Tableof Contents

 

 

 

**UNITEDSTATES**

**SECURITIESAND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

**FORM 10-Q**

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

##  

**Commission File Number 0-28312**

 

**FIRSTFEDERAL BANCSHARES OF ARKANSAS, INC.**

(Exact name of registrant as specified in its charter)

 

| **Texas**                                                     | ** ** | **71-0785261**                         |
|---------------------------------------------------------------|------------|----------------------------------------|
| (State or other jurisdiction of incorporationor organization) |       | (I.R.S. EmployerIdentification Number) |

 

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

 

**(870) 741-7641**

(Registrant’s telephone number, including area code)

 

Indicateby check mark whether the registrant (1) has filed all reports required tobe filed by Section 13 or 15(d) of the Securities Exchange Act of1934 during the preceding 12 months (or for such shorter period that theregistrant was required to file such reports), and (2) has been subject tosuch filing requirements for the past 90 days.

Yesx   No o

 

Indicateby check mark whether the registrant is a large accelerated filer, anaccelerated filer, a non-accelerated filer, or a smaller reportingcompany.  See the definitions of “largeaccelerated filer,” “accelerated filer,” and “smaller reporting company” in Rule 12b-2of the Exchange Act.  (Check one):

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

 

Indicateby check mark whether the registrant is a shell company (as defined in Rule 12b-2of the Exchange Act).

Yeso   No x

 

Indicatethe number of shares outstanding of each of the issuer’s classes of commonstock, as of the latest practicable date: As of October 24, 2008, there were issued and outstanding 4,848,385shares of the Registrant’s Common Stock, par value $.01 per share.

 

 

 

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Table of Contents

 

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

 

**TABLE OF CONTENTS**

 
| ** **        | ** **                                                                                                                                                                  | **Page**   |
|-------------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
| **Part I.**  | **Financial  Information**                                                                                                                                                  | ** ** |
|              |                                                                                                                                                                        |       |
| Item 1.           | Consolidated  Financial Statements                                                                                                                                          |       |
|              |                                                                                                                                                                        |       |
|              | Consolidated  Statements of Financial Condition as of September 30, 2008 and December 31,  2007 (unaudited)                                                                 | 1          |
|              |                                                                                                                                                                        |       |
|              | Consolidated  Statements of Income for the three and nine months ended September 30, 2008 and 2007  (unaudited)                                                        | 2          |
|              |                                                                                                                                                                        |       |
|              | Consolidated Statement of Stockholders’ Equity for the  nine months ended September 30,  2008 (unaudited)                                                         | 3          |
|              |                                                                                                                                                                        |       |
|              | Consolidated Statements of Cash Flows for the nine  months ended September 30,  2008 and 2007 (unaudited)                                                              | 4          |
|              |                                                                                                                                                                        |       |
|              | Notes to Unaudited Consolidated Financial Statements                                                                                                                        | 6          |
|              |                                                                                                                                                                        |       |
| Item 2.           | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                                                                                 | 10         |
|              |                                                                                                                                                                        |       |
| Item 3.           | Quantitative  and Qualitative Disclosures About Market Risk                                                                                                                 | 24         |
|              |                                                                                                                                                                        |       |
| Item 4.           | Controls and Procedures                                                                                                                                                     | 24         |
|              |                                                                                                                                                                        |       |
| **Part II.** | **Other Information**                                                                                                                                                       | ** ** |
| Item 1.           | Legal Proceedings                                                                                                                                                           | 25         |
| Item 1A.          | Risk Factors                                                                                                                                                                | 25         |
| Item 2.           | Unregistered  Sales of Equity Securities and Use of Proceeds                                                                                                                | 25         |
| Item 3.           | Defaults  Upon Senior Securities                                                                                                                                            | 25         |
| Item 4.           | Submission  of Matters to a Vote of Security Holders                                                                                                                        | 25         |
| Item 5.           | Other Information                                                                                                                                                           | 25         |
| Item 6.           | Exhibits                                                                                                                                                                    | 25         |
|              |                                                                                                                                                                        |       |
| **Signatures**    | ** **                                                                                                                                                                  | ** ** |
|              |                                                                                                                                                                        |       |
| **Exhibits**      | ** **                                                                                                                                                                  | ** ** |
| 31.1              | Certification  of Chief Executive Officer pursuant to Rule 13a-14(a) of Exchange  Act, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of  2002 |       |
| 31.2              | Certification  of Chief Financial Officer pursuant to Rule 13a-14(a) of Exchange  Act, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of  2002 |       |
| 32.1              | Section 906  Certification of the CEO                                                                                                                                  |       |
| 32.2              | Section 906  Certification of the CFO                                                                                                                                  |       |

 

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

**CONSOLIDATEDSTATEMENTS OF FINANCIAL CONDITION**

(In thousands, except share data)

(Unaudited)

 
| ** **                                                                                                                                                                                              | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                                                              | ** ** | **2008**               | ** ** | **2007**              | ** ** |
| ASSETS                                                                                                                                                                                                  |       |                   |       |                  |       |
|                                                                                                                                                                                                    |       |                   |       |                  |       |
| Cash and cash equivalents                                                                                                                                                                               |       | $                      | 14,484     |                  | $          | 27,387 |   |
| Investment securities held to maturity                                                                                                                                                                  |       | 131,437                |       | 95,590                |       |
| Federal Home Loan Bank stock                                                                                                                                                                            |       | 4,802                  |       | 4,433                 |       |
| Loans receivable, net                                                                                                                                                                                   |       | 566,775                |       | 601,256               |       |
| Accrued interest receivable                                                                                                                                                                             |       | 7,303                  |       | 9,042                 |       |
| Real estate owned, net                                                                                                                                                                                  |       | 17,402                 |       | 8,120                 |       |
| Office properties and equipment, net                                                                                                                                                                    |       | 24,961                 |       | 24,263                |       |
| Cash surrender value of life insurance                                                                                                                                                                  |       | 20,210                 |       | 20,159                |       |
| Prepaid expenses and other assets                                                                                                                                                                       |       | 2,454                  |       | 1,728                 |       |
|                                                                                                                                                                                                    |       |                   |       |                  |       |
| TOTAL ASSETS                                                                                                                                                                                            |       | $                      | 789,828    |                  | $          | 791,978 |   |
|                                                                                                                                                                                                    |       |                   |       |                  |       |
| LIABILITIES AND STOCKHOLDERS’ EQUITY                                                                                                                                                               |       |                   |       |                  |       |
|                                                                                                                                                                                                    |       |                   |       |                  |       |
| LIABILITIES:                                                                                                                                                                                            |       |                   |       |                  |       |
| Deposits                                                                                                                                                                                                |       | $                      | 612,572    |                  | $          | 630,414 |   |
| Other borrowings                                                                                                                                                                                        |       | 97,142                 |       | 82,087                |       |
| Advance payments by borrowers for taxes and  insurance                                                                                                                                                  |       | 690                    |       | 575                   |       |
| Other liabilities                                                                                                                                                                                       |       | 5,712                  |       | 5,239                 |       |
| Total liabilities                                                                                                                                                                                       |       | 716,116                |       | 718,315               |       |
|                                                                                                                                                                                                    |       |                   |       |                  |       |
| STOCKHOLDERS’ EQUITY:                                                                                                                                                                              |       |                   |       |                  |       |
| Preferred stock, no par value, 5,000,000  shares authorized, none issued                                                                                                                                |       |                   |       |                  |       |
| Common stock, $.01 par value, 20,000,000  shares authorized, 10,307,502 shares issued, 4,848,385 and 4,844,385 shares  outstanding at September 30, 2008 and December 31, 2007,  respectively |       | 103                    |       | 103                   |       |
| Additional paid-in capital                                                                                                                                                                              |       | 56,648                 |       | 56,653                |       |
| Employee stock benefit plans                                                                                                                                                                            |       | (27                    | )          | (42                   | )          |
| Retained earnings-substantially restricted                                                                                                                                                              |       | 87,587                 |       | 87,600                |       |
|                                                                                                                                                                                                    |       | 144,311                |       | 144,314               |       |
| Treasury stock, at cost, 5,459,117 and  5,463,117 shares at September 30, 2008 and December 31, 2007,  respectively                                                                           |       | (70,599                | )          | (70,651               | )          |
| Total stockholders’ equity                                                                                                                                                                         |       | 73,712                 |       | 73,663                |       |
|                                                                                                                                                                                                    |       |                   |       |                  |       |
| TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY                                                                                                                                                         |       | $                      | 789,828    |                  | $          | 791,978 |   |

 

See notes to unauditedconsolidated financial statements.

 

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

**CONSOLIDATEDSTATEMENTS OF INCOME**

(In thousands, except share data)

(Unaudited)

 
| ** **                                           | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|------------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                           | ** ** | **September 30,**           | ** ** | **September 30,**          | ** ** | **September 30,** | ** ** | **September 30,** | ** ** |
| ** **                                           | ** ** | **2008**                         | ** ** | **2007**                        | ** ** | **2008** | ** ** | **2007** | ** ** |
|                                                 |       |                             |       |                            |       |   |   |   |   |
| INTEREST INCOME:                                     |       |                             |       |                            |       |   |   |   |   |
| Loans receivable                                     |       | $                                | 8,601      |                            | $          | 11,020 |   | $ | 28,096 |   | $ | 35,225 |   |
| Investment securities:                               |       |                             |       |                            |       |   |   |   |   |
| Taxable                                              |       | 1,540                            |       | 952                             |       | 4,392 |   | 2,319 |   |
| Nontaxable                                           |       | 203                              |       | 177                             |       | 579 |   | 537 |   |
| Other                                                |       | 107                              |       | 232                             |       | 387 |   | 722 |   |
| Total interest income                                |       | 10,451                           |       | 12,381                          |       | 33,454 |   | 38,803 |   |
|                                                 |       |                             |       |                            |       |   |   |   |   |
| INTEREST EXPENSE:                                    |       |                             |       |                            |       |   |   |   |   |
| Deposits                                             |       | 4,224                            |       | 6,099                           |       | 14,572 |   | 17,991 |   |
| Other borrowings                                     |       | 931                              |       | 987                             |       | 2,711 |   | 3,353 |   |
| Total interest expense                               |       | 5,155                            |       | 7,086                           |       | 17,283 |   | 21,344 |   |
|                                                 |       |                             |       |                            |       |   |   |   |   |
| NET INTEREST INCOME                                  |       | 5,296                            |       | 5,295                           |       | 16,171 |   | 17,459 |   |
|                                                 |       |                             |       |                            |       |   |   |   |   |
| PROVISION FOR LOAN LOSSES                            |       | 1,611                            |       | 1,330                           |       | 4,110 |   | 3,662 |   |
|                                                 |       |                             |       |                            |       |   |   |   |   |
| NET INTEREST INCOME AFTER PROVISION FOR  LOAN LOSSES |       | 3,685                            |       | 3,965                           |       | 12,061 |   | 13,797 |   |
|                                                 |       |                             |       |                            |       |   |   |   |   |
| NONINTEREST INCOME:                                  |       |                             |       |                            |       |   |   |   |   |
| Deposit fee income                                   |       | 1,471                            |       | 1,235                           |       | 4,027 |   | 3,661 |   |
| Earnings on life insurance policies                  |       | 198                              |       | 194                             |       | 1,760 |   | 566 |   |
| Gain on sale of loans                                |       | 51                               |       | 201                             |       | 317 |   | 664 |   |
| Other                                                |       | 493                              |       | 365                             |       | 1,362 |   | 924 |   |
| Total noninterest income                             |       | 2,213                            |       | 1,995                           |       | 7,466 |   | 5,815 |   |
|                                                 |       |                             |       |                            |       |   |   |   |   |
| NONINTEREST EXPENSES:                                |       |                             |       |                            |       |   |   |   |   |
| Salaries and employee benefits                       |       | 3,085                            |       | 3,287                           |       | 9,717 |   | 10,016 |   |
| Net occupancy expense                                |       | 672                              |       | 560                             |       | 1,957 |   | 1,752 |   |
| Real estate owned, net                               |       | 509                              |       | 543                             |       | 1,207 |   | 826 |   |
| Data processing                                      |       | 378                              |       | 339                             |       | 1,065 |   | 1,143 |   |
| Professional fees                                    |       | 126                              |       | 119                             |       | 399 |   | 401 |   |
| Advertising and public relations                     |       | 188                              |       | 239                             |       | 748 |   | 849 |   |
| Postage and supplies                                 |       | 200                              |       | 187                             |       | 621 |   | 646 |   |
| Other                                                |       | 608                              |       | 535                             |       | 1,772 |   | 1,701 |   |
| Total noninterest expenses                           |       | 5,766                            |       | 5,809                           |       | 17,486 |   | 17,334 |   |
|                                                 |       |                             |       |                            |       |   |   |   |   |
| INCOME BEFORE INCOME TAXES                           |       | 132                              |       | 151                             |       | 2,041 |   | 2,278 |   |
| INCOME TAX PROVISION (BENEFIT)                       |       | (86                              | )          | (150                            | )          | (273 | ) | 284 |   |
| NET INCOME                                           |       | $                                | 218        |                            | $          | 301 |   | $ | 2,314 |   | $ | 1,994 |   |
|                                                 |       |                             |       |                            |       |   |   |   |   |
| EARNINGS PER SHARE:                                  |       |                             |       |                            |       |   |   |   |   |
| Basic                                                |       | $                                | 0.05       |                            | $          | 0.06 |   | $ | 0.48 |   | $ | 0.41 |   |
|                                                 |       |                             |       |                            |       |   |   |   |   |
| Diluted                                              |       | $                                | 0.05       |                            | $          | 0.06 |   | $ | 0.48 |   | $ | 0.41 |   |
|                                                 |       |                             |       |                            |       |   |   |   |   |
| Cash Dividends Declared                              |       | $                                | 0.16       |                            | $          | 0.16 |   | $ | 0.48 |   | $ | 0.48 |   |

 

See notes to unauditedconsolidated financial statements.

 

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

**CONSOLIDATEDSTATEMENT OF STOCKHOLDERS’ EQUITY**

**FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2008**

(In thousands, except share data)

(Unaudited)

 
| ** **                                                 | ** ** | **Issued   Common Stock** | ** ** | **Additional   Paid-In** | ** ** | **Employee   Stock   Benefit** | ** ** | **Retained   Earnings   (Substantially** | ** ** |
|------------------------------------------------------------|------------|-------------------------------------|------------|-------------------------------|------------|------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                                                 | ** ** | **Shares**                          | ** ** | **Amount**                    | ** ** | **Capital**                              | ** ** | **Plans**                                          | ** ** | **Restricted)** | ** ** |
|                                                       |       |                                |       |                          |       |                                     |       |                                               |       |   |   |
| Balance, January 1, 2008                              |       | 10,307,502                          |       | $                             | 103        |                                     | $          | 56,653                                             |       | $ | (42 | ) | $ | 87,600 |   |
| Net income                                                 |       |                                |       |                          |       |                                     |       |                                               |       | 2,314 |   |
| Tax effect of stock compensation plan                      |       |                                |       |                          |       | (2                                       | )          |                                               |       |   |   |
| Treasury shares reissued due to exercise of  stock options |       |                                |       |                          |       | (6                                       | )          |                                               |       |   |   |
| Stock compensation expense                                 |       |                                |       |                          |       | 3                                        |       | 15                                                 |       |   |   |
| Dividends paid                                             |       |                                |       |                          |       |                                     |       |                                               |       | (2,327 | ) |
|                                                       |       |                                |       |                          |       |                                     |       |                                               |       |   |   |
| Balance, September 30, 2008                           |       | 10,307,502                          |       | $                             | 103        |                                     | $          | 56,648                                             |       | $ | (27 | ) | $ | 87,587 |   |

 
| ** **                                                 | ** ** | **Treasury Stock** | ** ** | **Total   Stockholders’** | ** ** |
|------------------------------------------------------------|------------|-------------------------|------------|-------------------------------------|------------|
| ** **                                                 | ** ** | **Shares**              | ** ** | **Amount**                          | ** ** | **Equity** | ** ** |
|                                                       |       |                    |       |                                |       |   |   |
| Balance, January 1, 2008                              |       | 5,463,117               |       | $                                   | (70,651    | ) | $ | 73,663 |   |
| Net income                                                 |       |                    |       |                                |       | 2,314 |   |
| Tax effect of stock compensation plan                      |       |                    |       |                                |       | (2 | ) |
| Treasury shares reissued due to exercise of  stock options |       | (4,000                  | )          | 52                                  |       | 46 |   |
| Stock compensation expense                                 |       |                    |       |                                |       | 18 |   |
| Dividends paid                                             |       |                    |       |                                |       | (2,327 | ) |
|                                                       |       |                    |       |                                |       |   |   |
| Balance, September 30, 2008                           |       | 5,459,117               |       | $                                   | (70,599    | ) | $ | 73,712 |   |

 

Seenotes to unaudited consolidated financial statements.

 

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

**CONSOLIDATEDSTATEMENTS OF CASH FLOWS**

(In Thousands)

(Unaudited)

 
| ** **                                                                         | ** ** | **Nine Months Ended September 30,** | ** ** |
|------------------------------------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                                                                         | ** ** | **2008**                                                | ** ** | **2007** | ** ** |
|                                                                               |       |                                                    |       |   |   |
| OPERATING ACTIVITIES:                                                              |       |                                                    |       |   |   |
| Net income                                                                         |       | $                                                       | 2,314      |   | $ | 1,994 |   |
| Adjustments to reconcile net income to net  cash provided by operating activities: |       |                                                    |       |   |   |
| Provision for loan losses                                                          |       | 4,110                                                   |       | 3,662 |   |
| Provision for real estate losses                                                   |       | 480                                                     |       | 390 |   |
| Deferred tax benefit                                                               |       | (714                                                    | )          | (1,516 | ) |
| Accretion of discounts on investment  securities, net                              |       | (58                                                     | )          | (14 | ) |
| Federal Home Loan Bank stock dividends                                             |       | (108                                                    | )          | (246 | ) |
| Gain on disposition of office properties  and equipment                            |       | (19                                                     | )          | (4 | ) |
| Loss on sale of repossessed assets, net                                            |       | 207                                                     |       | 97 |   |
| Originations of loans held for sale                                                |       | (20,026                                                 | )          | (48,077 | ) |
| Proceeds from sales of loans held for sale                                         |       | 22,853                                                  |       | 47,787 |   |
| Gain on sale of loans originated to sell                                           |       | (317                                                    | )          | (664 | ) |
| Depreciation                                                                       |       | 1,102                                                   |       | 1,047 |   |
| Amortization of deferred loan fees, net                                            |       | 280                                                     |       | 334 |   |
| Stock compensation expense                                                         |       | 18                                                      |       | 31 |   |
| Earnings on life insurance policies                                                |       | (580                                                    | )          | (566 | ) |
| Changes in operating assets and  liabilities:                                      |       |                                                    |       |   |   |
| Accrued interest receivable                                                        |       | 1,739                                                   |       | 41 |   |
| Prepaid expenses and other assets                                                  |       | 472                                                     |       | 693 |   |
| Other liabilities                                                                  |       | 655                                                     |       | 691 |   |
| Net cash provided by operating activities                                          |       | 12,408                                                  |       | 5,680 |   |
|                                                                               |       |                                                    |       |   |   |
| INVESTING ACTIVITIES:                                                              |       |                                                    |       |   |   |
| Purchases of investment securities held to  maturity                               |       | (113,030                                                | )          | (29,118 | ) |
| Proceeds from maturities/calls of  investment securities held to maturity          |       | 77,051                                                  |       | 5,050 |   |
| Federal Home Loan Bank stock purchased                                             |       | (261                                                    | )          | — |   |
| Federal Home Loan Bank stock redeemed                                              |       | —                                                  |       | 2,959 |   |
| Loan participations purchased                                                      |       | (1,966                                                  | )          | (2,552 | ) |
| Loan participations sold                                                           |       | 4,045                                                   |       | 7,208 |   |
| Net loan repayments                                                                |       | 13,224                                                  |       | 57,871 |   |
| Proceeds from sales of repossessed assets                                          |       | 2,796                                                   |       | 3,389 |   |
| Improvements to real estate owned                                                  |       | (436                                                    | )          | (579 | ) |
| Proceeds from sales of office properties  and equipment                            |       | 30                                                      |       | 10 |   |
| Purchases of office properties and  equipment                                      |       | (1,811                                                  | )          | (1,525 | ) |
| Net cash provided by (used in) investing  activities                               |       | (20,358                                                 | )          | 42,713 |   |
|                                                                               |       |                                                    |       |   |   |
| FINANCING ACTIVITIES:                                                              |       |                                                    |       |   |   |
| Net decrease in deposits                                                           |       | (17,842                                                 | )          | (11,362 | ) |
| Proceeds from other borrowings                                                     |       | 66,000                                                  |       | 9,700 |   |
| Repayment of other borrowings                                                      |       | (50,945                                                 | )          | (50,256 | ) |
| Net increase (decrease) in advance payments  by borrowers for taxes and insurance  |       | 115                                                     |       | (141 | ) |
| Purchase of treasury stock                                                         |       | —                                                  |       | (1,997 | ) |
| Reissued treasury stock                                                            |       | 46                                                      |       | 350 |   |
| Dividends paid                                                                     |       | (2,327                                                  | )          | (2,336 | ) |
| Net cash used in financing activities                                              |       | (4,953                                                  | )          | (56,042 | ) |
|                                                                               |       |                                                    |       |   |   |
| Net decrease in cash and cash equivalents                                          |       | (12,903                                                 | )          | (7,649 | ) |
|                                                                                    |            |                                                         |            |  |  |  |  |

 

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

**CONSOLIDATED STATEMENTS OF CASH FLOWS**

(In Thousands)

(Unaudited)

 
| ** **                                                                     | ** ** | **Nine Months Ended September 30,** | ** ** |
|--------------------------------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                                                                     | ** ** | **2008**                                                | ** ** | **2007** | ** ** |
|                                                                           |       |                                                    |       |   |   |
| CASH AND CASH EQUIVALENTS:                                                     |       |                                                    |       |   |   |
| Beginning of period                                                            |       | $                                                       | 27,387     |   | $ | 35,518 |   |
| End of period                                                                  |       | $                                                       | 14,484     |   | $ | 27,869 |   |
|                                                                           |       |                                                    |       |   |   |
| SUPPLEMENTAL DISCLOSURES OF CASH FLOW  INFORMATION:                            |       |                                                    |       |   |   |
| Cash paid for:                                                                 |       |                                                    |       |   |   |
| Interest                                                                       |       | $                                                       | 17,412     |   | $ | 21,515 |   |
| Income taxes                                                                   |       | $                                                       | —     |   | $ | 951 |   |
|                                                                           |       |                                                    |       |   |   |
| SUPPLEMENTAL SCHEDULE OF NONCASH INVESTING  ACTIVITIES:                        |       |                                                    |       |   |   |
| Real estate and other assets acquired in  settlement of loans                  |       | $                                                       | 17,349     |   | $ | 9,297 |   |
| Loans to facilitate sales of real estate  owned                                |       | $                                                       | 5,071      |   | $ | 1,010 |   |
| Investment securities traded, recorded in  investments not yet settled in cash |       | $                                                       | 3,000      |   | $ | 170 |   |

 

Seenotes to unaudited consolidated financial statements.

 

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

 

**NOTES TOUNAUDITED CONSOLIDATED FINANCIAL STATEMENTS**

 

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

 

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

 

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

 

Theaccompanying unaudited consolidated financial statements include the accountsof the Company and the Bank.  All materialintercompany transactions have been eliminated in consolidation.

 

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

 

# **Note 2 – RecentlyAdopted Accounting Standards**

#  

Weadopted Financial Accounting Standards Board (“FASB”) Statement of FinancialAccounting Standards (“SFAS”) No. 157, *FairValue Measurements*, as of January 1, 2008.  See Note 7.

 

OnOctober 10, 2008, the FASB issued FASB Staff Position (“FSP”) No. 157-3,*Determining the Fair Value of a FinancialAsset When the Market for That Asset Is Not Active*.  FSP No. 157-3 amended SFAS No. 157by incorporating an example to illustrate key considerations in determining thefair value of a financial asset in an inactive market.  The FSP was effective upon issuance.  This FSP did not have an effect on theCompany’s financial statements.

 

Weadopted SFAS No. 159, *The Fair ValueOption for Financial Assets and Financial Liabilities*, as of January 1,2008 and have elected not to measure any of our current eligible financialassets or liabilities at fair value upon adoption; however, we may elect tomeasure future eligible financial assets or liabilities at fair value.

 

**Note 3 – Accounting Standards Issued Not Yet Effective**

 

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

 

a.              Recognizes and measures in its financialstatements the identifiable assets acquired, the liabilities assumed, and anynoncontrolling interest in the acquiree

b.              Recognizes and measures the goodwill acquiredin the business combination or a gain from a bargain purchase

c.               Determines what information to disclose toenable users of the financial statements to evaluate the nature and financialeffects of the business combination.

 

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

 

InMarch 2008, the FASB issued SFAS 161, *Disclosuresabout Derivative Instruments and Hedging Activities*, effective forfinancial statements issued for fiscal years beginning after November 15,2008.  The objective of this statement isto provide enhanced disclosures about derivative instruments and relatedhedging items.  Based on the Bank’scurrent activities, we estimate that the adoption of this statement will nothave a material effect on the financial statements of the Company.

 

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**Note 4 - Earnings per Share**

 

Theweighted average number of common shares used to calculate earnings per sharefor the periods ended September 30, 2008 and 2007 were as follows:

 
| ** **                        | ** ** | **Three months ended   September 30,** | ** ** | **Nine months ended   September 30,** | ** ** |
|-----------------------------------|------------|------------------------------------------------------------|------------|-----------------------------------------------------------|------------|
| ** **                        | ** ** | **2008**                                                   | ** ** | **2007**                                                  | ** ** | **2008** | ** ** | **2007** | ** ** |
| Basic weighted - average shares   |       | 4,848,385                                                  |       | 4,865,007                                                 |       | 4,848,356 |   | 4,867,729 |   |
| Effect of dilutive securities     |       | —                                                     |       | 7,700                                                     |       | 647 |   | 20,243 |   |
| Diluted weighted - average shares |       | 4,848,385                                                  |       | 4,872,707                                                 |       | 4,849,003 |   | 4,887,972 |   |

 

**Note 5 – Investment Securities**

 

Investment securities consisted of the following at September 30,2008 (in thousands):

 
| ** **                             | ** ** | ** **    | ** ** | **Gross**      | ** ** | **Gross**      | ** ** | ** ** | ** ** |
|----------------------------------------|------------|---------------|------------|----------------|------------|----------------|------------|------------|------------|
| ** **                             | ** ** | **Amortized** | ** ** | **Unrealized** | ** ** | **Unrealized** | ** ** | **Fair**   | ** ** |
| **Held To Maturity**         | ** ** | **Cost**      | ** ** | **Gains**      | ** ** | **Losses**     | ** ** | **Value**  | ** ** |
|                                   |       |          |       |           |       |           |       |       |       |
| Municipal securities                   |       | $             | 19,634     |           | $          | 26             |       | $          | 986        |   | $ | 18,674 |   |
| U.S. Government and Agency obligations |       | 111,803       |       | 2              |       | 2,394          |       | 109,411    |       |
|                                   |       |          |       |           |       |           |       |       |       |
| Total                                  |       | $             | 131,437    |           | $          | 28             |       | $          | 3,380      |   | $ | 128,085 |   |

 

The following tables summarize the gross unrealized losses and fairvalue of the Company’s investments with unrealized losses that are not deemedto be other-than-temporarily impaired (in thousands), aggregated by investmentcategory and length of time that individual securities have been in acontinuous unrealized loss position at September 30, 2008:

 
| ** **                             | ** ** | **Less than 12 Months** | ** ** | **12 Months or More** | ** ** | **Total** | ** ** |
|----------------------------------------|------------|----------------------------------------|------------|--------------------------------------|------------|-----------|------------|
| ** **                             | ** ** | **Fair**                               | ** ** | **Unrealized**                       | ** ** | **Fair**  | ** ** | **Unrealized** | ** ** | **Fair** | ** ** | **Unrealized** | ** ** |
| ** **                             | ** ** | **Value**                              | ** ** | **Losses**                           | ** ** | **Value** | ** ** | **Losses** | ** ** | **Value** | ** ** | **Losses** | ** ** |
|                                   |       |                                   |       |                                 |       |      |       |   |   |   |   |   |   |
| Municipal securities                   |       | $                                      | 9,537      |                                 | $          | 678       |       | $ | 5,162 |   | $ | 308 |   | $ | 14,699 |   | $ | 986 |   |
| U.S. Government and Agency obligations |       | 96,528                                 |       | 2,275                                |       | 7,881     |       | 119 |   | 104,409 |   | 2,394 |   |
|                                   |       |                                   |       |                                 |       |      |       |   |   |   |   |   |   |
|                                   |       | $                                      | 106,065    |                                 | $          | 2,953     |       | $ | 13,043 |   | $ | 427 |   | $ | 119,108 |   | $ | 3,380 |   |

 

The unrealized losses are primarily a result of the current disruptionsin the credit market resulting in historically wide credit spreads.  The contractual terms of those investments donot permit the issuer to settle the securities at a price less than theamortized cost of the investment.  Because the Company has the ability andintent to hold those investments until a recovery of fair value, which may bematurity, the Company does not consider those investments to beother-than-temporarily impaired at September 30, 2008.

 

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**Note 6 – Allowances for Loan and Real Estate Losses**

 

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

 
| ** **                       | ** ** | **Three Months Ended   September 30,   2008** | ** ** | **Three Months Ended   September 30,   2007** | ** ** |
|----------------------------------|------------|------------------------------------------------------------------------|------------|------------------------------------------------------------------------|------------|
| ** **                       | ** ** | **Loans**                                                              | ** ** | **Real Estate**                                                   | ** ** | **Loans** | ** ** | **Real Estate** | ** ** |
|                             |       |                                                                   |       |                                                                   |       |   |   |   |   |
| Balance—beginning of period |       | $                                                                      | 5,215      |                                                                   | $          | — |   | $ | 4,291 |   | $ | — |   |
|                             |       |                                                                   |       |                                                                   |       |   |   |   |   |
| Provisions for estimated losses  |       | 1,611                                                                  |       | 164                                                                    |       | 1,330 |   | 312 |   |
| Recoveries                       |       | 242                                                                    |       | —                                                                 |       | 43 |   | — |   |
| Losses charged off               |       | (246                                                                   | )          | (164                                                                   | )          | (628 | ) | (312 | ) |
|                             |       |                                                                   |       |                                                                   |       |   |   |   |   |
| Balance—end of period       |       | $                                                                      | 6,822      |                                                                   | $          | — |   | $ | 5,036 |   | $ | — |   |

 
| ** **                       | ** ** | **Nine Months Ended   September 30,   2008** | ** ** | **Nine Months Ended   September 30,   2007** | ** ** |
|----------------------------------|------------|-----------------------------------------------------------------------|------------|-----------------------------------------------------------------------|------------|
| ** **                       | ** ** | **Loans**                                                             | ** ** | **Real Estate**                                                  | ** ** | **Loans** | ** ** | **Real Estate** | ** ** |
|                             |       |                                                                  |       |                                                                  |       |   |   |   |   |
| Balance—beginning of period |       | $                                                                     | 5,162      |                                                                  | $          | — |   | $ | 2,572 |   | $ | — |   |
|                             |       |                                                                  |       |                                                                  |       |   |   |   |   |
| Provisions for estimated losses  |       | 4,110                                                                 |       | 480                                                                   |       | 3,662 |   | 390 |   |
| Recoveries                       |       | 436                                                                   |       | —                                                                |       | 132 |   | — |   |
| Losses charged off               |       | (2,886                                                                | )          | (480                                                                  | )          | (1,330 | ) | (390 | ) |
|                             |       |                                                                  |       |                                                                  |       |   |   |   |   |
| Balance—end of period       |       | $                                                                     | 6,822      |                                                                  | $          | — |   | $ | 5,036 |   | $ | — |   |

 

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**Note 7 – Fair Value Measurement**

 

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

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

 

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

 

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

 
| ** **             | ** ** | **December 31,  2007** | ** ** | **Additions** | ** ** | **Fair Value  Adjustments** | ** ** | **Transfers  Out** | ** ** | **Gain  (Loss)** | ** ** | **September 30,  2008** | ** ** |
|------------------------|------------|-----------------------------|------------|---------------|------------|----------------------------------|------------|--------------------|------------|------------------|------------|------------------------------|------------|
| ** **             | ** ** | ** **                  | ** ** | ** **    | ** ** | **(in thousands)**          | ** ** | ** **         | ** ** | ** **       | ** ** |
| Real estate owned, net |       | $                           | 8,120      |          | $          | 20,052                           |       | $                  | (2,685     | )                | $          | (7,909                       | )          | $ | (176 | ) | $ | 17,402 |   |
| Impaired loans         |       | $                           | 14,894     |          | $          | 6,691                            |       | $                  | (1,588     | )                | $          | (9,530                       | )          | $ | — |   | $ | 10,467 |   |

 

# **Realized and unrealized gains and losses on real estate owned arerecognized in noninterest expenses in the consolidated statements of incomeunder the caption “Real estate owned, net.” Gains on sales of real estate owned which are financed by the Bank aredeferred in certain circumstances and recognized as the borrower pays down therelated loan.  Fair value adjustments toimpaired loans are recorded through the allowance for loan losses.**

 

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**MANAGEMENT’S DISCUSSION AND ANALYSISOF FINANCIAL CONDITION AND RESULTS OF OPERATIONS**

 

### **CRITICAL ACCOUNTINGPOLICIES**

###  

Variouselements of our accounting policies, by their nature, are inherently subject toestimation techniques, valuation assumptions and other subjective assessments.  In particular, valuation of real estate ownedand the methodology for the determination of our allowance for loan losses, dueto the judgments, estimates and assumptions inherent in those policies, are criticalto preparation of our financial statements. These policies and the judgments, estimates and assumptions aredescribed in greater detail in subsequent sections of Management’s Discussionand Analysis and in the notes to the unaudited financial statements includedherein.  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 these critical accounting policies, the use of otherjudgments, estimates and assumptions could result in material differences inour financial condition or results of operations.

 

Inestimating the amount of credit losses inherent in our loan portfolio, variousjudgments and assumptions are made.  Forexample, when assessing the condition of the overall economic environment,assumptions are made regarding future market conditions and their impact on theloan portfolio.  If the current downturnin the economy is prolonged, the loss factors applied to our portfolios mayneed to be revised, which may significantly impact the measurement of theallowance for loan losses.  For impairedloans that are collateral-dependent and for real estate owned, the estimatedfair value of the collateral may deviate significantly from the proceedsreceived when the collateral is sold.

 

## **CHANGESIN FINANCIAL CONDITION**

##  

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

 
| ** **                                    | ** ** | **September 30,** | ** ** | **December 31,** | ** ** | **Increase**   | ** ** | **Percentage** | ** ** |
|-----------------------------------------------|------------|------------------------|------------|-----------------------|------------|----------------|------------|----------------|------------|
| ** **                                    | ** ** | **2008**               | ** ** | **2007**              | ** ** | **(Decrease)** | ** ** | **Change**     | ** ** |
| **ASSETS**                                    |       |                   |       |                  |       |           |       |           |       |
| Cash and cash equivalents                     |       | $                      | 14,484     |                  | $          | 27,387         |       | $              | (12,903    | ) | (47.1 | )% |
| Investment securities held to maturity        |       | 131,437                |       | 95,590                |       | 35,847         |       | 37.5           |       |
| Federal Home Loan Bank stock                  |       | 4,802                  |       | 4,433                 |       | 369            |       | 8.3            |       |
| Loans receivable, net                         |       | 566,775                |       | 601,256               |       | (34,481        | )          | (5.7           | )          |
| Accrued interest receivable                   |       | 7,303                  |       | 9,042                 |       | (1,739         | )          | (19.2          | )          |
| Real estate owned, net                        |       | 17,402                 |       | 8,120                 |       | 9,282          |       | 114.3          |       |
| Office properties and equipment, net          |       | 24,961                 |       | 24,263                |       | 698            |       | 2.9            |       |
| Prepaid expenses and other assets             |       | 22,664                 |       | 21,887                |       | 777            |       | 3.6            |       |
|                                          |       |                   |       |                  |       |           |       |           |       |
| TOTAL                                         |       | $                      | 789,828    |                  | $          | 791,978        |       | $              | (2,150     | ) | (0.3 | )% |
|                                          |       |                   |       |                  |       |           |       |           |       |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY** |       |                   |       |                  |       |           |       |           |       |
| LIABILITIES:                                  |       |                   |       |                  |       |           |       |           |       |
| Deposits                                      |       | $                      | 612,572    |                  | $          | 630,414        |       | $              | (17,842    | ) | (2.8 | )% |
| Other borrowings                              |       | 97,142                 |       | 82,087                |       | 15,055         |       | 18.3           |       |
| Other liabilities                             |       | 6,402                  |       | 5,814                 |       | 588            |       | 10.1           |       |
|                                          |       |                   |       |                  |       |           |       |           |       |
| Total liabilities                             |       | 716,116                |       | 718,315               |       | (2,199         | )          | (0.3           | )          |
|                                          |       |                   |       |                  |       |           |       |           |       |
| STOCKHOLDERS’ EQUITY                     |       | 73,712                 |       | 73,663                |       | 49             |       | 0.1            |       |
|                                          |       |                   |       |                  |       |           |       |           |       |
| TOTAL                                         |       | $                      | 789,828    |                  | $          | 791,978        |       | $              | (2,150     | ) | (0.3 | )% |
|                                          |       |                   |       |                  |       |           |       |           |       |
| BOOK VALUE PER SHARE                          |       | $                      | 15.20      |                  | $          | 15.21          |       |           |       |   |   |
|                                          |       |                   |       |                  |       |           |       |           |       |
| EQUITY TO ASSETS                              |       | 9.3                    | %          | 9.3                   | %          |           |       |           |       |

 

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**Loans Receivable. **Changes in loan composition between September 30,2008 and December 31, 2007 are presented in the following table (dollarsin thousands).

 
| ** **                                       | ** ** | **September 30,** | ** ** | **December 31,** | ** ** | **Increase**   | ** ** | ** **        | ** ** |
|--------------------------------------------------|------------|------------------------|------------|-----------------------|------------|----------------|------------|-------------------|------------|
| ** **                                       | ** ** | **2008**               | ** ** | **2007**              | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
|                                             |       |                   |       |                  |       |           |       |              |       |
| One- to four-family residences                   |       | $                      | 238,545    |                  | $          | 230,005        |       | $                 | 8,540      |   | 3.7 | % |
| Home equity lines of credit and second  mortgage |       | 33,848                 |       | 34,315                |       | (467           | )          | (1.4              | )          |
| Multifamily                                      |       | 20,231                 |       | 15,616                |       | 4,615          |       | 29.6              |       |
| Commercial real estate                           |       | 111,121                |       | 117,548               |       | (6,427         | )          | (5.5              | )          |
| Land                                             |       | 44,012                 |       | 42,843                |       | 1,169          |       | 2.7               |       |
| Construction:                                    |       |                   |       |                  |       |           |       |              |       |
| One- to four-family residences                   |       | 13,053                 |       | 20,815                |       | (7,762         | )          | (37.3             | )          |
| Speculative one-to four-family residences        |       | 18,766                 |       | 40,893                |       | (22,127        | )          | (54.1             | )          |
| Multifamily                                      |       | 16,850                 |       | 18,632                |       | (1,782         | )          | (9.6              | )          |
| Commercial real estate                           |       | 16,211                 |       | 31,239                |       | (15,028        | )          | (48.1             | )          |
| Land development                                 |       | 32,378                 |       | 42,145                |       | (9,767         | )          | (23.2             | )          |
| Total construction loans                         |       | 97,258                 |       | 153,724               |       | (56,466        | )          | (36.7             | )          |
| Total mortgage loans                             |       | 545,015                |       | 594,051               |       | (49,036        | )          | (8.3              | )          |
|                                             |       |                   |       |                  |       |           |       |              |       |
| Commercial                                       |       | 23,053                 |       | 24,846                |       | (1,793         | )          | (7.2              | )          |
|                                             |       |                   |       |                  |       |           |       |              |       |
| Automobile                                       |       | 8,918                  |       | 9,531                 |       | (613           | )          | (6.4              | )          |
| Other                                            |       | 12,715                 |       | 14,537                |       | (1,822         | )          | (12.5             | )          |
| Total consumer                                   |       | 21,633                 |       | 24,068                |       | (2,435         | )          | (10.1             | )          |
|                                             |       |                   |       |                  |       |           |       |              |       |
| Total loans receivable                           |       | 589,701                |       | 642,965               |       | (53,264        | )          | (8.3              | )          |
|                                             |       |                   |       |                  |       |           |       |              |       |
| Undisbursed loan funds                           |       | (16,625                | )          | (36,868               | )          | 20,243         |       | (54.9             | )          |
| Deferred loan costs – net                   |       | 521                    |       | 321                   |       | 200            |       | 62.3              |       |
| Allowance for loan losses                        |       | (6,822                 | )          | (5,162                | )          | (1,660         | )          | 32.2              |       |
|                                             |       |                   |       |                  |       |           |       |              |       |
| Loans receivable, net                            |       | $                      | 566,775    |                  | $          | 601,256        |       | $                 | (34,481    | ) | (5.7 | )% |

 

Thedecrease in the Bank’s loan portfolio was primarily due to the continuedsoftening of the housing market in the Bank’s market area.  Market data indicates an overall decrease inhome sales in Benton and Washington counties in 2008 and 2007.  The Bank’s loan originations were down 21.2%for the quarter ended September 30, 2008, compared to the third quarter of2007 and 16.4% for the nine months ended September 30, 2008 compared tothe first nine months in 2007.  Althoughthe Northwest Arkansas region continues to experience job market and populationgrowth, the supply of new residential lots and new speculative homes for salehas outpaced demand during the past several years.  We expect this trend to continue for theforeseeable future given the level of oversupply in the market.

 

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**Asset Quality.**  The following table sets forththe amounts and categories of the Bank’s nonperforming assets at the datesindicated.

 

| ** **                                                                                              | ** ** | **September 30,  2008**         | ** ** | **December 31,  2007** | ** ** | **Increase  (Decrease)** | ** ** | **Percentage  Change** | ** ** |
|---------------------------------------------------------------------------------------------------------|------------|--------------------------------------|------------|-----------------------------|------------|--------------------------|------------|------------------------|------------|
| ** **                                                                                              | ** ** | **(Dollars in Thousands)** | ** ** | ** **                  | ** ** | ** **               | ** ** |
| Nonaccrual loans:                                                                                       |       |                                 |       |                        |       |                     |       |                   |       |
| One- to four-family residential                                                                         |       | $                                    | 7,668      |                        | $          | 6,800                    |       | $                      | 868        |   | 12.8 | % |
| Home equity and second mortgage                                                                         |       | 926                                  |       | 1,194                       |       | (268                     | )          | (22.4                  | )          |
| Speculative one- to four-family  construction                                                           |       | 714                                  |       | 4,934                       |       | (4,220                   | )          | (85.5                  | )          |
| Multifamily                                                                                             |       | 210                                  |       | —                      |       | 210                      |       | —                 |       |
| Land development                                                                                        |       | 8,149                                |       | 11,428                      |       | (3,279                   | )          | (28.7                  | )          |
| Land                                                                                                    |       | 2,085                                |       | 1,311                       |       | 774                      |       | 59.0                   |       |
| Commercial real estate                                                                                  |       | 6,246                                |       | 4,027                       |       | 2,219                    |       | 55.1                   |       |
| Commercial loans                                                                                        |       | 1,955                                |       | 3,367                       |       | (1,412                   | )          | (41.9                  | )          |
| Consumer loans                                                                                          |       | 182                                  |       | 268                         |       | (86                      | )          | (32.1                  | )          |
| Total nonaccrual loans                                                                                  |       | 28,135                               |       | 33,329                      |       | (5,194                   | )          | (15.6                  | )          |
|                                                                                                    |       |                                 |       |                        |       |                     |       |                   |       |
| Accruing loans 90 days or more past due                                                                 |       | 6,171                                |       | 2,412                       |       | 3,759                    |       | 155.8                  |       |
| Real estate owned                                                                                       |       | 17,402                               |       | 8,120                       |       | 9,282                    |       | 114.3                  |       |
|                                                                                                    |       |                                 |       |                        |       |                     |       |                   |       |
| Total nonperforming assets                                                                              |       | $                                    | 51,708     |                        | $          | 43,861                   |       | $                      | 7,847      |   | 17.9 | % |
|                                                                                                    |       |                                 |       |                        |       |                     |       |                   |       |
| Total nonaccrual and accruing loans 90 days  or more past due as a percentage of total loans receivable |       | 5.82                                 | %          | 5.56                        | %          |                     |       |                   |       |
|                                                                                                    |       |                                 |       |                        |       |                     |       |                   |       |
| Total nonperforming assets as a percentage  of total assets                                             |       | 6.55                                 | %          | 5.54                        | %          |                     |       |                   |       |

 

Thedecrease in nonaccrual loans is primarily related to the transfer of nonaccrualland development and speculative single family construction loans to realestate owned, which was offset somewhat by an increase in nonaccrual land loansand commercial real estate loans.  TheNorthwest Arkansas market continues to experience an oversupply of lots andspeculative homes. Certain of the Bank’s homebuilders are experiencing extendedmarketing times for the sale of their homes which has resulted in inadequatecash flow to service the interest carry on their loans.  The specific loan loss allowance related toloans to builders and developers was approximately $2.6 million at September 30,2008.

 

Weexpect a significant amount of the nonaccrual real estate loans to eventuallymigrate to real estate owned as $15.7 million of the nonaccrual real estateloans reported above are in some stage of the foreclosure process as of September 30,2008.  Therefore, we expect real estateowned and associated expenses to continue to increase in future periods as suchloans migrate from loans to real estate owned.

 

Thelevel of nonaccrual speculative construction loans, land development loans andcommercial real estate loans is attributable primarily to five loanrelationships totaling $13.0 million, or 46.3% of nonaccrual loans.  These relationships are described in moredetail in the paragraphs that follow.

 

Thefirst relationship totaled $2.2 million with a specific loan loss allowance of$896,000 at September 30, 2008, and is comprised of a subdivision locatedin Cave Springs, Arkansas.  Thesubdivision is 100% complete.  The Bankobtained an updated valuation on the subdivision using discounted cash flowanalysis.  Due to the market conditionsand the oversupply of lots in Northwest Arkansas, the valuation indicated lowerlot prices and an extended marketing time over that in the original appraisalobtained when the loan was originated. Based on the nature of this loan and the possibility of continuedadverse changes in the market conditions, we may incur losses in the future inexcess of the specific allowance recorded as of September 30, 2008.

 

Thesecond relationship totaled $2.0 million at September 30, 2008, andconsists of a $1.3 million commercial loan secured by commercial real estate,franchise rights, inventory and equipment, a $650,000 loan on the borrower’sprimary residence, and a $20,000 unsecured loan. The loans in this relationshipbecame over 90 days past due during the third quarter of 2007.  Based on the borrower’s workout plans, theseloans were maintained on accrual status at that time.  However, due to the passage of time with noprogress on the workout plan, we placed the loans on nonaccrual status duringthe fourth quarter of 2007.  The borroweris attempting to sell all of the collateral securing his loans. During thefirst nine months of 2008 three of the franchise sales closed and the Bankreceived proceeds from these sales. However, the Bank agreed to accept less than the full amount of proceedson one of the sales as part of the workout. Based on this and other valuation changes during the first nine monthsof 2008, the Bank

 

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recordedan additional $555,000 in specific loan loss allowances, bringing the totalspecific allowance to $576,000 with respect to this relationship as of September 30,2008.

 

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

 

Thefourth relationship totaled $1.1 million at September 30, 2008, and iscomprised primarily of loans totaling $1.0 million for 35 completed lots in asubdivision located in Pea Ridge, Arkansas, and a $98,000 loan on a completedspeculative home.  As of September 30,2008, based on the then current estimated fair value of the collateral, theBank has established a specific loan loss allowance of $52,000.  Based on the nature of this loan and thecurrent adverse market conditions, we may incur losses in the future in excessof the specific allowance recorded at September 30, 2008.

 

Thefifth relationship is new to nonaccrual status this quarter and totaled $5.6million with a specific loan loss allowance of $973,000 at September 30,2008.  This relationship is comprised oftwo phases of a subdivision located in Elm Springs, Arkansas.  The first phase consists of 48 lots and is100% complete and the second phase consists of undeveloped land.  Based on the nature of this loan and thecurrent adverse market conditions, we may incur losses in the future in excessof the specific allowance recorded at September 30, 2008.

 

Accruingloans 90 days or more past due at September 30, 2008, consisted of threeloans whose past due interest is expected to be paid after September 30,2008.

 

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

 
| ** **                                       | ** ** | **September 30,  2008**         | ** ** | **December 31,  2007** | ** ** | **Increase** | ** ** | **Percentage  Change** | ** ** |
|--------------------------------------------------|------------|--------------------------------------|------------|-----------------------------|------------|--------------|------------|------------------------|------------|
| ** **                                       | ** ** | **(Dollars in Thousands)** | ** ** | ** **                  | ** ** | ** **   | ** ** |
| Real estate owned                                |       |                                 |       |                        |       |         |       |                   |       |
| One- to four-family residential                  |       | $                                    | 2,007      |                        | $          | 1,566        |       | $                      | 441        |   | 28.2 | % |
| Speculative one- to four-family  construction(1) |       | 5,798                                |       | 5,956                       |       | (158         | )          | (2.7                   | )          |
| Land(2)                                          |       | 8,769                                |       | 598                         |       | 8,171        |       | 1,366.4                |       |
| Commercial real estate                           |       | 828                                  |       | —                      |       | 828          |       | —                 |       |
| Total real estate owned                          |       | $                                    | 17,402     |                        | $          | 8,120        |       | $                      | 9,282      |   | 114.3 | % |

 

----

(1)                        At September 30, 2008, $4.9 million ofthese properties were 100% complete.  Theremainder range from 78% to 92% complete.

(2)                        At September 30, 2008, $7.1 million ofthe land balance represented 192 finished subdivision lots.  The remainder consisted of raw land.

 

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

 

TheBank is diligently working to dispose of its REO and has dedicated an experiencedspecial assets officer who is working full-time to liquidate the Bank’sproperties in the Northwest Arkansas market. Each property is evaluated on acase-by-case basis to determine the best course of action with respect toliquidation.  Properties are marketed directly by the Bank or listed withlocal real estate agents utilizing appraisals, market information fromrealtors, market research reports, and our own market evaluations to make pricingand selling decisions.  The Bank’s Chief Lending Officer, loan officers,credit manager, special assets officer, and team members in the collectionsdepartment all work together in this endeavor.  The Bank’s goal is toliquidate these properties in an orderly and efficient manner without incurringextraordinary losses due to quick sale pricing. During the nine months ended September 30, 2008, the Bankoriginated loans to facilitate the sales of real estate owned totaling $5.1million.  The Bank offers attractiverates and financing options to prospective buyers of real estate owned to helpfacilitate sales.

 

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**Potential Problem Loans.**  Basedon the oversupply of lots in Northwest Arkansas, our land development portfolioposes a higher risk of default.  Theseloans are typically structured with interest due at maturity and lot sales asthe source of repayment.  Since lot salesin the Northwest Arkansas market are significantly slower than when these loanswere originated, our borrowers typically must rely on a secondary source offunds to pay the interest as it becomes due. Due to the relatively large balances of these types of loans, theinterest due at maturity is usually significant.  At September 30, 2008, gross landdevelopment loans totaled $32.4 million with $2.3 million of accruedinterest.  Of this total, $8.1 million ison nonaccrual status with $1.2 million in accrued interest, $11.2 million with$492,000 in accrued interest is classified as special mention, and $12.7million with $615,000 in accrued interest is on our watch list.  There are three matured land developmentloans at September 30, 2008 with a total principal balance of $6.7 millionand accrued interest of $733,000.  We areworking with all three borrowers and, as of the date of this report, expect tobe repaid in full.  However, should anyof these land development loans default, the Bank may incur losses in the eventof a decline in value of the land securing these loans.

 

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

 

| ** **                      | ** ** | **Three Months Ended September 30,** | ** ** | **Nine Months Ended September 30,** | ** ** |
|---------------------------------|------------|----------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                      | ** ** | **2008**                                                 | ** ** | **2007**                                                | ** ** | **2008** | ** ** | **2007** | ** ** |
| Balance at beginning of period  |       | $                                                        | 5,215      |                                                    | $          | 4,291 |   | $ | 5,162 |   | $ | 2,572 |   |
| Provisions for estimated losses |       | 1,611                                                    |       | 1,330                                                   |       | 4,110 |   | 3,662 |   |
| Recoveries                      |       | 242                                                      |       | 43                                                      |       | 436 |   | 132 |   |
| Losses charged off              |       | (246                                                     | )          | (628                                                    | )          | (2,886 | ) | (1,330 | ) |
| Balance at end of period        |       | $                                                        | 6,822      |                                                    | $          | 5,036 |   | $ | 6,822 |   | $ | 5,036 |   |

#  

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

 
| ** ** | ** ** | **September 30,** | ** ** | **December 31,** | ** ** | ** **   | ** ** |
|------------|------------|------------------------|------------|-----------------------|------------|--------------|------------|
| ** ** | ** ** | **2008**               | ** ** | **2007**              | ** ** | **Increase** | ** ** |
| General    |       | $                      | 3,109      |                  | $          | 2,267        |       | $ | 842 |   |
| Specific   |       | 3,713                  |       | 2,895                 |       | 818          |       |
|       |       | $                      | 6,822      |                  | $          | 5,162        |       | $ | 1,660 |   |

 

Thegeneral component of the allowance for loan losses increased primarily due toincreases in the loss factors applied to land loans, land development loans andcommercial loans, partially offset by decreases in the related loanbalances.  These loss factors wereincreased due to the recent loss history on these types of loans.  The specific component of the allowance forloan losses increased primarily due to a specific valuation allowance of$973,000 recorded in the third quarter. See “Asset Quality.”

 

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

 

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

 

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

 

Aloan is considered impaired when, based on current information and events, itis probable that the Bank will be unable to collect the scheduled payments ofprincipal or interest when due according to the contractual terms of the loanagreement. Factors considered by management in determining impairment includepayment status, collateral value, and the probability of collecting scheduledprincipal and interest payments when due. Loans that experience insignificantpayment delays and payment shortfalls generally are not classified as impaired.Management determines the significance of payment delays and payment shortfallson a case-by-case basis, taking into consideration all of the circumstancessurrounding the loan and the borrower, including the length of the delay, thereasons for the delay, the borrower’s prior payment record, and the amount ofthe short fall in relation to the principal and interest owed. Impairment ismeasured on a loan by loan basis by either the present value of expected future

 

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cashflows discounted at the loan’s effective interest rate, the loan’s obtainablemarket price, or the fair value of the collateral if the loan is collateraldependent.  Multifamily residential,commercial real estate, land and land development, and commercial loans thatare delinquent or where the borrower’s total loan relationship exceeds $1million are evaluated on a loan by loan basis at least annually.

 

Largegroups of smaller balance homogeneous loans are collectively evaluated forimpairment. Accordingly, the Bank does not separately identify individualconsumer and residential loans for impairment disclosures.  Homogeneous loans are those that areconsidered to have common characteristics that provide for evaluation on anaggregate or pool basis. The Bank considers the characteristics of (1) one-to four-family residential first mortgage loans; (2) unsecured consumerloans; and (3) collateralized consumer loans to permit consideration ofthe appropriateness of the allowance for losses of each group of loans on apool basis. The primary methodology used to determine the appropriateness ofthe allowance for losses includes segregating certain specific, poorlyperforming loans based on their performance characteristics from the pools ofloans as to type, valuing these loans, and then applying a loss factor to theremaining pool balance based on several factors including past loss experience,inherent risks, and economic conditions in the primary market areas.

 

Inestimating the amount of credit losses inherent in our loan portfolio, variousjudgments and assumptions are made.  Forexample, when assessing the condition of the overall economic environment,assumptions are made regarding future market conditions and their impact on theloan portfolio.  If the current downturnin the economy is prolonged, the loss factors applied to our portfolios mayneed to be revised, which may significantly impact the measurement of theallowance for loan losses.  For impairedloans that are collateral dependent, the estimated fair value of the collateralmay deviate significantly from the proceeds received when the collateral issold in the event that the Bank has to foreclose or repossess the collateral.

 

Althoughwe consider the allowance for loan losses of approximately $6.8 millionadequate to cover losses inherent in our loan portfolio at September 30,2008, no assurance can be given that we will not sustain loan losses that aresignificantly different from the amount recorded, or that subsequentevaluations of the loan portfolio, in light of factors then prevailing, wouldnot result in a significant change in the allowance for loan losses.

 

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

 
| ** **                             | ** ** | **September 30,** | ** ** | **December 31,** | ** ** | ** **   | ** ** |
|----------------------------------------|------------|------------------------|------------|-----------------------|------------|--------------|------------|
| ** **                             | ** ** | **2008**               | ** ** | **2007**              | ** ** | **Increase** | ** ** |
| U.S. Government and agency obligations |       | $                      | 111,803    |                  | $          | 78,501       |       | $ | 33,302 |   |
| Municipal securities                   |       | 19,634                 |       | 17,089                |       | 2,545        |       |
| Total                                  |       | $                      | 131,437    |                  | $          | 95,590       |       | $ | 35,847 |   |

 

Duringthe first nine months of 2008, investment securities totaling $112.8 millionwith a weighted average tax equivalent yield of 6.06% were purchased and $77.1million with a weighted average tax equivalent yield of 6.15% matured or werecalled.

 

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

** **
| ** **                             | ** ** | **Amortized  Cost** | ** ** | **Fair  Value** | ** ** |
|----------------------------------------|------------|---------------------|------------|-----------------|------------|
|                                   |       |                |       |            |       |
| U.S. Government and agency obligations |       | $                   | 111,803    |            | $          | 109,411 |   |
| Municipal securities                   |       | 19,634              |       | 18,674          |       |
| Total                                  |       | $                   | 131,437    |            | $          | 128,085 |   |

 

**Accrued Interest Receivable. **The decrease inaccrued interest receivable was primarily due to a decrease in the loansreceivable balance as well as a decrease in the loan yield and the number ofdays accrued at September 30, 2008 compared to December 31, 2007.

 

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

 
| ** **                      | ** ** | **December 31,  2007** | ** ** | **Additions** | ** ** | **Fair Value  Adjustments** | ** ** | **Net Sales  Proceeds(1)** | ** ** | **Gain (Loss)** | ** ** | **September 30,  2008** | ** ** |
|---------------------------------|------------|-----------------------------|------------|---------------|------------|----------------------------------|------------|---------------------------------|------------|----------------------|------------|------------------------------|------------|
| One- to four-family residential |       | $                           | 1,566      |          | $          | 3,196                            |       | $                               | (313       | )                    | $          | (2,363                       | )          | $ | (79 | ) | $ | 2,007 |   |
| Speculative one- to four-family |       | 5,956                       |       | 5,984         |       | (797                             | )          | (5,212                          | )          | (133                 | )          | 5,798                        |       |
| Land                            |       | 598                         |       | 10,013        |       | (1,544                           | )          | (334                            | )          | 36                   |       | 8,769                        |       |
| Commercial real estate          |       | —                      |       | 859           |       | (31                              | )          | —                          |       | —               |       | 828                          |       |
|                            |       | $                           | 8,120      |          | $          | 20,052                           |       | $                               | (2,685     | )                    | $          | (7,909                       | )          | $ | (176 | ) | $ | 17,402 |   |

 

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(1)          Net sales proceeds include $5.1 million ofloans made by the Bank to facilitate the sale of real estate owned.

 

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

 
| ** **              | ** ** | **September 30,** | ** ** | **December 31,** | ** ** | **Increase**   | ** ** | **Percentage** | ** ** |
|-------------------------|------------|------------------------|------------|-----------------------|------------|----------------|------------|----------------|------------|
| ** **              | ** ** | **2008**               | ** ** | **2007**              | ** ** | **(Decrease)** | ** ** | **Change**     | ** ** |
|                    |       |                   |       |                  |       |           |       |           |       |
| Checking accounts       |       | $                      | 157,894    |                  | $          | 127,491        |       | $              | 30,403     |   | 23.9 | % |
| Money Market accounts   |       | 46,665                 |       | 51,424                |       | (4,759         | )          | (9.3           | )          |
| Savings accounts        |       | 24,001                 |       | 25,088                |       | (1,087         | )          | (4.3           | )          |
| Certificates of deposit |       | 384,012                |       | 426,411               |       | (42,399        | )          | (9.9           | )          |
|                    |       |                   |       |                  |       |           |       |           |       |
| Total deposits          |       | $                      | 612,572    |                  | $          | 630,414        |       | $              | (17,842    | ) | (2.8 | )% |

 

Depositsdecreased in the comparison period, primarily due to a decrease in certificatesof deposit. The decrease was partially offset by an increase in checkingaccounts. The Bank focused its marketing efforts to increase checking accountsby offering a checking product which has a higher interest rate than the Bank’sother checking account products.  To earnthe maximum rate under the new product, customers must qualify based on usageof electronic banking services such as debit card transactions, e-statements,and direct deposits or automatic payments. The Bank will continue to promotechecking accounts as they are an attractive source of funds for the Bank asthey offer overall low-interest deposits, fee income potential, and theopportunity to cross-sell other financial services.

 

**Other Borrowings.**  During the first nine months of2008, the use of FHLB of Dallas and Federal Reserve Bank borrowings increasedby $15.1 million or 18.3%.  The Bank usedthe funds primarily to purchase investment securities and to pay depositwithdrawals.

 

**Stockholders’ Equity. **Stockholders’ equity increased approximately$49,000 from December 31, 2007 to September 30, 2008.  The increase in stockholders’ equity wasprimarily due to net income totaling $2.3 million during the first nine monthsof 2008.  In addition, during the ninemonths ended September 30, 2008, cash dividends of approximately $2.3million were paid.  See the UnauditedConsolidated Statement of Stockholders’ Equity for the nine months ended September 30,2008 for more detail.

 

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### **Average BalanceSheets**

###  

Thefollowing table sets forth certain information relating to the Company’saverage balance sheets and reflects the average yield on assets and averagecost of liabilities for the periods indicated. Such yields and costs are derived by dividing income or expense by theaverage balance of assets or liabilities, respectively, for the periodspresented.  Average balances are based ondaily balances during the period.

 
| ** **                                                        | ** ** | **Three Months Ended ****September ****30,** | ** ** |
|-------------------------------------------------------------------|------------|------------------------------------------------------------------|------------|
| ** **                                                        | ** ** | **2008**                                                         | ** ** | **2007** | ** ** |
| ** **                                                        | ** ** | **Average  Balance**                                             | ** ** | **Interest** | ** ** | **Average   Yield/  Cost** | ** ** | **Average  Balance** | ** ** | **Interest** | ** ** | **Average  Yield/  Cost** | ** ** |
| ** **                                                        | ** ** | **(Dollars in Thousands)**                             | ** ** |
| Interest-earning assets:                                          |       |                                                             |       |   |   |   |   |   |   |   |   |   |   |
| Loans receivable(1)                                               |       | $                                                                | 572,572    |   | $ | 8,601 |   | 6.01 | % | $ | 632,106 |   | $ | 11,020 |   | 6.97 | % |
| Investment securities(2)                                          |       | 132,143                                                          |       | 1,743 |   | 5.28 |   | 85,666 |   | 1,129 |   | 5.27 |   |
| Other interest-earning assets                                     |       | 20,949                                                           |       | 107 |   | 2.04 |   | 18,111 |   | 232 |   | 5.13 |   |
| Total interest-earning assets                                     |       | 725,664                                                          |       | 10,451 |   | 5.76 |   | 735,883 |   | 12,381 |   | 6.73 |   |
| Noninterest-earning assets                                        |       | 79,510                                                           |       |   |   |   |   | 70,399 |   |   |   |   |   |
| Total assets                                                      |       | 805,174                                                          |       |   |   |   |   | 806,282 |   |   |   |   |   |
| Interest-bearing liabilities:                                     |       |                                                             |       |   |   |   |   |   |   |   |   |   |   |
| Deposits                                                          |       | 625,439                                                          |       | 4,224 |   | 2.70 |   | 639,452 |   | 6,099 |   | 3.82 |   |
| Other borrowings                                                  |       | 99,261                                                           |       | 931 |   | 3.75 |   | 85,806 |   | 987 |   | 4.60 |   |
| Total interest-bearing liabilities                                |       | 724,700                                                          |       | 5,155 |   | 2.84 |   | 725,258 |   | 7,086 |   | 3.91 |   |
| Noninterest-bearing liabilities                                   |       | 5,833                                                            |       |   |   |   |   | 5,803 |   |   |   |   |   |
| Total liabilities                                                 |       | 730,533                                                          |       |   |   |   |   | 731,061 |   |   |   |   |   |
| Stockholders’ equity                                         |       | 74,641                                                           |       |   |   |   |   | 75,221 |   |   |   |   |   |
| Total liabilities and stockholders’ equity                   |       | $                                                                | 805,174    |   |   |   |   |   | $ | 806,282 |   |   |   |   |   |
|                                                              |       |                                                             |       |   |   |   |   |   |   |   |   |   |   |
| Net interest income                                               |       |                                                             |       | $ | 5,296 |   |   |   |   |   | $ | 5,295 |   |   |   |
| Net earning assets                                                |       | $                                                                | 964        |   |   |   |   |   | $ | 10,625 |   |   |   |   |   |
| Interest rate spread                                              |       |                                                             |       |   |   | 2.92 | % |   |   |   |   | 2.82 | % |
| Net interest margin                                               |       |                                                             |       |   |   | 2.92 | % |   |   |   |   | 2.88 | % |
| Ratio of interest-earning assets to  interest-bearing liabilities |       |                                                             |       |   |   | 100.13 | % |   |   |   |   | 101.46 | % |

 
| ** **                                                        | ** ** | **Nine Months Ended September 30,** | ** ** |
|-------------------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                                                        | ** ** | **2008**                                                | ** ** | **2007** | ** ** |
| ** **                                                        | ** ** | **Average  Balance**                                    | ** ** | **Interest** | ** ** | **Average  Yield/  Cost** | ** ** | **Average  Balance** | ** ** | **Interest** | ** ** | **Average  Yield/  Cost** | ** ** |
| ** **                                                        | ** ** | **(Dollars in Thousands)**                    | ** ** |
| Interest-earning assets:                                          |       |                                                    |       |   |   |   |   |   |   |   |   |   |   |
| Loans receivable(1)                                               |       | $                                                       | 585,597    |   | $ | 28,096 |   | 6.40 | % | $ | 661,297 |   | $ | 35,225 |   | 7.10 | % |
| Investment securities(2)                                          |       | 124,259                                                 |       | 4,971 |   | 5.33 |   | 74,260 |   | 2,856 |   | 5.13 |   |
| Other interest-earning assets                                     |       | 20,752                                                  |       | 387 |   | 2.48 |   | 18,730 |   | 722 |   | 5.14 |   |
| Total interest-earning assets                                     |       | 730,608                                                 |       | 33,454 |   | 6.10 |   | 754,287 |   | 38,803 |   | 6.86 |   |
| Noninterest-earning assets                                        |       | 76,527                                                  |       |   |   |   |   | 67,917 |   |   |   |   |   |
| Total assets                                                      |       | 807,135                                                 |       |   |   |   |   | 822,204 |   |   |   |   |   |
| Interest-bearing liabilities:                                     |       |                                                    |       |   |   |   |   |   |   |   |   |   |   |
| Deposits                                                          |       | 634,797                                                 |       | 14,572 |   | 3.06 |   | 643,475 |   | 17,991 |   | 3.73 |   |
| Other borrowings                                                  |       | 91,413                                                  |       | 2,711 |   | 3.96 |   | 97,747 |   | 3,353 |   | 4.57 |   |
| Total interest-bearing liabilities                                |       | 726,210                                                 |       | 17,283 |   | 3.17 |   | 741,222 |   | 21,344 |   | 3.84 |   |
| Noninterest-bearing liabilities                                   |       | 6,583                                                   |       |   |   |   |   | 5,644 |   |   |   |   |   |
| Total liabilities                                                 |       | 732,793                                                 |       |   |   |   |   | 746,866 |   |   |   |   |   |
| Stockholders’ equity                                         |       | 74,342                                                  |       |   |   |   |   | 75,338 |   |   |   |   |   |
| Total liabilities and stockholders’ equity                   |       | $                                                       | 807,135    |   |   |   |   |   | $ | 822,204 |   |   |   |   |   |
|                                                              |       |                                                    |       |   |   |   |   |   |   |   |   |   |   |
| Net interest income                                               |       |                                                    |       | $ | 16,171 |   |   |   |   |   | $ | 17,459 |   |   |   |
| Net earning assets                                                |       | $                                                       | 4,398      |   |   |   |   |   | $ | 13,065 |   |   |   |   |   |
| Interest rate spread                                              |       |                                                    |       |   |   | 2.93 | % |   |   |   |   | 3.02 | % |
| Net interest margin                                               |       |                                                    |       |   |   | 2.95 | % |   |   |   |   | 3.09 | % |
| Ratio of interest-earning assets to  interest-bearing liabilities |       |                                                    |       |   |   | 100.61 | % |   |   |   |   | 101.76 | % |

 

----

(1) Includes nonaccrual loans.

(2) Includes FHLB of Dallas stock.

 

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## **Rate/VolumeAnalysis**

##  

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

 
| ** **                         | ** ** | **Three Months Ended September 30,** | ** ** |
|------------------------------------|------------|----------------------------------------------------------|------------|
| ** **                         | ** ** | **2008 vs. 2007**                              | ** ** |
| ** **                         | ** ** | **Increase (Decrease)  Due to**                | ** ** | ** ** | ** ** |
| ** **                         | ** ** | **Volume**                                               | ** ** | **Rate** | ** ** | **Rate/  Volume** | ** ** | **Total  Increase  (Decrease)** | ** ** |
| ** **                         | ** ** | **(In Thousands)**                                  | ** ** |
| Interest income:                   |       |                                                     |       |   |   |   |   |   |   |
| Loans receivable                   |       | $                                                        | (1,038     | ) | $ | (1,525 | ) | $ | 144 |   | $ | (2,419 | ) |
| Investment securities              |       | 613                                                      |       | 1 |   | — |   | 614 |   |
| Other interest-earning assets      |       | 36                                                       |       | (140 | ) | (21 | ) | (125 | ) |
| Total interest-earning assets      |       | (389                                                     | )          | (1,664 | ) | 123 |   | (1,930 | ) |
|                               |       |                                                     |       |   |   |   |   |   |   |
| Interest expense:                  |       |                                                     |       |   |   |   |   |   |   |
| Deposits                           |       | (134                                                     | )          | (1,780 | ) | 39 |   | (1,875 | ) |
| Other borrowings                   |       | 155                                                      |       | (183 | ) | (28 | ) | (56 | ) |
| Total interest-bearing liabilities |       | 21                                                       |       | (1,963 | ) | 11 |   | (1,931 | ) |
| Net change in net interest income  |       | $                                                        | (410       | ) | $ | 299 |   | $ | 112 |   | $ | 1 |   |

 
| ** **                         | ** ** | **Nine Months Ended September 30,** | ** ** |
|------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                         | ** ** | **2008 vs. 2007**                             | ** ** |
| ** **                         | ** ** | **Increase (Decrease)  Due to**               | ** ** | ** ** | ** ** |
| ** **                         | ** ** | **Volume**                                              | ** ** | **Rate** | ** ** | **Rate/  Volume** | ** ** | **Total  Increase  (Decrease)** | ** ** |
| ** **                         | ** ** | **(In Thousands)**                                 | ** ** |
| Interest income:                   |       |                                                    |       |   |   |   |   |   |   |
| Loans receivable                   |       | $                                                       | (4,032     | ) | $ | (3,497 | ) | $ | 400 |   | $ | (7,129 | ) |
| Investment securities              |       | 1,923                                                   |       | 115 |   | 77 |   | 2,115 |   |
| Other interest-earning assets      |       | 78                                                      |       | (373 | ) | (40 | ) | (335 | ) |
| Total interest-earning assets      |       | (2,031                                                  | )          | (3,755 | ) | 437 |   | (5,349 | ) |
|                               |       |                                                    |       |   |   |   |   |   |   |
| Interest expense:                  |       |                                                    |       |   |   |   |   |   |   |
| Deposits                           |       | (243                                                    | )          | (3,220 | ) | 44 |   | (3,419 | ) |
| Other borrowings                   |       | (217                                                    | )          | (454 | ) | 29 |   | (642 | ) |
| Total interest-bearing liabilities |       | (460                                                    | )          | (3,674 | ) | 73 |   | (4,061 | ) |
| Net change in net interest income  |       | $                                                       | (1,571     | ) | $ | (81 | ) | $ | 364 |   | $ | (1,288 | ) |

 

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**CHANGES INRESULTS OF OPERATIONS**

 

The table below presents acomparison of results of operations for the three months ended September 30,2008 and 2007 (dollars in thousands). Specific changes in captions are discussed in the sections which followthe table.

 
| ** **                                           | ** ** | **Three Months Ended  September 30,** | ** ** | **Increase  (Decrease)** | ** ** | **Percentage  Change**     | ** ** |
|------------------------------------------------------|------------|------------------------------------------------------|------------|--------------------------|------------|----------------------------|------------|
| ** **                                           | ** ** | **2008**                                             | ** ** | **2007**                 | ** ** | **2008 vs 2007** | ** ** | **2008 vs 2007** | ** ** |
| Interest income:                                     |       |                                                 |       |                     |       |                       |       |   |   |
| Loans receivable                                     |       | $                                                    | 8,601      |                     | $          | 11,020                     |       | $ | (2,419 | ) | (21.9 | )% |
| Investment securities                                |       | 1,743                                                |       | 1,129                    |       | 614                        |       | 54.4 |   |
| Other                                                |       | 107                                                  |       | 232                      |       | (125                       | )          | (53.9 | ) |
| Total interest income                                |       | 10,451                                               |       | 12,381                   |       | (1,930                     | )          | (15.6 | ) |
| Interest expense:                                    |       |                                                 |       |                     |       |                       |       |   |   |
| Deposits                                             |       | 4,224                                                |       | 6,099                    |       | (1,875                     | )          | (30.7 | ) |
| Other borrowings                                     |       | 931                                                  |       | 987                      |       | (56                        | )          | (5.7 | ) |
| Total interest expense                               |       | 5,155                                                |       | 7,086                    |       | (1,931                     | )          | (27.3 | ) |
| Net interest income before provision for loan losses |       | 5,296                                                |       | 5,295                    |       | 1                          |       | 0.0 |   |
| Provision for loan losses                            |       | 1,611                                                |       | 1,330                    |       | 281                        |       | 21.1 |   |
| Net interest income after provision for loan losses  |       | 3,685                                                |       | 3,965                    |       | (280                       | )          | (7.1 | ) |
| Noninterest income:                                  |       |                                                 |       |                     |       |                       |       |   |   |
| Deposit fee income                                   |       | 1,471                                                |       | 1,235                    |       | 236                        |       | 19.1 |   |
| Earnings on life insurance policies                  |       | 198                                                  |       | 194                      |       | 4                          |       | 2.1 |   |
| Gain on sale of loans                                |       | 51                                                   |       | 201                      |       | (150                       | )          | (74.6 | ) |
| Other                                                |       | 493                                                  |       | 365                      |       | 128                        |       | 35.1 |   |
| Total noninterest income                             |       | 2,213                                                |       | 1,995                    |       | 218                        |       | 10.9 |   |
| Noninterest expenses:                                |       |                                                 |       |                     |       |                       |       |   |   |
| Salaries and employee benefits                       |       | 3,085                                                |       | 3,287                    |       | (202                       | )          | (6.2 | ) |
| Net occupancy expense                                |       | 672                                                  |       | 560                      |       | 112                        |       | 20.0 | % |
| Real estate owned, net                               |       | 509                                                  |       | 543                      |       | (34                        | )          | (6.3 | ) |
| Other                                                |       | 1,500                                                |       | 1,419                    |       | 81                         |       | 5.7 |   |
| Total noninterest expenses                           |       | 5,766                                                |       | 5,809                    |       | (43                        | )          | (0.7 | ) |
| Income before income taxes                           |       | 132                                                  |       | 151                      |       | (19                        | )          | (12.6 | ) |
| Income tax provision                                 |       | (86                                                  | )          | (150                     | )          | 64                         |       | (42.7 | ) |
| Net income                                           |       | $                                                    | 218        |                     | $          | 301                        |       | $ | (83 | ) | (27.6 | )% |
|                                                 |       |                                                 |       |                     |       |                       |       |   |   |
| Basic earnings per share                             |       | $                                                    | 0.05       |                     | $          | 0.06                       |       | $ | (0.01 | ) | (16.7 | )% |
| Diluted earnings per share                           |       | $                                                    | 0.05       |                     | $          | 0.06                       |       | $ | (0.01 | ) | (16.7 | )% |
|                                                 |       |                                                 |       |                     |       |                       |       |   |   |
| Interest rate spread                                 |       | 2.92                                                 | %          | 2.82                     | %          |                       |       |   |   |
| Net interest margin                                  |       | 2.92                                                 | %          | 2.88                     | %          |                       |       |   |   |
|                                                 |       |                                                 |       |                     |       |                       |       |   |   |
| Average full-time equivalents                        |       | 300                                                  |       | 301                      |       |                       |       |   |   |
|                                                 |       |                                                 |       |                     |       |                       |       |   |   |
| Full-service offices                                 |       | 20                                                   |       | 18                       |       |                       |       |   |   |

 

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The table below presents acomparison of results of operations for the nine months ended September 30,2008 and 2007 (dollars in thousands). Specific changes in captions are discussed in the sections which followthe table.

 
| ** **                                           | ** ** | **Nine Months Ended  September 30,** | ** ** | **Increase  (Decrease)** | ** ** | **Percentage  Change**     | ** ** |
|------------------------------------------------------|------------|-----------------------------------------------------|------------|--------------------------|------------|----------------------------|------------|
| ** **                                           | ** ** | **2008**                                            | ** ** | **2007**                 | ** ** | **2008 vs 2007** | ** ** | **2008 vs 2007** | ** ** |
| Interest income:                                     |       |                                                |       |                     |       |                       |       |   |   |
| Loans receivable                                     |       | $                                                   | 28,096     |                     | $          | 35,225                     |       | $ | (7,129 | ) | (20.2 | )% |
| Investment securities                                |       | 4,971                                               |       | 2,856                    |       | 2,115                      |       | 74.1 |   |
| Other                                                |       | 387                                                 |       | 722                      |       | (335                       | )          | (46.4 | ) |
| Total interest income                                |       | 33,454                                              |       | 38,803                   |       | (5,349                     | )          | (13.8 | ) |
| Interest expense:                                    |       |                                                |       |                     |       |                       |       |   |   |
| Deposits                                             |       | 14,572                                              |       | 17,991                   |       | (3,419                     | )          | (19.0 | ) |
| Other borrowings                                     |       | 2,711                                               |       | 3,353                    |       | (642                       | )          | (19.2 | ) |
| Total interest expense                               |       | 17,283                                              |       | 21,344                   |       | (4,061                     | )          | (19.0 | ) |
| Net interest income before provision for loan losses |       | 16,171                                              |       | 17,459                   |       | (1,288                     | )          | (7.4 | ) |
| Provision for loan losses                            |       | 4,110                                               |       | 3,662                    |       | 448                        |       | 12.2 |   |
| Net interest income after provision for loan losses  |       | 12,061                                              |       | 13,797                   |       | (1,736                     | )          | (12.6 | ) |
| Noninterest income:                                  |       |                                                |       |                     |       |                       |       |   |   |
| Deposit fee income                                   |       | 4,027                                               |       | 3,661                    |       | 366                        |       | 10.0 |   |
| Earnings on life insurance policies                  |       | 1,760                                               |       | 566                      |       | 1,194                      |       | 211.0 |   |
| Gain on sale of loans                                |       | 317                                                 |       | 664                      |       | (347                       | )          | (52.3 | ) |
| Other                                                |       | 1,362                                               |       | 924                      |       | 438                        |       | 47.4 |   |
| Total noninterest income                             |       | 7,466                                               |       | 5,815                    |       | 1,651                      |       | 28.4 |   |
| Noninterest expenses:                                |       |                                                |       |                     |       |                       |       |   |   |
| Salaries and employee benefits                       |       | 9,717                                               |       | 10,016                   |       | (299                       | )          | (3.0 | ) |
| Net occupancy expense                                |       | 1,957                                               |       | 1,752                    |       | 205                        |       | 11.7 |   |
| Real estate owned, net                               |       | 1,207                                               |       | 826                      |       | 381                        |       | 46.1 |   |
| Other                                                |       | 4,605                                               |       | 4,740                    |       | (135                       | )          | (2.8 | ) |
| Total noninterest expenses                           |       | 17,486                                              |       | 17,334                   |       | 152                        |       | 0.9 |   |
| Income before income taxes                           |       | 2,041                                               |       | 2,278                    |       | (237                       | )          | (10.4 | ) |
| Income tax provision (benefit)                       |       | (273                                                | )          | 284                      |       | (557                       | )          | (196.1 | ) |
| Net income                                           |       | $                                                   | 2,314      |                     | $          | 1,994                      |       | $ | 320 |   | 16.1 | % |
|                                                 |       |                                                |       |                     |       |                       |       |   |   |
| Basic earnings per share                             |       | $                                                   | 0.48       |                     | $          | 0.41                       |       | $ | 0.07 |   | 17.1 | % |
| Diluted earnings per share                           |       | $                                                   | 0.48       |                     | $          | 0.41                       |       | $ | 0.07 |   | 17.1 | % |
|                                                 |       |                                                |       |                     |       |                       |       |   |   |
| Interest rate spread                                 |       | 2.93                                                | %          | 3.02                     | %          |                       |       |   |   |
| Net interest margin                                  |       | 2.95                                                | %          | 3.09                     | %          |                       |       |   |   |
|                                                 |       |                                                |       |                     |       |                       |       |   |   |
| Average full-time equivalents                        |       | 303                                                 |       | 304                      |       |                       |       |   |   |
|                                                 |       |                                                |       |                     |       |                       |       |   |   |
| Full-service offices                                 |       | 20                                                  |       | 18                       |       |                       |       |   |   |

 

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**Net InterestIncome. **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.  The decrease in net interest income wasprimarily due to the level of nonperforming loans.

 

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

###  

Dollar changes in interest incomeand interest expense for the comparison periods are presented in theRate/Volume Analysis table which appears on a previous page.

 

**InterestIncome. **Thedecrease in interest income for the three and nine month comparative periodswas primarily due to a decrease in the average yield earned on loans receivableas well as a decrease in the average balance of loans receivable and anincrease in the level of deferred interest on nonperforming loans.  These decreases were offset by an increase inthe average balance of investment securities. The decrease in average yields earned on loans receivable was due todecreases in market interest rates and the increased level of nonaccrualloans.  The average balance of loansreceivable decreased due to repayments and maturities as well as a decrease inloan originations.

 

**InterestExpense.  **Thedecrease in interest expense for the three and nine month comparative periodswas primarily due to a decrease in the average rates paid on deposits andborrowings.  The decrease in the averagerates paid on deposit accounts reflects the recent decreases in market interestrates.

 

**Provision for LoanLosses.**  The provision forloan losses includes charges to maintain an allowance for loan losses adequateto cover probable credit losses related to specifically identified loans aswell as probable credit losses inherent in the remainder of the loan portfoliothat 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 provision for loan lossesincreased $281,000 to $1.6 million for the quarter ended September 30,2008 compared to $1.3 million for the quarter ended September 30, 2007 andincreased $448,000 to $4.1 million for the nine months ended September 30,2008 compared to $3.7 million for the same period in 2007.  The increases in the provisions for loanlosses in both comparable periods were primarily due to an increase in our lossexperience on commercial loans and land development loans.

 

**NoninterestIncome. **Theincrease in the three month comparative period in 2008 was primarily related todeposit fee income due to an increased checking account fee structure put inplace during the second quarter of 2008. The increase in other noninterestincome for the nine month comparative period in 2008 was primarily due to a$1.2 million increase in earnings on life insurance policies due to a deathbenefit claim recorded during the first quarter in 2008.

 

**NoninterestExpense**

 

**Salaries andEmployee 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)** | ** ** |
|-----------------------------------|------------|------------------------------------------------------|------------|--------------------------|------------|-----------------------------------------------------|------------|------------------------------|------------|
| ** **                        | ** ** | **2008**                                             | ** ** | **2007**                 | ** ** | **2008 vs 2007**                          | ** ** | **2008**                     | ** ** | **2007** | ** ** | **2008 vs 2007** | ** ** |
| Salaries                          |       | $                                                    | 2,511      |                     | $          | 2,588                                               |       | $                            | (77        | ) | $ | 7,692 |   | $ | 7,824 |   | $ | (132 | ) |
| Payroll taxes                     |       | 194                                                  |       | 197                      |       | (3                                                  | )          | 666                          |       | 676 |   | (10 | ) |
| Insurance                         |       | 169                                                  |       | 168                      |       | 1                                                   |       | 507                          |       | 508 |   | (1 | ) |
| 401(k)                            |       | 78                                                   |       | 77                       |       | 1                                                   |       | 234                          |       | 233 |   | 1 |   |
| Defined benefit plan contribution |       | 88                                                   |       | 210                      |       | (122                                                | )          | 480                          |       | 630 |   | (150 | ) |
| Other                             |       | 45                                                   |       | 47                       |       | (2                                                  | )          | 138                          |       | 145 |   | (7 | ) |
| Total                             |       | $                                                    | 3,085      |                     | $          | 3,287                                               |       | $                            | (202       | ) | $ | 9,717 |   | $ | 10,016 |   | $ | (299 | ) |

 

**Net occupancyexpense. **Theincrease in net occupancy expense for the three month and nine monthcomparative periods was primarily due to two new branch locations opened during2008.

 

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**Real estate owned,net. **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** | ** ** |
|--------------------------|------------|------------------------------------------------------|------------|--------------------------|------------|-----------------------------------------------------|------------|--------------|------------|
| ** **               | ** ** | **2008**                                             | ** ** | **2007**                 | ** ** | **2008 vs 2007**                          | ** ** | **2008**     | ** ** | **2007** | ** ** | **2008 vs 2007** | ** ** |
| Loss provisions          |       | $                                                    | 164        |                     | $          | 312                                                 |       | $            | (148       | ) | $ | 480 |   | $ | 390 |   | $ | 90 |   |
| Net loss (gain) on sales |       | 179                                                  |       | 67                       |       | 112                                                 |       | 207          |       | 119 |   | 88 |   |
| Taxes and insurance      |       | 42                                                   |       | 69                       |       | (27                                                 | )          | 321          |       | 161 |   | 160 |   |
| Other                    |       | 124                                                  |       | 95                       |       | 29                                                  |       | 199          |       | 156 |   | 43 |   |
| Total                    |       | $                                                    | 509        |                     | $          | 543                                                 |       | $            | (34        | ) | $ | 1,207 |   | $ | 826 |   | $ | 381 |   |

 

Expenses associated with realestate owned have increased due to the increase in real estate owned balancesas discussed in “Asset Quality.”   Realestate owned is expected to continue to increase in the foreseeable future andreal estate owned expenses associated with maintaining the properties areexpected to increase accordingly.  Futurelevels of loss provisions and net gains or losses on sales of real estate ownedwill be dependent on market conditions.

 

**Income Taxes. **The income tax benefitincreased for the nine months ended September 30, 2008 primarily due to anincrease in nontaxable life insurance earnings. The decrease in income tax benefit for the three month comparativeperiod was related to a decrease in taxable income resulting from decreasedearnings and increased nontaxable interest from investment securities.

 

**OFF-BALANCE SHEET ARRANGEMENTS**

#  

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

 

·                  theorigination, purchase or sale of loans;

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

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

 

At September 30, 2008, theBank’s off-balance sheet arrangements principally included lending commitments,which are described below.  At September 30,2008, the Company had no interests in non-consolidated special purposeentities.

 

At September 30, 2008,commitments included:

 

·                  totalapproved commitments to originate or purchase loans amounting to $8.4 million,including $249,000 of loans committed to sell;

·                  ratelock agreements with customers of $3.0 million, all of which have been lockedwith an investor;

·                  fundedmortgage loans committed to sell of $322,000;

·                  unadvancedportion of construction loans of $16.6 million;

·                  unusedlines of credit of $20.0 million;

·                  outstandingstandby letters of credit of approximately $3.8 million;

·                  totalpredetermined overdraft protection limits of $15.1 million; and

·                  certificatesof deposit scheduled to mature in one year or less totaling $277.7 million.

 

Total unfunded commitments tooriginate loans for sale and the related commitments to sell of $3.0 millionmeet the definition of a derivative financial instrument.  The related asset and liability areconsidered immaterial at September 30, 2008.

 

Historically, a very smallpercentage of predetermined overdraft limits have been used.  At September 30, 2008, overdrafts ofaccounts with Bounce ProtectionTM represented usage of 4.47% of thelimit.  We expect utilization of theseoverdraft limits to remain at comparable levels in the future.

 

Based on historical experience,management believes that a significant portion of maturing deposits will remainwith the Bank.  We anticipate that wewill continue to have sufficient funds, through repayments, deposits andborrowings, to meet our current commitments.

 

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### **LIQUIDITY AND CAPITAL RESOURCES**

###  

The Bank’s liquidity, representedby cash and cash equivalents and eligible investment securities, is a productof its operating, investing and financing activities.  The Bank’s primary sources of funds aredeposits, borrowings, payments on outstanding loans, maturities and calls ofinvestment securities and other short-term investments and funds provided fromoperations.  While scheduled loanamortization and maturing investment securities and short-term investments arerelatively predictable sources of funds, deposit flows and loan prepayments aregreatly influenced by general interest rates, economic conditions andcompetition.  Calls of investmentsecurities are determined by the issuer and are generally influenced by thelevel of market interest rates at the bond’s call date compared to the couponrate of the bond.  The Bank manages thepricing of its deposits to maintain deposit balances at levels commensuratewith the operating, investing and financing activities of the Bank.  In addition, the Bank invests excess funds inovernight deposits and other short-term interest-earning assets that provideliquidity to meet lending requirements and pay deposit withdrawals. When fundsfrom the retail deposit market are inadequate for the liquidity needs of theBank or the pricing of deposits is not as favorable as other sources, the Bankhas borrowed from the FHLB of Dallas and the Federal Reserve Bank of St. Louis(“FRB”).    During the first nine monthsof 2008, the use of FHLB and FRB borrowings increased by $15.1 million or 18.3%.  The Bank uses U.S. government agencyinvestment securities and eligible one- to four-family loans as collateral forFHLB advances and commercial real estate and U.S. government agency investmentsecurities as collateral for FRB borrowings. The Bank’s borrowing capacity is based on the amount of securities andloans held in custody by the FHLB and FRB. The Bank may transfer additional collateral to provide additionalborrowing capacity if needed.  Currently,the Bank may borrow short-term FHLB advances with maturities up to thirtydays.  In addition, brokered deposits maybe used to augment the Bank’s primary funding sources.  At September 30, 2008, the Bank hadoutstanding brokered deposits of $1.1 million.

 

For each of the nine months ended September 30,2008 and 2007, the Company paid dividends of $0.48 per share.  The determination of future dividends on theCompany’s common stock will depend on conditions existing at that time withconsideration given to the Company’s earnings, capital, and liquidity needs.

 

Liquidity management is both adaily and long-term function of business management.  Excess liquidity is generally invested inshort-term investments such as overnight deposits and certificates of deposit.  On a longer-term basis, the Bank maintains astrategy of investing in various lending products and investmentsecurities.   The Bank uses its sourcesof funds primarily to meet its ongoing commitments, to pay maturing savingscertificates and savings withdrawals, to repay maturing borrowings, to fundloan commitments, and to purchase investment securities.

 

As of September 30, 2008, theBank’s regulatory capital was in excess of all applicable regulatoryrequirements.  At September 30,2008, the Bank’s tangible, core and risk-based capital ratios amounted to8.93%, 8.93% and 13.29%, respectively, compared to regulatory requirements of1.5%, 4.0% and 8.0%, respectively.

 

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

###  

The financial statements andrelated financial data presented herein have been prepared in accordance withgenerally 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 assets and liabilities are monetary in nature.  As a result, interest rates generally have amore significant impact on a financial institution’s performance than does theeffect of inflation.

 

### **FORWARD-LOOKING STATEMENTS**

###  

The Company’s Quarterly Report on Form 10-Qcontains certain forward-looking statements and information relating to theCompany that are based on the beliefs of management as well as assumptions madeby and information currently available to management.  In addition, in this document, 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 and assumptions.  Should one or more of these risks oruncertainties materialize or should underlying assumptions prove incorrect,actual results may vary materially from those described herein as anticipated,believed, estimated, expected or intended. The Company does not intend to update these forward-looking statements.

 

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**QUANTITATIVE AND QUALITATIVE DISCLOSURESABOUT MARKET RISK**

 

There has been no material changein the market value of the Bank’s portfolio equity since December 31,2007.  Similarly, while there has been nomaterial change in the Company’s asset and liability position since such time,the Bank’s increased level of nonperforming assets continued to impact thelevel of net interest income during the nine months ended September 30,2008.  Correspondingly, the Bank’s netinterest margin decreased from 3.09% for the nine months ended September 30,2007 to 2.95% for the same period in 2008.  Based on the level of nonperforming assets and competitive pressures onloan and deposit rates, management anticipates continued pressure on the Bank’sinterest rate spread and interest margin for the fourth quarter of 2008although the level of maturing certificate of deposits repricing to lower rateswill somewhat offset the pressure on the interest rate spread and margin.

 

**CONTROLS AND PROCEDURES**

 

Our management evaluated, with theparticipation of our Chief Executive Officer and Chief Financial Officer, theeffectiveness of the design and operation of our disclosure controls andprocedures (as defined in Rules 13a-15(e) and 15d-15(e) underthe Securities Exchange Act of 1934) as of the end of the period covered bythis report.  Based on such evaluation,our Chief Executive Officer and Chief Financial Officer have concluded that ourdisclosure controls and procedures are 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 andare operating in an effective manner.

 

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

 

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**FIRSTFEDERAL BANCSHARES OF ARKANSAS, INC.**

 

**Part II**

 

Item1.                                      LegalProceedings

 

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

 

Item1A.                            Risk Factors

 

There have been no material changesin the Company’s risk factors from those previously disclosed in the Company’s Form 10-Kfor the year ended December 31, 2007.

 

Item2.                                      UnregisteredSales of Equity Securities and Use of Proceeds

 
| ** **                                    | ** ** | **ISSUER PURCHASES OF EQUITY SECURITIES** | ** ** | ** **                                        | ** ** |
|-----------------------------------------------|------------|---------------------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                    | ** ** | ** **                                                    | ** ** | ** **                                        | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                    | ** ** | **(a) Total  Number of  Shares  Purchased**         | ** ** | **(b)  Average  Price Paid  per Share** | ** ** | **(c) Total Number of  Shares Purchased as  Part of Publicly  Announced Plans or  Programs** | ** ** | **(d) Maximum Number  of Shares that May  Yet Be Purchased  Under the Plans or  Programs** | ** ** |
| ** **                                    | ** ** | ** **                                                    | ** ** | ** **                                        | ** ** | ** ** | ** ** | ** ** | ** ** |
| July 1 to   July 31, 2008           |       | —                                                        |       | —                                            |       | — |   | — |   |
| August 1 to   August 31, 2008       |       | —                                                        |       | —                                            |       | — |   | — |   |
| September 1 to   September 30, 2008 |       | —                                                        |       | —                                            |       | — |   | — |   |

 

The Company is in its 19thannounced repurchase program, which was approved by the board of directors on July 25,2006, and publicly announced on November 8, 2006.  Total shares approved to be purchased in thisprogram are 245,197 of which 214,587 have been purchased as of September 30,2008.  All treasury stock purchases aremade under publicly announced repurchase programs.

 

Item3.                                      DefaultsUpon Senior Securities

 

Not applicable.

 

Item4.                                      Submissionof Matters to a Vote of Security Holders

 

Not applicable.

 

Item5.                                      OtherInformation

 

None.

 

Item6.                                      Exhibits

Exhibit 31.1 – Certificationof Chief Executive Officer,

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

Exhibit 31.2 – Certificationof Chief Financial Officer,

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

Exhibit 32.1 – Certificationof Chief Executive Officer,

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

Exhibit 32.2 – Certificationof Chief Financial Officer,

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

 

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**SIGNATURES**

 

Pursuant to the requirements of theSecurities Exchange Act of 1934, the Registrant has duly caused this report tobe signed on its behalf by the undersigned thereunto duly authorized.

 

 

**FIRSTFEDERAL BANCSHARES OF ARKANSAS, INC.**

 

 
| Date:  | October 28, 2008 | By:    |   /s/ Larry J. Brandt      |
|--------|-----------------------|--------|--------------------------------------|
|   |                  |   |   Larry J. Brandt          |
|   |                  |   |   Chief Executive  Officer |

 

 
| Date:  | October 28, 2008 | By:    |   /s/ Sherri R.  Billings                               |
|--------|-----------------------|--------|-------------------------------------------------------------------|
|   |                  |   |   Sherri R. Billings                                    |
|   |                  |   |   Chief Financial  Officer and Chief Accounting Officer |

 

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