Total nonaccrual  and restructured loans as a percentage of total loans receivable |       | 2.19%                                |       | 1.67%                           |       |
|                                                                               |       |                                 |       |                            |       |
| Total nonperforming  assets as a percentage of total assets                        |       | 2.12%                                |       | 1.65%                           |       |

 

Total nonaccrual loansincreased $8.4 million to $13.7 million at September 30, 2006, compared toDecember 31, 2005, due primarily to an increase of $5.6 million in nonaccrualconstruction loans. As indicated previously, in recent months the NorthwestArkansas market has experienced a general slowdown in housing as well as anoversupply of lots and speculative homes. Certain of the Bank’s homebuilders are experiencing extended marketingtimes for the sales of their speculative homes which has resulted in inadequatecash flow to service the interest carry on their loans.  The Bank’s policy is to cease accrual ofinterest on loans more than 90 days delinquent unless the Bank reasonablybelieves it will collect the interest without extraordinary collectionefforts.  The Bank is exercisingforbearance with some of its construction borrowers in order to allowadditional time to liquidate the homes and believes it is adequatelycollateralized on these loans.

The increase in realestate owned was due to the addition of six speculative homes during the thirdquarter, two of which were sold and closed prior to quarter end.  Three of the four remaining homes are notcomplete and the Bank plans to complete the construction of these homes.  Construction costs are added to the realestate owned balance to the extent that the resulting balance does not exceedthe estimated fair value of the property less estimated selling costs.

At December 31,2005, restructured loans consisted of commercial and commercial real estateloans to two borrowers.  During thequarter ended September 30, 2006, one of these relationships was removed fromthe nonperforming asset list as the loans have paid as agreed for over one yearsince the restructuring took place and the Bank believes it will be able tocollect all principal and interest due under the notes.  The other borrowing relationship totaled $3.8million at September 30, 2006, $800,000 of which is reported under thecommercial category of nonaccrual loans. All of the loans in this relationship are over 90 days past due atSeptember 30, 2006.  We have estimated aloss of approximately $128,000 on this relationship and have recorded such as aspecific loan loss allowance as of September 30, 2006.  However, the collateral on certain of theseloans includes accounts receivable, inventory, and franchise rights which areinherently more difficult to value than real estate.  The Bank intends to obtain updated financialinformation to estimate the current value of the collateral.  Subsequent to September 30, 2006, the Bank’scounsel sent a letter to the borrower demanding payment in full of theoutstanding indebtedness owed to the Bank. The Bank may be required to record loan losses significantly greaterthan the amount estimated, particularly in light of the nature of thecollateral.

In addition, theBank has $10.0 million of potential problem loans with three homebuilders.  The first relationship totals $6.6 millionand consists of five speculative homes, two subdivision development loans, anda first mortgage and a home equity loan on the borrower’s primaryresidence.  At September 30, 2006, thetwo subdivision loans had matured and were less than 30 days past due.  The borrower has formulated a plan to pay theinterest due and has

9

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made a partialpayment. The second relationship totals $2.4 million and consists of threespeculative homes and three lots totaling $1.8 million and commercial loanstotaling $600,000.  At September 30,2006, four of the loans totaling $441,000 were over 90 days past due and arereflected in the commercial loans total in nonaccrual loans above. Fouradditional loans totaling $1.1 million were less than 30 days past due and theremainder of the loans were current. The third relationship totals $1.1 millionand consists of six speculative homes. This borrower filed for bankruptcy protection subsequent to quarterend.  Based on facts and circumstances atSeptember 30, 2006, including market conditions, we have estimated no loss onthese relationships.

**Allowance for Loan Losses**. A summary of the activity in the allowance for loan losses is asfollows (in thousands):
| ** **                      | ** ** | **Three Months Ended September 30,** | ** ** | **Nine Months Ended September 30,** | ** ** |
|---------------------------------|------------|----------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                      | ** ** | **2006**                                                 | ** ** | **2005**                                                | ** ** | **2006** | ** ** | **2005** | ** ** |
| Balance at  beginning of period |       | $                                                        | 2,448      |                                                    | $          | 2,022 |   | $ | 2,114 |   | $ | 1,846 |   |
| Provisions for estimated losses |       | 484                                                      |       | 285                                                     |       | 1,128 |   | 820 |   |
| Recoveries                      |       | 55                                                       |       | 31                                                      |       | 139 |   | 82 |   |
| Losses charged off              |       | (556                                                     | )          | (262                                                    | )          | (950 | ) | (672 | ) |
| Balance at end of  period       |       | $                                                        | 2,431      |                                                    | $          | 2,076 |   | $ | 2,431 |   | $ | 2,076 |   |

#  

Changes in the composition of the allowance for loan losses between September30, 2006 and December 31,2005 are presented in the following table (in thousands):

|             | ** ** | **September **30, | ** ** | **December 31,** | ** ** | **Increase**   | ** ** |
|-------------|------------|------------------------|------------|-----------------------|------------|----------------|------------|
| ** **  | ** ** | **2006**               | ** ** | **2005**              | ** ** | **(Decrease)** | ** ** |
| General     |       | $                      | 2,011      |                  | $          | 1,831          |       | $ | 180 |   |
| Specific    |       | 383                    |       | 183                   |       | 200            |       |
| Unallocated |       | 37                     |       | 100                   |       | (63            | )          |
|        |       | $                      | 2,431      |                  | $          | 2,114          |       | $ | 317 |   |

 

The general component ofthe allowance for loan losses increased due to an increase in loss experienceon construction loans.  The specificcomponent of the allowance for loan losses increased primarily due to specificallowances on home equity loans and the $128,000 specific allowance discussedpreviously.

The allowance for loan losses is evaluated on a regular basis bymanagement and is based upon management’s periodic review of the collectibilityof the loans in light of historical experience, the nature and volume of theloan portfolio, adverse situations that may affect the borrower’s ability torepay, the estimated value of any underlying collateral and prevailing economicconditions.  This evaluation isinherently subjective as it requires estimates that are susceptible tosignificant revision as conditions change and more information becomesavailable.

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

The Bank reviews its non-homogeneous loans for impairment on aquarterly basis.  The Bank considerscommercial real estate, construction, multi-family, and commercial loans to benon-homogeneous loans.  A loan isconsidered impaired when, based on current information and events, it isprobable 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 bymanagement in determining impairment include payment status, collateral value,and the probability of collecting scheduled principal and interest paymentswhen due.  Loans that experienceinsignificant payment delays and payment shortfalls generally are notclassified as impaired.  Management determinesthe significance of payment delays and payment shortfalls on a case-by-casebasis, taking into consideration all of the circumstances surrounding the loanand the borrower, including the length of the delay, the reasons for the delay,the

10

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borrower’s prior payment record, and the amount of the shortfall inrelation to the principal and interest owed. Impairment is measured on a loan by loan basis by either the presentvalue of expected future cash flows discounted at the loan’s effective interestrate, the loan’s obtainable market price, or the fair value of the collateralif the loan is collateral dependent.

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

In estimating the amount 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 economy were to sustain a prolongeddownturn, the loss factors applied to our portfolios may need to be revised,which may significantly impact the measurement of the allowance for loanlosses.  For impaired loans that arecollateral-dependent, the estimated fair value of the collateral may deviatesignificantly from the proceeds received when the collateral is sold.

Although we consider the allowance for loan losses of approximately$2.4 million appropriate and adequate to cover losses inherent in our loanportfolio at September 30,2006, no assurance can be given that we will not sustain loan losses that aresignificantly different from the amount provided, or that subsequentevaluations of the loan portfolio, in light of factors then prevailing,including future declines in real estate market conditions, would not result ina significant change in the allowance for loan losses.

**Investment Securities. **Changes in the composition of investment securities held to maturitybetween September 30,2006 and December 31, 2005 are presented in the following table (inthousands).
| ** **                              | ** ** | **September 30,** | ** ** | **December 31,** | ** ** | **Increase**   | ** ** |
|-----------------------------------------|------------|------------------------|------------|-----------------------|------------|----------------|------------|
| ** **                              | ** ** | **2006**               | ** ** | **2005**              | ** ** | **(Decrease)** | ** ** |
| U.S. Government  and agency obligations |       | $                      | 44,357     |                  | $          | 40,034         |       | $ | 4,323 |   |
| Municipal  securities                   |       | 16,498                 |       | 16,661                |       | (163           | )          |
| Total                                   |       | $                      | 60,855     |                  | $          | 56,695         |       | $ | 4,160 |   |

 

During the first nine months of 2006, investment securities totaling$6.4 million were purchased and $2.3 matured or were called.

At September 30, 2006, estimated fair valuesof investment securities held to maturity were as follows (in thousands):
| ** **                             | ** ** | **Amortized Cost** | ** ** | **Fair Value** | ** ** |
|----------------------------------------|------------|-------------------------|------------|---------------------|------------|
|                                   |       |                    |       |                |       |
| U.S. Government and agency obligations |       | $                       | 44,357     |                | $          | 43,199 |   |
| Municipal securities                   |       | 16,498                  |       | 16,627              |       |
| Total                                  |       | $                       | 60,855     |                | $          | 59,826 |   |

 

**Accrued Interest Receivable. ** The increase in accruedinterest receivable was primarily due to an increase in the number of daysaccrued as well as an increase in the loan yield at September 30, 2006 compared to December 31,2005.

**Real Estate Acquired in Settlement of Loans,Net. ** The increase in real estate acquired insettlement of loans, net, was due to four construction loans foreclosed in thethird quarter.  See Asset Qualitysection.

11

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**Deposits. **Changes in the composition of depositsbetween September 30,2006 and December 31, 2005 are presented in the following table (dollars inthousands).
| ** **              | ** ** | **September 30,** | ** ** | **December 31,** | ** ** | **Increase**   | ** ** | **Percentage** | ** ** |
|-------------------------|------------|------------------------|------------|-----------------------|------------|----------------|------------|----------------|------------|
| ** **              | ** ** | **2006**               | ** ** | **2005**              | ** ** | **(Decrease)** | ** ** | **Change**     | ** ** |
| DDA and NOW accounts    |       | $                      | 134,143    |                  | $          | 125,397        |       | $              | 8,746      |   |   | 7.0 | % |   |
| Money Market accounts   |       | 53,816                 |       | 64,021                |       | (10,205        | )          |           | (15.9      | )% |   |
| Savings accounts        |       | 28,004                 |       | 30,521                |       | (2,517         | )          |           | (8.3       | )% |   |
| Certificates of deposit |       | 425,637                |       | 391,728               |       | 33,909         |       |           | 8.7        | % |   |
|                    |       |                   |       |                  |       |           |       |           |       |   |   |
| Total deposits          |       | $                      | 641,600    |                  | $          | 611,667        |       | $              | 29,933     |   |   | 4.9 | % |   |

 

Deposits increasedin the comparison period primarily due to an increase in public unit accounts,focused marketing efforts to increase checking accounts and the offering of CDspecials.  During the period, DDA and NOWaccount balances increased by $8.7 million and the number of such accountsincreased by 3.4%.  The Bank will continue to aggressivelypromote checking accounts by targeting households and small- and medium-sizedbusiness accounts with its direct mail campaign and “thank you” gifts.   Checkingaccounts are an attractive source of funds for the Bank as they offerlow-interest deposits, fee income potential, and the opportunity to cross-sellother financial services.

Certificates of deposit have continued to increase as interest ratescontinue to rise.  Further, the Bank hasadvertised several CD products with special rates and terms ranging from 7 to40 months.  The cost of deposit fundsincreased from 2.85% at December 31, 2005 to 3.51% at September 30, 2006.

**FederalHome Loan Bank Advances. **TheBank was able to use funds from deposit growth to repay FHLB of Dallas advancesduring the quarter.  FHLB advancesdecreased by $14.2 million or 9% during the nine months ended September 30,2006.  The balance of advances atSeptember 30, 2006 of $144.0 million consisted of $90.0 million of fixed rateadvances with an average cost of 4.20% and $54.0 million of floating rateadvances with an average cost of 5.35%.

**Stockholders’ Equity. **Stockholders’ equity increased $860,000 from December 31, 2005 to September30, 2006.  The increase in stockholders’ equity wasprimarily due to net income of $6.0 million and the issuance of treasury stockdue to proceeds received from the exercise of stock options of $906,000, offsetby the purchase of treasury stock totaling $4.7 million during the first ninemonths of 2006.  In addition, during the ninemonths ended September 30,2006, cash dividends of $2.2 million were paid. See the Unaudited Consolidated Statement of Stockholders’ Equity for thenine months ended September 30,2006 for more detail.

12

----

###  

### **AverageBalance Sheets**

The followingtable sets forth certain information relating to the Company’s average balancesheets and reflects the average yield on assets and average cost of liabilitiesfor the periods indicated and the yields earned and rates paid at September 30,2006.  Such yields and costs are derivedby dividing income or expense by the average balance of assets or liabilities,respectively, for the periods presented and outstanding balances at September30, 2006.  Average balances are based ondaily balances during the period.
| ** **                                                       | ** ** | ** **                   | ** ** | **Three Months Ended September 30,** | ** ** |
|------------------------------------------------------------------|------------|------------------------------|------------|----------------------------------------------------------|------------|
| ** **                                                       | ** ** | **September **30,  2006 | ** ** | **2006**                                                 | ** ** | **2005** | ** ** |
| ** **                                                       | ** ** | **Yield/Cost**               | ** ** | **Average  Balance**                                     | ** ** | **Interest** | ** ** | **Average  Yield/  Cost** | ** ** | **Average  Balance** | ** ** | **Interest** | ** ** | **Average  Yield/  Cost** | ** ** |
| ** **                                                       | ** ** | ** **                   | ** ** | ** **                                               | ** ** | **(Dollars in Thousands)** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Interest-earning assets:                                         |       |                         |       |                                                     |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Loans receivable(1)                                              |       |                         | 7.33       | %                                                        |       | $ | 730,630 |   | $ | 12,627 |   |   | 6.91 | % |   | $ | 697,983 |   | $ | 11,150 |   |   | 6.39 | % |   |
| Investment  securities(2)                                        |       |                         | 4.89       |                                                     |       | 68,496 |   | 835 |   |   | 4.87 |   |   | 63,272 |   | 741 |   |   | 4.68 |   |   |
| Other  interest-earning assets                                   |       |                         | 5.21       |                                                     |       | 16,972 |   | 219 |   |   | 5.17 |   |   | 3,079 |   | 25 |   |   | 3.29 |   |   |
| Total  interest-earning assets                                   |       |                         | 7.08       |                                                     |       | 816,098 |   | 13,681 |   |   | 6.71 |   |   | 764,334 |   | 11,916 |   |   | 6.24 |   |   |
| Noninterest-earning assets                                       |       |                         |       |                                                     |       | 62,556 |   |   |   |   |   |   |   | 51,215 |   |   |   |   |   |   |   |
| Total assets                                                     |       |                         |       |                                                     |       | 878,654 |   |   |   |   |   |   |   | $ | 815,549 |   |   |   |   |   |   |   |
| Interest-bearing liabilities:                                    |       |                         |       |                                                     |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Deposits                                                         |       |                         | 3.51       |                                                     |       | 635,245 |   | 5,449 |   |   | 3.43 |   |   | 588,858 |   | 3,742 |   |   | 2.54 |   |   |
| FHLB advances                                                    |       |                         | 4.63       |                                                     |       | 157,615 |   | 1,858 |   |   | 4.72 |   |   | 148,273 |   | 1,393 |   |   | 3.76 |   |   |
| Total  interest-bearing liabilities                              |       |                         | 3.71       |                                                     |       | 792,860 |   | 7,307 |   |   | 3.69 |   |   | 737,131 |   | 5,135 |   |   | 2.79 |   |   |
| Noninterest-bearing liabilities                                  |       |                         |       |                                                     |       | 6,216 |   |   |   |   |   |   |   | 5,354 |   |   |   |   |   |   |   |
| Total liabilities                                                |       |                         |       |                                                     |       | 799,076 |   |   |   |   |   |   |   | 742,485 |   |   |   |   |   |   |   |
| Stockholders’ equity                                        |       |                         |       |                                                     |       | 79,578 |   |   |   |   |   |   |   | 73,064 |   |   |   |   |   |   |   |
| Total liabilities  and stockholders’ equity                 |       |                         |       |                                                     |       | $ | 878,654 |   |   |   |   |   |   |   | $ | 815,549 |   |   |   |   |   |   |   |
|                                                             |       |                         |       |                                                     |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Net interest income                                              |       |                         |       |                                                     |       |   |   | $ | 6,374 |   |   |   |   |   |   |   | $ | 6,781 |   |   |   |   |   |
| Net earning assets                                               |       |                         |       |                                                     |       | $ | 23,238 |   |   |   |   |   |   |   | $ | 27,203 |   |   |   |   |   |   |   |
| Interest rate spread                                             |       |                         | 3.37       | %                                                        |       |   |   |   |   |   | 3.02 | % |   |   |   |   |   |   | 3.45 | % |   |
| Net interest margin                                              |       |                         |       |                                                     |       |   |   |   |   |   | 3.12 | % |   |   |   |   |   |   | 3.55 | % |   |
| Ratio of interest-earning assets to interest-bearing liabilities |       |                         |       |                                                     |       |   |   |   |   |   | 102.93 | % |   |   |   |   |   |   | 103.69 | % |   |

 

 
| ** **                                                       | ** ** | **Nine Months Ended September** 30, | ** ** |
|------------------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                                                       | ** ** | **2006**                                                | ** ** | **2005** | ** ** |
| ** **                                                       | ** ** | **Average  Balance**                                    | ** ** | **Interest** | ** ** | **Average  Yield/  Cost** | ** ** | **Average  Balance** | ** ** | **Interest** | ** ** | **Average  Yield/  Cost** | ** ** |
| ** **                                                       | ** ** | **(Dollars in Thousands)**                    | ** ** |
| Interest-earning assets:                                         |       |                                                    |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
|  Loans receivable(1)                                        |       | $                                                       | 733,842    |   | $ | 37,703 |   |   | 6.85 | % |   | $ | 676,037 |   | $ | 31,300 |   |   | 6.17 | % |   |
|  Investment securities(2)                                   |       | 66,917                                                  |       | 2,411 |   |   | 4.80 |   |   | 62,097 |   | 2,148 |   |   | 4.61 |   |   |
|  Other interest-earning assets                              |       | 10,769                                                  |       | 393 |   |   | 4.87 |   |   | 2,986 |   | 64 |   |   | 2.86 |   |   |
| Total  interest-earning assets                                   |       | 811,528                                                 |       | 40,507 |   |   | 6.66 |   |   | 741,120 |   | 33,512 |   |   | 6.03 |   |   |
| Noninterest-earning assets                                       |       | 61,233                                                  |       |   |   |   |   |   |   | 51,709 |   |   |   |   |   |   |   |
| Total assets                                                     |       | 872,761                                                 |       |   |   |   |   |   |   | $ | 792,829 |   |   |   |   |   |   |   |
| Interest-bearing liabilities:                                    |       |                                                    |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
|  Deposits                                                   |       | 626,745                                                 |       | 14,819 |   |   | 3.15 |   |   | 586,762 |   | 10,505 |   |   | 2.39 |   |   |
|  FHLB advances                                              |       | 161,103                                                 |       | 5,378 |   |   | 4.45 |   |   | 126,015 |   | 3,345 |   |   | 3.54 |   |   |
| Total  interest-bearing liabilities                              |       | 787,848                                                 |       | 20,197 |   |   | 3.42 |   |   | 712,777 |   | 13,850 |   |   | 2.59 |   |   |
| Noninterest-bearing liabilities                                  |       | 6,194                                                   |       |   |   |   |   |   |   | 5,227 |   |   |   |   |   |   |   |
| Total liabilities                                                |       | 794,042                                                 |       |   |   |   |   |   |   | 718,004 |   |   |   |   |   |   |   |
| Stockholders’ equity                                        |       | 78,719                                                  |       |   |   |   |   |   |   | 74,825 |   |   |   |   |   |   |   |
| Total liabilities  and stockholders’ equity                 |       | $                                                       | 872,761    |   |   |   |   |   |   |   | $ | 792,829 |   |   |   |   |   |   |   |
|                                                             |       |                                                    |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Net interest income                                              |       |                                                    |       | $ | 20,310 |   |   |   |   |   |   |   | $ | 19,662 |   |   |   |   |   |
| Net earning assets                                               |       | $                                                       | 23,680     |   |   |   |   |   |   |   | $ | 28,343 |   |   |   |   |   |   |   |
| Interest rate spread                                             |       |                                                    |       |   |   |   | 3.24 | % |   |   |   |   |   |   | 3.44 | % |   |
| Net interest margin                                              |       |                                                    |       |   |   |   | 3.34 | % |   |   |   |   |   |   | 3.54 | % |   |
| Ratio of interest-earning assets to interest-bearing liabilities |       |                                                    |       |   |   |   | 103.01 | % |   |   |   |   |   |   | 103.98 | % |   |

----

(1)             Includes nonaccrualloans.

(2)             IncludesFHLB of Dallas stock.

13

----

## ** **

## **Rate/VolumeAnalysis**

The table belowsets forth certain information regarding changes in interest income andinterest expense of the Company for the periods indicated.  For each category of interest-earning assetsand interest-bearing liabilities, information is provided on changesattributable to (i) changes in volume (changes in average volume multiplied byprior rate); (ii) changes in rate (change in rate multiplied by prior averagevolume); (iii) changes in rate-volume (changes in rate multiplied by the changein average volume); and (iv) the net change.
| ** **                          | ** ** | **Three Months Ended September 30,** | ** ** |
|-------------------------------------|------------|----------------------------------------------------------|------------|
| ** **                          | ** ** | **2006 vs. 2005**                              | ** ** |
| ** **                          | ** ** | **Increase (Decrease)  Due to**                | ** ** | ** ** | ** ** |
| ** **                          | ** ** | **Volume**                                               | ** ** | **Rate** | ** ** | **Rate/  Volume** | ** ** | **Total  Increase  (Decrease)** | ** ** |
| ** **                          | ** ** | **(In Thousands)**                                  | ** ** |
| Interest income:                    |       |                                                     |       |   |   |   |   |   |   |
| Loans receivable                    |       | $                                                        | 522        |   | $ | 913 |   | $ | 42 |   | $ | 1,477 |   |
| Investment  securities              |       | 61                                                       |       | 30 |   | 3 |   | 94 |   |
| Other  interest-earning assets      |       | 114                                                      |       | 14 |   | 66 |   | 194 |   |
| Total  interest-earning assets      |       | 697                                                      |       | 957 |   | 111 |   | 1,765 |   |
|                                |       |                                                     |       |   |   |   |   |   |   |
| Interest expense:                   |       |                                                     |       |   |   |   |   |   |   |
| Deposits                            |       | 295                                                      |       | 1,309 |   | 103 |   | 1,707 |   |
| FHLB advances                       |       | 88                                                       |       | 355 |   | 22 |   | 465 |   |
| Total  interest-bearing liabilities |       | 383                                                      |       | 1,664 |   | 125 |   | 2,172 |   |
| Net change in net interest income   |       | $                                                        | 314        |   | $ | (707 | ) | $ | (14 | ) | $ | (407 | ) |

 
| ** **                          | ** ** | **Nine Months Ended September 30,** | ** ** |
|-------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                          | ** ** | **2006 vs. 2005**                             | ** ** |
| ** **                          | ** ** | **Increase (Decrease)  Due to**               | ** ** | ** ** | ** ** |
| ** **                          | ** ** | **Volume**                                              | ** ** | **Rate** | ** ** | **Rate/  Volume** | ** ** | **Total  Increase** | ** ** |
| ** **                          | ** ** | **(In Thousands)**                                 | ** ** |
| Interest income:                    |       |                                                    |       |   |   |   |   |   |   |
| Loans receivable                    |       | $                                                       | 2,676      |   | $ | 3,434 |   | $ | 293 |   | $ | 6,403 |   |
| Investment  securities              |       | 167                                                     |       | 89 |   | 7 |   | 263 |   |
| Other  interest-earning assets      |       | 167                                                     |       | 45 |   | 117 |   | 329 |   |
| Total  interest-earning assets      |       | 3,010                                                   |       | 3,568 |   | 417 |   | 6,995 |   |
|                                |       |                                                    |       |   |   |   |   |   |   |
| Interest expense:                   |       |                                                    |       |   |   |   |   |   |   |
| Deposits                            |       | 716                                                     |       | 3,369 |   | 229 |   | 4,314 |   |
| FHLB advances                       |       | 931                                                     |       | 862 |   | 240 |   | 2,033 |   |
| Total  interest-bearing liabilities |       | 1,647                                                   |       | 4,231 |   | 469 |   | 6,347 |   |
| Net change in net interest income   |       | $                                                       | 1,363      |   | $ | (663 | ) | $ | (52 | ) | $ | 648 |   |

 

14

----

** **

**CHANGES IN RESULTS OF OPERATIONS**

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

 
| ** **                                            | ** ** | **Three Months Ended**September 30, | ** ** | **Increase  (Decrease)** | ** ** | **Percentage  Change**     | ** ** |
|-------------------------------------------------------|------------|----------------------------------------------------|------------|--------------------------|------------|----------------------------|------------|
| ** **                                            | ** ** | **2006**                                           | ** ** | **2005**                 | ** ** | **2006 vs 2005** | ** ** | **2006 vs 2005** | ** ** |
| Interest income:                                      |       |                                               |       |                     |       |                       |       |   |   |
| Loans receivable                                      |       | $                                                  | 12,627     |                     | $          | 11,150                     |       | $ | 1,477 |   | 13.2 | % |
| Investment securities                                 |       | 835                                                |       | 741                      |       | 94                         |       | 12.7 | % |
| Other                                                 |       | 219                                                |       | 25                       |       | 194                        |       | 776.0 | % |
| Total interest income                                 |       | 13,681                                             |       | 11,916                   |       | 1,765                      |       | 14.8 | % |
| Interest  expense:                                    |       |                                               |       |                     |       |                       |       |   |   |
| Deposits                                              |       | 5,449                                              |       | 3,742                    |       | 1,707                      |       | 45.6 | % |
| Other borrowings                                      |       | 1,858                                              |       | 1,393                    |       | 465                        |       | 33.4 | % |
| Total interest expense                                |       | 7,307                                              |       | 5,135                    |       | 2,172                      |       | 42.3 | % |
| Net interest  income before provision for loan losses |       | 6,374                                              |       | 6,781                    |       | (407                       | )          | (6.0 | )% |
| Provision for  loan losses                            |       | 484                                                |       | 285                      |       | 199                        |       | 69.8 | % |
| Net interest  income after provision for loan losses  |       | 5,890                                              |       | 6,496                    |       | (606                       | )          | (9.3 | )% |
| Noninterest  income:                                  |       |                                               |       |                     |       |                       |       |   |   |
| Deposit fee income                                    |       | 1,264                                              |       | 1,193                    |       | 71                         |       | 6.0 | % |
| Gain on sale of loans                                 |       | 252                                                |       | 195                      |       | 57                         |       | 29.2 | % |
| Other                                                 |       | 514                                                |       | 430                      |       | 84                         |       | 19.5 | % |
| Total noninterest income                              |       | 2,030                                              |       | 1,818                    |       | 212                        |       | 11.7 | % |
| Noninterest  expenses:                                |       |                                               |       |                     |       |                       |       |   |   |
| Salaries and employee benefits                        |       | 3,195                                              |       | 3,256                    |       | (61                        | )          | (1.9 | )% |
| Net occupancy expense                                 |       | 613                                                |       | 532                      |       | 81                         |       | 15.2 | % |
| Advertising and public relations                      |       | 342                                                |       | 318                      |       | 24                         |       | 7.6 | % |
| Other                                                 |       | 1,316                                              |       | 1,207                    |       | 109                        |       | 9.0 | % |
| Total noninterest expenses                            |       | 5,466                                              |       | 5,313                    |       | 153                        |       | 2.9 | % |
| Income before  income taxes                           |       | 2,454                                              |       | 3,001                    |       | (547                       | )          | (18.2 | )% |
| Provision for  income taxes                           |       | 754                                                |       | 965                      |       | (211                       | )          | (21.9 | )% |
| Net income                                            |       | $                                                  | 1,700      |                     | $          | 2,036                      |       | $ | (336 | ) | (16.5 | )% |
|                                                  |       |                                               |       |                     |       |                       |       |   |   |
| Basic earnings  per share                             |       | $                                                  | 0.34       |                     | $          | 0.41                       |       | $ | (0.07 | ) | (17.1 | )% |
| Diluted earnings per share                            |       | $                                                  | 0.33       |                     | $          | 0.39                       |       | $ | (0.06 | ) | (15.4 | )% |
|                                                  |       |                                               |       |                     |       |                       |       |   |   |
| Interest rate  spread                                 |       | 3.02                                               | %          | 3.45                     | %          |                       |       |   |   |
| Net interest  margin                                  |       | 3.12                                               | %          | 3.55                     | %          |                       |       |   |   |
|                                                  |       |                                               |       |                     |       |                       |       |   |   |
| Average  full-time equivalents                        |       | 305                                                |       | 276                      |       |                       |       |   |   |
|                                                  |       |                                               |       |                     |       |                       |       |   |   |
| Full-service offices                                  |       | 18                                                 |       | 16                       |       |                       |       |   |   |

 

15

----

 

The table below presents a comparison of results of operations forthe nine months ended September 30, 2006 and 2005 (dollars inthousands).  Specific changes in captionsare discussed in the sections which follow the table.
| ** **                                            | ** ** | **Nine Months Ended  September 30,** | ** ** | **Increase  (Decrease)** | ** ** | **Percentage  Change**     | ** ** |
|-------------------------------------------------------|------------|-----------------------------------------------------|------------|--------------------------|------------|----------------------------|------------|
| ** **                                            | ** ** | **2006**                                            | ** ** | **2005**                 | ** ** | **2006 vs 2005** | ** ** | **2006 vs 2005** | ** ** |
| Interest income:                                      |       |                                                |       |                     |       |                       |       |   |   |
| Loans receivable                                      |       | $                                                   | 37,703     |                     | $          | 31,300                     |       | $ | 6,403 |   | 20.5 | % |
| Investment securities                                 |       | 2,411                                               |       | 2,148                    |       | 263                        |       | 12.2 | % |
| Other                                                 |       | 393                                                 |       | 64                       |       | 329                        |       | 514.1 | % |
| Total interest income                                 |       | 40,507                                              |       | 33,512                   |       | 6,995                      |       | 20.9 | % |
| Interest  expense:                                    |       |                                                |       |                     |       |                       |       |   |   |
| Deposits                                              |       | 14,819                                              |       | 10,505                   |       | 4,314                      |       | 41.1 | % |
| Other borrowings                                      |       | 5,378                                               |       | 3,345                    |       | 2,033                      |       | 60.8 | % |
| Total interest expense                                |       | 20,197                                              |       | 13,850                   |       | 6,347                      |       | 45.8 | % |
| Net interest  income before provision for loan losses |       | 20,310                                              |       | 19,662                   |       | 648                        |       | 3.3 | % |
| Provision for  loan losses                            |       | 1,128                                               |       | 820                      |       | 308                        |       | 37.6 | % |
| Net interest  income after provision for loan losses  |       | 19,182                                              |       | 18,842                   |       | 340                        |       | 1.8 | % |
| Noninterest  income:                                  |       |                                                |       |                     |       |                       |       |   |   |
| Deposit fee income                                    |       | 3,579                                               |       | 3,307                    |       | 272                        |       | 8.2 | % |
| Gain on sale of loans                                 |       | 727                                                 |       | 511                      |       | 216                        |       | 42.3 | % |
| Other                                                 |       | 2,126                                               |       | 1,293                    |       | 833                        |       | 64.4 | % |
| Total noninterest income                              |       | 6,432                                               |       | 5,111                    |       | 1,321                      |       | 25.9 | % |
| Noninterest expenses:                                 |       |                                                |       |                     |       |                       |       |   |   |
| Salaries and employee benefits                        |       | 10,174                                              |       | 9,272                    |       | 902                        |       | 9.7 | % |
| Net occupancy expense                                 |       | 1,784                                               |       | 1,537                    |       | 247                        |       | 16.1 | % |
| Advertising and public relations                      |       | 982                                                 |       | 801                      |       | 181                        |       | 22.6 | % |
| Other                                                 |       | 3,927                                               |       | 3,578                    |       | 349                        |       | 9.8 | % |
| Total noninterest expenses                            |       | 16,867                                              |       | 15,188                   |       | 1,679                      |       | 11.1 | % |
| Income before  income taxes                           |       | 8,747                                               |       | 8,765                    |       | (18                        | )          | (.2 | )% |
| Provision for  income taxes                           |       | 2,787                                               |       | 2,815                    |       | (28                        | )          | (1.0 | )% |
| Net income                                            |       | $                                                   | 5,960      |                     | $          | 5,950                      |       | $ | 10 |   | .2 | % |
|                                                  |       |                                                |       |                     |       |                       |       |   |   |
| Basic earnings  per share                             |       | $                                                   | 1.19       |                     | $          | 1.19                       |       | $ | 0.00 |   | 0.0 | % |
| Diluted earnings  per share                           |       | $                                                   | 1.16       |                     | $          | 1.14                       |       | $ | 0.02 |   | 1.8 | % |
|                                                  |       |                                                |       |                     |       |                       |       |   |   |
| Interest rate  spread                                 |       | 3.24                                                | %          | 3.44                     | %          |                       |       |   |   |
| Net interest  margin                                  |       | 3.34                                                | %          | 3.54                     | %          |                       |       |   |   |
|                                                  |       |                                                |       |                     |       |                       |       |   |   |
| Average  full-time equivalents                        |       | 306                                                 |       | 261                      |       |                       |       |   |   |
|                                                  |       |                                                |       |                     |       |                       |       |   |   |
| Full-service offices                                  |       | 18                                                  |       | 16                       |       |                       |       |   |   |

 

16

----

 

**NetInterest Income. **Netinterest income is determined by the Company’s interest rate spread (i.e., thedifference between the yields earned on its interest-earning assets and therates paid on its interest-bearing liabilities) and the relative amounts ofinterest-earning assets and interest-bearing liabilities.

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

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

**InterestIncome. **The increasein interest income for the three and nine month comparative periods wasprimarily due to an increase in the average balance of loans, an increase inthe average yield earned on loans, an increase in the average balance of otherinterest-earning assets, and an increase in the average yield earned on otherinterest-earning assets. The increase in the average yield earned on loans wasdue to increased rates on new loans, particularly construction loans, inconjunction with recent increases in market interest rates.  The average balance of loans increasedprimarily due to an increase in the average balance of construction loans. Theaverage balance of other interest-earning assets increased due to an increasein the average balance of our FHLB demand deposit account, which occurredprimarily as a result of funds generated from the increase in deposits.  The average yield earned on otherinterest-earning assets increased due to increases in market interest rates.

**InterestExpense.  **The increasein interest expense for the three and nine month comparative periods wasprimarily due to an increase in the average rates paid on deposits and FHLBadvances as well as an increase in the average balances of deposits and FHLBadvances.  The increase in the averagerates paid on deposit accounts reflects both the shift in deposits from moneymarket accounts to higher rate certificates of deposit as well as increases inmarket interest rates. The rates paid on FHLB advances increased due to increasesin market interest rates.  The averagebalance of deposits increased due to growth in certificates of deposit.  The average balance of FHLB advancesincreased due to the use of advances to fund loan growth.

**Provisionfor 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.

The increase in theprovision for loan losses in the three and nine month comparative periods wasdue primarily to an increase in loss experience on construction loans, specificallowances on home equity loans and an increase in specific loan lossallowances on commercial loans.  Thechargeoffs and net gains/losses on sales of speculative real estate owned havebeen taken into consideration in estimating the general loan loss allowance onspeculative construction loans and as a result, the loss rate used for thatportion of the portfolio has been increased during the quarter.

**NoninterestIncome. **Deposit feeincome increased for both the three and nine month comparative periods as aresult of the Bank’s continued promotion of Bounce ProtectionTM overdraft service as well as an increase in the number ofchecking accounts.  The number ofchecking accounts increased approximately 4.3% from September 30, 2005 toSeptember 30, 2006.  The Bank willcontinue to aggressively promote checking accounts through direct mailcampaigns to expand its checking accounts and increase deposit fee income.

Gain on sale of loansincreased for the three and nine month comparative period due to an increase involume of loans sold.

The increase in othernoninterest income for the nine month comparative period was primarily due tononrecurring gains on the sales of two properties totaling approximately$528,000 during the first quarter of 2006. These properties represented excess land and a building adjacent to twoexisting branches.

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**NoninterestExpense**

**Salariesand Employee Benefits. **Thechanges in the composition of this line item are presented below (inthousands):
| ** **                         | ** ** | **Three Months Ended  September 30,** | ** ** | **Increase  (Decrease)** | ** ** | **Nine Months Ended  September 30,** | ** ** | **Increase  (Decrease)** | ** ** |
|------------------------------------|------------|------------------------------------------------------|------------|--------------------------|------------|-----------------------------------------------------|------------|--------------------------|------------|
| ** **                         | ** ** | **2006**                                             | ** ** | **2005**                 | ** ** | **2006 vs 2005**                          | ** ** | **2006**                 | ** ** | **2005** | ** ** | **2006 vs 2005** | ** ** |
| Salaries                           |       | $                                                    | 2,495      |                     | $          | 2,187                                               |       | $                        | 308        |   | $ | 7,620 |   | $ | 6,187 |   | $ | 1,433 |   |
| Payroll taxes                      |       | 194                                                  |       | 174                      |       | 20                                                  |       | 662                      |       | 582 |   | 80 |   |
| Insurance                          |       | 173                                                  |       | 161                      |       | 12                                                  |       | 517                      |       | 461 |   | 56 |   |
| ESOP (1)                           |       | —                                               |       | 502                      |       | (502                                                | )          | 508                      |       | 1,478 |   | (970 | ) |
| 401(k)                             |       | 72                                                   |       | —                   |       | 72                                                  |       | 94                       |       | — |   | 94 |   |
| Stock  compensation (2)            |       | 12                                                   |       | 7                        |       | 5                                                   |       | 54                       |       | 20 |   | 34 |   |
| Defined benefit  plan contribution |       | 210                                                  |       | 186                      |       | 24                                                  |       | 603                      |       | 431 |   | 172 |   |
| Other                              |       | 39                                                   |       | 39                       |       | —                                              |       | 116                      |       | 113 |   | 3 |   |
| Total                              |       | $                                                    | 3,195      |                     | $          | 3,256                                               |       | $                        | (61        | ) | $ | 10,174 |   | $ | 9,272 |   | $ | 902 |   |

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(1)          Employee Stock OwnershipPlan

(2)          Includes stock optionsand Management Recognition and Retention Plan (“MRP”) expense.

The increases in salariesfor the three and nine months ended September 30, 2006 compared to the sameperiods in 2005 were due primarily to an increase in the number of employeesand normal salary and merit increases. Payroll taxes increased during the periods due to the increase insalaries.  The decreases in employeestock ownership plan expense during the three and nine month comparativeperiods were due to the plan shares becoming fully allocated as of March 31,2006.  Defined benefit plan expenseincreased due to an increase in the required contribution to our multi-employerplan primarily resulting from an increase in amortization cost.

The Company implemented a401(k) Plan on June 1, 2006.  Employermatching of employee 401(k) contributions averages approximately 3% of salary expense.

**NetOccupancy Expense.**  Netoccupancy expense increased in the three and nine month periods ended September30 due to the opening of two new branches since the third quarter of 2005.

**Advertisingand Public Relations.** Advertising and public relations increased for the three and nine monthsended September 30, 2006, compared to the same periods in 2005, primarily dueto expenses associated with grand openings of branches during the first quarterof 2006.

**OtherExpenses.**  Otherexpenses increased in the three and nine month comparative periods primarilydue  to increases in loan-relatedexpenses, REO-related expenses, and consulting fees.  Loan expenses increased primarily due tosecondary market-related loan expenses resulting from increased secondarymarket loan volume.  REO-related expensesincreased primarily due to losses on sales of REO and delinquent taxes paid inconnection with sales of REO.  Consultingfees increased due to fees paid to third party providers for internal controlself-assessment and implementation of new software.

**IncomeTaxes. **Income taxexpense for the three month and nine month comparable periods ended September30 decreased primarily due to decreases in taxable income in each of theperiods.

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# **OFF-BALANCE SHEET ARRANGEMENTS**

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

·                  the origination, purchase or sale ofloans;

·                  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 September 30, 2006,the Bank’s off-balance sheet arrangements principally included lendingcommitments, which are described below. At September 30, 2006, the Company had no interests in non-consolidatedspecial purpose entities.

At September 30, 2006,commitments included:

·                  total approved commitments tooriginate loans amounting to $7.4 million, including $3.3 million of loanscommitted to sell;

·                  rate lock agreements with customersof $7.8 million, all of which have been locked with an investor;

·                  funded mortgage loans committed tosell of $2.4 million;

·                  unadvanced portion of constructionloans of $44.3 million;

·                  unused lines of credit of $32.6million;

·                  outstanding standby letters of creditof approximately $4.0 million;

·                  total predetermined overdraftprotection limits of $11.7 million; and

·                  certificates of deposit scheduled tomature in one year or less totaling $314.5 million.

Total unfundedcommitments to originate loans for sale and the related commitments to sell of$3.3 million meet the definition of a derivative financial instrument.  The related asset and liability areconsidered immaterial at September 30, 2006.

Historically, a verysmall percentage of predetermined overdraft limits have been used.  At September 30, 2006, overdrafts of accountswith Bounce ProtectionTM represented usage of 2.5% of the limit.  We expect utilization of these overdraftlimits to remain at comparable levels in the future.

Based on historicalexperience, management believes that a significant portion of maturing depositswill remain with the Bank.  We anticipatethat we will continue to have sufficient funds, through repayments, depositsand borrowings, to meet our current commitments.

### **LIQUIDITYAND CAPITAL RESOURCES**

The Bank’s liquidity, represented by cash and cash equivalents andeligible investment securities, is a product of its operating, investing andfinancing activities.  The Bank’s primarysources of funds are deposits, borrowings, collections on outstanding loans,maturities and calls of investment securities and other short-term investmentsand funds provided from operations. While scheduled loan amortization and maturing investment securities andshort-term investments are relatively predictable sources of funds, depositflows and loan prepayments are greatly influenced by general interest rates,economic conditions and competition.  TheBank manages the pricing of its deposits to maintain a steady depositbalance.  In addition, the Bank investsexcess funds in overnight deposits and other short-term interest-earning assetswhich provide liquidity to meet lending requirements.  At September 30, 2006, available borrowing capacity withthe FHLB was in excess of $168.5 million.

Liquidity management is both a daily and long-term function ofbusiness management.  Excess liquidity isgenerally invested in short-term investments such as overnight deposits andcertificates of deposit.  On alonger-term basis, the Bank maintains a strategy of investing in variouslending products.   The Bank uses itssources of funds primarily to meet its ongoing commitments, to pay maturingsavings certificates and savings withdrawals, to repay maturing FHLB of Dallasadvances, and to fund loan commitments.

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As of September 30, 2006, the Bank’s regulatory capital was in excess of all applicableregulatory requirements.  At September 30,2006, the Bank’s tangible, coreand risk-based capital ratios amounted to 8.89%, 8.89% and 12.12%,respectively, compared to regulatory requirements of 1.5%, 4.0% and 8.0%,respectively.

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

The financial statementsand related financial data presented herein have been prepared in accordancewith generally accepted accounting principles, which require the measurement offinancial position and operating results in terms of historical dollars,without considering changes in relative purchasing power over time due toinflation.

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

### **FORWARD-LOOKINGSTATEMENTS**

The Company’s QuarterlyReport on Form 10-Q contains certain forward-looking statements and informationrelating to the Company that are based on the beliefs of management as well asassumptions made by and information currently available to management.  In addition, in this document, the words “anticipate”,“believe,” “estimate,”****“expect,” “intend,”“should” and similar expressions, or the negative thereof, as they relate tothe Company or the Company’s management, are intended to identifyforward-looking statements.  Suchstatements reflect the current views of the Company with respect to futurelooking events and are subject to certain risks, uncertainties andassumptions.  Should one or more of theserisks or uncertainties materialize or should underlying assumptions proveincorrect, actual results may vary materially from those described herein asanticipated, believed, estimated, expected or intended.  The Company does not intend to update theseforward-looking statements.

**QUANTITATIVEAND QUALITATIVE DISCLOSURESABOUT MARKET RISK**

There has been nomaterial change in the market value of the Bank’s portfolio equity sinceDecember 31, 2005.  Similarly, while therehas been no material change in the Company’s asset and liability position sincesuch time, the Bank’s negative gap position has adversely impacted net incomeas interest expense during the nine months ended September 30, 2006 increasedat a greater pace than the comparable increase in interest income.  Correspondingly, the Bank’s net interestmargin decreased from 3.54% for the nine months ended September 30, 2005 to3.34% for the same period in 2006.  Basedon the current market interest rate environment and increased competition,management anticipates continued pressure on the Bank’s interest rate spreadand interest margin for the fourth quarter of 2006.

**CONTROLSAND PROCEDURES**

Our management evaluated,with the participation of our Chief Executive Officer and Chief FinancialOfficer, the effectiveness of the design and operation of our disclosurecontrols and procedures (as defined in Rules 13a-15(e) and 15d-15(e)) under theSecurities Exchange Act of 1934) as of the end of the period covered by thisreport.  Based on such evaluation, ourChief Executive Officer and Chief Financial Officer have concluded that ourdisclosure controls and procedures are designed to ensure that informationrequired to be disclosed by us in the reports that we file or submit under theSecurities Exchange Act of 1934 is recorded, processed, summarized and reportedwithin the time periods specified in the SEC’s rules and regulations and areoperating in an effective manner.

No change in the Company’sinternal control over financial reporting (as defined in Rules 13a-15(f) and15d-15(f)) under the Securities Exchange Act) occurred during the most recentfiscal quarter that has materially affected, or is reasonably likely tomaterially affect, the Company’s internal control over financialreporting.  However, in the third quarterof 2006, the Company converted to a new general ledger system.  This conversion did not have a materialaffect on our internal control over financial reporting.

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**FIRSTFEDERAL BANCSHARES OF ARKANSAS, INC.**

**PartII**

Item 1.             Legal Proceedings

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

Item 1A.         Risk Factors

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

Item 2.             Unregistered Sales of EquitySecurities 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** | ** ** |
| ** **       | ** ** | ** **                                                    | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
|        |       | July 1, to  July 31, 2006                           |       | — |   | — |   | — |   | — |   |
|        |       | August  1, to                                                 |       |   |   |   |   |   |   |   |   |
|        |       | August 31, 2006                                               |       | 10,000 |   | $22.72 |   | 10,000 |   | 101,084 |   |
|        |       | September  1, to                                              |       |   |   |   |   |   |   |   |   |
|        |       | September 31, 2006                                            |       | 48,763 |   | $24.05 |   | 48,763 |   | 52,321 |   |

 

The Company is in its 18th announced repurchase program, which wasapproved by the board of directors on July 28, 2005, and publicly announced onDecember 2, 2005.  Total shares approvedto be purchased in this program are 248,316 of which 195,995 have beenpurchased as of September 30, 2006.

Item 3.             Defaults Upon Senior Securities

Not applicable.

Item 4.             Submission of Matters to a Voteof Security Holders

Not applicable.

Item 5.             Other Information

None.

Item 6.             Exhibits 

Exhibit 31.1 — Certificationof Chief Executive Officer,Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 (18 U.S.C. 1350)

Exhibit 31.2 —Certification of Chief Financial Officer,Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 (18 U.S.C. 1350)

Exhibit 32.1 —Certification of Chief Executive Officer,Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (18 U.S.C. 1350)

Exhibit 32.2 —Certification of Chief Financial Officer,Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (18 U.S.C. 1350)

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**SIGNATURES**

Pursuant to therequirements of the Securities Exchange Act of 1934, the Registrant has dulycaused this report to be signed on its behalf by the undersigned thereunto dulyauthorized.
| **  **       | **FIRST FEDERAL BANCSHARES OF ARKANSAS, INC.** |
|------------------------|------------------------------------------------|
| ** **             | ** **                                     |
| ** **             | ** **                                     | ** ** |
| ** **             | ** **                                     | ** ** |
| Date: October 26, 2006 | By:                                            | /s/Larry J. Brandt |
| **  **       |                                           | Larry J. Brandt |
| **  **       |                                           | Chief Executive Officer |
| ** **             |                                           |   |
| ** **             |                                           |   |
| ** **             |                                           |   |
| Date: October 26, 2006 | By:                                            | /s/Sherri R. Billings |
| **  **       |                                           | Sherri R. Billings |
| **  **       |                                           | Chief Financial Officer and |
| **  **       |                                           | Chief Accounting Officer |

 

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